What is Bitcoin?
Bitcoin Review & Guide
Many people may have heard of the phenomena of cryptocurrencies and may have even heard the name “Bitcoin” thrown around, but are not clear on exactly what it is or how it works. Given all the hype and media attention, a thorough understanding of the basics of what Bitcoin is, and how it works can provide much-needed context for a greater understanding of this emerging and exciting technology.
Bitcoin, in fact, is both a network protocol as well as an actual digital token. Typically, capitalized Bitcoin is used to refer to the technology/network protocol, and lower-case bitcoin is used to refer to the actual currency, though this has not been universally adopted in language. Throughout this article, we’ll capitalize on Bitcoin as a proper name, just to keep things as simple as possible.
Bitcoin is the original cryptocurrency, and the network protocol to implement it. As the foundational currency of the modern cryptocurrency trend, it implemented a number of features that were, at the time, considered novel, and has largely served as the starting point for many of the other crypto projects, protocols, networks, tokens, coins, etc. that have been developed in the last few years.
In addition to having practical uses as a currency, and explaining how it works, it should be noted that Bitcoin has also been something of an investment darling, providing new opportunities for speculators and currency/commodity trading. Under the symbol BTC, Bitcoin has formed the basis of most of the major cryptocurrency exchanges in operation today. Along with Ethereum, which has been billed as “Bitcoin 2.0”, Bitcoin remains one of the top couples of leading cryptocurrencies, both in terms of individual value and market capitalization.
Put simply, Bitcoin was designed as a digital currency, with a finite supply, based on mathematics and cryptography, on a distributed and decentralized, transparent system, to cut out the middleman (in traditional currency, banks or governments). In practice, there’s a lot more to it than that, but really that is the fundamental nature of what Bitcoin is.
It was first floated as a whitepaper by Satoshi Nakamoto in 2008 – a pseudonym, as, to this day, no one has come forward and conclusively claimed or proved to be Nakamoto. What was unique or novel about the approach highlighted in the whitepaper was utilizing distributed computing technology and a network protocol to essentially allow direct currency transaction – from person A to person B, without the need for an intermediary. Further, the nature of these transactions, recorded and maintained on a transaction ledger, would be distributed and transparent, eliminating the classic “double-spend problem” inherent to digital assets.
In the strictest terms, Bitcoin doesn’t exist as a physical form or printed money. As such, it can be considered to be very different from traditional currencies or stores of value, where you can actually own, if not something valuable itself (e.g. gold), then a bank note or other denomination representing funds, in the form of paper money or coins. In the case of Bitcoin, it is merely a ledger of values as to who owns coins and how many, and the transactions that occur. Although in practice, this can also be said to be similar to electronic forms of regular circulating currency – if you remove cash from the equation, Bitcoin can be said to be similar to digital funds we use to pay bills, deposit our paychecks, fund credit cards, etc. While representing real value, we never physically interact with those funds, either.
The distributed ledger and how transactions are processed, verified, and appended, are based on what is known as blockchain technology. Essentially, it is a record of every transaction involving a denomination of Bitcoin from the beginning of time. This is shared, updated, and distributed among all users, and checked against other users’ records, as part of the integrity of transactions and the system as a whole.
How Bitcoin Works?
It is perhaps most instructive to walk through a transaction that uses Bitcoin and explain the technology and interactions along the way through the process. This can illustrate exactly how Bitcoin works, from theory and practical sense.
To begin with, Bitcoin exists in a fixed pool of coins. Unlike traditional currencies where additional money can be printed at any time, the Bitcoin coins only come into existence in a few ways, and will never exceed the hard cap limit of the system, which is set at 21m coins. Also unlike traditional currency, these did not all come into existence at once – quite the contrary. New coins are produced by “mining”, or “lending” computer power to the network in order to confirm transactions and reinforce network security. For this, participants earn a small reward in the form of fractions of a coin, at a rate that decreases over time so as to control inflation. The other means of obtaining Bitcoins generally involve purchasing for real-world currencies on an exchange.
Once a user has some Bitcoins, even fractional amounts, they are stored in a digital wallet, which is analogous to a real-world wallet for paper money. There are many different digital wallet applications for use on various platforms and mobile operating systems. Using this wallet, users can then purchase goods or services from merchants, or send Bitcoins to others, simply by inputting the wallet designator for the person or company to whom you are sending the funds.
Once a transaction is initiated on the network, miners (in reality autonomous systems running validation programs) perform mathematical calculations to verify the transaction, usually, multiple verifications occur, and then the transaction is appended to the ledger. This triggers the update of the wallets and is where the ownership transfer of coins takes place.
