Bitcoin is a cryptocurrency for online payments between two parties in a decentralized manner and without an intermediary. Bitcoin uses peer-to-peer technology and exhibits characteristics of money but it is unlike conventional cash.
For example, just like cash, it is a bearer instrument, meaning the person who has keys to an online wallet containing Bitcoin, owns the coins. It is also fungible. This means that one Bitcoin is equivalent in value to another Bitcoin, making it possible to use them for trading. But transactions that utilize Bitcoin are not anonymous. Publicly-available ledgers on blockchain, Bitcoin’s underlying technology, ensure that anyone can see the transfers and withdrawals taking place in the cryptocurrency’s network. In contrast, cash-based transactions are anonymous.
A rapid appreciation in price and limited availability has converted Bitcoin into a store of value for investors. In this role, it acts in a fashion similar to gold. Only 21 million Bitcoin will ever exist and the rate at which they are being mined is a decreasing curve. The resulting rarity translates to significant and increasing monetary value being attached to each Bitcoin in existence. For example, consider that Bitcoin price had recorded an appreciation of 9,000,000 percent since inception, as of last December.
How Does Bitcoin Work?
There are two parts to understanding Bitcoin’s working.
Validating Transactions Through Bitcoin Mining
The first one is the process to generate or mine Bitcoins and validating transactions in its network. No single authority or organization controls Bitcoin’s mining or distribution because it is a decentralized system. Mining and distribution in Bitcoins is automated. Mining algorithms define rules to award Bitcoin to miners. Cryptography functions are used for user privacy and transaction transparency. Finally, consensus is reached by database verification between nodes (or systems running the mining algorithms) in Bitcoin’s network. Instead, a combination of consensus algorithms, that define rules for awarding Bitcoin to miners, and cryptography functions, that ensure user privacy and transaction transparency, are used.
Anyone can mine Bitcoins by downloading its mining software and a copy of its transaction database. Each miner is a node in Bitcoin’s network and holds a record of all transactions that occurred in the network. These transactions are organized into blocks and each block has a header that points to the following one in its chain.
In a centralized system, transactions are validated and verified by a third party that consults its ledger of entries to make sure that there are no frauds. Bitcoin works differently; miners are instead responsible for validating and confirming transactions. They do this by consulting their stored digital ledgers. User privacy in the network is ensured through use of the SHA-256 hash functions, which scramble and hide user and transaction information. These functions are part of a block header and contain pointers to the previous batch of transactions in another block.
Bitcoin is mined using the Proof-of-Work consensus protocol. The protocol requires miners to solve mathematical puzzles while competing against each other. The first miner to come up with the closest approximation to the correct answer is awarded a fixed number of Bitcoins. These awards follow a logic of decreasing returns i.e., miners earn fewer Bitcoin with time. The number of Bitcoin awarded is divided by two every four years in events known as halving. For example, the miner reward in 2012 was 25 Bitcoins and 12.5 Bitcoins in 2016. The latest halving event occurred in May 2020 and resulted in a further decrease of the overall reward to 6.25 Bitcoins.
The second important thing to understand is the manner in which transactions are conducted on Bitcoin’s network. Consider a very simple case involving Alice and Bob. Both have mined Bitcoins that are stored in their respective cryptocurrency wallets online. The wallets are secured by public and private keys. The public key, which is actually a hash (or scrambled version) of the private key, is also known as an address and identifies their respective wallets on Bitcoin’s network. The private keys are specific to Alice and Bob and are used to access the Bitcoin contained in their wallets.
If Alice wants to send 1 Bitcoin to Bob, she will use her private key to access her crypto wallet and enter Bob’s address on Bitcoin’s network. The transaction is broadcasted across the entire network and miners, after verifying balances at the respective addresses and checking Alice’s history to make sure that she is not double-spending, will confirm the transaction and update their database. Even as miners confirm the transactions, crypto hash functions will ensure that Alice and Bob are not identified on the public ledger.
Thus, while Alice and Bob’s transactions are publicly-accessible on Bitcoin’s network, their individual identities remain hidden. As long as Alice retains control of her private key, she owns the Bitcoin in her wallet. If her wallet is hacked or if she discloses the key to another user, Alice loses control of her coins.
