Bitcoin: What Is It, How It Works & What It Means For The Future Of Money
March 14th, 2017
Image source: coindesk
In recent years, the popularity of Bitcoin has increased. Besides being accepted by over 1,00,000 merchants as a legit form of payment, many public personalities have come out in support of the Bitcoin system.
Bill Gates, for example, once said, “Bitcoin is better than currency in that you don’t have to be physically in the same place and, of course, for large transactions, currency can get pretty inconvenient.” Hailing Bitcoin as unstoppable, Gates said that, in the future, financial transactions will eventually “be digital, universal and almost free”.
Image Source: amazonaws
The Logical Indian gives you a brief, introductory overview of Bitcoin. For more detailed information on Bitcoin, the reader can access the several articles on this topic that are available online. For a detailed overview, you could go here.
What is Bitcoin?
Bitcoin is a new payment system and a completely digital currency. It was introduced on 31 October 2008 to a cryptography mailing list and released as open-source software in 2009.
What is crypto-currency?
Bitcoin is the first implementation of a concept called crypto-currency. Crypto-currency is the idea of a new form of money that uses cryptography to control its creation and transactions rather than a central authority. This means that Bitcoin is encrypted in a way that prevents it from being copied or counterfeited.
Bitcoin is often called the first cryptocurrency (although prior systems existed). It can be more correctly described as the first decentralised digital currency. Bitcoin is certainly the largest of its kind in terms of total market value.
Origins of Bitcoin
The first Bitcoin specification and proof of concept was published in 2009 in a cryptography mailing list by Satoshi Nakamoto. The identity of Nakamoto remains unknown, though many have claimed to know it.
Satoshi left the project in late 2010 without revealing much about himself. The community has since grown exponentially with many developers working on Bitcoin. You can read the original Bitcoin whitepaper here.
Image Source: tinypic
How does the Bitcoin system work?
Imagine you and I are sitting on a park bench.
I have a bottle of water in my hand. It belongs to me, it is one of my possessions. You don’t have a water
Say I give you the bottle. Now, you were the complete owner of the bottle. I don’t have a water bottle anymore.
What just happened was a transaction.
Additionally, this transaction happened without the presence of a third party. It only involved you and me.
Now picture a digital bottle.
The same transaction can occur between you and me. However, now a problem arises. Due to the fact that the transaction happens digitally, who’s to say that I don’t make a copy of the digital bottle before giving you one? Who’s to say you won’t make ten copies of the digital bottle once you get it from me?
Obviously, sending digital bottles is very different from sending physical bottles.
Bitcoins are essentially the digital bottles of the above transaction. They are created by users, exchanged between them without any third-party involvement, and – significantly – all transactions in a Bitcoin system are recorded in a public ledger. This ledger is available to all users. Thus, counterfeit currency and unlawful transactions are virtually impossible in a Bitcoin system since all transactions can be tracked.
Importantly, transactions are known to have occurred, but identifying the parties involved in a Bitcoin transaction is very difficult. Therefore, a degree of anonymity is maintained.
When someone new wants to join the Bitcoin system, they request a copy of all of the notes – the blockchain – and thus have their own copy of the public ledger. They can look at everyone’s transactions and add their own to the mix.
The problem of double-spending
Now picture both the above scenarios with money – with actual notes.
In a physical money transaction, a third party – like a bank – will automatically be involved. The presence of these third parties or middlemen will lead to two consequences:
- When I transfer money from me to you, it involves a bank in between. The bank takes a part of the money transferred as transaction fees. Thus, the entire sum is not transferred from me to you.
- If the bank crashes or there is some political disturbance like a strike or terrorist attack, interest rates change, exchange rates swing, and the stock market vary erratically. All of this affects the transaction between you and me.
In a digital money transaction, there is always the threat of counterfeiting digital currency. This is called the risk of double-spending – the risk that a digital currency can be spent twice.
Double-spending is a problem unique to digital currencies because digital information can be reproduced relatively easily. Physical currencies do not have this issue because they cannot be easily replicated, and the parties involved in a transaction can immediately verify the bona fides of the physical currency. With digital currency, there is a risk that the holder could make a copy of the digital token and send it to a merchant or another party while retaining the original. (Read more about double-spending here.)
So wouldn’t double-spending be a problem with Bitcoin?
This was a concern initially with Bitcoin since it is a decentralised currency with no central agency to verify that it is spent only once. However, Bitcoin has a mechanism based on transaction logs to verify the authenticity of each transaction and prevent double-counting.
What are the main points to note about Bitcoin?
Bitcoin is different than any currency you’ve used before, so it’s very important to understand some key points.
- Bitcoin is the first decentralised peer-to-peer payment network.
