Virtual currency Bitcoin skyrockets in value, but what is it and why should I care?

This image, courtesy of bitcoincharts.com, show's the virtual currency's rise over the past month.

Bitcoin, a new virtual currency based on a mathematical formula, has more than doubled in value in the past week, skyrocketing to well over $200 per unit as people flee the shaky global economy and look for alternative safe havens for their money.

Bitcoins aren't backed by gold or by a major bank, but instead rely on a sort of honour system and are traded on the Web.

The currency’s value closed at a cost of US$250.80 on Tuesday. Last week, the digital currency was hovering around $100 per share and a year ago the going rate for bitcoins was just $5.

The recent financial troubles in Cyprus appears to have been a catalyst for the digital currency's rapid rise -- stoking fears that traditional banks are vulnerable to the whims of politicians who could decide, as in Cyprus' case, that the solution to the country's economic troubles is to skim a bit off of every single bank account.

So just what is this rogue currency and how does it work? Following is a Q-and-A about Bitcoins:

What is a Bitcoin?

A Bitcoin is a virtual currency created in 2009, the collective value of which has now reached the $1-billion mark worldwide. A Bitcoin is a decentralized currency, meaning it is not backed by any financial institution. It is free from the highs and lows of inflation, interest rates and market fluctuations, its value instead determined by the number of bitcoins in circulation. A maximum of 21 million bitcoins will be issued and there are roughly 11 million currently in circulation.

From the Bitcoin website: "Building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of using cryptography to control the creation and transfer of money, rather than relying on central authorities."

How does it work?

Bitcoins can be traded person-to-person (P2P) or between customers and merchants. But you can't just go to a bank or currency kiosk to purchase your Bitcoins. Instead, purchasers must visit an online market to find dealers and make a transaction. (One example of an online market is Mt. Gox.)

Bitcoins are created through a process called mining, whereby users donate their computer's processing power to Bitcoin so it can be used to solve the difficult mathematical problems required to validate transactions. When a problem is solved, coins are issued as a reward.

Every single transaction ever made using Bitcoins is recorded and posted publicly. But the identity of the users making those purchases is private, making the currency attractive to anyone seeking to make virtually untraceable online purchases.

How are they traded?

Once you have Bitcoins in your virtual wallet, you can spend them or hold out in hopes that the value will continue to rise. But although bitcoins are quickly rising in value and popularity, there aren't all that many places to actually spend them just yet. The website spendbitcoins.com lists a number of businesses that accept the currency -- mostly small independent start-ups selling products such as digital services, custom t-shirts and cigarettes.

On websites such as Craigslist and eBay, more and more retailers are advertising "Bitcoins accepted," as payment for products. Silk Road, a website that offers online illicit drug sales, also allows customers to use the non-traceable Bitcoin currency.

Bitcoins are encrypted specifically to the owner. Once an exchange is made, the encryption changes to reflect the new owner.

Are they safe?

Because Bitcoin isn't backed by a major bank, and is by its very nature decentralized, security is a concern. In June 2011, the Mt. Gox Bitcoin exchange was hacked, and the site crashed last week.

Bitcoinica, another Bitcoin retailer, experienced a cyber-attack last May that resulted in the theft of 18,000 bitcoins. If your bank account was hacked, your funds would likely be protected by the institution, but no such security blanket exists with Bitcoins.

Is it a good investment?

Most analysts predict Bitcoins' value will soon reach a plateau. Though the recent media attention has triggered a flurry of interest in the currency, most buyers appear to view it as an investment as opposed to a cash product they would use for online purchases. Essentially, that means many people are buying bitcoins as an investment, then hoarding them in hopes their value will continue to rise. Because a limit has been put on the total number of bitcoins to be produced (21 million), the value may be affected by the fact many bitcoin owners aren't spending the currency.