How Does Bitcoin Work?

By now, you have surely heard of bitcoin.

Bitcoin attracted a lot of attention back in 2017, when the price went from about US$1,000 up to almost US$20,000. That´s a 1,900% gain!

Bitcoin is one of the 1600-plus cryptocurrencies in existence today. A cryptocurrency is money that exists and transacts only in digital form.

But apart from being a digital currency, bitcoin is also a payment system. Bitcoin allows you to send payments from one person to another.

The thing that makes bitcoin different to other world currencies like the Australian dollar or the euro is that it is a decentralised system. And bitcoin achieves this truly decentralised system through blockchain technology.

In the traditional banking system, each commercial bank has its own ledger. They share this ledger with the central bank, which oversees a commercial bank’s transactions.

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With bitcoin, payments between users don’t go through a central and trusted authority, like a bank. Instead, there is only one ledger — the blockchain. The blockchain is essentially a shared public ledger — a database that every member of the network can see and contribute to, which records and holds every transaction.

Blockchain allows us to transfer value over the internet without the need of a middleman. Because the ledger is open and shared, nobody can change it without other users noticing. That’s why, to date, no one has been able to hack bitcoin.

The creator of bitcoin is Satoshi Nakamoto. The name though, is a pseudonym… nobody really knows who the true creator is.

Satoshi created the digital currency as a response to the 2007 crisis. How do we know this? Well, there was a bit of text written on the genesis block — that is, the first block (block zero) — of the chain. It said:

The Times, 03/Jan/09, Chancellor on brink of second bailout for banks.

This was the headline of The Times on the day the genesis block was created. It is most likely there as a time stamp…and to remark on the instability created by central banks when they lowered interest rates to zero and pumped cash into the system.

Bitcoin is borderless, anonymous and scarce.

Why is bitcoin’s scarcity so interesting?

Bitcoin price rise

Because when we talk about digital, we always think of unlimited resources.

Take the publishing business, for example.

For a publisher to print new books, it takes a lot of money, time and effort. The number of books they can sell is limited by the amount they print. Once all the books are done, they can’t sell anymore until they print another batch.

Yet things changed massively with eBooks.

They are available instantly, and are easy and cheap to duplicate. And with eBooks, there are no limits to how many you can sell. There are no concerns with storage either.

Scarcity has never been applied to the digital world. Digital files can be duplicated, downloaded or even streamed from any corner around the world. That is, until bitcoin.

Bitcoins are not printed or created with a few keystrokes. 

They are generated by people known as ‘miners’. To mine bitcoin, you don´t use a pick and shovel. Instead, it requires a powerful computer and huge amounts of electricity. The computer needs to solve difficult mathematical puzzles at high speeds to generate bitcoin.

Bitcoin supply is limited. The number of expected bitcoins in existence will never pass 21 million. That’s it.

And the more bitcoin that gets mined, the harder it is to find as time goes by. That´s where bitcoin gets some of its value, because there is a limited supply of them.

Another interesting thing about bitcoin is that, unlike our current banking system, it is not based on debt. That’s right; no one owes anyone anything.

You see, in our current monetary system, commercial banks create money by lending it out. When you deposit your money in the bank, the bank keeps a part of it. Banks are required to hold a fraction of their deposits, something that is called fractional reserve banking.

They then loan out the rest.

When they lend this money out, they don´t take it out of your savings and give it to the borrower. Instead, with a few keystrokes, your money stays in your account and the borrower receives their loan. This is how commercial banks create new money. The money supply expands when banks give out debt.

The problem is that this leaves the whole system exposed if there is a loss in confidence. That is, if everyone went to the bank at the same time to ask for their money, the bank would not have enough cash to honour the deposits it holds. It would have to default.

Cryptocurrencies are different, as they are not based on debt. When you own a bitcoin, it’s yours, and you can do as you please with it. You own it, and no one else can use it to create or lend out money.

That’s why bitcoin is also getting a rep as the go-to currency when things get tough. It is an alternative financial system to our current one.

The fact is, bitcoin thrives on crisis and uncertainty

More to Bitcoin than just it's price

It rallied during Brexit fears and during the Cypriot bank bail in. It is popular in places suffering economic turmoil like Venezuela.

Venezuela has the highest inflation rate in the world. Things have become so bad, that people have stopped counting money and are instead weighing it!

However, there are also some concerns about digital currencies.

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As bitcoin has been getting more popular, it has struggled with scaling and its ability to process transactions.

It is also highly volatile, which can mean big gains or losses in a very short time.

And it is hard to store. You need a digital wallet to store bitcoin and must have some technical knowledge to keep your bitcoins safe.

Since its creation, bitcoin has been dividing the financial community.

Is it a bubble? Or, an investment opportunity?

Your guess, dear reader, is as good as ours. But, it is certainly something to consider.

You can read all of our latest articles on bitcoin and blockchain here.

Regards,

Selva Freigedo,
For Markets & Money

Markets & Money