History of Bitcoin
The whitepaper explaining Bitcoin was released on October 31, 2008 by a pseudonymous person (or group of persons) called Satoshi Nakamoto. He mined the first block of Bitcoin, also known as genesis block, and inscribed it with the words “The Times 03/Jan/2009 Chancellor on the brink of second bailout for banks” in a reference to the newspaper’s headline that day. Not much is known about Nakamoto even though there have been multiple efforts to locate or identify him/them. Several individuals have claimed to be Nakamoto but they have not provided enough proof to bolster their assertions.
While it is an important detail of the story, Nakamoto’s identity is only a part of the overall narrative about a digital equivalent of money. Bitcoin’s origins actually lie in the development of various protocols that enabled digital money.
The cryptocurrency’s roots lie in the Cypherpunk movement, which sought to build anonymous systems to escape government control and foment social and political change. Among the most important problems they solved was that of double-spending or the problem of preventing original users from spending their digital money repeatedly without the first party knowing about it. The second problem was that of anonymity. Much like physical cash, which is a bearer instrument, digital money also needed to incorporate privacy principles to hide the identity of its users.
Over the years, multiple advances in cryptography and online protocols have contributed to the development of digital money which, in turn, led to Bitcoin. For example, David Chaum, a scientist at UC Berkeley, is credited with developing the first commercial venture for digital money. DigiCash was launched in 1989 and used protocols developed by Chaum and his colleagues at the university to solve the double-spending and privacy problems. It used two forms of money – ecash and cyberbucks. Some banks incorporated DigiCash into their systems but it failed to gain traction within the wider financial services market. Subsequent advancements to the concept of digital money came in the form of protocols that were developed to “mint” money using computational puzzles. Adam Back used the idea to launch Hashcash in 1997. Nick Szabo, who is often suspected of being Satoshi Nakamoto, developed the idea for Bitgold the following year. His solution used timestamping, a technique used in Bitcoin to confirm the date and time of a transaction.
Is Bitcoin a Store of Value or Digital Payments System?
As it has garnered mainstream spotlight, Bitcoin has generated debate and controversy among economists, it’s enthusiasts, and the larger public. Most of these debates center around its identity and viability in a modern finance infrastructure underpinned by centralized institutions and geographical boundaries.
Bitcoin was conceptualized and released as a payment mechanism. But its design and working bucks the conventional logic of such systems. It is not backed by a central authority, such as the Federal Reserve, or known assets like gold. It is available across boundaries and has largely remained unregulated since its launch in 2008.
A growing list of technical problems in its network has further complicated the case for Bitcoin as digital money. For example, at the height of a surge in Bitcoin prices in 2017, transaction confirmation times and fees on its network skyrocketed, making it an expensive and slow form of payment. Very few vendors accept Bitcoin and fewer customers use it. Well-known economists and governments have criticized Bitcoin and the idea of cryptocurrencies as legal tender in their countries.
Meanwhile, halving events have reduced the number of Bitcoin in existence and increased the worth of those already available. The rapid influx of a horde of investors and traders led to a stratospheric increase in the asset’s prices to almost $20,000 per pop in 2017. While it has declined considerably since then, Bitcoin price continues to generate impressive returns for its investors.
But the market for Bitcoin investing suffers from several problems. These range from lack of sufficient liquidity to volatile price swings within the span of a few hours. That is why well-known investors have dismissed Bitcoin’s value proposition as a store of value. Legendary investor Warren Buffett even went so far as to call the cryptocurrency “rat-poison squared” during an interview.
Various initiatives have been launched in recent years to improve Bitcoin’s technology and to familiarize investors with its workings. For example, the Lightning Network seeks to make Bitcoin’s network faster and more efficient by creating channels to handle transaction confirmation tasks. Some famous investors and trading outfits are also said to have put money into Bitcoin.
A trickle of positive developments notwithstanding, it remains to be seen whether Bitcoin can live up to its original promise of decentralizing modern financial infrastructure.
Curious about Crypto?
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.