- It is a form of crypto-currency.
- It is powered by its users – it has no central authority or middlemen.
- It is not tied to any political system or government. Thus, it is not at risk of any bank failures, economic bubble bursts, or financial crises.
- It is pretty much like cash for the Internet. It is virtual money that you can use to buy things online.
- All transactions are recorded in a public ledger, which is available to all users and in all computers.
- Unlike government-issued money that can be inflated at will, the supply of Bitcoin is mathematically limited to twenty-one million bitcoins and that can never be changed.
A Bitcoin ATM in California. Image Source: wikimedia
How are Bitcoins created?
New bitcoins are generated by a competitive and decentralised process called “mining”.
This process involves individuals who are rewarded by the network for their services. Bitcoin miners process transactions using specialised hardware and collect new bitcoins in exchange.
The Bitcoin protocol is designed in such a way that new bitcoins are created at a fixed rate. This makes Bitcoin mining a very competitive business. When more miners join the network, it becomes increasingly difficult to make a profit and miners must seek efficiency to cut their operating costs.
No central authority or developer has any power to control or manipulate the system to increase their profits.
If a user wants to get some money, they can try to solve math problems (mining), exchange some valuable item with someone already in the group in exchange for some money (exchanges or stores), or do something to help someone in the group so that they can earn the money, like mowing their lawn or cleaning their room.
Bitcoin mining involves solving math problems. It used to be really easy to do the math problems, but it is getting harder and harder daily.
What determines Bitcoin’s price?
The price of a bitcoin is determined by supply and demand. When demand for bitcoins increases, the price increases, and when demand falls, the price falls.
There is only a limited number of bitcoins in circulation and new bitcoins are created at a predictable and decreasing rate, which means that demand must follow this level of inflation to keep the price stable.
What does the future look like for Bitcoin?
As of February 2015, over 1,00,000 merchants and vendors accept Bitcoin as payment. Bitcoin has not been made illegal by legislation in most jurisdictions. However, some jurisdictions (such as Argentina and Russia) severely restrict or ban foreign currencies. Other jurisdictions (such as Thailand) may limit the licensing of certain entities such as Bitcoin exchanges.
Regulators from various jurisdictions are taking steps to provide individuals and businesses with rules on how to integrate this new technology with the formal, regulated financial system.
So, what are we getting out of Bitcoin?
As a Reddit user pointed out, the current currency system is rotting because governments keep printing more money. The more they print, the less it is worth. This is inflation this is where your hard earned money is becoming more and more worthless. Venezuela is a good example of this – right now, inflation is about 800% per month. That means every month, your money is worth 1/8th what it was last month.
That cannot happen in Bitcoin. So, right away, it gives you a safe haven. What if you have saved for 40 years and you have $1 million dollars saved for your pension? At 800% inflation, in 6 months your entire life savings will be worth 1 cup of coffee. The answer is you convert to Bitcoin.
Another point is capital control. Governments control how people move and use money. It is called “structuring”. Basically, governments control your money and they can and do abuse that power and abuse you with it – depending on your status and the nature of your government.
With Bitcoin, there is no central authority. It cannot be inflated, or confiscated, or blocked.
Total Bitcoins in circulation. Image Source: wikimedia
Advantages of Bitcoin
As weusecoins.com pointed out, these are a few advantages of Bitcoin:
- Payment freedom – It is possible to send and receive any amount of money instantly anywhere in the world at any time. No bank holidays. No borders. No imposed limits. Bitcoin allows its users to be in full control of their money.
- Very low fees – Bitcoin payments are currently processed with either no fees or extremely small fees.
- Fewer risks for merchants – Bitcoin transactions are secure, irreversible, and do not contain customers’ sensitive or personal information.
- Security and control – Bitcoin users are in full control of their transactions; it is impossible for merchants to force unwanted or unnoticed charges as can happen with other payment methods. Bitcoin payments can be made without personal information tied to the transaction. This offers strong protection against identity theft. Bitcoin users can also protect their money with backup and encryption.
- Transparent and neutral – All information concerning the Bitcoin money supply itself is readily available for anybody to verify and use in real-time. No individual or organization can control or manipulate the Bitcoin protocol because it is cryptographically secure. This allows the core of Bitcoin to be trusted for being completely neutral, transparent and predictable.
Disadvantages of Bitcoin
These are a few disadvantages of Bitcoin:
- Degree of acceptance – Many people are still unaware of Bitcoin.
- Volatility – The total value of bitcoins in circulation and the number of businesses using Bitcoin are still very small compared to what they could be.
- Ongoing development – Bitcoin software is still in beta with many incomplete features in active development. New tools, features, and services are being developed to make Bitcoin more secure and accessible to the masses.