An introduction to Bitcoin
We’ve all heard the term bandied around and realize it’s a form of currency. We also remember in 2017 when a lot of people got very rich, and then very poor, trading it when there was a huge surge followed by a downturn.
In the last few weeks, it’s made the news again thanks to a surge in price and reaching a new all-time high.
But what is this mysterious currency, and how does it work? To understand Bitcoin, we must first understand the network that it’s built upon, the blockchain network. A blockchain network can be used for many things, and only one of them is currency.
A blockchain network is a decentralized store of data that becomes a timeline of events due to the fact that changes become finalized in blocks, which are then uneditable. There is also no single owner of the data, as the chain exists in multiple locations rather than on one server. This is because anyone can download a copy of a blockchain, and it updates as the chain of events becomes longer. A blockchain relies on this duplication of data to establish an incorruptible series of events.
What does this mean, though?
If we think, for a moment, about any website online, its data is stored on servers. These servers are owned and run by companies or individuals. This means the data is owned and can be controlled. The control of data has become a hot topic lately, particularly on the subject of fake news, with media outlets having the potential to spread disinformation.
In a word, centralized structures are open to manipulation. One of the closest centralized structures, that uses principles similar to a blockchain network, is Wikipedia. It has multiple editors all working to reach a general consensus about ‘the truth’. We know we can rely on Wikipedia because we realize that no single person can get away (in the long term, at least) with making up something factually incorrect, as others will come along and verify this information.
But even open-source platforms like Wikipedia can be tampered with, in the short term, and can be moderated by people who potentially have corruptible agendas. A blockchain is unique because, in order for new blocks (of data) to be added, the data has to be agreed upon by a minimum of 3 computers. When these computers have all agreed (reached consensus) that an event happened, the block is sealed with a hash code and added to the chain. At this point, it can never be edited again. If you need more real-world examples of how blockchains work, there are some great ones in this article.
So what data is in the blocks?
In the case of Bitcoin, the data is a transactional ledger. A record of who bought what, and where the money moved to-and-from as a result. A blockchain works well as a ledger because of the fact it is an uneditable timeline of events.
Because blocks can only be a maximum of 1MB, synchronization of the chain is quick and can be relied upon absolutely. As you can imagine, the reliability of data is absolutely crucial when it comes to dealing with any kind of ledger. So just how do blockchains become currency?
Blockchains as Cryptocurrency
Bitcoin was not just the first cryptocurrency, but also the first practical application of blockchain technology. But how did the principle of a decentralized structure lead to something with value comparable to the ‘gold standard’?
The idea was first proposed in a paper by the elusive, (and never identified) Satoshi Nakamoto, in 2009. Rumors are rife that Satoshi could be an organization rather than an individual, or multiple developers working together. But never-the-less, it’s ‘Satoshi Nakamoto’ who will go down in history as the creator of Bitcoin — whoever they are.
Where does Bitcoin get its value?
Firstly, it’s worth asking what a Bitcoin is. A Bitcoin is comprised of numerous lines of unique code, so no two people can hold the same Bitcoin.
It’s perhaps easiest to imagine it in the same way we imagine money that’s in our banks, rather than physically in our wallets. In that, really, we don’t imagine what it is, we just understand that it’s there, and it is limited in supply. You can’t just obtain it, because it is worth something to someone else, so you have to earn or buy it (think travel money when we speak of ‘buying it’).
You can buy Bitcoin in a similar way to buying other commodities or currencies (albeit a slightly different process), but it’s essentially exchanging your everyday dollar, pound, euro, etc for the equivalent value in Bitcoin.
Perhaps most importantly, you can also earn it, which is arguably how Bitcoin gets its value in the first place. They are given out to those maintaining the network by approving transactions. Because it is linked to ‘work’ in this way, it can be seen as a reward, and therefore, something of value.
This process, perhaps misleadingly, is known as ‘mining’. Misleading, because Bitcoins aren’t wrought out of the mining process — you aren’t materializing Bitcoin out of ether by mining, they are just issued by a governing program if you work for them.
And because they are unique and limited in supply, they have value. At first, it was worth $0. But as the unique nature of Bitcoin’s application became well-known, more and more people wanted to use, or even own it, the value skyrocketed. The first major boost was in 2010, when one bitcoin went from $0.0008 to $0.08. At the time of writing, one Bitcoin is worth around $36,000.
