What is bitcoin and how does it work?

What is bitcoin and how does it work?

The question remains: can something so new and revolutionary be profitable? In fact, it might not. One of the most popular currencies in human history is a strange invention that has shaken up the world: digital money (or cryptocurrency), which operates on blockchain technology but whose value relies entirely on faith. The first “blockchain” was created in 2009 by someone who worked at IBM but did not know it. Blockchain now provides an alternative standard for transactions in financial services — although its use in this context is less mainstream than cryptocurrencies such as bitcoin or ethereum. As I explain, bitcoin may not be perfect, but it could provide better tools for payment, as well as reduce the risk of fraud.

How does bitcoin work? There are dozens of ways people have tried using bitcoin since its inception. Many of them failed, and all of them require some kind of third-party exchange to trade with the currency. But perhaps no other method has been more successful: It allows anyone with an Internet connection to buy the same amount of any cryptocurrency without having to deal with banks, middlemen, brokers and others. Some people worry that bitcoin will become worthless because central authorities keep control over its supply, and there has been a spate of thefts, both from exchanges and from accounts held within those systems. Even when the original bitcoin network collapsed, hackers found ways to send out massive amounts of coins across the web even though many countries’ governments had outlawed them. However, after a few years, it became clear bitcoin wasn’t worth the trouble.

The biggest problem has been fraud, especially in online payments where consumers often lack money and identity and where traditional banking has been forced off the market due to government sanctions. Because bitcoin works via public networks rather than private ones, there’s no way to limit the flow of bitcoins. So far, however, it seems the idea is working. A recent Bank of International Settlements study estimates that by mid-2021, about 45% of the total number of bitcoin would be controlled by 21 different entities. At the end of 2019, several large corporations already held approximately $1 trillion of bitcoin. More recently, Walmart announced plans to spend $3 billion on buying 100 million dollars in bitcoin, while AT&T said that it planned to issue a coin backed by gold. Other major players in finance, including Visa, Mastercard and PayPal have also shown interest in bitcoin.

What will happen if your bank tells you they can’t touch your money? It doesn’t sound like the future anymore, does it? Perhaps. One advantage of crypto money is that it doesn’t rely upon a centralized authority to decide how it should be used, nor do government institutions to decide whether it should be legal. This means there’s room for regulators to monitor, interpret and act on bitcoin transactions without relying on individual institutions and governments. Most importantly, this means the system is open to outsiders, unlike legacy financial systems. That’s important not just because bitcoin is unique but also because it helps increase confidence among investors.

Bitcoin vs. fiat money The basic difference between bitcoin and fiat money is the underlying platform. For example, the US dollar is pegged by the Federal Reserve to its national reserves. On the other hand, a euro is issued by Eurostat, a European agency responsible for setting monetary policies within the EU. Another distinction is that cryptocurrencies operate outside of the global capital markets, and they need a trusted party — such as a company or government — to handle their creation and transaction processing. Fiat money is backed by reserves of existing assets such as real estate or commodities; these assets can provide collateral to cover losses and ensure liquidity.

Bitcoin vs. asset-backed loans In contrast, asset-backed loans are debt or equity securities sold off in order to raise capital for companies issuing bonds or shares. These types of investments offer guaranteed returns (usually 5% or higher) to investors. Unlike the US dollar, an asset-backed loan cannot be directly controlled by an issuer. With bitcoin payments, the parties involved in buying and selling contracts can retain full responsibility for the risks of investment decisions made, though the issuers take on the costs related to running the project. While bitcoin is based on the notion of trust in public blockchains, asset-backed lending is dependent on a certain level of credibility in the marketplace or investor. That’s why asset-backed loans tend to be risky business opportunities that typically don’t involve high profits. They are also subject to stringent regulations similar to those imposed on conventional lenders and investors.

