Understanding the basics of Bitcoin
Bitcoin is a decentralized, peer-to-peer digital currency that allows instant payments to anyone across the world through encryption keys, thereby protecting the identity of the traders. In other words, Bitcoin is electronic cash that uses peer-to-peer networks and eliminates the need for a financial institution. This means that there is no physical currency, and it is not issued or controlled by any authority, unlike traditional currency which is governed by banks and government regulations.
It all started in 2009 when ‘Satoshi Nakamoto,’ who claimed to be a 36-year-old Japanese man, made an announcement on The Cryptography Mailing list and published his whitepaper. He had allegedly spent over a year writing the software for Bitcoin, driven by a buildup of resentment over the 2008 financial crisis.
Nakamoto wanted to create an independent currency that was impervious to unpredictable monetary policies. The software designed by Nakamoto would release a total of 21 million bitcoins over the years: like gold, silver and other precious metals, Bitcoin has a finite supply, but it does not have any intrinsic value.
The identity of Bitcoin’s inventor Nakamoto is still unknown. He handed over the source code and domains to other people and disappeared in 2011.
Public and Private Keys
Bitcoin balances are recorded using public and private ‘keys,’ which are a series of numbers and letters linked through a mathematical encryption algorithm.
The public key, similar to a bank account number, is referred to as the ‘Bitcoin address,’ which is shared with others in order to send and receive Bitcoins. The private key or ‘seed’, equivalent to a credit card PIN, is used to authorize Bitcoin transactions and prevents the transactions from being altered by anybody once they have been issued. The use of Bitcoin addresses ensures that the identities of buyers and sellers remain anonymous.
Technically, Bitcoins are not stored in any one location. However, a Bitcoin wallet helps create public addresses and stores the secure private key used to authorize transactions. The wallet gives ownership of the Bitcoin balance to the user; like a bank balance, it reflects the balance of Bitcoins owned by the user.
For fiat currencies, banks act as middlemen for all transactions, which are recorded in a private ledger. Bitcoin, on the other hand, has a shared public ledger known as the blockchain, which eliminates the need for a trusted third party. All confirmed transactions are recorded on the block chain. This helps avoid double spending, since the ledger–available to everyone–allows people to verify whether the Bitcoins are owned by the spender. The integrity and chronological order of the blockchain are preserved using cryptography.
All Bitcoin transactions are broadcast to the network, and are confirmed within 10-20 minutes through a process called ‘mining.’
In Bitcoin mining, a group of people use powerful computers to run complex calculations in order to guess a random number that solves a complex equation generated by the system. The more powerful the computer, the higher the number of guesses it can make per second, thereby increasing its chances of success. In essence, Bitcoin mining is the equivalent of a competitive lottery.
The computer that solves the equation gets the opportunity to update the blockchain by confirming Bitcoin transactions over a certain time and arranging them into a block. It enforces a chronological order in the blockchain, protects the neutrality of the network, and allows different computers to agree on the state of the system.
In other words, miners act as auditors and update the blockchain in a fashion similar to banks maintaining ledgers. For transactions to be confirmed, they must be packed in a block that fits very strict cryptographic rules that are verified by the network. These rules prevent previous blocks from being altered because doing so would invalidate all the subsequent blocks. The first Bitcoin block, known as the genesis block, was mined on January 3, 2009 by Nakamoto.
The lottery system prevents any individual from easily adding new blocks. In this way, no group, individual, or institution can control what is included in the blockchain, or replace parts of the blockchain to roll back their own spending. Furthermore, the system rewards the miner who solved the equation with a fixed number of bitcoins, currently 12.5 bitcoins, as compensation for their time and effort.
The level of difficulty involved in mining Bitcoins depends on the amount of network power involved in the mining process. The level of difficulty increases proportional to the increase in the number of computers involved in mining; in other words, mining gets easier when less people are doing it.
Currently, the ‘difficulty level’ of mining bitcoins is approximately 6.379 million, as opposed to just 1 in 2009. Bitcoin mining at present is therefore highly difficult, energy intensive, and much less profitable. For this reason, individuals often join mining pools (a group of miners who combine computational resources over a network) in order to have better chances of success and share the rewards with pool members.
Bitcoins can be traded in any digital asset trading platform called Bitcoin Exchanges, where people can buy bitcoins with fiat currencies or other cryptocurrencies, collectively known as Altcoins. Bitcoin Exchanges act as intermediaries and match buyers with sellers, much like a stock exchange. In order to trade Bitcoins, one has to have a Bitcoin wallet.
Value of Bitcoin
The value of Bitcoin reached a record high of US$20,000 per Bitcoin in late 2017, but plummeted shortly afterwards. In February 2020 the value of 1 Bitcoin was approximately US$9,900 before it declined in March to approximately US$5,900 following the rapid spread of Coronavirus and its widespread economic repercussions.
Fiat currencies derive their value from the legal status provided by governments. These currencies are ‘legal tenders,’ meaning that they have to be accepted when offered as payment. Bitcoin, on the other hand, derives its value from the growing base of people, merchants and businesses willing to accept it as a medium of exchange. While there are plenty of cryptocurrency advocates who may even prefer being paid in Bitcoins to fiat currency, the high volatility of Bitcoin prices makes trading in Bitcoins risky for the average person.