The evolution of money
Money at its core represents value and is used as a medium of exchange between two parties. Centuries ago, people used to exchange goods or services for other goods or services during the era of the barter system. However, the difficulty to calculate the value of goods on a large scale and the challenges of finding someone who needed what you were offering in exchange for something you also needed forced people to create an alternative system. Gold seemed like a viable solution since it was scarce and provided a good store of value. However gold was also difficult to transport and store, not to mention the challenge of verifying its authenticity. This was when the concept of paper money began to emerge, and the trust model of people slowly changed from trusting something to trusting someone. Banks or ruling governments began to take possession of commodities like gold in exchange for paper notes and consequently, led to the creation of paper money.
Initially, the value of many paper currencies like the US Dollar and the British Pound were actually linked to the price of gold and this was called the Gold Standard. A country that followed the gold standard established the price of gold and exchanged paper notes for gold at the mentioned price. This fixed price was used to establish the value of a currency. Later on, the US government unpegged the dollar from gold. Therefore, the gold standard was completely abolished and replaced by fiat currencies. Consequently, a currency that was created by the government's order, or fiat, was mandatorily accepted as a means of payment for everything.
As mentioned, fiat currency is a paper currency issued by the ruling authority or government and is not backed by any physical commodity such as gold or silver. In other words, fiat currency holds its value because the government maintains its value and the parties, who use it as a medium of exchange, agree to its value.
The two major challenges of fiat currencies are that they are centralized and have an unlimited supply. The central banks or the ruling government issues and controls the fiat currencies. Under the discretion of a centralized authority, fiat currencies can be printed in unlimited quantities whenever required and this can inflate the monetary supply. The problem of printing a lot of money, even if it is to cope with any critical situation, is that the market gets flooded with more money and this, in turn, erodes the value of the citizen’s money.
The enormous power a centralized authority holds paved the way for corruption and mismanagement. The right of the government to cancel the legal status of the currency (demonetization) also creates an environment of turbulence in the public’s mind. The emergence of malpractices like printing of fake currency notes and the difficulty for the common public to differentiate it from legitimate ones also creates problems.
To address all of these issues, we needed an alternative to the current monetary system. This was when in 2008 the concept of a decentralized digital currency called ‘Bitcoin’ came into action.
What is Bitcoin?
Bitcoin (BTC) is the world’s first decentralized form of digital money. Bitcoin was first published as a white paper by an anonymous programmer or a mysterious group under the name of Satoshi Nakamoto. The goal of Satoshi was to build a peer-to-peer electronic cash system that would be governed by computer code and secured by cryptography. Unlike traditional fiat currencies, Bitcoin cannot be printed, and its quantity is limited to only 21 million bitcoin. In addition, BTC can be exchanged between two parties anywhere across the globe and does not require a bank to approve the transaction.
How does Bitcoin work?
Bitcoin transactions are stored in a public, distributed ledger called the blockchain. The concept of blockchain technology was first implemented to process Bitcoin transactions. As the name indicates, a public distributed ledger in a blockchain is made of blocks that contain digital data. Each block is linked with the data of the previous block and this chain of blocks is called the blockchain. The public, distributed ledger used in the Bitcoin network is consensually shared and synchronized across multiple sites/locations. All the transactions in the bitcoin network are publicly stored and can be witnessed by anyone. Therefore the goal of implementing blockchain technology in the Bitcoin network is to permit digital data to be stored, distributed, and witnessed by people across the globe without it being tampered.
One of the most important features of bitcoin is that it is decentralized, which means it is not controlled by any banks or ruling government of any country or any other central authority. Unlike banks, there is no single computer that holds the transaction details. In Bitcoin, every computer participating in the network is interlinked with one another and each one holds a copy of the ledger. To make it clearer, before a transaction is processed by the network (i.e. a bitcoin is sent to another person), the network verifies the authenticity of the transaction. Also, if for some reason any part of the network fails, the processing of money continues as the entire network holds a copy of all the transactions.
Bitcoin maintains a completely transparent ledger. What does transparency mean? Let’s compare bitcoin transactions with that of the traditional banks. A bank normally maintains a ledger of the balances and the transactions that are stored on its main computer. The ledger is however not transparent, and there is no access for anyone other than the banks who keep complete control of it. Bitcoin, on the other hand, is completely transparent, and anyone can view the balances and the transactions that are getting processed within the network. The only thing that a user cannot track is who owns what balances, and who is the owner of each transaction. In other words, Bitcoin creates a certain level of anonymity while maintaining transparency.
