By Paul Tocatlian.
The first time I heard about Bitcoin was in 2012. Jeff, one of the software architects I worked with at the time, was enthusiastic about the matter. What I took away from our conversations is that Bitcoin is a virtual currency that can be used anonymously to buy things online. My limited – and naive – research led me to believe that the primary use cases for Bitcoin were money laundering and purchasing illegal goods on the Silk Road. Given that I had no money to launder and no interest in what was being sold on the Silk Road, I dismissed Bitcoin altogether, despite Jeff’s repeated attempts to convince me that it was the future of money and very cool technology.
Fast forward two years… I’m in Montreal with a few colleagues. One of them, Fred, was even more passionate about Bitcoin than Jeff. Fred had purchased bitcoins as an investment, which appreciated fivefold. His only regret was not buying more. Had I missed the boat? So I returned online to seek the truth. Fred was right. Bitcoin had significantly appreciated in value. But was the bubble about to burst? Should I ignore the news stories about Mount Gox – a Bitcoin exchange – getting hacked and losing $450 million worth of bitcoins? Silk Road was also back in the headlines with Ross Ulbricht‘s arrest, conviction of seven charges related to the Silk Road, and sentence to life in prison without parole. There and then, I dismissed Bitcoin for the second time. Sigh.
Which brings us to today. Right before Christmas, Netflix recommended a Bitcoin documentary… so I watched. It piqued my curiosity enough to watch a second documentary that was equally interesting. At this point, I wanted to learn more, so I decided to go straight to the source and downloaded Satoshi Nakamoto’s original paper on Bitcoin. After reading the paper, I realized that Bitcoin was a lot more than just a currency that could be used for illegal activities. Jeff was right – but don’t tell him I said so. The underlying technology described in the paper has the potential to disrupt entire industries. That week, I read two books on the subject, setup a wallet, and purchased my first Bitcoin. As they say, third time’s a charm.
Bitcoin is a complex topic, covering cryptography, software engineering and economics. It is difficult to grasp its essence with only a superficial look at it. But that is all this article has to offer. We’ll try to answer a few basic questions and wet your appetite for more:
- What is Bitcoin?
- How does Bitcoin work?
- Who invented Bitcoin?
- What can you do with bitcoins?
- How many bitcoins are there?
- How much is a bitcoin worth?
- Are your bitcoin gains taxable?
Before diving into a somewhat dry and elaborate overview of Bitcoin, I suggest you take a short detour and enjoy the following Bitcoin commercial parody which aired on Late Night with Seth Meyers:
Without further due, let me introduce you to Bitcoin…
What is Bitcoin?
Originally referred to as a peer-to-peer electronic cash system by its inventor Satoshi Nakamoto, Bitcoin consists of a cryptographic currency that is transferred, stored and traded on a decentralized network of computer nodes that manage a distributed ledger used to validate transactions.
Bitcoin is a cryptographic currency
Bitcoin is called a cryptographic currency (or crypto-currency for short) because it is based on the science of cryptography, which involves the encoding and decoding of information in order to protect its integrity or secrecy. Without cryptography, Bitcoin could not have existed. Cryptographic tools used by Bitcoin include:
- Public-private key cryptography to handle transactions
- Cryptographic hash functions to secure the information in the ledger
- Symmetric key cryptography to protect a user’s private keys
Bitcoin uses these cryptographic tools to institute trust between otherwise untrustworthy third parties. For example, when a PEZ dispenser seller trusts that the buyer has made a valid payment, the seller can confidently ship the PEZ dispenser. Without Bitcoin, that trust depends on credit cards and banks. Bitcoin establishes that trust without going through established payment systems. It doesn’t require the approval of any private financial institution or government central bank.
The legal status of Bitcoin as a currency varies substantially from country to country and is still undefined or changing in many of them. While some countries have explicitly allowed its use and trade, others have banned or restricted it. The United States classifies bitcoin as a convertible decentralized virtual currency. In Argentina, where the inflation rate averaged 203.46 percent from 1944 until 2015, bitcoin is considered money but not legal currency. Bitcoin is illegal in Russia. While private parties can hold and trade bitcoins in China, regulation prohibits financial firms like banks from doing the same.
Bitcoin is a decentralized network
One of the most innovative features of Bitcoin is that it is decentralized. Most currencies in use today are fiat money, where the currency is issued by a government and its supply managed by a central bank. Bitcoin on the other hand is independent from any institution or government.
Bitcoin operates as a peer-to-peer network of computers – called nodes – that allows its users to engage in pseudo-anonymous financial transactions while ensuring that payments are properly processed. For their efforts, the miners that operate the computers and take on the role of validating transactions are awarded small transaction fees and newly created bitcoins.
