Cryptos in general and Bitcoin, in particular, are very confusing to most people, and for good reason. For openers, it is a very new concept. In addition, Bitcoin is not something you can pick up and touch. It is something out of the Matrix (the movie) where it is a currency that exists in the virtual world, not the real world as we know it.
To properly address the concept of bitcoin, it is useful to separate it into its two component parts. On the one hand, you have bitcoin-the-token. It is a snippet of computer code that represents ownership of a digital concept. Think of it as a virtual IOU. On the other hand, there is the bitcoin-the-protocol. The protocol a distributed network that maintains a ledger of balances of bitcoin-the-token. While these are desperately different concepts, both are referred to as “bitcoin.”
The distributed network enables users to send payments without passing through a central authority, such as a bank or payment gateway (PayPal, Visa, Mastercard, etc.) Bitcoin is created and held electronically. Bitcoins are not coined or printed, like dollars or euros – they’re produced by computers all around the world, using free software. There is no coin such as nickels or quarters. These are just analogies.
Bitcoin is the first example of what we call cryptocurrencies. Cryptos are a growing asset class that shares some characteristics of traditional currencies, but unique features such as verification based on cryptography.
Bitcoin was created by a pseudonymous software developer going by the name of Satoshi Nakamoto. He 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 way. While some people like John McAfee know who he is, we are not sure who Satoshi Nakamoto really is.
Bitcoin can be used to pay for things electronically, just like you might do by using a credit card on a retailers website. But when using a cryptocurrency, the value does not have to pass through the hands of a financial institution on its way to its final destination. So in some sense, cryptos currencies in general and bitcoin, in particular, are like conventional dollars, euros, or yen, which are also traded digitally.
But it differs from fiat digital currencies in several important ways:
- Decentralization – Bitcoin’s most important characteristic is that it is decentralized. No single institution controls the bitcoin network. The network is maintained by a group of volunteer open source coders and computer programmers. It is run by an open network of dedicated computers spread around the world. This attracts individuals and groups that are uncomfortable with the control that banks or government institutions have over their money. Anyone can run a “node” on the network. All you have to do is download the software from Bitcoin.Org
- Double Spend. – Bitcoin solves the “double spending problem” of electronic currencies. This problem arises when there is not one centralized ledger that shows who owns what. In traditional systems of electronic fiat currencies, the maintenance of a ledger is fulfilled by banks, which gives them control over the traditional system. In the world of Bitcoin, anyone and everyone can have a copy of the ledger. In such a world, it is possible and even quite probably that everyone’s ledger does not agree on who owns what because the various ledgers may not be up to date. This challenge is solved through an ingenious combination of cryptography and economic incentives. Once everyone’s ledgers come into an agreement of ownership, a transaction can take place. This process maintains the integrity of the transactions any anyone can see the transaction.
- Limited supply. – There is potentially an unlimited supply of fiat currencies. Central banks and governments can issue as much money as they want, and indeed they do. This manipulation of supply influences the value of the currency. We witness the effect of this money printing with price inflation. That is to say, we wee prices rise. Those who hold the currency, lose purchasing power. With bitcoin, on the other hand, the supply is tightly controlled by the underlying algorithm. A small number of new bitcoins come into existence out every hour and will continue to do so at a diminishing rate until a maximum of 21 million coins has been produced. Since bitcoin cannot be hyperinflated, it is theoretically more attractive as an asset.
- Pseudonymity. – While senders of traditional electronic payments are usually identified. Verification of counterparties is necessary to comply with anti-money laundering, tax, and other financial regulations. Transactors of bitcoin, in theory, operate in semi-anonymity. Since there is no central actor to validate individuals or companies that what to transact. In the crypto world, 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 as well as the authority to send them. The network 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. Also, law enforcement has developed methods to identify users if necessary. 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 makes bitcoin not an ideal currency for criminals, terrorists or money-launderers.
- Immutability. – Unlike electronic fiat currency transactions, Bitcoin transactions cannot be reversed. This occurs because there is no central “adjudicator” that can say “ok, return the money.” If a transaction is recorded on the network, and if more than an hour has passed, it is impossible to modify. Some may find this disquieting. But it has a big positive feature. Any transaction on the bitcoin network cannot be tampered with.
- Divisibility. – The smallest unit of a bitcoin is called a satoshi. It is one hundred millionth of a bitcoin (0.00000001). This could conceivably enable microtransactions that traditional electronic money cannot.