Bitcoin has been much in the news lately. I have written a draft of a paper on “The Economics of Private Digital Currencies”. The paper uses Bitcoin to concretely summarize how private digital currencies work.
There are two major innovations associated with recent private digital currencies such as Bitcoin. The first is the settling of transactions by a peer-to-peer network. Instead of settling transactions on the books of a single institution such as the Federal Reserve in the United States, transactions are settled on a network in which no link inherently has more standing than any other link. More concretely, transactions are settled by agreement among participants in the network, for example Bitcoin’s network. The paper goes somewhat into the details without, I hope, becoming tedious for non-programmers.
The second innovation is the creation of exchanges in which buyers and sellers of Bitcoins are “end users” – people how hold bitcoins or want to buy bitcoins instead of agents such as brokers – and the trading is computerized without human intervention. This has resulted in 24/7 trading, which is quite different than trading on organized exchanges. It is more similar to Ebay than the New York Stock Exchange.
Whether Bitcoin or any other digital currency will exist in a couple of years is an open question. A close examination of Bitcoin reveals no inherent design flaws indicating that it will ultimately fail. The question is whether it will be useful. As with many other innovations, this is hard to tell.
The paper is available at http://www.jerrydwyer.com/pdf/digitalcurrency.pdf.