What Are Bitcoin and How Do They Work?

Michael Zajac

What makes Bitcoin and the
blockchain novel and important?

Bitcoin is a few firsts. Bitcoin was the first cryptocurrency, created by a mysterious person (or group) with the pen name Satoshi Nakamoto, who wrote the now famous“Bitcoin: A Peer-to-Peer Electronic Cash System.” A cryptocurrency, also called a crypto, is a digital currency that can be used like other currencies to buy goods and services; however, cryptos use an online ledger with strong cryptography to secure transactions.

Bitcoin was also the first application to use the Blockchain, which is the fundamentalbuilding block of any crypto. The Blockchain is a system of thousands of computers linked in a peer-to-peer network which maintains the record of transactions made inBitcoin; in Bitcoins case, when and how much of the currency was sent and received.

Double spending

Because of their digital nature, a crypto could potentially be copied by a savvy criminal and spent a second time or simultaneously as perfect copy of the original. Physical currencies cannot usually be perfectly copied or easily counterfeited and soin fewer cases suffer from this issue. Parties involved in standard bank-to-bank transactions can also verify the authenticity and previous ownership of a physical currency represented electronically.

Distributed Ledger

Bitcoin solved double spening with its distributed ledger. A distributed ledger is a database shared consensually and synchronized across multiple sites/geographies which allows transactions to have multiple public "witnesses". Prior to distributed ledgers there was always a central clearing center that could be either attacked or circumvented. Bitcoin’s accuracy is constantly being verified by a huge amount of computing power and the list of transactions embedded in the blockchain enables anonymous payments to be made securely between digital wallets of people who don’t need to know each other. Distributed ledgers don’t require a third-party verifier like a bank or credit card company. Adding cryptography to the network means that payments via a blockchain and its distributed ledger potentially have more security than standard debit/credit card transactions. When making a Bitcoin payment no sensitive financial information needs to be provided, lowering the risk of identity theft.

Known inflation that stops eventually

The other important attribute of Bitcoin is that there will only be 21 million total Bitcoins produced ever. This happens over a defined number of years(ending in 2140) and once complete will prevent its future inflation. With fiat currency a
country’s central bank can decide if and when to produce more currency with no limits to its total supply. This increase in the total money supply means that the prices of other goods will always increase in price due to inflation. Bitcoin’s limited supply allows it to resist this inflation. Bitcoin is slowly produced through “mining” which is a process of resolving transactions on the blockchain and this process is compensated with the new Bitcoins produced. After all are produced transactions will compensated with fees.

What is Bitcoin Used for?

Because of these attributes there are two general things that Bitcoin is used for. First like all currencies it is a mode of exchange. Rather than bartering one item foranother we use currency in the place of bartered goods with a defined value to trade with. Because there is no need for a bank to be involved the fees for these transactions are less, especially for any international transfers.

Second Bitcoin is used as a Store of Value(SoA) the most common store of value over the years has been gold. Gold has a finite amount that is either above or below ground and there will never been more than this (similar to Bitcoin).

Owners of Bitcoin believe that by being resistant to inflation and having other positive attributes Bitcoin’s value will increase relative to the dollar and they theirfore will covert their dollars or other fiat currency to Bitcoin in order to take advantage of this.

What are the drawbacks of Bitcoin?

The main drawbacks of Bitcoin are that:
  • Bitcoin is is yet to be widely accepted as a mode of commerce, and in fact some countries ban Bitcoin’s (and other cryptos) use. 
  • Because of regulatory issues and a relatively small market the price volatility of Bitcoin to the USD can be significant and trading is still speculative.
  • The energy requirements to keep the network up are significant.
  • Ledger checks are done every 15 mintues which is insufficient and causing bottlenecks.
  • Too anonymous, leading to problems of acceptance by countries and potential self reulation.

Where are the Blockchain and cryptos going in the future?

The use of Bitcoin and other cryptos continues to grow. In the future this may become a standard payment system. As newer cryptos have been created, their functionality has increased, and they have attempted to improve on Bitcoins faults. The most important evolution is that of smart contracts (sometimes called Dapps). Smart contracts add, to the functionality of a crypto, the ability to execute more than the transfer of money but other digital transactions. If I put the digital deed to my house in a smart contract a buyer can supply $250,000 worth of Bitcoin and the deed will be instantly and automatically be released to the buyer. If they supply insufficient funds they will not receive the deed. Smart contracts remove the need for a middle man who charges fees for surety and escrow. This type of transaction is the basis of Distributed Finance or DiFi.

Summary

Bitcoin is a useful beginning to the crypto world. It has several novel features not before seen that make it valuable however there are some limitations that have been solved by other cryptos. Going forward the acceptance of Bitcoin may increase but for the time being it still remains a fairly risky investment. If you would like more information about how best to invest in Bitcoin Click HERE

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