By Deepak Machado (@dpkmac)
In the previous part of the series, we learned the basic qualities of money and how it evolves. In this part of the series I will explain,
* What is bitcoin?
* How bitcoin works?
* What gives value to bitcoin?
What is bitcoin?
Before getting into defining what is bitcoin, it is better to understand the background as to why bitcoin was invented in the first place. You definitely have heard about the 2008 recession that shook the biggest of the financial institutions throughout the world. But the fact that may not be known to most readers is that this was exacerbated by the aggressive risk taking by banks.
Banks by virtue of design operate on a something called fractional reserve system. For example, if you deposit 10,000 rupees (or dollars), banks would hold 1,000 ruppes with them or with central bank (depending on the cash reserve ratio) and lend the rest 9,000 rupees or invest it. If banks lend 9,000 rupees of your 10,000 rupees, your bank balance is 10,000 rupees and the bank balance of the borrower is 9,000 rupees; so the total money available now is 19,000 rupees. Now replicate this over millions of individuals.
Even many literate among us find it hard to comprehend this. I being an ex-banker, knew it only recently when I started reading more about monetary policies. Money is created with click of a button. This creation of new money coupled with the quantitative easing (just a jargon for free printing of money), gives rise to inflation. This increased inflation results in general increase in the price of goods and services. Your 1,000 rupees this year will lose its value in the coming years, precisely due to inflation. Just think, why is there general rise in the prices of goods and services every year? Why isn’t there a control on this?
Going back to our example, what if one fine day all the depositors landed up on the bank to seek their deposits back? This is called the bank run and this is precisely what has happened in many parts of the world, especially in countries like Cyprus, Greece etc. Governments guarantee deposits up to a certain amount. The situation becomes severe if the banks face defaults from borrowers, eventually going bankrupt with depositors losing their hard earned money. Thus creating a havoc in the economy and consumer confidence.
Lucky that India has a prudent governance model under RBI (Reserve Bank of India) that our monetary policies are closely monitored. But the lure of easy money is hard to let go. Despite this, look at the situation of public sector banks which are currently reeling under NPAs that have become a headache for the government and RBI. This kind of situation becomes a burden on taxpayer money, which would be routed to save these banks from collapse. The opportunity cost here is too much to talk about. Imagine incompetent governments like in Venezuela or Zimbabwe or Argentina. Their currencies are under hyperinflation taking down the savings, deposits and bankrupting the country. I recently read, if you had saved 1 million $ in Venezuelan Bolivar a year ago, it would be roughly 4 $ today. By printing more and more currency, the government is only reducing the value of the existing currency in circulation. Even the mighty US$ is not immune to this. In the first decade of its existence, US$ was 10 times more volatile than bitcoin today.
Fiat currencies are manipulated by governments as they wish, printing excessive amounts, controlling the circulation, controlling the interest rates and so on. These are controlled by one single entity. Too much power wielded by a single authority. When more money is printed, the existing units would be less valuable. This is true with anything for that matter, more so for currencies. The result of this is a high inflation leading to, as I have already mentioned, rise in the prices of goods and services plus, reducing the value of the existing units.
Gold, on the other hand had no central authority, it could not be created out of thin air and was most suitable as a form of currency and store of value. The new stock coming into circulation is limited. Nobody can influence the amount of gold that is available and it can not be inflated. It only makes sense why in India gold is revered as the ultimate store of value. We buy it, we gift it, it is part of our culture, our religious practices. In short, we believe in the inherent quality and scarcity of gold which makes for a great store of value over long periods of time.
But gold, has one important drawback. It is not practical to use it as currency. You can not walk into a store a say that you will pay in gold. That may create problems for you and the store owner. Since the end of gold standard, the importance of gold as a reserve has reduced although many countries still hold huge amounts of gold. Adding to this, the attempts to confiscate gold by by governments is well documents in the pages of history, including in India. Gold is not an effective currency for all practical reasons.
There have been calls from several front to move the control of money/currency from under government control. The value of a currency is quite dependent on the sovereignty of the nation issuing it. And many considered this a great risk.
What’s the solution?
The solution is something that is decentralised and which can store value. And I believe bitcoin suits the bill on all fronts. It is decentralised, meaning no one party, company, individual controls the protocol. No one can influence the circulation by printing more of bitcoin. It is a store of value, where the stock to flow is predictable over its lifetime. Bitcoin in simple words in the digital money best suitable in the internet era.
This is the first time in the history that we are able to transfer value over great distances without relying on any trusted third party, such as banks, paypal, paytm etc. In the year 2008, Satoshi Nakamoto (no one knows whether he is male, or female, group of people. Some say he is alien from another universe and some say he is someone from distant future and has time traveled. Actually it does not matter.) solved a long standing problem within computer science, known as ‘Byzantine General’s problem.’ The solution provided by Nakamoto would result in transfer of value over distances, in a completely trustless way. Read the bitcoin whitepaper.