We know that the supply of bitcoins is fixed at 21 million. In the case of new bitcoin, only a small amount enters into circulation every hour, and this process is strictly controlled by an underlying mathematical formula. The fixed supply of bitcoin makes it scarce and therefore a reliable store of value.
Safety, Security, and Immutability
In Bitcoin, once a transaction gets recorded on the network, it cannot be reversed or modified, unlike traditional currencies. The computers that secure the Bitcoin network are inter-connected to each other and each computer holds a copy of all the transactions and also keeps on updating it. So, to pull down or hack the network, data stored at every computer participating in the network needs to be modified at the same time. So any kind of data tampering is almost next to impossible and this makes the Bitcoin transactions highly safe, secure, and immutable. This also solves the “double-spend problem” (using the same money twice) as a transaction once recorded on the Bitcoin network cannot be altered or reversed.
What is Bitcoin mining?
Bitcoin mining is the process of asking computers to solve mathematical problems in order to confirm transactions and secure the network. As a reward for their work, transaction fees are distributed to miners. In addition, they collect newly released bitcoin. Mining is very competitive and the distribution of rewards is based on the computer processing power of each miner. Therefore, mining Bitcoin is not easy money as some people assume.
What happens when a transaction is initiated?
When a Bitcoin transaction is initiated, the transaction message is broadcasted across network participants called nodes. A node is simply a computer running the Bitcoin program. Nodes form networks that verify each transaction to ensure it follows the rules of the Bitcoin protocol.
What is a miner?
A miner is a node that passes a transaction into a block. In order to validate the block, the miner must solve a complex math puzzle generated by the system. A miner needs a lot of processing power to find the answer to the math problem. To successfully mine a block, a miner needs to be the first to guess the string of numbers. Once the miner solves the puzzle, the new block along with the mathematical solution is then transferred to the other nodes within the Bitcoin network. The network then authenticates the transaction by verifying the work of the miner to ensure it meets the guidelines of the protocol. Once the work of the miner passes through all of the checks and balances, each network updates its copy of the Bitcoin ledger with the list of transactions that are selected to be included in the new block.
What is a block reward?
When a miner successfully mines a block, the system releases a specific amount of bitcoin and rewards them to the miner. This reward is given to the miner as compensation for the time and energy spent in solving the complex math puzzle and it is agreed upon by everyone within the network. Besides the block reward, the miners are also awarded transaction fees that were attached to the transactions included in the block.
What is mining difficulty?
As previously mentioned, mining Bitcoin is expensive and competitive. The Bitcoin network is designed in such a way that the more mining power the network has, the tougher it is to figure out the solution to the mathematical puzzle. This difficulty is self-adjusting to the accrued mining power the Bitcoin network holds. If more miners participate in the network, the more difficult it is to solve the math problem. However if some of the miners leave the network, it becomes easier. This is called the mining difficulty. Mining difficulty is a measure that determines the difficulty level to solve the complex mathematical puzzle during the mining process. Mining difficulty was set to generate a steady flow of Bitcoin and maintain inflation in check. The mining difficulty is set so that on average, a new block gets added to the system every 10 minutes.
Evolution of miners since 2009
Back in 2009, the CPU or the central processing unit of a system was sufficient to mine bitcoin as the mining difficulty rate was low. However as the network began to expand and difficulty levels rose, users had to look for more powerful solutions. CPU gave way to GPUs (Graphical Processing Units) initially, which were further replaced by FPGAs (Field Programmable Gate Arrays) and recently to ASICs (Application Specific Integrated Circuits).
What is a mining pool?
Individual miners join together to form a pool in order to combine their mining power and compete more effectively in the mining race. This is called a mining pool. If a pool succeeds in winning the mining race, the block reward is equally distributed among the pool members based on the mining power each member contributes to the mining activity. Mining pools allow even small miners to take part in the mining game even though they only get a part of the mining reward.
Is the mining process profitable?
Bitcoin mining’s profitability is based on many different factors. Let’s look at each of these factors:
Hash rate: The mathematical puzzle a miner needs to solve is called the hash. The number of guesses made per second by the computer is called the hash rate. This can be measured in megahash per second, gigahash per second, terahash per second, and even petahash per second.
