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| The many sides of Bitcoin the electronic cash payment network and bitcoin the cryptocurrency |
Plastic (card) payments became mainstream over 50 years ago and digital payments, first introduced in 1990, for 25 years. Bitcoin, a revolutionary innovation in digital payments was introduced in 2009. The seven year old platform is a subject of much debate all over the world.
Bitcoin is a complex and innovative solution and there are many sides to it. Although spoken about as a currency, Bitcoin is actually a digital payments network which uses bitcoins as a currency.
Confusing? This article is a simplified introduction to the Bitcoin network. For those just in on the Bitcoin and blockchain world, this may be a good place to start.
Purpose of Bitcoin: Digital Payment Network and Currency
Bitcoin is an innovative digital payment network. A bitcoin in the system is an electronically generated coin and has no physical existence. Its value and function as money depends on the existence of the network.
Bitcoins are used as digital crypto-currency for making online payments through the Bitcoin system anywhere in the world. All bitcoins in existence and their transaction history is encoded into a single public digital ledger called the block chain. A block in the chain is an encrypted timestamped transaction record. A block contains reference to preceding transactions and payment destination.
A bitcoin payment is recorded by creating a new block. This process is called mining in Bitcoin. A transaction block is created automatically and, simultaneously verified by a peer to peer network of computers which collectively maintain the distributed public ledger. A transaction is not completed unless all peers automatically reach a consensus on its validity. Any attempt to spend the same money again is automatically rejected based on consensus rules (accepting earliest transaction, longest chain etc.).
Bitcoin differs from other digital payment systems in that the public block chain removes the need of trusted third party institution such as a financial intermediary or clearing house to certify the transaction and prevent double spending.
Bitcoins are not physical currency. Bitcoins are not recognized as "real" currency by many prevailing financial systems at present although this situation is gradually changing.
Bitcoins are used by their owners in the physical world for goods and services, and have become a part of the global economy. Businesses across the world accept bitcoins.
Bitcoins are used by their owners in the physical world for goods and services, and have become a part of the global economy. Businesses across the world accept bitcoins.
Bitcoins are not backed by any physical reserve (commodity such as gold or prevailing currency such as US dollars). Bitcoins be converted into physical currencies and vice versa through bitcoin exchanges.
Bitcoin is not owned or issued by any central authority, government, financial institution or business. It is an open source distributed system without ownership. Bitcoin is managed and operated by a worldwide community of developers and users.
Bitcoin is not owned or issued by any central authority, government, financial institution or business. It is an open source distributed system without ownership. Bitcoin is managed and operated by a worldwide community of developers and users.
The rate of supply and number of bitcoins generated is built into the system and cannot be changed. The Bitcoin platform is also designed to generate a finite number of coins and thus the currency is deflationary.
Bitcoins can be called the digital equivalent of gold.
Features of the Bitcoin System
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Bitcoin transactions are recorded on a single ledger and peer to peer payments can be made very quickly to anyone across the world. Transactions are recorded automatically by “miners” on the system who generate new blocks through a computing process called proof of work which is required to ensure that blockchain integrity is maintained (the process of mining and the rationale of proof of work will be covered separately).
The system is designed such that a miner generates the proof of work which others then verify through system based consensus rules. One miner does not necessarily mean one individual person. The overall process is designed such so that proof of work and up to six verifications can be completed in a period of 10 minutes after which the new block is added to the blockchain and the transaction is completed.
The system is designed such that a miner generates the proof of work which others then verify through system based consensus rules. One miner does not necessarily mean one individual person. The overall process is designed such so that proof of work and up to six verifications can be completed in a period of 10 minutes after which the new block is added to the blockchain and the transaction is completed.
The ledger grows as new blocks are added to the chain each referencing the previous block. The very first block in Bitcoin is known as genesis block. The blockchain structure also prevents automatic charge backs or reversals of a transaction.
Any person can send or receive payments using Bitcoin. Bitcoins move across virtual addresses generated by recipients for a transaction. Blocks in the chain are public and include the address and transaction value. There are no user identities in the system and participants remain anonymous.
The Tangible Value of Bitcoins
The Bitcoin payment system does not assign a unit monetary value to bitcoins. Bitcoins are not linked to or backed by prevailing commodities or currencies. There is a worldwide trading marketplace for bitcoins where coins can be exchanged for physical currencies. Bitcoin rates are driven by a mix of speculation and the organic growth of the system. Bitcoin trading dominates the headlines and will be covered in a post on the bitcoin ecosystem. As of start of February 2016, bitcoins are trading around $375 and have a market capitalization of $5.6 billion. There are over 15 million bitcoins in supply.
Bitcoin’s user base and transaction volume has been growing since its inception in 2009. Bitcoins have been used for physical goods and services since 2010.
In the section on Bitcoin myths, answering if bitcoins have no intrinsic worth, Bitcoin Wiki determines the intrinsic value of a bitcoin at $10,000 based on block chain application to electronic contracts and using electronic notarization fees as a measure.
The Innovations of Bitcoin
The idea of cryptocurrencies, distributed public ledgers and a computer based monetary systems had been in circulation since 1990s. The Bitcoin implementation is the most successful implementation of these ideas. Bitcoin has also introduced a number of disruptive innovations in the payments industry. The blockchain protocol is applicable to and can revolutionize contracts and record keeping. The economic principles behind the design of bitcoin have also made it an alternative asset class to government or central bank controlled fiat currencies.
