“Bitcoin is a remarkable cryptographic
achievement and the ability to create something that is not duplicable in the
digital world has enormous value”
Eric Schmidt
On November 1, 2008, a man named Satoshi Nakamoto posted a research paper
to an obscure cryptography journal describing his design for a new digital
currency that he called bitcoin. Google searches for his name turned up no
relevant information; it was clearly a pseudonym. But while Nakamoto himself
may have been a puzzle, his creation cracked a problem that had stumped
cryptographers for decades. The idea of digital money—convenient and
untraceable, liberated from the oversight of governments and banks—had been a
hot topic since the birth of the Internet.
Bitcoin is best thought of as a natural next step in the evolution of
money. Throughout history, many items have been used as a store of value and
medium of exchange, such as cowrie shells, clay tablets, coins, and now paper
money.
As the global economy became more complex in the second half of the 20th century, most
nations eventually moved away from the gold standard, creating fiat currencies
built on laws and trust in government.As our understanding of money as a store
of value, medium of exchange, and unit of account has matured, so have the
methods and modes for exchanging it. In this sense, the exchange of money has
always been a function of the technology available. We moved from precious
metal coins to paper money before inventing checks, then credit cards. Yet
credit cards weren’t created for the Internet era. They've simply been adapted
to meet the needs of consumers operating in a networked and digital world. With
the consumer-accessible Internet now 20 years old, the question is not why a
currency specifically designed for the Internet has emerged, but what took it
so long.
How does Bitcoin work?
Bitcoin is a protocol for exchanging value over
the Internet without an intermediary. It’s based on a public ledger system,
known as the block chain, that uses cryptography to validate transactions.
Bitcoin users gain access to their balance through a password known as a
private key. Transactions are validated by a network of users called miners,
who donate their computer power in exchange for the chance to gain additional
bitcoins. There is a fixed supply of 21 million bitcoins that will be gradually
released over time at a publicly known rate. There is no monetary authority
that creates bitcoins. The capped supply of 21 million is known to all, and the
rate of supply diminishes over time in a predictable way. As a store of value,
this means that bitcoins are inherently deflationary. It also means that there
is no government or central entity to make discretionary decisions about how
much currency to create or attempt to defend it through monetary policy
actions.
In order to process a bitcoin-denominated transaction, Bitcoin verifies two
facts addressed by current payment systems like PayPal or Visa. The first is
that when user A transfers a bitcoin to user B, user A has a bitcoin to spend
(that is, prevention of counterfeiting). The second is that when user A
transfers a bitcoin to user B, user A is not trying to transfer the same
bitcoin to another user, user C, simultaneously (that is, prevention of double
spending).
As Bitcoin matures, an ecosystem of companies is emerging to support
consumers and retailers in storing, exchanging, and accepting bitcoins for
goods and services:
· Banks and wallets store bitcoins for users either
online or on storage devices not connected to the Internet, known as “cold
storage.”
· Exchanges provide access to the Bitcoin protocol
by exchanging traditional currencies for bitcoins and vice versa.
· Payment processers support merchants in accepting
bitcoins for goods and services.
· Financial service providers support Bitcoin
through insurance or Bitcoin-inspired financial instruments.
What are the
qualities of Bitcoin as a technology system?
Bitcoin has three
qualities that differentiate it from other currencies and payment systems.
· First, Bitcoin is peer to peer, transferring
value directly over the Internet through a decentralized network without an
intermediary. Current payment systems, like credit cards and PayPal, require an
intermediary to validate transactions; Bitcoin does not. As a result, Bitcoin
has been referred to as “Internet cash,” as it can be exchanged from person to
person much like paper currency today.
· Second, Bitcoin is open, yet securely
authenticated. Traditional payment systems rely on the privacy of transaction
information to maintain security. For example, the compromise of a credit card
transaction can result in the release of valuable information that can be used
to conduct future transactions. In comparison, Bitcoin relies on cryptography.
As every transaction is validated with cryptography by the network of miners,
Bitcoin functions because of its openness, not despite it.
· Third, Bitcoin is self-propelling. Bitcoin uses
its own product, bitcoins, to reward or “pay” miners who are providing the
computing power that serves as the engine of the transaction verification
system. As a result, the system does not require the same type of overhead that
traditional payment systems might require. In this sense, Bitcoin functions
because of those participating in the system.
These three aspects
are part of what drives Bitcoin’s success, enabling a nearly frictionless
global payment system. However, these same factors have also created
challenges.Today much of the thinking about the bitcoins and it's applications
to institutional finance remains grandiose and undetailed; perhaps
understandably given the technology and it's early stage of development. Much
of it presupposes that bitcoin-based applications will be simple and trustworthy
enough for investors to use with confidence.Bitcoin was constructed to behave
like a currency: it’s very easy to use bitcoins to pay for goods and services,
especially if what you’re buying is in a different country.But it’s very hard
to be a currency when you’re also a commodity, governed by rules of scarcity
and subject to speculative attack. Given the choice between something old and
solid, on the one hand, and something new and virtual, on the other, the market
is still voting for the asset class which has proved its worth over millennia.
Sree Lakshmi Addepalli
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