What is Bitcoin and How Does It Work?
Its official, 2017 was the year of the Bitcoin as the digital currency garnered a lot of media attention. Both Wall Street and Main Street investors alike turned their heads to the cryptocurrency markets as the word “Bitcoin” seemed to be in every news article and on the tip of every one’s lounge. This awareness reached a fever pitch in late quarter 4 2017 and into the beginning of 2018, causing the price of Bitcoin to skyrocket above $20,000 USD. With such a rush of attention came a wave of new potential crypto investors who have been all asking “What is Bitcoin and How Does It Work”?
The Legend of Bitcoin
Bitcoin is the first, most widely known and most valuable cryptocurrency. While there are now many cryptocurrencies with all kinds of use cases, Bitcoin continues to focus on its primary application of providing a store of value and to increase the efficiency of exchange in financial transactions.
The Bitcoin white paper was proposed in a 2008 by an anonymous person (or persons) who goes by the alias of Satoshi Nakamoto. Legend has it that since Satoshi was the creator of Bitcoin, he (or they) were the first to be aware of its existence. It is believed that they were the first to mine Bitcoin and are now in possession of approximately 1 million (read more about mining below).
The main cause for this speculation is largely because there is an anonymous wallet address on the Bitcoin Blockchain that is actually in possession of 1 Million Bitcoin; and putting two and two together, people believe that several Billion dollar fortune to be Satoshi’s. However, there are many who are of the opinion that Satoshi may not still be alive. The smallest unit of Bitcoin is called a satoshi (a hundredth of a millionth of a Bitcoin) in honor of this mysterious figure.
After a year the Bitcoin Blockchain was released in 2009 and that is when the development of the Bitcoin and cryptocurrency ecosystem began to take off.
Around the time of Bitcoin’s launch, the Great Recession had just occurred. Snowballing from the subprime mortgage crisis and turning into a full-fledged international banking crisis avalanche; the world economy was in shambles and was sitting on the brink of collapse.
The public, not understanding how or why such irresponsibility was allowed to take place in such a vital sector of the economy, lost trust in financial institutions all over the world. The U.S. government was bailing out large corporations/banks in various industries with taxpayers’ money under the guise of “keeping the economy afloat”–to much public scrutiny.
There was a growing disgust with the government’s hand in and manipulation of the monetary system. This was the philosophical backdrop that led to the creation of Bitcoin. Bitcoin, being completely decentralized, was designed to be free of the manipulations that are common to fiat currencies like the U.S. dollar and the Euro. A fixed deflationary currency that takes the power away from governments/corporations and places it back in the hands of the people.
How Does Bitcoin Work?
Bitcoin relies on an innovative technology called “Blockchain“. This Blockchain is an open public ledger that is shared among different computers scattered all over the globe, commonly referred to as nodes. This distributed ledger stores all the transactions that occur on the network; meaning, the Bitcoin blockchain is a trust less system because all send and receive transactions can be viewed by anyone at any time.
A Decentralized Network
Because Bitcoin has no central authority or issuer, all decisions on the Bitcoin blockchain are made by consensus of the nodes. That is, 51% of the nodes must agree in order for a transaction to be valid. This makes the Bitcoin network more robust against fraud or other malicious attacks than if the ledger was held in only one location.
Attackers with malicious intent might concentrate their focus to gain control of one node, but that is simply is not enough. They would have to gain control a total of 51% of the nodes to be able to manipulate the entire network; which would cost up to the tune of several billion dollars and has never been achieved before. This decentralization also democratizes the control of Bitcoin among those who control the nodes; preventing a central controlling authority from calling the shots and allowing the voice of many to determine the future path of the Bitcoins development.
Transactions are Verified by Miners
Transactions on the network are verified by nodes which are referred to as “miners”. These miners solve cryptographic problems using specific computer hardware (or a mining rig) that verifies the transaction being sent on the Bitcoin Blockchain.
This scheme of using the solution to cryptographic problems that are hard to solve but easy to verify is known as proof-of-work (which is a method of securing the blockchain and processing the transactions that occur it). In essence; this process verifies transactions and ensures that no double-spending takes place (spending the same Bitcoin twice). The fees paid by Bitcoin users when they submit a transaction on the blockchain go to these Bitcoin miners to incentivize them to continue verifying transactions.
Miners Verify Transactions in Exchange for Fees
Miners also mine new Bitcoins into existence by solving these cryptographic problems on new blocks of the blockchain. The difficulty of these problems and the reward for solving them vary according to the mining output to keep the supply of new Bitcoin at a constant rate.
The supply of Bitcoin is capped at 21 million, after which point the network will compensate miners for verifying transactions only (estimated to take place around the year 2140 based on the Bitcoin Halving schedule). Because the cryptographic problems that these nodes solve can be extremely resource-intensive, the hardware required for Bitcoin mining can be quite expensive both in terms of the hardware itself and the electricity required. On average, it cost miners approximately $1,000 USD in electricity costs in order to mine one Bitcoin; that cost is expected to increase dramatically over time.
