What is Bitcoin?

What is Bitcoin?

Cryptocurrency has gone truly mainstream over the past couple of years – and no form of crypto is more ubiquitous than Bitcoin (CRYPTO: BTC)

Sometimes referred to as ‘digital gold’, Bitcoin is the oldest and most valuable cryptocurrency, with a market capitalisation approaching US$900 billion as of January 2022 (though it has previously topped US$1 trillion). However, as with many cryptos, Bitcoin still remains a bit of a mystery to many investors.

In this article, we will explain what Bitcoin is and the technology that makes it possible, so strap yourselves in.

What is Bitcoin?

Bitcoin is a type of digital asset. It is the first – and still, the most widely recognised and traded – cryptocurrency ever created. Like any traditional currency, Bitcoin can be used as a medium of exchange, although it is more popularly seen as part of a new and speculative investment class. Unlike traditional currency, Bitcoin is entirely digital, meaning there are no physical Bitcoin notes or coins in circulation.

Bitcoin’s origins remain shrouded in mystery, with its creator’s true identity still unknown. While Bitcoin was apparently conceived by a Japanese coder named Satoshi Nakamoto, no one has yet been able to confirm any details about Nakamoto, including their real name or whereabouts, and no viable candidates have so far presented themselves.

Whatever their true identity, someone claiming to be Nakamoto published a paper titled Bitcoin: A Peer-to-Peer Electronic Cash System in October 2008. The paper proposed a new type of digital payments network that would allow users to transact directly with one another, without the need for financial intermediaries like banks. This network – now better known as a blockchain – sought to remove central sources of authority from the financial system. It also created the world’s first digital currency: Bitcoin.

What is a Blockchain?

In the paper, Nakamoto described the proposed network as “a system for electronic transactions without relying on trust”. Traditional financial systems are opaque. As customers, we invest a lot of our trust in banks and other financial services providers to execute our transactions faithfully. But a blockchain is transparent, removing the need to trust any central authority.

Think of it like this: in a traditional financial system, a customer deposits their money with a bank, and the bank then takes some of this cash and lends it out to borrowers. The bank records both the deposit and the loan on its balance sheet, but the 2 customers – the depositor and the borrower – are invisible to one another, and simply have to trust in the bank’s ability to properly maintain their respective accounts.

In a blockchain, each user on the network has a ‘copy’ of the balance sheet, with the entire network taking on the role of the bank. For a transaction to be processed successfully, the entire network needs to come to a consensus. In other words, all their balance sheets need to match. When a new batch of transactions is successfully processed, it is encoded in a ‘block’, which is added to an immutable ‘chain’ of previous transactions.

Each block in the chain is connected by a cryptographic code called a ‘hash’. Maintaining the blockchain and coming up with increasingly complex hash code requires time and consumes computing power. So, Nakamoto proposed that peers on the network be compensated with a new type of digital token – called a bitcoin – in exchange for lending their resources to the blockchain.

Coming up with the code, and thereby creating new Bitcoin, is done via a process called ‘mining’.

Bitcoin mining

Mining is how new Bitcoin is created, and it is an essential part of the blockchain. In order to confirm a new block of transactions and add them to the existing chain, users in the network compete to solve complex computational problems. This is how the cryptographic hash that links the chain together is derived. The first computer to solve the problem creates the hash and is awarded an amount of Bitcoin. Then the process repeats itself.

Bitcoin mining requires a lot of computing power and can be a costly and time-consuming enterprise. However, many investors are drawn to the idea that they can literally mint new Bitcoin simply by harnessing the power of their home computer.

Real-world mining is a bit tougher because solving these computational problems requires an incredible amount of processing power. Miners have to sometimes spend thousands of dollars on computer equipment capable of successfully mining Bitcoin.

Oddly enough, it is the size of the network that determines the complexity of these problems, rather than the number of transactions in the blockchain. In the early days of Bitcoin, when there were fewer users on the network, many home computers had the processing capacity to solve these problems. However, as the network grew in popularity and added more users, the problems grew in complexity so that they wouldn’t be solved more rapidly by a larger group of computers.

The rationale behind this is actually to stabilise the flow of new Bitcoin into circulation and thereby preserve its scarcity. The Bitcoin network aims to add one block to the chain roughly every 10 minutes, and it will adjust the complexity of the cryptographic problems in order to maintain that rhythm. This prevents the market from being flooded with new Bitcoin, but it also makes mining increasingly expensive – and energy-inefficient.

