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Cryptocurrency Bitcoin has the potential to change banking and how we use money

27 January 2016 7:08 PM
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You might think Bitcoin is just anther way to make online payments, but some argue that block chain can replace the internet!

The value of Bitcoin for the last two years. The relatively small number of users and potential regulatory challenges has seen the value move often and significantly. Use caution. image credit: Blockchain.info

This subject is complex, so please excuse the oversimplification in an attempt to illustrate what cryptocurrency is and how it works.

There are three parts to this introduction:

  • What is cryptocurrency?
  • What is the block chain?
  • Why is bitcoin mined?

What is Bitcoin?

It is the best known and one of original versions of a cryptocurrency. It has a value determined by the demand for the coins and the the supply available in the network. Supply of Bitcoin is designed to only ever be 21 million. They are added to the available pool at a rate of about 25 per 10 minutes. There are currently (27 January 2016) 15 million available. They are worth $5.9 trillion.

Users download software which acts as an account called a wallet and purchase coins through exchanges. They can be used to pay for anything provided the person you are paying also has an electronic wallet to receive the payment.

Conventional electronic payment are made via a "trusted third party" like a bank. They confirm that the buyer has the funds needed for the purchase and that the seller account is credited once a transaction takes place. A fee is charged for providing the transaction.

Cryptocurrencies do not use trusted third parties but instead a public database of all transactions that are processed through all the accounts on the network. The means of verification is explained in the next section.

A challenge for digital assets is that, unlike physical currency, which is physically moved from one person to the next and is hard to replicate, it prevents someone from spending the money twice.

Safety measures discourage counterfeiting and in part is the reason why physical currencies are not available in denominations that make counterfeiting worthwhile. It is why you might find a high denomination value, but never a very high value note (for example, a $5000 bill).

It is very easy to copy digital items though which is why banks have been critical for electronic payments to prevent people claiming to have funds they don't. Cyptocurrency solves this with the block chain.

What is a block chain?

If you have not heard of it before, don't be disappointed if, after the first reading, it still does not make sense.

[Block chain](https://en.wikipedia.org/wiki/Block<i>chain</i>(database) is a database of all bitcoin transactions made over a period of time or that make up a certain size block of data. All transactions are public, listing the accounts that paid and received bitcoins and the value of the transaction. They are encrypted in such a way that they can only be decrypted using a very intensive computer process. When the block is verified it can be tested by all the nodes in the network and allows those transactions to be reconciled with the precious block of transactions forming a continuous chain of blocks all the way back to the very first one.

If the block does not fit, the transactions are reversed and need to be submitted again.

The network is aware of how much computer power is being used to resolve the blocks and either makes them easier or harder to decrypt so that blocks are verified approximately every 10 minutes. This is where mining comes in.

An indication of how many people use Bitcoin. The number of wallets indicate the total accounts in the network - individuals may have more than one. There are approximately 400 000 transactions daily. (image credit: Blockchain.info)

Why are bitcoins mined?

Again the idea of mining is illustrative to describe a much more complicated process. The integrity of the currency is maintained by making it very hard to artificially manipulate or create fraudulent transactions.

This is achieved using the very intensive block chain decryption, but it would be unlikely for someone to use their computers to run such intensive operations for no reward.

Each time a block is decrypted the person or group that performed the work is rewarded with 25 bitcoin (this reduces over time and is expected to drop to 12 bitcoins in the near future). In January 2016 the mining reward was just under $10 000 and between $1 million and $2 million are earned by miners every day. Only the person that manages to decrypt the block is rewarded, everyone else's work at that point is discarded and work begins again on the next block.

If you are tempted to download the mining software to earn some bitcoin yourself you are welcome. However, the processing power needed and the electricity it will use might already cost more that the money you are likely to earn.

Why is it disruptive?

If you are comfortable with the information above you are ready for the potentially mind blowing aspects and impact of this open source software on our economic systems.

It can do away with the need for banks and financial institutions to manage online payments. It can bypass restrictions on trade and allow you to buy or sell anything including banned or illegal items.

It is not regulated by a country or a central bank, so you can't manage money supply.

Bitcoins are not actually even money. Each bitcoin can be defined into 100 million smaller units and those, like any bitcoin, can be used to prove ownership, provide access, vote, be a store of value and even regulate how they they may be used.

And while there are dozens that are in use, a future version launched last year might one day replace the Internet as we know it.

But this is as far as this simple explanation goes. Hopefully the more in-depth articles available will make more sense and help you take the next steps to understanding how it actually works.

Below is helpful recap of the main concepts.


27 January 2016 7:08 PM
by

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