Since its invention in 2008, bitcoin has moved from being the exclusive domain of cryptography experts and geeks into a serious financial landscape that has drawn the attention of large investors, government agencies and average users who know little or nothing about encryption and digital currencies.
But despite being the subject of news headlines and discussions in different forums and social media networks, Bitcoin is still largely misunderstood. Many people who talk about Bitcoin know little more about it beyond its price surge in the past year and have little understanding of the innovation and foundations that underlie the most valuable and popular cryptocurrency.
Bitcoin actually stands for two things: a currency and a protocol. The currency, marked by the BTC symbol, refers to the monetary value that cryptocurrency represents. In 2010, every bitcoin was worth a few cents. At the time of this writing, each BTC is worth around $6,300. You can buy and sell bitcoin at exchanges such as Coinbase and Bitstamp, and you can use it to buy goods and services at vendors that accept it.
The Bitcoin protocol is the software that supports the cryptocurrency and that’s where the real magic is happening. This is the code that runs on a network of volunteer computers, which make it possible to trade monetary value online without going through centralized authorities such as banks or payment services. The Bitcoin software sets the rules for verifying and confirming bitcoin transactions, called the consensus, and also specifies how new bitcoins are created and distributed among the computers that support the network.
Unlike traditional payment services, which are owned by centralized companies, no one owns the Bitcoin protocol. It’s an open-source software that anyone can install on their computer and join the network that maintains the currency.
To this day, the real identity of Bitcoin’s creator remains a mystery. Bitcoin’s source code, a masterfully crafted piece of software that many believe couldn’t have been created by a single person, and the whitepaper that lays out its concepts were written and published under the name of Satoshi Nakamoto, a person of supposedly Japanese descent. But to this day, no one has been able to find or prove who is (or are) Satoshi Nakamoto.
While you can use bitcoin to pay for goods and services just like any other type of currency (given the vendor you’re buying from accepts bitcoin as payment), the technical infrastructure that supports it gives it unique characteristics that can’t be found in any other type of currency.
Traditional payment systems are controlled by centralized gatekeepers. Government agencies control the printing and distribution of national currencies. Big banks and financial companies such as PayPal control online monetary transactions. Wherever you want to exchange monetary value, you must go through one of these intermediaries and you must trust them to maintain the integrity of their payment systems. However, that trust doesn’t come for free, and even the most trustworthy and reputable financial institutions fail every once in a while.
On the other hand, bitcoin is the first currency that is truly decentralized. No single entity has control over how and when transactions are made. Bitcoin is supported by blockchain, the distributed ledger technology that replaces centralized servers with a network of disparate computers that keep record of account balances and handle transactions. Bitcoin uses cryptography, mathematics and computational power to prevent digital assets from being duplicated or spent more than once, a challenge known in the digital world as the “double spending” problem.
The Bitcoin protocol has been designed to generate new bitcoins every ten minutes, when a new block of transactions are processed and appended to the bitcoin blockchain. Those bitcoins go to the miners, the computers that solve complex mathematical equations to ensure the validity of transactions.
However, the protocol also contains code that slashes the mining rewards by half at ever 210,000 blocks, or around every four years. Currently, every block comes with a 12.5 BTC reward. At the current rate, the last bitcoin will be mined in 2140 (What happens when all the bitcoins are mined?). The limited supply of bitcoins and the diminishing rewards means that the value of bitcoin will increase as its popularity rises and more people and organizations use it for payments.
Unlike banks and payment services, you don’t need to reveal your identity and share your personal information to have a bitcoin wallet. All you need is a set of public and private keys that enable others to send bitcoins to your address and you to send bitcoin to others. However since bitcoin is transparent (explained in the next section), and your anonymity depends on being able to keep your bitcoin wallet address or addresses secret.
Furthermore, if you want to convert your bitcoins to fiat or purchase bitcoin with fiat currency, you must go through centralized gateways such as Coinbase. The law requires these companies to obtain legal documents from their customers before buying or selling bitcoin.
Traditional payments are stored on ledgers that are stored in walled gardens, where only their gatekeepers can update them and decide who accesses their content. In contrast, bitcoin payments are stored on the blockchain. Everyone can access the blockchain and see the history of payments made to a specific address without going through an intermediary.
This means that if someone knows the bitcoin addresses associated to your wallet, they’ll be able to see all the addresses you’ve received payments from and sent payments to. The bright side to this is that it also makes is possible to track stolen bitcoins and prevent the perpetrators from cashing them out at exchanges.
When a bitcoin transaction is confirmed and registered on the blockchain, you can no longer reverse it. This is because bitcoin transactions are sequentially linked to each other through cryptographic hashes, and changing any of the transactions from the middle of the chain breaks the mathematical formulas that hold the ledger together.
The upside to bitcoin’s immutability is that no one can tamper with transactions, because it would require recreating the entire sequence of transactions and distributing them across a considerable number of computers that store the blockchain, a feat that is virtually impossible.
The downside is that if you accidentally send bitcoins to the wrong address or if your account becomes hacked, there’s no central authority that can reverse the transaction and give you back your funds.
The bottom line is, as a decentralized payment technology, bitcoin is great, but it also comes with its own tradeoffs.
Written by Ben Dickson