There are currently over 6000 nodes distributed across eighty countries. Anyone can support the Bitcoin network by running a node to validate transactions and blocks. However, Bitcoin mining can be difficult, costly, and not without risk. As it stands, mining solo is nearly deprecated. The energy cost and equipment depreciation can cost more than the actual bitcoins earned are worth.
Bitcoin is a distributed ledger
When you purchase a bitcoin, you buy a slot in the ledger that is maintained across the decentralized network.
The idea of a crypto-currency has been popular for years, but it did not gain traction until Bitcoin, which incorporated a ledger combined with financial incentives to keep the system honest and protect it from hackers. The ledger does not store accounts and balances. The ledger – or blockchain – holds the transactions that have occurred in the past as well as the current holders of the funds. It is a financial database that is designed to be immutable and resilient against users trying to double-spend their funds.
How does Bitcoin work?
By solving the double-spending problem
The main technological breakthrough accomplished by Bitcoin is solving the double-spending problem, which occurs when a user tries to spend the same funds twice. This is relatively straightforward to address in a centralized system. However, in a decentralized system, many copies of the ledger are shared among the nodes, which must agree on the state of the ledger when messages between the nodes can be corrupted.
By verifying transactions using a system of consensus
What is consensus? Potential transactions are broadcast to nodes on the network, which in turn devote large amounts of computational power to verify that the transactions are valid using a proof-of-work system. A transaction is considered valid only when a majority of nodes in the network determine that it is valid. This computational power serves the purpose of providing protection against attacks and is rewarded with the payment of small transaction fees and issuance of new bitcoins.
By not identifying users with their personal information
All financial information flowing through the Bitcoin network is public, except for the identities behind the transactions. Bitcoin does not use personal information to identify the holders of funds, but Bitcoin addresses. An address is a long string of seemingly random letters and numbers. An address is the public part of a public–private cryptographic key. The private part of the key is under the safeguard of the user.
By creating an immutable chain of blocks of transactions
Transactions are grouped in blocks of transactions roughly every 10 minutes. These blocks are then recorded one after the other in a chain of blocks, hence the name blockchain. Blocks are linked to create a record of the history of transactions that cannot be altered. The link between blocks is a cryptographic link that cannot be forged unless the attacker has vast computational resources at their disposal.
Who invented Bitcoin?
Bitcoin began as a paper released to a mailing list of cryptography enthusiasts in November 2008 by an individual or group known only pseudonymously as Satoshi Nakamoto.
In January 2009, Satoshi released the first code for using Bitcoin and started the network by mining the first bitcoins. Bitcoin is open source. This makes the source code available for anyone to use, modify, and redistribute free of charge. Interested? Download it from here.
Nakamoto’s release of Bitcoin came one month after Lehman Brothers declared bankruptcy, setting the stage for the 2008 financial crisis. Although the timing was most likely unintentional, it certainly came at a time when many people were losing trust in fiat currencies and methods of controlling money.
Satoshi Nakamoto is believed to hold an estimated 1 million bitcoins, worth $428 million as of April 17, 2016. Satoshi largely went underground in 2010. However, as intended, Bitcoin’s popularity and the range of use cases for its distributed ledger protocol have continued to grow despite the absence of its creator.
Who is Satoshi Nakamoto? No one knows. Not conclusively at any rate. Numerous people have been suggested as possible Satoshi Nakamoto’s by major media outlets:
- On Oct. 10, 2011, the New Yorker published an article speculating that Nakamoto might be Irish cryptography student Michael Clear or economic sociologist Vili Lehdonvirta.
- A day later, Fast Company suggested that Nakamoto could be a group of three people – Neal King, Vladimir Oksman and Charles Bry – who together appear on a patent related to secure communications that was filed two months before bitcoin.org was registered.
- A Vice article published in May 2013 added more suspects to the list, including Gavin Andresen, the Bitcoin project’s lead developer; Jed McCaleb, co-founder of now-defunct Bitcoin exchange Mt. Gox; and famed Japanese mathematician Shinichi Mochizuki.
- Perhaps most famously, in March 2014, Newsweek ran a cover article claiming that Satoshi is actually Satoshi Nakamoto, a 64-year-old Japanese American engineer living in California.
- Or is Nakamoto this unknown Australia genius? Maybe yes, maybe no.
What can you do with bitcoins?
Very much like traditional money, Bitcoin is expected to satisfy three functions:
- As a medium of exchange, bitcoins can be used to facilitate the sale, purchase or trade of goods between parties.
- As a store of value, bitcoins have value and can be stored and retrieved over time.
