Bitcoin. Blockchain. Mining. If you haven’t come across these words in the last few months, chances are that you may just be living under a rock. This year has been all about cryptocurrency—from the skyrocketing valuation of Bitcoin to the rise of mining farms around the world, to thefts in the tens of millions of dollars. Despite its rapid rise in popularity in today’s world, many still don’t understand the concept of cryptocurrency. Just an online search will leave you befuddled with the information overload, and I can vouch for that. When I first started, I was inundated with jargon and concepts, which left me more confused than I was at the start. But after scrolling through many forums, articles, and infographics, I realised that while learning the in-depth working of cryptocurrencies requires sound technical knowledge, learning its basics is rather simple.
In this article, I’ve covered the absolute basics of cryptocurrency: why was it created? How does it work? What gives it value? If any of these questions have ever crossed your mind, read on to find the answers.
Conventional digital money works on a payment network with balances, accounts, and transactions. A central entity or regulatory authority governs the entire network and is responsible for ensuring the legitimacy of all transactions. Preventing double-spending (when one entity spends the same amount twice), for example, is something that is under the purview of this central entity.
The problem with this system, however, is that all participants in the payment network are relying solely on the records maintained by the central server. The legitimacy of every transaction is based solely on the trust placed in this authority, who can easily exploit it for personal gain or be exploited by others. The quest to find a solution to this problem led to the creation of cryptocurrency.
In late 2008, a pseudonymous person/group of persons named Satoshi Nakamoto announced the creation of a new ‘peer-to-peer electronic cash system’ named Bitcoin. This invention changed digital payment systems through one key feature – it was decentralised. It redistributed the process of verifying the legitimacy of digital transactions from a central node to every single participant in the payment network, plugging the hole of misappropriations of transactions, and dividing authority. This new digital cash operated on an absolute consensus of peers and not the word of a third-party. A single disagreement about the smallest balance between the peers could now collapse the entire system.
But how is this absolute consensus reached? That’s where blockchain technology comes into play. The working of a blockchain is quite technical and difficult to understand, but this ‘Guide to understand blockchain in plain English’ does a great job of explaining the concept.
A brief explanation can be put forth thus: a block is a set of limited entries in a database that cannot be changed once it has been agreed upon by the peers in the network. These blocks link together to form a series of distributed registers that are known as a blockchain. The first application of this technology was to conduct financial transactions and the currency that was first transacted was Bitcoin.
On a side note, Blockchain has been touted as one of the most important technological advancements of the last few years. While it is primarily being used to operate cryptocurrencies today, there are several other possible applications of blockchain in fields such as IoT, data security, and smart contracts.
We’ve covered why Bitcoin was started and the technology it operates on. But what is it exactly? Where does it derive its value from? For that, we need to learn the difference between fiat and non-fiat currencies.
A fiat currency is a currency whose value is established by governmental decree, such as the Rupee or the Dollar; it has no intrinsic value on its own. A non-fiat currency, meanwhile, is one that is not legal tender but nonetheless has a value backed by a physical commodity, such as gold. It is the limited quantity of gold that makes it valuable.
Cryptocurrencies like Bitcoin fall somewhere between fiat and non-fiat currencies. They are legal tender recognised by many of the world’s governments but are not backed by a physical quantity. Like gold, however, Bitcoin does have a limited quantity, and the difficulty in ‘mining’ (more on this later) has increased in tandem with its growing popularity. Bitcoin was designed to have a fixed supply of 21 million coins, out of which 16,682,262 coins are currently in circulation.
But that doesn’t explain why Bitcoin has a market cap of over $1.57 billion, with one BTC valued over $9,300 (at the time of writing this). To understand why Bitcoin and other cryptocurrencies (referred to as ‘altcoins’) have such high values, it helps to regard them as stocks — they are being traded on several exchanges — rather than currencies.
When enough people possess Bitcoin, their value increases, making more people want Bitcoins, which increases their value furthermore. Bitcoin derives its value from the people who recognise it as a viable store of wealth and/or as a medium of exchange to buy and sell things. Hence, the more people invest in it, the higher its price will climb. However, since Bitcoin isn’t a value-producing asset, several people are convinced that its popularity is a fad and will go the same way as the dot-com bubble did at the turn of the century.
We’ve covered that the transactions in a blockchain are confirmed by the members of a peer network and not a regulatory entity. Transactions once confirmed can never be tampered with. But since every participant can, in principle, confirm transactions, it leaves the system open to the possibility of fraud. For example, one individual can create several thousand peers and begin spreading forged transactions; this would lead to an immediate collapse of the system.
To prevent this from taking place, the creators of Bitcoin incorporated a rule whereby only those who invest their computers’ processing power can confirm transactions. This is done by solving a cryptographic puzzle or, to be more specific, by finding a hash which is a product of a cryptographic function. The solution is called the ‘Proof-of-Work’ and obtaining this awards bitcoins to people in the peer network.
The process of solving these cryptographic puzzles to create bitcoins (or other cryptocurrencies) is known as ‘mining’ and those who do it are called ‘miners’. Also, the difficulty of these puzzles continues to increase which translates to more processing power required to solve them. For example, bitcoins could be mined by the dozen with a couple of GPUs 7-8 years ago, but today one requires a custom-built ASIC mining rig to obtain even a fraction of one bitcoin. There are, however, altcoins like Dash and ZCash that can still be mined with GPUs.
Even though the value of cryptocurrencies is still volatile, with unforeseen rapid increases and sudden plunges, the currency is currently going from strength to strength with no signs of slowing down. Several countries have even taken a positive stance towards this new wave of digital currency. But the true power of cryptocurrencies lies in the hands of the people. The market may be unpredictable, but while everyone backs cryptocurrencies, they will only grow in use and acceptance. With the volatility of national fiat currencies and the burgeoning environment of digital transactions, cryptocurrencies look like they’re here to stay.