Bitcoin is akin to gold, but in a digital way. It can be called as ‘digital gold’, scarce and trustless. Pay real attention here: We generally know that something that is digital is never scarce. Think about the pictures, videos, PDFs you receive on WhatsApp or email. They can be replicated n number of times. Nakamoto’s solution in the creation of Bitcoin protocol solves this problem. For the person who invests in bitcoin, the invention of Bitcoin has created new scarce digital gold, bitcoins. Bitcoins are created through a process known as ‘mining.’ Bitcoin ‘mining’ derives its name from gold mining, which requires investment of time and capital. Gold miners employ mining equipment, labour and so on. Bitcoin miners invest in buying specially designed computers (known as Application Specific Integrated Circuits or ASICs) for mining and invest in electricity to power them. Bitcoin has a predictable production schedule and nothing can influence this whereas more gold can be mined as the demand rises.
What’s a blockchain?
You may have heard about this buzzword these days and how it could save the world of all the troubles.. Blockchain is the underlying technology of bitcoin. The blockchain is the ledger that contains the records of all the transactions that have happened on bitcoin since its inception. Each block holds information about transactions and these are attached to the previous block creating a chain and hence the name blockchain.
The ledger of transactions cannot ever be changed or edited. It is practically impossible to change the transactions once they are on the blockchain. If someone could tamper with this, the value proposition of bitcoin would not be justified. When a miner mines a block, independent nodes need to verify the transactions.
How bitcoin works
Explaining how bitcoin works may end up being very complicated and dry. It’s like telling people how combustion engine works or how internet works under the hood. All you want to do is drive the vehicle or use the Chrome browser.
Let’s simplify the things.
Let’s say we are in a garden. I have one mango, you have zero mangoes. I give my mango to you. Now you have one mango, I have zero mangoes. Simple. We both agreed to this. We did not need another person to verify that the mango exchanged hands. Now that I have zero mangoes, i can not give you or anyone else any mangoes.
Let’s say there is digital mango. Let’s say I send you the digital mango. How on earth would you know that I sent the digital mango only to you and not to another friend or friends? If you noticed, dealing in digital goods is tricky.
There is a term for this, it’s called ‘double spending’, meaning spending the same good twice. So, as a solution to double spending may be to create a ledger which tracks the balances and transactions, basically an accounting book. Some company would be incharge of maintaining this ledger. But this also creates problems. What if the company incharge creates more of the same digital copies and what happens when the company servers are down or get hacked?
This is where the Distributed Ledger Technology (DLT) comes into picture.
Under DLT, every participating node or computer keeps record of all the transactions meaning no one party can change the records and even if they change it, other computers on the network will not agree to this and may even distance themselves from the cheating node.
By virtue of being public ledger, it enables multiple aspects. It is open source and the quantity of mangoes are defined and it is scarce. It keeps accurate records of transactions which cannot be reversed or amended. Because it is DLT / public ledger it does not need trusted 3rd parties to verify transactions. Think of the possibilities of this technology in other spheres of life.
Apply this same thing to bitcoin.
Coming back to bitcoin, there mainly 2 parties to creation and maintenance of bitcoin. (There are users of course)
New bitcoins are created with a process called mining. These are computer networks with massive computing power which create blocks. To create blocks the miners need to solve a mathematical puzzle, which incorporates hash power and cryptography. (more of this later). As a reward for their effort, a miner who solves the puzzle gets certain amount of bitcoins. This is the only way new bitcoin can be generated.
Nodes are independent devices which verify the transactions and this is a voluntary network and can be run on a decent computer. For a transaction to be valid, majority nodes on the bitcoin blockchain have to agree to this.
The production of bitcoin is controlled by the algorithm which says that the miner must find a specific answer to a given hashing function to create a block. The objective of the miner is to find the hashing solution in order to unlock fresh bitcoins.
Wallets: Let’s say Ramesh and Suresh have bitcoin wallets on their computer or mobile phone. Bitcoin wallets are specialised programs that help you hold your bitcoins. Under your wallet you have something called wallet address. You can have more than one bitcoin wallet address. A bitcoin wallet address is a string of numbers and letters. There are different kinds of wallets, hardware, mobile, computer, paper, brain etc
Bitcoin addresses: For example, following is one of my bitcoin addresses where anyone could send me bitcoins (just try ;):
The thing is this address is completely auditable and public. You can go to www.blockchain.info and check the history of transactions.
Go to this address: 1HB5XMLmzFVj8ALj6mfBsbifRoD4miY36v. This belongs to Wikileaks.org. Everything is transparent. Anybody, anywhere in the world can send you bitcoin and no one can stop this.. But what you can not do is to take bitcoin from this address without the corresponding private key.
Getting back to our example, let’s suppose Ramesh wants to send 1 bitcoin to Suresh. Ramesh asks Suresh for his bitcoin address. When Suresh creates the bitcoin address in his bitcoin wallet, it creates a new public address. Actually at the background, the bitcoin client is creating a key pair consisting of a Public Key and a Private Key. Public key is like email address and Private key is like the email password. You could share your Public address, but if your Private key is shared, anyone with access to the blockchain can compromise your bitcoins.