Block reward: The number of bitcoins awarded to the miners when the miner completes the mathematical puzzle. The block reward was set to 50 coins per block when Bitcoin mining began in 2009.
Mining difficulty: The value that determines how hard it is to mine a bitcoin at a particular period based on the mining power currently active within the network.
Electricity cost and power consumption: The electricity rate that is spent per month for mining activity is required to calculate profitability. Electricity is required both for powering up the computer and for cooling it down as the computer tends to become hot during the mining process.
Pool fees: If the mining activity is processed through a mining pool, the pool takes a certain amount of the profit in return for their services.
Bitcoin’s Price: As Bitcoin is highly volatile, it’s hard to predict Bitcoin’s price in the future which in turn makes it hard to predict if Bitcoin mining will be profitable in the future.
Increase in difficulty per year: The fact that it is hard to predict the rate of miners joining the Bitcoin network in the future makes it equally tough to predict the mining difficulty rate in a few weeks, few months, or few years.
Once upon a time, individuals could mine Bitcoin in their basement. However today, the Bitcoin mining industry is dominated by large companies and high net worth individuals. Although the mining process allows miners to earn bitcoins from the network, the main objective is to validate the Bitcoin transactions and maintain the ledger in a decentralized environment.
What is the Bitcoin halving?
The Bitcoin halving or the halvening process is an event where the block reward distributed to the miners for mining new blocks get cut into half. This means that the miners will receive 50% fewer bitcoin for confirming new transactions in the block. The halvening event is scheduled to occur approximately once every 4 years or once every 210,000 blocks get mined. The halvening process continues until the maximum supply of 21 million bitcoin have been released into the Bitcoin network. This is expected to happen sometime around the year 2140.
When did the last halving take place?
The May 2020 halvening event was the third in Bitcoin history and the number of mined blocks reached 630,000 at this time. The block reward received by miners was cut from 12.5 Bitcoin to 6.25 Bitcoin per block.
What is the impact on the price of Bitcoin?
In the previous two halving events, the Bitcoin price experienced a sharp rise. For example, the first halving which occurred in November 2012 resulted in the price of one bitcoin going from $11 to $1150. After the second halving event, the price of Bitcoin surged from $576 in June 2016 to $20 000 in December 2017. Later it fell to around $3200, which was still nearly four times the price before the last halving.
What is the impact on mining?
The halving of block rewards has a significant impact on the mining industry. Due to high hardware and electricity costs, the decrease in mining rewards may force some miners to tighten their belts in the short-term. Some miners may stop mining altogether if the price of Bitcoin doesn’t increase to compensate for the reduction in bitcoins earned. However, some mining companies are prepared for this event and adjust their resources in order to adapt to any volatility in revenue. They upgrade their systems to incorporate next-generation power-chips and make their systems faster and more energy-efficient. Irrespective of the state of the miners, the speed at which the blocks are mined remains stable in the same way as it was before the halvening event. The Bitcoin software automatically adjusts the mining difficulty rate of verifying transactions to retain a steady rate. As it is said, “Adversity is the mother of innovation”, miners tend to find cheaper and more efficient sources of energy to reduce their costs. Consequently, the halving also opens the door to new miners who have access to cheaper sources of power. Recently, rewards were halved but prices did not increase proportionally right after the third halving event. Such a scenario should have reduced the mining competition as well. However the mining difficulty reached an all-time high during June 2020, potentially implying that the mining competition has only increased.
How to keep your bitcoin safe?
What is a Bitcoin wallet?
A Bitcoin wallet is an application that is used to store, send, and receive bitcoin. Similar to how your Gmail allows you to manage the emails you send and receive, a Bitcoin wallet allows you to easily manage your Bitcoin transactions.
How does a Bitcoin wallet work?
A Bitcoin wallet contains software that stores your private key. The private key allows you to control the bitcoin that the wallet holds on the blockchain. Two important factors are associated with a Bitcoin wallet; your public address and your private key.
What is a private key?
A private key is a secret string of data that is generated using the Bitcoin wallet software and this piece of data acts as a password for your money. The password is a long string of numbers and letters. The private key allows the wallet to send and receive Bitcoin. The most critical aspect here is that anyone who knows the private key gains control of all the Bitcoin stored on the wallet. Therefore, the private key must never be revealed to anyone.
