What you need to know about bitcoin in order use it and invest in it.
In this episode, you’ll learn:
- What is bitcoin.
- How to store bitcoin.
- How new bitcoin is created.
- How bitcoin protects against money being double spent.
- What are the security issues with bitcoin.
- How bitcoin differs from other currencies.
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How Bitcoin Works
A listener to my podcast sent me some bitcoin the other day. 0.0078 bitcoin to be exact or roughly $1.75.
To get this bitcoin, I downloaded an app on my iPhone called Hive.
Hive created two things for me: a public digital address to receive my bitcoin and a private key that allows me to receive and spend bitcoin.
When the listener sent me bitcoin, he used his private key to sign a message with the amount of bitcoin and the bitcoin’s transaction history.
What Actually Is Bitcoin
What do I mean by transaction history?
Bitcoin is not a physical coin or even a static digital coin. Rather, bitcoin is a digital record of previous transactions between various bitcoin addresses that is stored in a digital universal ledger called the blockchain.
So the 0.0078 bitcoin my listener sent me isn’t really in my Hive wallet. All that is there is a record of the transaction of my listener sending me the bitcoin, which is just the latest transaction in a long series of transactions for that bitcoin that are all recorded in the blockchain (i.e. the ledger).
Before the bitcoin “arrived” in my wallet the transaction was verified by miners to ensure the bitcoin was legitimate and wasn’t being spent twice at the same time.
Miners are computers that not only verify transactions, but do so in a way that leads to the creation of new bitcoin.
Here is how mining works.
A series of bitcoin transactions that occur over a set period of time are combined into a block.
Miners compete to verify the transactions that comprise the block and solve a special algorithm to create a “hash” that accompanies the block when it is added to the blockchain.
A hash is a series of numbers and letters that are created by applying a mathematical formula to both the transaction data in the block as well as the numbers and letters in the most recent block’s hash.
The output of this mathematical formula has to meet the specific criteria set up by the bitcoin protocol. In other words, the special algorithm has to be solved.
Networks of computers compete with each other to solve the hash algorithm that accompanies the block that is then added to the blockchain.
Whoever solves the algorithm to create the hash receives 25 new bitcoins as a reward.
The Upper Limit On Bitcoin
This ingenious but complicated process is set up in such a way to ensure not only the accuracy and integrity of blocks and the blockchain, but the timing and amount of new bitcoin created.
The bitcoin protocol adjusts the difficulty of solving the algorithm based on the amount of computing resources distributed throughout the world that are trying to solve the hash alogrithm for each block.
The protocol’s goal is for six new blocks to be created and solved per hour.
The number of bitcoins awarded for each block is cut in half every 210,000 blocks or approximately every four years.
By 2040, there will be no new bitcoin rewards for creating and solving blocks as the upper limit of 21 million bitcoin will have been reached.
Instead, miners who verify transactions and solve for the hash algorithm will receive a transaction fee for doing so.
How Bitcoin Differs From Other Currencies
Bitcoin differs from traditional currencies because of this specified rate of new bitcoin creation and the upper limit on bitcoin in circulation.
Traditional currencies contribute to inflation or a persistent rise in prices because the supply of money in circulation keeps increasing.
Goods and services priced in bitcoin will not suffer from inflation because the supply of bitcoin is strictly controlled.
If anything, goods and services priced in bitcoin will fall in price over time. They will experience deflation.
In theory, if the supply of dollars is increasing faster than the supply of bitcoin, the price of bitcoin in dollars should increase over time.
That has been the case in practice. In early 2013, one bitcoin was worth approximately $14. Today, one bitcoin is worth $225.
The price has been quite volatile though. Bitcoin’s price per dollar has fallen 30% year-to-date, but it has been as high as $945 per bitcoin.
Clearly, speculative demand for bitcoin influences its price.
Spending and Securing Bitcoin
Like any currency though, bitcoin’s long-term viability depends on its ease of use as a medium of exchange.
In other words, how easy is it to spend bitcoin on goods and services and how safe is it to store.
More and more companies take bitcoin as payment, although a large percentage of these businesses use a middleman such as Coinbase or Bitpay, and then immediately convert the bitcoin payments back to dollars.
One reason these business might immediately convert back into dollars is bitcoin has been difficult to store safely in large amounts.
A number of prominent bitcoin exchanges where depositors stored bitcoin have been robbed. For example, Mt. Gox, one of the largest bitcoin exchanges, lost $600 million worth of its depositors’ bitcoin to theft and was forced into bankruptcy.
New exchanges such as Circle have insurance policies underwritten by major insurance companies to protect depositors against bitcoin theft.
As more and more businesses accept bitcoin and as bitcoin deposits become more secure, bitcoin’s adoption as a global digital currency should continue to increase.
And given the supply of bitcoin is growing slower than the supply of dollars then the price of bitcoin in dollars while volatile should increase over time.