- As a unit of account, a bitcoin is a measurement of value that is divisible, fungible, and countable.
Some of the most common Bitcoin business applications include:
- Money transfer. The average fee in the remittance market is reported to be in the range of 8% to 9%. Bitcoin transaction fees on the other hand are in the order of 0.01% to 0.05%. In principle, Bitcoin has a cost advantage compared to current money transmitters.
- Exchanges. Exchanges allow users to convert bitcoins (and other cryptocurrencies) to money. Some exchanges allow the conversion of different cryptocurrencies, such as between bitcoin and other alt-coins.
- Thousands of merchants have signed up with the leading payment processors. The fees charged stand at around 1%, which compare favorably with fees of around 2% to 3% for other payment methods such as credit cards.
- Web wallets. Web wallets are companies that hide the complexity of managing a Bitcoin wallet from their users, providing an experience more similar to online banking services.
- Mining. Miners receive revenues via block rewards and transaction fees. Total mining revenue for a year is around 1.3 million bitcoins. Mining is therefore one of the biggest businesses in Bitcoin.
- ATMs. Bitcoin ATMs allow users to buy or sell bitcoins with cash. Optionally, some ATMs might generate a paper wallet, that would include the public and private keys for users that do not have a wallet.
Regardless of what you plan to do with your bitcoins, be sure you store them in a safe place…
How many bitcoins are there?
There are approximately 15 million bitcoins in circulation today. New bitcoins are minted approximately every ten minutes when a transaction block is added to the ledger. This will continue until 21 million bitcoins have been created in the year 2041. At that time, no further bitcoins will ever be issued. Contrast this to a central bank that has the authority to issue new currencies at any time, therefore deflating its value.
How much is a bitcoin worth?
Bitcoins are the unit of currency of the Bitcoin system. A commonly used shorthand for this is “BTC” to refer to a price or amount (e.g. “1 BTC”). The price of bitcoin will fluctuate based on it’s perceived value. As of April 17, 2016, a bitcoin was worth $428. See how much a bitcoin is worth today.
[Update: The price of a Bitcoin has skyrocketed in 2017. Its price hit a record high of $19,343.04 on December 16, 2017. The value of a Bitcoin has gone up 1,467.95% ($13,126.48) in the last year. But it’s also down 26.54% ($5,065.97) in the last week. So if you’re thinking of getting in on the Bitcoin rush, be prepared for some volatility, or as my colleague John Kelley calls it “the rollercoaster ride of a lifetime.”]
A bitcoin can be divided down to 8 decimal places, known as a Satoshi. Therefore, 0.00000001 BTC is the smallest amount that can be handled in a transaction. If necessary, the protocol and related software can be modified to handle even smaller amounts.
Are your bitcoin gains taxable?
Yes. Most sales of bitcoins and cryptocurrencies of many sorts are considered taxable as sales. The IRS currently considers cryptocurrency to be property, not currency, despite the name. Before December 31st, 2017, a “like kind exchange” under IRC Code Code Section 1031 was technically possible for some cryptocurrencies. But you’d have had to have found a tax professional willing to sign your tax forms with such a position.
Bitcoin is a cryptographic currency that has the potential to empower people of all nations to take back control over their financial lives. It removes government monopolies over the creation and management of money, replacing politicians with mathematics in a decentralized network. It cuts down on the cost and burdens imposed by middlemen such as banks, credit card companies, and money transfers. More than 100,000 merchants accept Bitcoin as payment and the number of Bitcoin users is now estimated to be at around 10 million worldwide and constantly rising. Yet, it is just be beginning.
Bitcoin is more than a cryptographic currency. Its underlying distributed ledger technology – called the blockchain – has the potential to transform entire industries beyond financial services including art, education, energy, entertainment, from fine wine to lotteries, governments, healthcare, insurance, IoT, law, music, pay TV, real estate, smart cities, supply chain management, travel, and many more businesses and society altogether.
Alternative blockchain implementations such as the Ethereum and Hyperledger projects are beginning to emerge. Blockchain technology could be the most disruptive invention since the Internet – driving the forth Industrial Revolution – and deserves its own article. Until then, checkout this video and follow Bitcoin Twit on Twitter for the latest stories on Bitcoin and the blockchain.
One More Thing
Before venturing into the world of Bitcoin, check out John Oliver for a dose of reality!
One Last Thing
Thinking about launching your own Initial Coin Offering (ICO)?
This article contains derivative works of Mastering Bitcoin by Andreas M. Antonopoulos used under CC BY 4.0, and Wikipedia used under CC BY-SA 3.0. This work is licensed under CC BY 4.0 by Paul Tocatlian.