The Basis of Bitcoin
Bitcoin’s price or value is not tied to a real-world asset like gold, nor backed by the faith and credit of a government, as in the case of most fiat currencies. Instead, because the supply is finite, and the difficulty in mining new coins increases over time as the pool gets closer and closer to the 21m coin cap, the value of the coins in circulation naturally rise. The only assumption is that sufficient people are using the network and the coins, otherwise the value could collapse. This is not dissimilar to what happens if people lose faith in a fiat currency. At the same time, it is different than stocks or other investments, because, with Bitcoin, no financial performance goals are being hit by a company. For example – it is merely a currency, and one without direct market manipulation capabilities because it is not controlled by a central authority, such as the US Federal Reserve in the case of US dollars.
Therefore, changes in value are largely a function of confidence in the coin and the network, supply and demand, and what the current purchase price(s) are on major exchanges as well as other inputs such as the cost/value of computing power for mining/maintaining the network, transaction fees used to reward miners, etc.
What Makes Bitcoin Special
Bitcoin was revolutionary when it first premiered due to the many different benefits it has over traditional currencies and other forms of payment currently in use. In brief, these benefits include:
- Decentralized – there is no government or bank/institution controlling the currency, manipulating prices/values or supply.
- Limited supply – as the pool of total Bitcoins is fixed at 21m, new coins cannot simply be created like traditional currencies, nor issued like new shares of stock in the case of stocks, thus avoiding inflation and/or devaluation.
- Anonymity – though not completely anonymous, the general information that is available to the world through the ledger is not immediately identifiable to an individual or organization – simply wallets and amounts of coins.
- Easy to use – compared to many “new” technologies, Bitcoin is fairly easy to use, with simple internet or mobile apps, and easy-to-use public exchanges online. It is no harder to use than Paypal or a credit card.
- Transparent – because all transactions exist on the ledger, and it is verified by distributed computing, everything is confirmable and available for verification, timestamped, and trackable.
- Fees – fees are relatively low compared to traditional means of payment, as, again, without a central authority and the requisite profits and overhead they require, it is simply a matter of incentivizing computer use for miners to validate transactions via processing power.
- Speed – there are no meaningful delays, post and holds, etc. like with traditional financial transactions. While not instant (blocks take about 10 minutes to post to the chain, specifically to allow for multiple verifications), it is much faster than the several hours to several days involved in traditional electronic funds transfers.
- Immutable/Non-Refundable – there is no authority to adjudicate or reverse transactions, which puts all users on an even playing field. This runs contrary to Paypal or credit cards, for example, who almost always favor a merchant or seller over a purchaser of goods or services, and often reverse transactions to their favor.
Why Do We Need Bitcoin?
Bitcoin, in addition to its fundamental advantages highlighted above, can provide a truly global payment and currency platform. It allows for decentralized means of storing and transferring wealth, without losses to middlemen, without government controls, and without being subjected to potential fluctuations from centralized control, such as printing more money, altering exchange rates with other currencies, etc. The only price fluctuations come from the pure action of the market and the valuation of the currency, not from artificially managed means.
Traditional merchant transactions with a credit card, for example, may cost the merchant 1-3% of the transaction price, as a fee paid to the credit card company. With Bitcoin, fees are variable and often track the price (e.g. they skyrocketed in January 2018 when the price of Bitcoin did likewise), but typically amount to $1 USD or less equivalency, and aren’t pegged to the value of the transaction itself.
Bitcoin Value and Price Growth
Bitcoin’s price and growth have been fairly flat for the majority of its life, up until the last 2 years or so. A lot of this was the function of the network population, merchant acceptability, and overall confidence in the coin and the network/marketplace. As mentioned earlier, these are fundamental aspects of determining Bitcoin’s value. As the number of users grows, and the number of merchants accepting payments or transactions in BTC increases, the coin becomes mainstream and its utility increases. Correspondingly, since the number of coins that can ever exist is finite, as more people use the coins, the demand increases, with a more-or-less fixed supply, meaning the value rises.
Recent price spikes in the 2017 and early 2018 period were largely aberrations caused by frenzy speculation across the entire cryptocurrency market. While the long-term forecast is for significant growth in the value of Bitcoin, the price spikes that have occurred, and subsequent corrections, can be compared to typical market and commodity price spikes and corrections in traditional investment markets.
Put another way, if someone invested $1,000 in BTC on the first trading day of January 2011, when it was still relatively new and not widely accepted, they would have been able to purchase approximately 3,225 coins. At the coin’s peak value in December 2017, these would have been worth upwards of $56m! Even after the price corrected, the value as of June 4, 2018, would still be over $24m, compared to their original value of $1,000 at time of purchase, an increase of 24,000x (2,400,000%)!
In conclusion, Bitcoin has proven to not only be a good investment but a real, viable cryptocurrency and network protocol that have opened up for secure, decentralized, transparent online transactions. If the promise of the Bitcoin technology, and the various children technologies that have developed from it, is realized, it will radically shift the way we purchase and pay for goods and services in the future. It will reduce governmental and monetary policy controls, reduce the “games” that are played by devaluing or issuing additional currency units, and provide faster, lower-cost transactions on a global scale.