Dogecoins and Litecoins and Peercoins oh my: What you need to know about Bitcoin alternatives

By now, most people have heard of Bitcoin, the peer-to-peer currency whose value has soared over the past couple of years. But more recently there’s been growing press attention to Bitcoin alternatives with silly names like Dogecoin, sexcoin and Hobo Nickels. Is this all a big joke, or should people take some of these Bitcoin competitors seriously? Read on to find out.

What’s Bitcoin and why does it have so many imitators?

Conventional payment systems like PayPal and Visa are centralized. A for-profit company operates the network and ensures that it is secure and reliable. But Bitcoin operates on a different model. Instead of being run by a for-profit company, Bitcoin operates as a peer-to-peer network. Its security is guaranteed by cryptographic algorithms instead of government or corporate managers.

One consequence of this design: the Bitcoin network has its own currency. The PayPal corporation guarantees that if you deposit one dollar into a PayPal account, you’ll be able to get a dollar back later. But no one owns the Bitcoin network, so there’s no one to guarantee that one unit of Bitcoin currency will have a stable value against conventional currencies. Instead, Bitcoin’s unit of value, also called the Bitcoin, floats against conventional currencies. One bitcoin is currently worth about $800, up from less than a dollar at the start of 2011.

Bitcoin’s success has attracted a legion of imitators, called “altcoins.” One list shows 63 different altcoins in existence.

I read that one of these alternatives is called the “Dogecoin,” named after a dumb Internet meme. This is all a big joke, right?

Yes, Dogecoin is a joke. Though weirdly it’s a joke that, at least on paper, is worth millions of dollars.

Because Bitcoin is an open-source project, anyone can take the source code, modify it, and then use the modified software to create their own Bitcoin-like network. The founders of Dogecoin took the source code of another Bitcoin variant called Litecoin, made some further tweaks, and rebranded it as “Dogecoin.” That’s a reference to the canine variant of lolcats, an Internet meme where a grammatically challenged dog makes excited statements.

Dogecoin has been around for less than a month. In that time, the value of all dogecoins in existence has skyrockted from zero to more than $8 million.

How can an imaginary currency based on an annoying Internet meme be worth millions of dollars? I must be missing something.

People waste money on stupid stuff all the time. Look at the Beanie Babies craze, for example. You only have to find a few thousand suckers before a previously worthless asset becomes worth millions of dollars.

And there really are a lot of people willing to pay cash (or at least Bitcoins, which are easily converted into cash) for dogecoins. The order book of the virtual currency exchange Cryptsy shows there are buyers willing to spend hundreds of Bitcoins, worth hundreds of thousands of dollars, for Dogecoins.

Presumably some of these buyers are people who are willing to drop a few dozen dollars to participate in a fun Internet joke. And others may be speculators hoping that they’ll be able to unload their Dogecoins at a profit before the market collapses.

What about the other virtual currencies? They’re all jokes too, right?

Maybe not. While the value of Dogecoins has been rising quickly, the currency still isn’t among the top 10 alternatives to Bitcoin. Unlike Dogecoins, the leading Bitcoin alternatives were designed to be serious alternatives to Bitcoin.

Bitcoin’s pseudonymous creator, Satoshi Nakamoto, did an amazing job of building a payment network that is secure, scalable and useful. But he wasn’t perfect; he made some design decisions that might not look so great in retrospect.

The problem is that thanks to Bitcoin’s decentralized design, it’s not easy to change the core Bitcoin protocol. Hence, if you have an idea for an improved version of Bitcoin, it’s easier to start your own virtual currency than to try to convince the Bitcoin community to change how Bitcoin works. So over the past three years, a number of people have introduced Bitcoin alternatives that borrow some ideas from Bitcoins but also fix perceived flaws.

What kind of flaws does Bitcoin have?

Most of the altcoins have focused on improving mining, the process the Bitcoin network uses to process transactions. In the Bitcoin mining process, hundreds of computers race to solve a repetitive math problem. The winner of the race gets to add a “block” to the Bitcoin network’s global transaction register, and to award itself 25 bitcoins (roughly $20,000) for its trouble.

Critics see two big problems with this system. One problem is that the mathematical formula at the core of the Bitcoin mining process, called a hash function, can be performed much more efficiently by expensive, custom-designed computers than with an ordinary PC. As a result, mining has become an increasingly specialized activity, with people spending thousands of dollars on chips whose only function is to mine Bitcoins. This hardware is so much more efficient than ordinary PCs that it’s no longer cost-efficient to mine Bitcoins with an ordinary PC — the electricity consumed is worth more than the bitcoins produced.

That, critics warn, risks undermining one of Bitcoin’s core virtues: its decentralization. The security of Bitcoin’s transaction-clearing process requires that no one control more than 50 percent of the network’s computing power. Bitcoin’s designer envisioned thousands of ordinary users running Bitcoin software on their PCs, ensuring that no one could gain a large market share.

But thanks to the rise of dedicated hardware, Bitcoin mining has become increasingly professionalized. Miners have organized themselves into “pools,” and a handful of pools control the overwhelming majority of the network’s computing power. Critics worry that these pools could eventually gain de facto control over the network, undermining one of the network’s key selling points.

A Bitcoin alternative called Litecoin replaces Bitcoin’s hash-based mining process with an alternative that’s harder to accelerate with dedicated hardware. Litecoin’s developers hope that this will make Litecoin mining a more democratic activity, with anyone being able to cost-effectively mine Litecoins on their PCs.

Litecoin was one of the first Bitcoin alternatives to be introduced, and it is the most popular decentralized payment network after Bitcoin. As this is being written, the value of all Litecoins is more than $500 million.