A Beginners Guide to Bitcoin
Recently, a relatively niche branch of computing has become mainstream in everyday life. Cryptocurrency is a rapidly growing financial technology which utilizes the internet for everyday transactions, investing, and valuation. More specifically, a cryptocurrency known as Bitcoin has garnered the collection of many individuals including, but not limited to, Elon Musk and Bill Gates. However, even with the backing of tech moguls, there are still millions of people in the world who are either wholly unaware, ill-informed, or resentful towards this virtual currency. This article will illustrate how Bitcoin works and will demystify its relatively obscure background.
What is Bitcoin?
Bitcoin is a form of payment similar to the fiat currencies people utilize in various nations. Bitcoin, Ethereum, Litecoin, and 4000 other cryptocurrencies together create a market valued at over one trillion dollars, with Bitcoin constituting half of that. The cryptocurrency employs the use of a relatively new technology known as blockchain, which will be discussed later in the article. Blockchains cause cryptocurrencies like Bitcoin to become a decentralized, highly permissible, and very secure medium of exchange for the common consumer. Its creator, under the pseudonym Satoshi Nakamoto, is a Japanese programmer who created the virtual currency in 2009. Within Bitcoin’s original documentation, Nakamoto states the issue that “commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model.” (Nakamoto, 2008, p. 1) Therefore, using the new blockchain technology, Nakamoto created a “payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” (Nakamoto, 2008, p. 1)
What is a blockchain?
Before getting into the intricacies of Bitcoin and its value in the global economy, we first have to understand the basis upon which Bitcoin was founded: the blockchain. A blockchain is a system of chronological data consisting of transactions, withdrawals, and records. As the name implies, the blockchain is made up of individual blocks which allocate sets of data into a hash. The blocks containing hashes are then placed in chronological order starting with the very first set of data recorded for the blockchain. With this said, blockchain systems are recognized as highly distributed, permissible, and very secure forms of financial technology. Here’s why:
Distributed: Blockchains are decentralized, meaning there is no one computer controlling the string of transactions. They contain hundreds, sometimes thousands of collaborative computers - known as nodes - across the globe which all contain a copy of the blockchain history (For example, the Bitcoin blockchain recruits the use of over ten thousand of these nodes).
Permissible: Not only is most of blockchain transaction history available to the public, but the systems are also open source. This means that any person with a computer can take part in the development and writing of a blockchain’s code in a collaborative effort.
Secure: A blockchain’s main selling point is its security. As previously mentioned, each block in the chain contains what is known as a hash. The hash is an encrypted replacement of stored data. For example, if one block contains the sentence “dogs are loyal companions” and another contains “cats are sly companions,” a hash would return only the word “pet” for both. This way if a hacker were to observe the data within a block, visually, it would only contain the word “pet.” Typically, a hash encodes a large amount of data. In addition to the hash, blockchains use a chronological order of transactions to lock in past trades and confirm future ones. Each block not only contains the hash of its own data, but the hash of a previous block as well. This design works in conjunction with the fact that anytime someone tries to modify a hash—to change, delete, or relocate its contents—the hash of that block only will change. However, since the succeeding block contains the hash of the previous block, this invalidates the succeeding block and all subsequent blocks eventually kick the malicious node out of the system. In order to successfully edit the data, one would need either the consensus of all nodes which carry the blockchain transaction history and require 51% of 83,000 nodes to allow a change to occur or an unfathomable amount of allocated computational power to create or “mine” the new blocks replacing the corrupted ones. These factors are a testament to the incredible security a blockchain financial system offers.
Bitcoin’s Value
Bitcoins are created and valued through blockchain technologies, and this is done through the act of mining. Although this term may seem out of place in the realm of computers and cryptography, it is not entirely unsuitable. Mining is a relatively straightforward process involving the auditing of financial transactions and the computation of cryptographic math problems in order to create the blocks which constitute a blockchain. For Bitcoin’s blockchain, a miner is tasked with verifying one megabyte of transaction information and adding this block to the chain. In doing so, the miner is rewarded with a certain amount of Bitcoins. However, since the blockchain is public, miners need to compete to prove they compiled and verified this data. This process is known as the ‘Proof of Work’: it is a 64 digit hexadecimal value which creates a target hash that miners have to hit or get close to. Given that there are billions of possible hash values, this process could take up to ten minutes for a single computer. The process of mining rewards miners with Bitcoins which consequently adds to the supply of Bitcoin available. In addition to the process of mining, there are a few pre-programmed behaviors of Bitcoin which help either retain or increase its value over long periods of time. In the original coding of Bitcoin, Satoshi Nakamoto coded a caveat for miners: every 210 thousand blocks mined (or around every 4 years), the lottery size of Bitcoin mining will be cut in half. As of the most recent halving event, May 11, 2020, the current rate of Bitcoin mining is 6.25 BTC per block mined. In 2024, this rate will become 3.125 BTC per block and every subsequent milestone hit will halve the lottery size until it reaches zero. This halving event will lower the supply of Bitcoin as the rate of minting new coins decreases, increasing the currency’s scarcity and driving its price to higher levels. In addition to the halving, Bitcoin also has a perceived upper limit of 21 million coins due to the process. This transforms Bitcoin into an inflation hedge as eventually mining will cease, adding nothing to the supply of the cryptocurrency and lowering the inflation rate to an unseen zero percent. It is important to note that under current economic conditions, Bitcoin’s price is predicted to continue rising.As long as no anomalistic issues arise in Bitcoin’s existence, the currency will theoretically always possess value. Still, it is also crucial to remember that Bitcoin, like many other fiat currencies, is not backed by a commodity or resource; Bitcoin obtains its value through the trust of everyday consumers and speculative interest.