What is a Bitcoin address?
The Bitcoin address is similar to your email address and can be given to all those who wish to send you bitcoin. Your Bitcoin address is also called the public key. In other words, your private key is like the key to your house and the public key is like your house’s address. Similarly to how you need your house key to gain access to your belongings, you also need the private key to send and receive your bitcoin. Therefore, you need to securely store your private key the same way you store your house key. Luckily the wallet software automatically locks up the private key and unlocks it when you need to transact. Therefore you don’t have to enter any private key information each time you send or receive money with your wallet.
What is a digital signature?
Apart from holding your Bitcoin address and private key, a Bitcoin wallet also signs Bitcoin transactions on behalf of the user using the user’s private key and broadcasts the Bitcoin transactions to the network. When a user needs to send bitcoin to a different person, the user needs to prove ownership of the corresponding bitcoin. When the user proves his/her ownership, the network agrees to update the ledger of transactions. In order to achieve this, the signature links the wallet to the private key without exposing it. The digital signature is generated by using complex mathematical rules called cryptography. This process is similar to the process of signing a cheque to approve the transfer of money from your bank account. The broadcasted digital signature is then validated for authenticity by the whole network. Once verified, the miners include the transaction on the blockchain and the transaction is marked as complete. In a nutshell, the primary purpose of a Bitcoin wallet is to generate, store and permit the usage of the private key to process Bitcoin transactions.
What is a recovery seed?
As the concept of Bitcoin wallets began to develop, Hierarchical Deterministic Wallets or HD wallets were created. HD wallets create an initial mnemonic phrase called a seed. A seed is a string that is a combination of commonly used words and can be easily memorized. This seed is used as an alternative to the long private key. In case the wallet gets lost or damaged, this seed can be used to reconstruct the private key and recover your wallet. Also, an HD Wallet can generate several Bitcoin addresses using the same seed. All the transactions that are sent to the Bitcoin addresses created by this seed belong to the same Bitcoin wallet. In fact, it is recommended that each address should only be used for a single transaction.
As the seed and the private key provide access to all the Bitcoin available in the wallet, they must be saved and stored with utmost care. If the recovery seed and the private key get lost, then the Bitcoin it controls is also lost forever.
Where is the private key stored on a Bitcoin wallet?
When you use a software wallet, the private key is stored on the computer. However when you use a web based wallet, the private key is stored on a remote server. In a standard Bitcoin wallet, a wallet.dat file is created that contains the private key. It is important to back up this file by copying it to a safe location such as an external hard drive or a piece of paper that is securely stored. In the case of an HD wallet, a seed phrase of about 24 commonly used words gets generated and these words also need to be stored in a safe place.
What are the various wallets that are available today?
- Full nodes and SPV wallets
Many types of wallets are currently available to store your Bitcoin. Some wallets contain a full copy of the blockchain ledger to verify every transaction. These wallets are referred to as full nodes. There are certain wallets called SPV or Simple Payment Verification Wallet or lite wallets that do not hold the entire copy of the blockchain. Such wallets depend on the full nodes to validate the transactions. SPV wallets are much faster than their peers and consume very little disk space. As the Bitcoin network is expanding day by day, many wallets provide the SPV solution to make them compatible with limited capacity devices like mobile phones, tablets, and desktops.
- Hot wallets
Hot wallets require an internet connection to function. It can either be a wallet that is connected to a website such as an exchange or a wallet that is installed on a desktop or even a wallet that is installed on a mobile device. Although hot wallets are popular due to their convenience, they are not the most secure way of storing your Bitcoin since they are more accessible.
1) Web service wallets
Web services wallets are the online wallets that websites like exchanges use to manage your funds. The greatest advantage of web wallets is that they are generally easy to use and are a quick way to buy and sell bitcoin. On the downside, web wallets are highly insecure as the user does not have control of his/her private key. When you use a wallet on a website, you are trusting them to hold your bitcoin securely. Such wallets are highly prone to hacking and other malpractices. There are many loopholes in web wallets and these are highly favorable to bad players. The website that stores the private keys, the mobile phones that are used for accessing the website or the internet connection used can be compromised by hackers to confiscate your bitcoin. The web service provider’s honesty and the security practices implemented by them play a crucial role in the security of a web wallet. Many trusted web wallets provide multi-factor authentication options like verifying every login with a text message to prevent any external fraud. Despite these factors, there is always some risk involved in storing any significant amount of bitcoin on a web wallet.
