Bitcoin has become very popular. But sometimes you also hear negative things about Bitcoin. Is is really secure? Why is the price of Bitcoin going up and down? Here is an overview of Bitcoin.
Bitcoin is a relatively new phenomenon. It was created in 2008 by Satoshi Nakamoto, which is believed to be a pseudonym. It is the first widespread distributed digital currency.
Explaining how Bitcoin works is not easy, an understanding of cryptography, software engineering, economics and some other areas is required if one wants to dig deeper into how Bitcoin works. A couple of terms that are good to know are the following:
Wallet: Software which is used to store bitcoins, can be online or offline. Note that bitcoins can also be stored in paper wallets
Bitcoin Exchanges: Market place where users sell and buy bitcoins.
Mining: Bitcoins are created by solving mathematical puzzles, this is called mining.
Cryptocurrency: A form of currency based on mathematics alone.
First of all, Bitcoin is based on open source. Everyone can download the source code and have a look at it. This has the advantage that it allows users to check that the code does not contain any backdoors or security vulnerabilities. That said, this requires not just programming skills but also advanced skills in cryptography.
Currencies are typically controlled by a central authority, Bitcoin on the other hand is a distributed currency. It lives in a peer-to-peer network, there is no central control of Bitcoin. Being an electronic currency means also that there are no coins or banknotes. Not that far ago, a digital currency would have been very odd. Nowadays, it is not that strange. But Bitcoin has a number of strange features compared to normal currencies such as the US dollar or the euro.
Despite being a digital product, there will be a finite supply of Bitcoins. This may sound odd, since it is very easy to make perfect copies of digital products, both quickly and cheaply. But the Bitcoin generation algorithm has limited the supply to a maximum of 21,000,000 bitcoins. In order to prevent people creating their own bitcoins, several sophisticated technical features have been used in the Bitcoin algorithm.
The heart of Bitcoin is a distributed database, this means that each participant in the network keeps a copy of it. Traditional financial systems have one central database, which means that the users are trusting the operator of the database with their money. In order to get a distributed database to work, a number of problems had to be overcome. The solution is very elegant, in essence all financial information flowing through the Bitcoin network is public. The only exception are the identities behind the transactions.
One thing to be aware is that while Bitcoin may be anonymous, it is possible to follow the flow of transactions. If you paid someone, you can find out what he or she spent the money on.
The Bitcoin distributed database is known as the blockchain. This is due to the fact that transactions are grouped in blocks, which are recorded in the database in a chain of blocks. By itself this is not a very efficient way of storing database records. But thanks to the chain, transactions are linked so that they create a history of all transactions which can not be altered. The links between the blocks are based on cryptographic algorithms which can not be forged unless an attacker has enormous computational resources.
The identities of the owners of bitcoins is not used in the Bitcoin system. Bitcoin addresses are used to identify funds. The software which helps a bitcoin owner to manage his funds is called a wallet. The wallet is protected by a cryptographic key, if the owner loses or forgets the key, the funds in the wallet are lost. Or more exactly, the funds are still there but without the key there is no possibility of using the funds.
Is Bitcoin really money? This is hotly debated, there is no clear answer. Most economists agree that Bitcoin is a medium of exchange, one of the main three characteristics of money. Additionally, money is supposed to be a store of value. Here Bitcoin gets a little bit in trouble. Yes, Bitcoin is a store of value but with a very high volatility, which makes it less useful as a store of value. The high volatility also makes Bitcoin a poor unit of account which is the third characteristics of money. Few goods or services have their price quoted in bitcoins.
All in all, understanding how Bitcoin works requires a fair bit of skills in several areas. But you can use Bitcoins without knowing the details how it works. Bitcoin is reasonably safe but you must know how to keep your funds secure. One of the main problems with Bitcoin is the high volatility. Bitcoin was for a long time worth about $10, then it increased quickly to more than $100 and then skyrocketed to more than $1,000. But after that the value of Bitcoin has kept on dropping, at the moment is a bit above $200.
Quite clearly, Bitcoin is a risky investment. The currency itself may be safe but its high volatility makes it possible to lose a lot of money quickly. It is also worth remembering that Bitcoin works outside government regulations. This has some advantages but also makes it more risky. It is worth remembering that governments may crack down on Bitcoin, many governments are fond of keeping their currency under strict control and don’t like competition.