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A Quick Primer on Bitcoin

Bitcoin Overview

Financial innovation has a long history dating back hundreds of years with such constructs as double-entry bookkeeping, wire transfers and online banking. A relatively recent innovation is Bitcoin which was designed as a decentralized, cyber-crypto-currency. Its anonymous creator, Satoshi Nakamoto, first described this new technology in a white paper which detailed the key innovation to making bitcoins functional; namely, the blockchain.

Bitcoin exists exclusively in a digital world. There is no one brick-and-mortar bank or company that issues nor manages bitcoins. This responsibility is designated to the Bitcoin network, a collection of distributed nodes spread out across the world. Each participating node contains a copy of the entire blockchain. The blockchain itself can be thought of as a massive public ledger that houses all of the transactions conducted up to the present moment. Each transaction is simply a transfer of bitcoins from one owner to another. By adhering to the Bitcoin Protocol (embodied in computer code), these nodes work together to confirm each transaction and prevent double spending without the need of a trusted third-party such as a bank or other central clearing agency. Later we will discuss how this works and how to get bitcoins.

From a computer science perspective, Bitcoin works by marrying cryptography and distributed systems. These two technologies have been practical since the 1970s. For example, if you conduct online banking, then you probably know about ensuring that your connection to your bank’s website is secure. After all, you wouldn’t want all of your private financial details traversing the Internet as plain text. Rather, you want the assurance that the communication between your computer and the bank’s server is encrypted. Plus, you want to be sure that you are in fact communicating with your actual bank’s server and not some hacker’s PC. Cryptography helps make this a reality.

An example of a distributed system is the Internet itself. There are millions of computers scattered around the globe communicating with each other, thus forming a massive network. This is made possible by adhering to protocols such as TCP/IP and HTTP among many others. So by combining these two technologies and creating a new protocol, bitcoins are now a reality.

From a financial standpoint, Bitcoin allows any two people anywhere on the planet to conduct trade. Moreover, these two people have absolutely no need for a third-party to complete the transaction. Think of it as Jane handing over a $100 bill to Bill for some product Bill sold her, but they are located on separate continents. Up until now, this would have been impossible. That is why we had very complex banking systems such as SWIFT developed. These wire transfer systems consisted of a collection of trusted intermediaries to collect information, handle management and exchange of the fiduciary instruments, take care of the communications between themselves and the overall settlement of the transactions. All of this complexity added costs to each transaction and the settlement process added a delay (usually three or more days) before the transaction was considered complete. With Bitcoin, a transaction only requires the two parties, the network itself, low transaction fees (usually pennies) and a confirmation within about 10 minutes. These are some great savings! But instead of dealing with US dollars and South African rands, the unit of account is bitcoin.

Transacting in bitcoin

So how does one transfer value via bitcoin? Well the first step is to attain some bitcoin. There are three main ways to do this. First is to purchase some through an exchange. Second is to sell a product or service for bitcoins. You can search the web for many ways to implement ways of accepting bitcoin at your store or business. Third is to become a bitcoin miner. Nowadays it is expensive to be a miner, but you can join mining pools/co-operatives. Bitcoin mining is the actual process that creates new bitcoins. Think of it as mining for gold. However, instead of digging up earth, bitcoin miners must perform a computationally intense calculation to earn bitcoins. This concept is called “proof-of-work”.

In the early days of Bitcoin, mining for bitcoin was easy and people simply used their home PC to run the mining software. Today, by design, mining is more difficult and requires specialized hardware. As we approach the the upper limit of 21 million bitcoin sometime in the year 2140, mining will become more and more difficult. Nonetheless, mining is an essential part in issuing new currency. Essentially, every time there is a transfer of bitcoin from one person to another, a signal is broadcast to the network. The miners use this information and run their proof-of-work algorithm to “mine” a new block which is then attached to the blockchain after a certain number of confirmations by the nodes on the network. For doing this work, the miners are rewarded some bitcoins, which they can then spend, thereby distributing it across the Bitcoin economy.

Going back to our two actors, Jane (living in the USA) and Bill (living in South Africa), let’s imagine a scenario where Bill is offering web design services. Jane wants to purchase a new website design package from Bill.  Bill may charge the equivalent of $100 USD in bitcoin. There are many sites listing bitcoin exchange rates with the major currencies of the world. When Bill is ready to deliver his work to Jane, she opens up her favorite bitcoin wallet and enters the amount to send along with the target address. In this case, the target address is Bill’s wallet address. Think of the wallet address as a globally unique identifier that only belongs to the owner; sort of like your unique checking account id at your bank. In about 10 minutes, the transaction is confirmed by the network (through the work of the miners and nodes). Bill has increased his bitcoin balance in his wallet and Jane now has a new web site design. Both are happy. In this case we demonstrated a transaction conducted by wallets running on Bill and Jane’s PCs. However, there are online wallets and exchange services that enable users to transact in bitcoin as well.

Significance

Notice from our example above that Jane and Bill did not need to call up their bank to initiate the wire transfer and to collect the proceeds days (if not, weeks) later. Furthermore, the transaction cost was only mere pennies whereas with a traditional wire transfer it may have cost $25 or more. In addition, nobody else knew the details of what they were trading; Bill and Jane retained their financial privacy. Only the bitcoin addresses and amounts are public information (remember the blockchain?) as this is the only data necessary by the protocol. No name, phone number, address, source of income, or goods exchanged information is recorded on the blockchain. This is truly a powerful innovation and it is here to stay in one way or another.

We have been discussing bitcoin as a currency, but there are other “alt-coins” that exist. Actually, there are hundreds each filling a certain niche. Bitcoin just happens to be the first using blockchain technology and it is currently the largest in terms of use and market capitalization.

Bitcoin is not without risk, though, as it is still a relatively nascent innovation, but adoption has been growing steadily. The beauty in its design is that it is truly decentralized, so there is no one entity that can be raided, sued or otherwise attacked to destroy it. Notwithstanding loss of electricity or destruction of the Internet, the only real risk to Bitcoin technology is if people abandon the network. As time moves forward, this risk seems to diminish evermore.

Conclusion

Hopefully this article has been helpful in describing Bitcoin. The inner workings of the technology can be quite complex, but so is that of modern cars. Nevertheless, people still use cars even without fully understanding what makes them run. We hope that Bitcoin adoption will continue to grow as people all over the world realize the true strength and the many advantages that Bitcoin offers compared to traditional currency transactions.

Lastly, there is one other way to earn bitcoins. Consider joining Collabovestor where our private membership pays out bitcoin to those who share valuable market information and analysis.

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