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Bitcoin is set to revolutionize finance, here's what you need to know

By now you’ve probably heard about bitcoin, and maybe even checked the price now and then. You may have seen it trading at a few cents just 3 years ago, a few dollars 2 years ago, or saw it at its most recent peak of over $1000. Since then it’s lost 67% of its value, but the decentralized currency and protocol is still very much alive.

But before investing in the digital currency, it’s important to have a basic understanding of how the underlying protocol works. Bitcoin, at its core, is a technological innovation that facilitates financial transactions, much like how the Linux kernal powers the banks and financial institutions of the world.

The Basics

Bitcoin is a revolutionary decentralized ledger system (Bitcoin with a big B) that uses a peer to peer network to transfer value (a token called bitcoin, with a little b). This digital token can be sent anywhere in the world, instantly, at practically no cost.

Nobody owns the Bitcoin network, there is no Bitcoin head office, and the software is completely open source. There is a core group of developers improving the system, and anyone can join the effort. Anyone can also build products and services on top of the network. This is referred to as permissionless innovation. Over US$314 million dollars have been invested into companies innovating in the space in the past 12 months alone.

How It Works

The Bitcoin ledger is stored by thousands of computers (called nodes) all over the world. When a transaction is made, eg Alice sending Bob one bitcoin, the transaction is sent out to the network and all the nodes rebroadcast it out to all the other nodes.

Imagine a digital bearer bond, whose ownership is determined by the ledger, but control of the instrument is by using a private key (like your safety deposit box key) to unlock and move ownership to another account holder public address (like your safety deposit box number).

Bitcoin uses a sophisticated system called public/private keypair cryptography to create these keys. Software like digital wallets can generate an infinite number of these keypairs and a single private key can be used to generate an infinite number of public wallet addresses.

Imagine being able to create a new safety deposit box at will, and unlock them all with a single key. Or, you can generate a new set of boxes and keys. This keypair can be completely private and as long as you secure your private key properly, no one can take the contents of the box.

Preventing Double Spending: Solving a Hard Problem Innovatively

Bitcoin solves a very important problem of how do you send value from Alice to Bob without a central authority like a bank making sure that the accounts balance between them? Bitcoin solved this by putting the nodes into competition with one another to basically win a lottery.

When a transaction is made, it’s added to the last 10 minutes of transactions which are called a block. This block is verified by specialized nodes called ‘miners’ who by doing a hard math puzzle are able to win the lottery. This puzzle cannot be ‘solved’ with a formula, but is done by brute force guessing.

The miner who successfully guesses the solution verifies the block and is rewarded with some bitcoin and small fees attached to the transactions in the block. This block is added to the ledger, which is copied to all other nodes, keeping track of which public address now has ownership of those bitcoin. The chains of blocks are then linked to one another in what is known as the ‘Blockchain’. The first block known as ‘The Genesis Block’ was mined on January 3, 2009.

The protocol has a feedback mechanism to adjust the time it takes to confirm or mine a block to an average of 10 minute. The total number of bitcoin that are generated during mining is set by the protocol, initially at 50, but halves approximately every four years. Currently the reward is 25 and should halve again in July 2016. The current total supply of bitcoin is around 13 million, and will eventually be 21 million in 2140, when the block halving will stop and all coins are mined. This is a set, predictable supply inflation rate, which will eventually be deflationary.

Bitcoin's Value & Current Market

Since there is no central authority like a government to demand payment in bitcoin for taxes, there is no central authority to place a value on bitcoin. In May 2010, 10,000 bitcoin were exchanged for two pizza pies, establishing a price for bitcoin of about $0.0002.

The price of a bitcoin is determined by local and global supply and demand more like gold than a currency. When demand for bitcoins increases, the price increases, and when demand falls, the price falls.

Bitcoin at the moment is like the internet in 1995. Still very much in it’s infancy; the media and politicians often label it a tool for criminals and fringe elements. Because of its small market cap of around $4 billion, and global trading exposure, the price can fluctuate wildly with any news event.

There are still very few high volume exchanges, and if there’s a problem with any of these, the price can plummet quickly. It’s also much faster to move and sell bitcoin for dollars on an exchange than put in more dollars to buy- leading to fast downward movements.

Expected Value of Bitcoin

Like the internet, Bitcoin the technology and bitcoin the currency has the power to disrupt multiple markets. Because there is no middleman in transactions, merchants can sell their goods for bitcoin globally, near instantly and with no transaction cost- unless they want to convert it back to their local currency.

Payment processors like Mastercard and Visa will have their margins eaten away. Many firms are targeting various remittance corridors, challenging traditional wire transfers and Western Union-type outfits.

Beyond the currency, the underlying protocol will bring on new innovations and disruptions. It’s already possible to create additional tokens on top of the existing bitcoin blockchain. For example, a gold dealer can now create a digital asset to represent 1 oz of gold, and allow it to be traded globally. Companies can now issue shares directly to the public, which can be traded on decentralized exchanges.

Some other uses of the timestamp and incorruptible nature of the ledger are using it as a registry of assets, to issue and control software licenses, and even as a way to prevent voting fraud. Many more innovations will be built that we can’t even conceive of today. Many of these require small amounts of bitcoin to verify the transaction, which investors believe will increase the value of the token.

In the next article, I'll explain the different ways people are currently investing in Bitcoin the protocol and bitcoin the currency.

david_moskowitz
David Moskowitz

Founder, Coin Republic – Online Bitcoin Brokerage and Offline Seminars and Consulting

David Moskowitz founded Coin Republic to help educate the public about Bitcoin and create a platform to help them buy and sell Bitcoin easily. In June 2013, he launched an online Autobuy system, which allows clients to use their Singapore iBanking accounts to quickly purchase Bitcoin and send them directly to their wallets. He is a well-known Singapore evangelist for Bitcoin and local Bitcoin businesses and has helped to promote Singapore as a Bitcoin hub to the wider world.