The Bitcoin Reward Halving
Within Bitcoin’s code there is a requirement that every time 210,000 blocks are mined the new amount of Bitcoin that is created will be cut in half (thus the term “reward halving” or “halvening”); this event occurs roughly ever 4 years. This is made possible by the hard cap on total supply of Bitcoin that can ever exist.
During Bitcoin’s launch in 2009 miners were initially receiving 50 Bitcoin per block mined (equating to 10,500,000 Bitcoin being produced in the first 4 years of the cryptocurrency’s existence). A second halving occurred in 2012 and reduced the amount of newly created coins to 25 Bitcoin per block (meaning 5,250,000 Bitcoins over the course of 2012 to 2016).
The third halving occurred at the tail end on 2016 and further reduced the newly created supply to 12.5 coins per block mined (bringing the newly created Bitcoin count to only 2,625,000 coins between the years 2016 to 2020). The next Bitcoin halving is set for 2020 and the reduction of the newly created Bitcoin between 2020 and 2024 will be brought to a meager 6.25 per block mined (equating to 1,312,500 Bitcoin over 4 years).
There is one thing for certain, as you can see with the ever dwindling supply), there will never be more Bitcoin then there is right now. Check out our sweet graphic below to better understand just how scarce Bitcoin will be in the coming years.
Bitcoin is More Rare Than Gold
As dictated by Bitcoin’s code, assuming not one coin is lost, there will only ever be 21 million Bitcoins in circulation. As time marches on, given the coin’s efficiency in financial transactions, the demand for Bitcoin will increase as the newly minted amount of coins decrease; this is a recipe for the greatest short squeeze (demand greater than supply) that the world has ever known.
Bitcoin’s older decentralized brother, gold, shares many of the same properties as cryptocurrency and has been the safe haven asset for countless civilizations for thousands of years. According to Thomson Reuters gold survey there is an estimated 171,300 tons of gold on planet Earth which comes out to a whopping 5.5 billion ounces.
To help put it in perspective, at the time of writing this article, there is roughly 7.6 billion people on this planet. Imagine if all the gold was distributed evenly among us.that would mean each person would receive .72 ounces of gold. Should the same be done with Bitcoin each person would receive 0.003 BTC. With such a small supply spread across such a large amount of people it is no wonder why Bitcoin is being labeled as the “ultimate deflationary asset”.
Hard to Track, Yes, But Not Impossible
Bitcoin users send and receive Bitcoin through software called wallets. These wallets generate an address for the user that is used to reference them in transactions. While this does prevent a user’s identity from being explicitly associated with a transaction, it does not prevent someone from being identified. Click here to learn more about software wallets or read our Keepkey and Ledger Nano S wallet reviews.
The address is essentially a pseudonym. Therefore, transactions on the Bitcoin blockchain are said to be pseudonymous, rather than anonymous. It is possible, though quite difficult and time-consuming, to track down who an address is associated with. This pseudonymity also ties into the philosophy behind Bitcoin, offering some degree of privacy from government surveillance.
With that said, Amazon was awarded a patent to analyze the Bitcoin Blockchain. This method allows Amazon to match up transactions/wallet addresses with the individuals that made them and allows them to sell that information to government agencies (big brother much?).
Bitcoin as Investment Vs a Means of Exchange
There is two schools of thought within the Bitcoin community; those that value the coin for its investment potential and those that value it as a means of exchange. There are still many purists who decry the growing perception of Bitcoin as an investment instrument as opposed to a digital currency for the buying and selling of goods and services.
These two camps clash at times, with those users who value Bitcoin as a currency blaming those who value Bitcoin as a means of speculation for causing the wild volatility in Bitcoin’s price. However, what they both fail to see is that Bitcoin is not one or the other; it is both an explosive investment vehicle and a revolutionary means of exchange. The volatility that has been experienced is normal and is simply the market trying to find fair value for this new technology.
It’s Only A Matter Of Time
As the first cryptocurrency and the one that the media and the popular imagination has latched onto, Bitcoin is something of a standard-bearer for cryptocurrencies in general. As blockchain technology begins to make serious inroads in the supply chain management and other fields, people will begin to trust blockchain technology more and more and this will give more popularity to cryptocurrencies in general and Bitcoin in particular.
As time progresses, traditional financial institution (such as Goldman Sachs, JP Morgan Chase, NASDAQ, the New York Stock exchange, etc) have taken more and more of an interest in Bitcoin. Long-standing questions of legality and regulation for Bitcoin and cryptocurrency in general are slowly being answered by courts and government officials.
The regulatory stances of the world’s governments are becoming clearer and with that clarity comes stability and maturity. Though some governments have provided a negative stance toward Bitcoin and cryptocurrency, their stance was previously unknown until recently. All camps of thought can agree that even with some regulation, Bitcoin will be a more stable and successful investment vehicle than it would be while operating in a fog of confusion.