Bitcoin is a bit of a buzzword in the worlds of finance and technology right now. It has been featured on broadcast news as well as nearly every major financial and tech publication both online and print. But what exactly is it?
Well Bitcoin is the first of a new breed of digital currencies known as cryptocurrencies. They are a completely electronic means of holding and transferring wealth in the digital world. They are currency just like the dollar, euro, and yen in that they are used as a standardized means for conducting trade. The difference is in how these new currencies are created.
Traditional or fiat currency like the dollar is issued by a nation’s central bank and backed by the credit of the issuing institution. Rather than being issued by some central power, Bitcoin is created, or “mined” by users on the network. There is no central authority which controls or issues bitcoins. They are backed up by the total of all the users and miners who are connected to the blockchain through the bitcoin protocol.
There are essentially two types of users who comprise the blockchain network. The first and most critical are the miners. Miners started out as individuals using personal computers and graphics processors to “mine” the coins. Mining bitcoins involves solving incredibly complex mathematical equations, and the difficulty is ever increasing. The name cryptocurrency comes from the fact that the blockchain and bitcoin protocol are based on the sha-256 cryptographic algorithm which has been used for data encryption for some time. Solving one of these cryptographic problems generates a new block in the blockchain. Once the solution is confirmed by the network the miner who solved it is awarded the bitcoins assigned to that block.
As the difficulty of solving the problems increased so did the computing power necessary to achieve it. Nowadays mining bitcoin is beyond the reach of an individual with a pc and a few graphics cards. Companies have developed purpose made processors which are vastly more efficient than graphics cards when it comes to solving the cryptographic hashes.
The blockchain serves as a huge public ledger which keeps record of every bitcoin transaction. When a transaction takes place or a new block is solved every computer connected to the bitcoin protocol checks the requested change against their own local copy of the blockchain to validate it. At least 51% of the computers on the network must agree that the transaction is valid in order for it to be added permanently to the ledger.
Each tiny fraction of a bitcoin is unique and accounted for somewhere in the blockchain. To limit the number in circulation the difficulty rises every time a new block is discovered. The bitcoin protocol is set up so that only 21 million bitcoins will ever be produced. As the difficulty of finding new blocks increases and the reward decreases the miners will rely on the transaction fees to offset the cost of maintaining the network. Right now the transaction fees are small compared to the reward from solving blocks, but as more and more people use bitcoin and the number of transactions increases the fees will hopefully be enough to pay for the computing power.
Bitcoin and its many cryptocurrency cousins are a step forward in the world of digital finance. Which ones will come to dominate the market remain to be seen. The one thing that is for sure is that digital trust and decentralized finance are making waves in the world economy.