From Bitcoin's own website:
Bitcoin has the characteristics of money (durability, portability, fungibility, scarcity, divisibility, and recognizability) based on the properties of mathematics rather than relying on physical properties (like gold and silver) or trust in central authorities (like fiat currencies). In short, Bitcoin is backed by mathematics.
So what is Bitcoin, anyway?
Bitcoin is a relatively new currency (think dollars, euros, or yen), and was introduced by anonymous creators in 2009. First, how much is one bitcoin worth? As with all things: however much someone is willing to pay for it. Here's a graph of how much people have been willing to pay for one bitcoin over the last few months.
Bitcoin price has been fluctuating recently, and hit a maximum of over $1200 on December 4.
Unlike other currencies, Bitcoin is digital. You can't hold a Bitcoin in your hand. So how do you know how many Bitcoins (or "BTCs") you have? Well, it's a matter of public record! Every time someone pays someone else in Bitcoin, the transaction gets logged in a digital ledger (essentially a list of every single transaction) known as the "block chain."
So the list of who has how many BTCs is publicly available. But many Bitcoin addresses (long chains of numbers and letters) are anonymous -- everyone knows how many BTCs they have, but almost no one knows who owns the address.
In addition to an address, each Bitcoin user also has a private key, which he/she needs when making Bitcoin payments. These keys are additional long chains of numbers and letters, but they are not publicly available.
When Person A makes a payment to Person B in Bitcoin, the transaction gets added to the block chain. But how does Person B (and everyone else) know this is a real payment, as opposed to some fraud who's only pretending to be Person A (perhaps using their Bitcoin address)? Just like a bank verifies the authenticity of checks, Bitcoin transactions get verified as well, but mathematically.
Many individuals, known as Bitcoin "miners," verify transactions. Miners do this using cryptographic hash functions, which are functions for which:
- Given an input, it's easy to calculate an output
- But given an output, it's really hard to find any input.
The miners get paid for verifying transactions with -- you guessed it -- more Bitcoin! By verifying transactions, they're "mining" for Bitcoin, much like a 49er would mine for gold. But the rate at which miners are rewarded exponentially decays over time, so that the total number of BTCs in circulation is tightly controlled.
So Bitcoin involves mathematics and cryptography rather than centralized institutions (like mints and banks) to create currency and prevent fraudulent transactions. Over the next few years, we'll see if digital currencies like Bitcoin catch on.