Tuesday, November 6, 2018

Bitcoin 101

Bitcoin and bitcoin

Bitcoin has 2 distinctly different components that need to be described: 
  • "bitcoin" token - a snippet of code that represents ownership of a digital concept. Note: bitcoin with a lowercase b refers to the token or currency
  • "Bitcoin" protocol - a distributed network of nodes that maintain a ledger of balances of bitcoin tokens. Note: Bitcoin with a capital B refers to the protocol
Both are referred to as "bitcoin".

Note: The image shows bitcoin commemorative coins and are worthless - bitcoin is not a physical coin and cannot be stored in wallet... 

The Bitcoin protocol enables payments to be sent between users without passing through a central authority, such as a bank or payment gateway. This is often referred to as a Peer-to-Peer transaction. The financial transaction is created and held digitally. Bitcoins aren't printed, like fiat currencies. They are produced by computer nodes all around the world, using free open-source software. 

Bitcoin was the first working example of a cryptocurrency, an asset class that shares some characteristics of traditional currencies but is significantly different as will be described in more detail below. Verification of transactions is based on cryptography.

Who created it?

A pseudonymous software developer or developers going by the name of Satoshi Nakamoto proposed bitcoin in 2008, as an electronic payment system based on mathematical proof. The idea was to produce a means of exchange, independent of any central authority, that could be transferred electronically in a secure, verifiable and immutable (cannot be altered) way. There is still an ongoing healthy debate as to who Satoshi Nakamoto really is…

How does bitcoin differ from a traditional fiat currency?

As long as both the buying and selling party agrees to it, bitcoin can be used to purchase anything. In this way it can be seen as similar to fiat currencies like US dollars, euros or yen, which can also be traded digitally.

But it differs from fiat digital currencies in several key areas:

1 – Decentralization

One of bitcoin's most important characteristics is that operates on a decentralized platform. No single institution controls the bitcoin network. The Bitcoin protocol is maintained by a group of volunteer coders, and run by an open network of dedicated computers spread throughout the world. Bitcoin is not subject to government or financial institution meddling… The value of bitcoin is determined by traditional supply and demand principles.

Bitcoin solves the "double spending problem" of electronic currencies (in which digital assets can easily be copied and re-used) through an ingenious combination of cryptography and economic incentives. In electronic fiat currencies, this function is fulfilled by banks, which gives them control over the traditional system. With bitcoin, the integrity of the transactions is maintained by a distributed and open network, owned by no-one.

2 - Limited supply

Fiat currencies (dollars, euros, yen, etc.) have an unlimited supply – central banks can issue as many as they want, and can attempt to manipulate a currency's value relative to others. Holders of the currency (and especially citizens with little alternative) are held to ransom by these institutions. E.g. The Zimbabwean dollar, once equivalent to a US dollar, was completely delisted as the government made many ill-advised decisions leading to hyperinflation. Those folks that held their entire wealth in Zimbabwean dollars were left penniless thanks to a rogue government. Had they the option of holding bitcoin at the time they would have been immune to the recklessness of the Zimbabwean central authority.

With bitcoin, on the other hand, the supply is tightly controlled by the underlying algorithm. A small number of new bitcoins trickle out every hour, and will continue to do so at a diminishing rate until a maximum of 21 million has been reached. This makes bitcoin more attractive as an asset – in theory, if demand grows and the supply remains the same, the value will ultimately increase.

3 - Pseudonymity

While senders of traditional electronic payments are identified (for verification purposes, and to comply with anti-money laundering and other legislation), users of bitcoin in theory operate in semi-anonymity. Since there is no central "validator," users do not need to identify themselves when sending bitcoin to another user. When a transaction request is submitted, the protocol checks all previous transactions to confirm that the sender has the necessary bitcoin (the current balance must be greater than the transaction bitcoin amount) as well as the authority to send them. The system does not need to know his or her identity.

In practice, each user is identified by the address of his or her wallet. Transactions can, with some effort, be tracked this way. Don't think that your transactions are anonymous - There are algorithms and analytical tools out there that can link transactions to your identity…

Furthermore, most exchanges are required by law to perform identity checks on their customers before they are allowed to buy or sell bitcoin, facilitating another way that bitcoin usage can be tracked. Since the network is transparent, the progress of a particular transaction is visible to all.

This does not make bitcoin an ideal currency for criminals, terrorists or money-launderers. Once a criminal's address is made known it is possible for the Bitcoin developers to ensure that those funds can no longer be used or transferred.

4 - Immutability 

Unlike electronic fiat transactions, bitcoin transactions cannot be reversed or changed in any way. There is no central authority that can authorize an adjustment to a prior transaction. If a transaction is recorded on the Bitcoin network, and if more than an hour has passed, it is basically impossible to modify.

5 - Divisibility 

The smallest unit of a bitcoin is called a Satoshi (named for its inventor). It is one hundred millionth (8 significant decimals) of a bitcoin (0.00000001). At today's price 1 Satoshi is worth 6.5 thousandth of a cent… Or 1USD is worth 15,312 Santoshi's. This could conceivably enable microtransactions that traditional electronic money cannot.

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