So, to round up. The coins themselves have achieved value by being limited in supply, difficult (increasingly so) to obtain, and finally, they have a unique use case that cannot be replicated by regular currency. Bitcoin are an effective means of securely transferring money, particularly long-distance, without paying huge fees to banks or wire transfer companies. You simply pay a small fee in bitcoin to those operating the blockchain to validate your transactions.
How is Bitcoin mined?
Computers must carry out a two-part operation to be in with a chance of successfully earning a Bitcoin reward:
- Verify a transaction block on the blockchain which is necessary for allowing people to send and spend bitcoin
- Be the first to complete an equation to ensure only one person is rewarded with the new bitcoin token
Being first to complete these two processes, gives miners a bitcoin reward. Learn more about the process of mining bitcoin.
Get my mining trowel!
If only it were still 2010. Sadly, mining bitcoin costs considerable computational power and time. Computers also need to be powerful (read expensive) to solve the equations before you can start, even if you join a mining pool (a group of people joining forces to mine).
Also, as we mentioned, Bitcoin is becoming harder and harder to mine, and the demand keeps increasing. When all of the possible coins are mined (predicted to be the year 2150) there will be 21 million of them in total.
Why does the price fluctuate so much?
We’ve looked at the core reasons for Bitcoin’s value, but that doesn’t really explain the extreme fluctuations in price, often on a daily basis. It’s easiest to understand this if we look at the stock market.
Most of us realize that the value of a company listed on the stock market is not necessarily indicative of its true value. This is because of the perception people have of the company. Plus, companies are notoriously careful about when and how they release information that could influence the price of their shares.
So, if we remove from that the concrete value you can attribute to a business (the buildings, the stock, the patents, you name it), and consider the business as a string of numbers in the ether (like Bitcoin), suddenly we begin to understand why Bitcoin (and cryptocurrencies like it) are so susceptible to swings in price.
When you’re dealing with a wholly digital asset, almost the entirety of the value comes from perception. If suddenly there’s a rumor that it’s going to be made illegal somewhere, the price could plummet.
Bitcoin as a store of value
Or, the polar opposite of this. If regular currencies themselves become unstable, Bitcoin can be seen as a safer place to keep assets.
In 2020, it’s estimated that 22% of the total amount of US Dollars were issued — around 9 trillion dollars. And things aren’t dissimilar in many other countries, due to the current global crisis.
Bitcoin can be likened to gold in situations like these, where it stores value while currencies struggle around it, being a relatively safe bet (in an extreme scenario).
What if a blockchain is hacked?
It’s inevitable, especially where currency is involved, for people to try and steal, or commit other acts of fraud. Cryptocurrencies are no exception to the rule. People try all sorts, but it usually involves putting fraudulent transactions into a block of honest transactions.
Why this doesn’t work is quite complicated, but essentially, the mistake is spotted because the amount of honest miners (validators) on the network vastly outnumbers the amount of people corrupting the system, and the numerous copies of the blockchain make it easy to spot anomalies from ‘bad actors’, as they are known in the world of crypto.
Can Bitcoin be updated?
Bitcoin abides by a set of rules set out in its very code. Everything from how the miners are rewarded to how bad actors are dealt with, and the number of Bitcoin that can exist in total.
If enough people want to change the rules, or process, a splinter currency (like Bitcoin Cash) can be created in a process known as a fork.
Bitcoin, the undisputed champion
All cryptocurrencies operate in much the same way, so why is Bitcoin the one that everyone talks about?
As the originator, Bitcoin still has the edge over other cryptocurrencies — a Coca-Cola-like effect. Ironically, many of the newer cryptocurrencies attempt to improve upon various elements of the system used by Bitcoin.
But ultimately, it comes down to perception. Bitcoin is seen as gold, and therefore undisputedly the most valuable, versus the silver of say, Etherium.
But one thing is for sure, none of the strongest cryptocurrencies are going anywhere any time soon.
One question: once all the bitcoins are mined, where do the future rewards for confirming transactions come from? Will they be paid as a percentage of the actual transaction, like a notary fee?
Bitcoin does have the first-mover advantage — thus, it is not ironic that newer cryptocurrencies attempt to (and dramatically succeed in) improving upon Bitcoin. However, it is safe to say that the vast majority of cryptocurrencies improve upon Bitcoin so much that there is really no reason for Bitcoin to exist — except for those whose value is trapped in it and who must therefore both hype it and get gains while it is possible to do so. Bitcoin’s high transactions fees and lack of volume and speed means that it is inappropriate for all but the largest transactions. Indeed,… Read more »