How to Use Bitcoin
Growing interest demonstrated by influential societal figures as well as the recent halving event in Bitcoin has spurred a large increase in mainstream popularity for currency and many other blockchain-based cryptocurrencies. Consumers from all over the world have found a purpose in Bitcoins in many ways. Here are three of the most popular uses:
Payment: Major companies in the technology industry such as Tesla, Microsoft and AT&T have accepted Bitcoin as payment for over half a decade already. Popular food chains are slowly following suit with KFC and Burger King, adding Bitcoin to their accepted payment methods.
Investing: Bitcoin is actively traded on many popular trading platforms including Robinhood, Binance, and Coinbase, the latter of which has over 13 million registered users. Because the supply and demand determines the value and price of Bitcoin on a given day, many dramatic rises in prices in short periods has fueled a large influx of interested traders. For example as of recently, Bitcoin’s price has risen from around $40,000 per coin just under $60,000 in just under three months’ time.
Exchanges: Not only is Bitcoin a store of value, but it is also readily exchanged on many popular trading platforms as well. It can be converted into other popular crypto currencies, carried in virtual Bitcoin wallets that transfer funds to bank accounts, and converted into the US Dollar, European Euro, British Pound, Japanese Yen among others. Rather than availing services of an exchange company, Bitcoin can act as a more versatile third party exchanging system.
In addition to these three uses for Bitcoin, one it’s most important features is its divisibility. Its smallest denomination, aptly named a Satoshi, is a hundred millionth of a single Bitcoin. This feature allows minute changes in prices or values to be accurately represented and shared while using Bitcoins. Another feature is its versatility. Since Bitcoin is a virtual currency, it can be transported anywhere in the world with just a phone. Although not every country accepts Bitcoin or any transaction involving the cryptocurrency, the exchanged currencies using Bitcoin are completely legal and provide an easy and safe form of payment for many traveling users.
Danger of Bitcoin
Despite the many positive benefits that Bitcoin provides, there are still drawbacks with its use. The foremost drawback is its extreme volatility as a currency. Bitcoin is not a government backed currency which means that the value of Bitcoin can fluctuate without the support of cash flow by the government or interest rate changes. It also means that the government and the IRS views Bitcoin as property. Since this property is actively traded and shared on public exchange platforms, Bitcoin is taxed by the IRS as an investment rather than a currency.
Bitcoin’s value is largely determined by the straightforward impacts of consumer supply and demand. Currently, a single Bitcoin commands a value of $45,000. However, this value is subject to sporadic change based on public perception and the sentiments held by consumers. For example, Tesla’s recent $1.5 billion investment into this cryptocurrency led Bitcoin to an increase in excess of $10,000 over a span of three days. This is shocking in comparison to the U.S. dollar, whose purchasing power has depreciated around $90 only. On top of a standard deviation of $1000 from a 5 day average, the volatility of Bitcoin is unparalleled by any other currency in the world.
Other than the fiscal aspects of Bitcoin’s potential dangers, there are also many social issues which create issues for Bitcoin holders. Cryptocurrency in general has risen in popularity greatly, but financial technology has not kept up to speed with this recent burst in usage. Converting Bitcoin (a virtual asset) into other assets such as physical cash or online credit is difficult because many companies and industries lack the supply to support transactions in Bitcoin. In doing so, large corporations would need to register in the Bitcoin blockchain system, a public network which could potentially harm company security.
Lastly, the creation of bitcoins, similar to the process of producing other digital or physical products, is not completely eco-friendly. Due to the large amount of computer power and capital required to mine and distribute the cryptocurrency, large quantities of carbon dioxide emit into the atmosphere as the byproduct of the energy expenditure for the computers working on the blockchain. The actual carbon emissions volume of mining bitcoin is relatively low compared to other processes such as driving a vehicle or creating plastic objects—just under 40 megatons every year. However, with the growing concerns about global warming as well as the popularizing of cryptocurrencies, any addition to the human carbon footprint will be massively detrimental to life on Earth as a whole.
Bitcoin has had a young and relatively uneventful history with its growth and development in the current day financial market is unprecedented and new to many consumers like you or me. However, given that society normalizes the use of blockchain currencies, popularizing their rise, it becomes inevitable that bitcoin will homogenize within human culture as a precious commodity.
Written by Christopher Yang, Undergraduate Economics Student