Bitcoin vs. credit cards Credit cards have come under fire from lawmakers and regulators who allege their rules create loopholes for criminals. According to the Consumer Financial Protection Bureau (CFPB), about 9.5 million Americans used credit cards in 2017. Meanwhile, according to FBI data, between 4 and 11% of small businesses use credit cards per year in the United States. Not all card issuers are regulated by CFPB, which explains why some merchants opt to pay their customers in bitcoin instead of paying a fee. Cardholders often report high levels of fraud, particularly for transactions involving purchases of goods or services. Also, as the industry grows, banks begin to cut ties with merchant networks, and most card issuers cut back on fees and charge rates. Ultimately, as these factors become more evident in the media, legislators will likely continue scrutinizing the activities of key issuers.

Bitcoin vs. peer-to-peer networks Peer-to-peer networks (P2P), like Facebook, allow multiple groups of people to participate in a shared activity. P2P platforms rely on nodes — computers that run the network as part of the protocol — that validate transactions and verify the authenticity of incoming information. Blockchains depend on those nodes in a decentralized manner. P2P networks do not run on a single computer; instead, each user contributes computing power to add data to the ledger. Transactions are verified by group consensus or proof-of-work (PoW). PoW takes time since miners have to solve complex equations. Instead of verifying every transaction by themselves, the node sends the result to the next-door users so everyone participates in verifying it. Once it verifies the transaction, the rest of the network validates it too before it reaches the actual participants. To maintain efficiency, P2P networks also record what happened to the distributed blockchain. If there is a bug, it is removed from the chain. Users in a given P2P network are expected to have adequate knowledge regarding network security. All in all, these systems are widely considered safer for privacy reasons, unlike Bitcoin.

Bitcoin in banking Since 2015, many U.S. banks have adopted bitcoin as a form of payment. This trend continues today. Two banks now accept bitcoin payments: Santander, a Swiss bank and JPMorgan Chase & Co., a New York City-based bank. The two banks offer customers access to bitcoin accounts linked to debit or credit cards. This service has attracted attention because of the promise of lower prices: While buyers of bitcoin need to complete a long personal identification process and download software to buy the currency, there has been little evidence indicating the price has gone down in recent months. Others say it’s only natural for banks to adopt digital payment methods since they offer much greater convenience to clients and generate additional revenues. Banks may consider the increasing popularity of cryptocurrency when making strategic plans.

Bitcoin mining In addition to being easier to mine than electricity, computing power is a huge driver of economic growth. For instance, China’s economy grew significantly faster over the past seven years than the U.S. In 2018, China accounted for nearly 60% of the world’s hash rate while generating almost 3.5 gigawatts of energy. Mining requires massive amounts of energy to perform mathematical calculations. To produce 1,000 megawatts, a typical computer has to consume over 10,000 watts. Over the last one month, North American miners reportedly processed roughly 30 terabytes worth of activity — or more than 130,000 Terabits/sec. By comparison, Chinese miners were responsible for over 840,000 Terabits/sec over the same period. Overall, according to analytics firm EHarmony’s latest analysis, Russia took home $732 million worth of revenue in Q4 of 2021 — or about four times the amount generated by coal mining exports and eight times that of Venezuela. Although it isn’t exactly unusual for big economies to benefit from emerging technologies, it indicates growing demand for bitcoin mining in China and elsewhere. This suggests that bitcoin has the potential to expand the wealth gap through international commerce.

Bitcoin as a store of value Due to the perceived volatility of bitcoins, investors have expressed concerns about purchasing them and storing them long term. Digital wallet providers — such as Meta Platforms and Microsoft Coin — are trying to address these issues and help customers secure the transactions. For example, Meta stores wallets in cold storage, whereas Coinbase offers hot storage, allowing customers to transact online and store funds offline. Likewise, Terra has partnered with BitGo, a leading provider of hardware wallets. People’s favorite cryptocurrency “has fallen into disfavor as speculation mounts that retail traders and institutional investors are shifting away from Bitcoin” (Nedeljakovic et al., 2020). Nevertheless, bitcoin has proven itself an increasingly attractive investment option. Bloomberg reported that bitcoin is trading at around $34,000 as of January 28, 2022, above the previous peak of $23,000 set in November 2013. Moreover, Goldman Sachs recently gave Bitcoin a rating of BB-, meaning investors expect more gains and are comfortable holding on. Still, the bank notes that its outlook sees bitcoin heading toward $55,000 in 2023,