Verifying transactions (Proof of Work): Now, Ramesh instructs the bitcoin wallet to send 1 bitcoin to Suresh’s bitcoin address. At this point, the nodes will actually check the entire history of the transactions for Ramesh and check the balances of bitcoin under the address. Once they have been satisfied that there actually is balance, it instructs the wallet to carry on with the transactions. At this point miners, let’s call them Khaleel, Pavan, James, use their computers to bundle Ramesh’s transaction along other transactions in the last 10 minutes.
The objective of the miners is to create a block by solving a puzzle. The miners now compete to calculate the cryptographic hash function matching the previous block’s ‘nonce’. Let’s not get too technical here. The end result of mining is that whoever has higher computer power will be able to guess / calculate the cryptographic hash faster and as a result of their effort they are rewarded with bitcoins. At present whoever is successful in mining a single block is rewarded 12.5 bitcoins, at today’s rate is roughly $ 86000. So, at this rate, everyday roughly 1800 bitcoins are created. This rate halves every 4 years, making bitcoin a deflationary currency.
Congrats James, you’ve just mined the bitcoin block and here are your 12.5 bitcoins!
Suppose you say that someone may bring his super computers to mine the blocks faster. Well, the bitcoin algorithm is quite ingenious. If this is the case, the algorithm would adjust the difficulty level of finding nonce depending on the hash rate of the network to match with the block time of 10 minutes.
That was tedious even to write!
What gives value to bitcoin?
Now you might say, bitcoin is not backed by any physical commodity or backed by any government. So why does bitcoin have any value?
Unlike companies, real estate or stocks, bitcoins can not be valued using traditional valuations methods. Bitcoins for that matter fall into a totally different category of goods known as monetary goods. Its value is entirely dependent upon what the market participants are ready to pay for them given its inherent qualities of decentralisation, scarcity and immutability. In the part 1 of the series I mentioned about the origins of money.
At one point, humans valued many goods based on their unique characteristics like scarcity, utility. For example, feathers for their scarcity, salt for utility, gold for its chemical properties etc. Bitcoin on the other hand comes with double whammy. It is disruptive to several industries such as banking, exchanges, money transfer etc and it also disintermediates several industries. By being a currency as well as a protocol bitcoin is poised to disrupt and disintermediate.
The value proposition is not only these. Bitcoin is also a better standard than gold was because it is inherently scarce. It is a sound money (hard money) as against the easy money (fiat) that we are used to. By being open source technology, anyone could build new technology as second layer solutions (Segwit, Lightening network). At present due to its volatile nature, bitcoin does not seem like great store of value and is evolving. It may take decades before the price stabilises to become a great store of value as bitcoin is currently in the transition period between being a collectible and being store of value.
Understanding bitcoin is bit of a challenge and many are curious about diving into the depths of mining and how bitcoin works. Many get disappointed that they are not able to understand this part. But I would say, you need not completely understand the technologies reap the benefits. Many reading this, including me, would not understand how the internet or email works at the backend. But we still use them.
But I truly believe that bitcoin could rid us of many systemic problems and risks that have been injected into the financial system that we currently have. Further, blockchain technology (However, I am yet to see any successful implementation of any blockchain project in the real world other than bitcoin) which is quite revolutionary, can make many things more democratic, agile and straight forward. In no way I am discounting the importance of financial institutions or saying that bitcoin would replace them. The aim is to reduce dependence on the centralised institutes that wield negative effect on our lives and bitcoin very much enables this, a democratic, decentralised, immutable currency and store of value. Bitcoin is governed by mathematics and cryptography. And I believe mathematics is the truth. Bitcoin is truly currency of the people, by the people, for the people.
In the upcoming part of the series, I will cover common misconceptions about bitcoin.
Important note: Kindly note, bitcoin is highly volatile and I would not recommend you buy bitcoin. Even if you do, do not buy more than you can afford to lose. I have heard several people taking huge personal loans, mortgaging house to buy bitcoin. Please do not borrow to buy bitcoin.
Bitcoin hash rate, visit: Blockchain.info
Bitcoin network hash rate is currently at 51.5 terra hashes (51.5 million trillion, or more than a trillion powerful laptops). In comparison, Google’s network hash rate is approximately not even 3% of this. This hash rate is the one which protects the bitcoin protocol. The network has never been compromised by hackers or anyone for that matter. Additionally you may have a look at various charts related to bitcoin on blockchain.info.
Cryptographic hash functions
Bitcoin uses SHA 256 hashing algorithm originally developed by NSA (National Security Agency). Hash functions are one way functions where it is easy to find output for a given input but it is almost impossible to find input value given the output.
For example, for the sentence, ‘i love daijiworld’, hash is bf31ee4fa1ce13b3d5e950dc304ba0274683b7ad66562f34295f7ee0f075c2e6, but given this hash, it is impossible to know what’s the seed word. Even if there is a small change in the input the output completely changes. This is an integral part of bitcoin protocol. If anyone is able to break this algorithm, they can virtually steal your bitcoins. (SHA 256 related, visit: Xorbin)
Disclaimer: The contents of the article are gathered / referred from various sources, are for information purposes only and are not to be considered as financial advice. The opinions expressed are that of the author and do not necessarily reflect that of Daijiworld Media Pvt Ltd.