2) Desktop Wallets
Desktop wallets are a type of wallet that stores the private key on your computer. As long as the desktop is protected and free from any malware, the bitcoin stored is secure. However in today’s world, no device is 100% protected and this fact makes the desktop wallets relatively vulnerable if your computer gets hacked.
3) Mobile Wallets
Mobile wallets are applications that store the private key on a mobile phone. A mobile phone is indeed a personal device where people tend to store personal data. It is also possible to trace the location details with respect to a cell phone. Therefore, privacy and security may be a concern. The portability factor of a mobile phone poses the threat of your phone getting lost or damaged too. Hence, it is highly recommended to keep a recovery seed or a private key backup for all mobile wallets. Although most of the mobile wallets are designed to provide high security in an insecure environment, it is advisable not to store large funds on a mobile wallet.
- Cold Storage Wallets
A cold wallet is considered to be highly safe and secure as it is kept offline. This ensures that cold wallets cannot be hacked remotely as in the case of hot wallets. Let’s look at some of the cold storage options.
1) Paper Wallets
Paper wallets store the private key on a piece of paper. Such wallets tend to get destroyed easily and so it is ideal to have multiple backup copies. Backup copies ensure that even if one paper wallet gets destroyed, it is still possible to retrieve the bitcoin safely. One factor that needs to be considered in the case of a paper wallet is that in order to send bitcoinji to another address, it is required to import or sweep the private key to any kind of digital wallet (i.e. transferring a copy of the private key to the software of the digital wallet).
2) Hardware Wallets
Hardware wallets are a physical piece of equipment similar to a USB key that stores the private key on the actual device. In order to access a hardware wallet, it must be plugged into a USB port. In this case, the private key remains secure even if the computer gets attacked by any malware. Hardware wallets can be safely used on any public computer without the fear of being hacked. Hardware wallets also have a recovery seed that ensures security in cases where the device is broken or is lost. A hardware wallet needs to be connected to a computer and a specific type of program must be downloaded to communicate with it. This program acts as a link and prepares the wallet to process transactions. Once the hardware wallet receives a Bitcoin transaction from the program, the wallet uses its private key and signs the transaction on the wallet itself. The signature is then transferred back to the program. The private key is not transferred and remains on the hardware wallet. In this case, only the signed and the unsigned transaction get transferred between the computer and the hardware wallet. To make sure the bitcoin is safe, one thing we need to ensure is that the transaction that gets displayed on the device matches the transaction that is shown on the computer. Hardware wallets are one of the safest ways to store the private key. The only downside is that you need to transport the hardware wallet when you want to send bitcoin. Some of the most popular hardware wallets are Trezor, Ledger Nano S, and KeepKey.
Multisig or a multi-signature is a product that allows users to send bitcoin only with the validation of enough private keys from a set of predefined wallets. For example, if an agreement is made between two parties and it’s decided that the bitcoin can be spent only if both agree, then both of their private keys are required to validate a transaction. There are currently companies that also offer multisig services as well.
To conclude, security, convenience and usage play a major role in the choice of wallets. Other potential decision influencers are the need to entrust a third-party for storing the wallet and the need for sharing a wallet. Depending upon the above factors, one may choose to go with a single wallet or multiple wallet options as well. For example, if you need to send or receive a small amount of bitcoin, a hot wallet may be a good option. Whereas if you need to store a large amount of bitcoin, a cold wallet may be a better option.
Who uses Bitcoin?
Since Bitcoin is scarce and immutable, it is regarded by many as the ultimate store of value. This is why some people refer to Bitcoin as digital gold. However Bitcoin is much easier to transact with and to store than gold. Therefore investors all over the world now hold bitcoin in their portfolios. In fact, hedge funds and large financial institutions are also pouring into Bitcoin because they recognize the value of Bitcoin as a financial asset. Furthermore, Bitcoin is a decentralized payment system, thus making it accessible to individuals who do not have access to the traditional banking system. Today, with the availability of mobile phones and with just the click of a button, Bitcoin can be sent by anyone to anyone across the globe within minutes. In addition, Bitcoin is now being accepted as a method of payment in certain online stores, ticket/ hotel booking sites, and even by some brick and mortar stores.