Payments Innovation
A bitcoin payment takes places between two parties without a trusted third party required to certify and clear the transaction. The transaction is completed when the block chain is updated which is currently around 10 minutes. Bitcoin digital payments are the fastest means of transfer and have low transaction fees.
(Note that the Bitcoin protocol is not designed to scale inherently as volumes increase as does the block chain. Bitcoin's creator had made the assumption that computing capabilities will continue to increase in line with Moore’s law, to handle future requirements).
(Note that the Bitcoin protocol is not designed to scale inherently as volumes increase as does the block chain. Bitcoin's creator had made the assumption that computing capabilities will continue to increase in line with Moore’s law, to handle future requirements).
Seller Protection
Bitcoin payments are non-repudiable meaning once a bitcoin is paid, it cannot be refunded by a system charge back or reversal. The only way to receive a bitcoin in a disputed transaction is if the seller actually pays back the buyer.
Universal Digital Currency
A universal digital currency fits “naturally” into the digital payment ecosystem where transactions are cashless. A universal digital currency allows for low transaction fees and better portability in cross-border transactions.
Double spending
A dishonest buyer can potentially make payments to more than one seller before the transaction is completed. Bitcoin removes this issue by the block chain, where only block can be added. Peers who generate blocks have to follow set rules of consensus on proof of work ensuring further integrity of transactions.
Security
The Bitcoin block chain is computationally difficult to hack, destroy or tamper as a hacker would have to re-build the entire block chain to modify a transaction and all mining nodes would have to verify and agree on any changes. Bitcoin uses some of the strongest encryption techniques available today such as SHA256 algorithm in generation of the blocks, making them easy to verify but difficult to tamper, while bitcoin addresses use ESDCA public key cryptography.
Confidentiality
Bitcoins move across secure addresses in a transaction. A unique address can be used for every separate transaction. While addressees are public (in the block) only recipients who have the private key for the address can spend the bitcoins. The system thus provides anonymity and confidentiality. If a user loses private key for an address, the bitcoins are lost forever.
Bitcoin’s user anonymity has led to the (mis)use of bitcoins for transactions in illicit, illegal activities, which again has grabbed headlines and brought the system into conflict with governments and regulators across the world.
Bitcoin's impact on prevailing economic systems
Controlled Supply
The Bitcoin protocol is designed to generate a limited supply of coins, much like a natural resource. Bitcoin rewards (new coin generation) are halved every four years (or 210,000 blocks) by which estimates a maximum total of 21 million coins will be generated by 2140. One bitcoin is divisible into 100 million smaller units (the smallest unit is called a satoshi).
New bitcoins are also not generated at a uniform rate. The level of difficulty to solve the algorithm for block chains is adjusted every two weeks or when 2016 blocks are generated. If demand is high, the difficulty is increased and vice versa so that time taken to add new blocks stays at the 10 minute average.
Bitcoin’s limited and automatic supply generation ensures it is a deflationary currency i.e. its buying power increases with time.
Bitcoin’s limited and automatic supply generation ensures it is a deflationary currency i.e. its buying power increases with time.
De-centralized
Bitcoins are de-centralized and bitcoin value cannot be adjusted like fiat currencies controlled by central banks. This gives bitcoins an immunity from local and global events that can have major economic consequences. This includes (now frequent) bailout measures taken by central banks to "stimulate" economies and manage deficits by inflating currencies, eroding savings and creating future debt.
Alternative Asset Class
Bitcoins are increasingly being used as an alternative asset class in times of economic turmoil (such as Greece or war in Syria). Similar to gold, bitcoins are being treated by investors as a safe haven in times of economic instability.Summary
Bitcoin's high valuations, existence outside prevailing financial systems, investments into projects that would seemingly do the opposite, its emergence as an alternative asset class, de-centralized nature, mysterious inventor, emergence of new cryptocurrencies are all topics of discussion across the world.
The design ideas and working of Bitcoin are complex and fascinating and beyond the scope of this site to cover in great detail. Its constructs are designed to re-think how financial systems and economies operate. One can predict that the technology and ideas, and the creators of this system will have a major impact on the world.
The Bitcoin ecosystem and other cryptocurrencies to follow in future posts.
Bitcoin References
1. If you have to read only one article on Bitcoin, look no further than the original paper by Bitcoin inventor Satoshi Nakamoto.
2. Bitcoin Wiki is maintained by the bitcoin community of developers and users. It has separate sections on general descriptions, usage, technical specifications and FAQs .
3. Bitcoin.org the website originally launched by the Bitcoin creator, a go to resource for users and businesses.
The Bitcoin ecosystem and other cryptocurrencies to follow in future posts.
Bitcoin References
1. If you have to read only one article on Bitcoin, look no further than the original paper by Bitcoin inventor Satoshi Nakamoto.
2. Bitcoin Wiki is maintained by the bitcoin community of developers and users. It has separate sections on general descriptions, usage, technical specifications and FAQs .
3. Bitcoin.org the website originally launched by the Bitcoin creator, a go to resource for users and businesses.
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