The other major downside is that it is mostly chance as to which computer on the network will solve the problem – meaning you could invest all that processing power, and energy, and still get little in return. However, many die hard miners would still argue that it’s worth all the costs for the potential reward: brand new Bitcoin.

Bitcoin halving

As of January 2022, the computer that solves the cryptographic problems the fastest is awarded 6.25 brand spanking new bitcoins for their efforts. The award changes over time. Back in 2009, just after Nakamoto proposed the Bitcoin network, the winner was awarded a whopping 50 new bitcoins for their troubles.

The reduction in the number of bitcoins awarded is driven by a process called ‘halving’. Every time an additional 210,000 blocks are mined – which is roughly every 4 years – the number of new bitcoins minted through the mining process drops by half. In 2012, it dropped to 25, in 2016 it went down to 12.5, and then in 2020 it fell to its current amount in January 2022, 6.25.

It’s worth pointing out that 6.25 bitcoins created every 10 minutes is nothing to scoff at, considering it still translates to around $370,000 based on current market prices. It’s potentially so lucrative that many companies focusing solely on Bitcoin mining have sprung up right across the globe.

The halving process is theoretically intended to continue until a limit of 21 million bitcoins is reached, at which point computers on the network will be compensated with other types of fees for maintaining the fidelity of the blockchain. But we don’t have to worry about this until around 2140, which is when it is estimated that the halving process will end.

Like the increasing complexity of the cryptographic problems, halving helps to preserve the scarcity of Bitcoin. For many Bitcoin investors and enthusiasts, this element of scarcity is the thing that gives Bitcoin its value. Knowing that only a finite number will ever exist tends to make them intrinsically more valuable to people – as is the case with gold and other precious metals. Many investors even refer to Bitcoin as ‘digital gold’, for this very reason.

The recent history of Bitcoin

In early 2009, shortly after Nakamoto first published the paper, the Bitcoin network was launched. The first ever Bitcoin transaction via the blockchain network happened only a few days later, when Nakamoto transferred 10 bitcoins to software programmer Hal Finney. The first commercial transaction using Bitcoin didn’t take place until 2010, when a Florida computer programmer named Laszlo Hanyecz traded 10,000 bitcoins for 2 pizzas.

From these humble beginnings, Bitcoin has grown into an asset with a global market capitalisation approaching US$1 trillion. Just for context, that means by today’s standards, Hanyecz would have paid more than US$600 million for those 2 pizzas. Hope they were worth it!

Bitcoin brought about an entirely new digital asset class – cryptocurrency. Other tech entrepreneurs are continuing to build on blockchain technology, with the Ethereum (CRYPTO: ETH) network, in particular, expanding the applications of blockchain.

Key recent developments in the evolution of Bitcoin include:

 

Creation of Bitcoin cash

Bitcoin cash was launched in August 2017, following an event called a ‘hard fork’. This is when there is a substantial change in the protocol or rules of a blockchain, such that the newest version of the blockchain no longer accepts the older chain of transactions. You can imagine this as a literal ‘fork in the blockchain’, where one chain continues on under the ‘old’ rules, while a second branches off, obeying an updated set of rules.

In the case of Bitcoin, the hard fork was a change in protocol that allowed for a larger number of transactions to be stored in each block, speeding up processing times. This hard fork effectively created a new blockchain with different rules and a new native cryptocurrency, dubbed ‘Bitcoin cash’. The crypto never took off with investors in the same way Bitcoin did, and it has lost about 85% of its value since launching.

 

Bitcoin halving

The halving process discussed earlier can have a significant impact on the price of Bitcoin. A reduction in the supply of an asset tends to result in its price increasing, which is observed with Bitcoin. The price of Bitcoin skyrocketed following its most recent halving in May 2020. A similar, though not as dramatic, surge in price occurred around the time of its 2016 halving as well. Who knows what impact the next halving – due some time in 2024 – will have on the Bitcoin price?

Bitcoin performance so far

Despite its price volatility, Bitcoin has delivered some staggering returns. It’s mindboggling to think that, as recently as 2016, you could buy a bitcoin for well under $1,000. The coins are now valued at well over $60,000 apiece!

However, investing in Bitcoin is not for the fainthearted. Although it has delivered some astounding long-term returns, the price of Bitcoin has been incredibly unstable – meaning that plenty of investors have still lost big by mistiming the market.

If you choose to invest in Bitcoin, make sure you understand the risks involved, and don’t invest any money that you can’t afford to lose.

 

This article last updated on 12 January 2022. Motley Fool contributor Rhys Brock has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and has recommended Bitcoin and Ethereum. The Motley Fool Australia owns shares of and has recommended Bitcoin and Ethereum. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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