In just one year Bitcoin’s value has risen over 1500% (no that’s not a typo), so it’s no wonder everyone is really interested in learning more about it.Unfortunately, most articles about Bitcoin these days are overly complex and still leave readers with more questions about what it actually is and why it has value. This article is meant to change that.
The Distributed Ledger
To really grasp Bitcoin and cryptocurrencies in general you have to first have an understanding of the blockchain. The blockchain is the underlying technology that drives bitcoin and all cryptocurrencies, but at its core has nothing to do with currency specifically.
The blockchain in the most simple terms is a ledger — a record of transactions. More specifically it is a ledger that is distributed, verifiable, and immutable.
The primary reason for the creation of the blockchain was to remove third parties from transactions that should be peer to peer. When third parties are involved they control the central store of data and can compromise the integrity of that data. Additionally, they can impose unnecessary fees on transactions between individuals.
For instance — if Alice and Bob do not know each other and do not trust each other, but want to make an exchange of assets they have to rely on a trusted third party. Let’s call that third party Eve. Alice and Bob use Eve as an intermediary. Eve controls the entire flow of the transaction.
The assets involved in these transactions can be anything — from currency, to deeds, to wills and trusts, etc… Eve can impose fees on both Alice and Bob for making the transaction through her. Eve can also modify the details and record of the transaction if she chooses to, so Alice and Bob are left just having to trust that Eve will do the right thing and will never be compromised.
The blockchain is a distributed ledger that solves these issues. It allows individuals who do not trust each other to exchange assets without having to rely on a third party. Every participant in the blockchain maintains a copy of this ledger and every verified transaction that occurs on the blockchain is sent to every copy of the ledger.
Verification & Mining
Verification is the most important part of the blockchain. This ensures that only valid transactions make it onto the ledger and that no transaction can be removed from the ledger. This verification happens by multiple participants of the blockchain performing a computationally hard math problem and arriving at a consensus of what transactions actually happened. This process is known as “mining”.
If a majority of participants agree on what happened that action is added to the ledger and distributed to every other participant. Here’s a quick example of how the blockchain handles this:
Alice, Bob, and Eve are participants and “miners” on the blockchain.
New transactions occur on the blockchain and Alice, Bob, and Eve each receive those transactions. Each of them runs a verification function on the transactions. Alice and Bob both compute the answer A.
Eve, however, tries to modify the ledger and computes answer B. Because both Alice and Bob computed the same answer, that set of transactions is chosen as the set of valid transactions and is distributed to every participant of this blockchain. Majority rules. In practice this verification happens with many more miners. There are estimated to be 150,000 miners.
Bitcoin and the Blockchain
This is where bitcoin comes from. Bitcoin was created in order to give individuals incentives to verify (or “mine”) the ledger. Participants are providing resources from their computers to verify transactions and over time these verification tasks become harder. This expends energy and power on the computing resources.
Bitcoin was the “currency” in which participants were paid for their part in verifying the ledger. Initially individuals only exchanged this currency for other digital goods. Bitcoin can be given or received in any fraction of a value (for instance 0.00132596 BTC).
One other interesting facet of the blockchain is that while the ledger is public, the transactions are effectively anonymous as the transactions only indicate wallet IDs which are text values that look like this: 1Kr6QSydW9bFQG1mXiPNNu6WpJGmUa9i1g. Only the individual with the corresponding “key” for that particular wallet can access its contents.
Because of this anonymity factor, for a time, bitcoin was primarily used for illicit activities (purchasing drugs, hitmen, hackers, etc…). There was an online black market known as the Silk Road that relied on bitcoin for anonymous transactions.
The Value of Bitcoin
On May 22, 2010 one participant paid another 10,000 bitcoin for 2 Papa John’s pizzas. This is now known as Bitcoin Pizza Day. At the time, this equated to $25. At today’s exchange rates, it’s about $150M. Today, a large number of businesses accept bitcoins as a valid form of payment.
Because of the way the blockchain was designed, there will only ever be 21M bitcoins in circulation and those bitcoins must all be mined. As time goes on, mining these bitcoins becomes much harder which increases the value of an individual bitcoin (Today at ~$15,500 USD). There are currently 16.8M bitcoins in circulation.
The fact that there are a predetermined number of bitcoins that will ever be in existence significantly decreases the adverse affects that inflation can have on its value. As the value of individual coins increases, few people will hold a whole bitcoin and will leverage the currency using fractions of whole bitcoins.
The value of bitcoin at any given time is a function of supply, demand, and speculation on its future worth. In a way, bitcoin is only valuable because individuals believe it is valuable. Like all currencies, people can only trade with it because other parties want it and believe it has value. Some individuals believe bitcoin will become the only currency in the world. Others are interested because it is popular at the moment, which continues to drive it’s popularity, and thus its value.
Because of this interest by individuals that don’t understand it, bitcoin is extremely volatile. Individuals that only trade in bitcoin, rather than leveraging it as a currency treat it like a commodity — which it is not. If bitcoin is accepted as a standard currency at some point in the future, it will continue to thrive and grow in value. If individuals continue to treat it like a commodity, it will continue to be very volatile and the value may very well go to zero at some point.