What in the World are Bitcoins? Part 1:Foundation

We’ve been focusing more attention on bitcoin, so we thought it was about time to provide a piece explaining more
Photo: Ron Finberg

We’ve been focusing more attention on bitcoin, so we thought it was about time to provide a piece explaining more details about the digital currency. If you are a regular reader you probably know that we are excited about the trading potential of this new currency as well as the cost effective payment solution it can avail companies.

What are bitcoins & P2P transfers?

bitcoin logoBitcoins are a digital currency that was invented by Satoshi Nakamoto in 2008 and went live in 2009. According to Nakamoto, in his 2008 essay ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, he envisioned a P2P network that was based on an electronic currency that would work without the need of a financial intermediary. In his view, there was need to remove the middleman firms from internet based transactions as they increased costs. In his opinion, the existence of financial intermediaries is based on the need for a “trusted third party” to process payments. Specifically, in the world of credit card fraud, scam online stores, and deficient goods, middleman act as the trusted counterparty for merchants and consumers to contact when there is a transactional problem.

The downsides of financial intermediaries are their  costs and control of a transaction. For example, in an industry or region that is known to have a high percentage of chargebacks (when a consumer cancels a credit card transaction), merchants risk seeing their processing fees being raised. As such, even in the event that a firm has a long standing relationship with its customers, and there is a built trust, fees are liable to rise. Also, to maintain the payment networks, fund processors very often charge minimum fees that have adverse effects on smaller size transfers. Nakamoto also pointed out that internet based transactions are often reversible (specifically in the case of credit card transactions). This causes merchants to be vulnerable to a cancellation of orders.

Working to create a solution that would provide a non-reversible and cost effective form of electronic payments, bitcoins were created. Nakamoto wrote “what is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” Basically, rather than trusting a third party to process a payment, users would trust a mathematical formula that was created to ensure that a transaction was irreversible.

The formula is based on the creation of a universal ledger that records all transactions. In addition, each bitcoin, sender, and receiver has its own identifier. Therefore, when Jack sends Jill 1 bitcoin (ID:ABC) to fetch his pail of water (Jack’s head still hurts, so he sends Jill on her own), the ledger records a transaction of one bitcoin being sent from Jack to Jill. At this point, on the ledger, Jill has become the owner of the bitcoin ‘ABC’. Therefore, if Jack tries to send the same bitcoin to Jane, the universal ledger rejects the transaction.

Formula, hmmmmm

In bitcoin terminology, the universal ledger is called the ‘block chain’. It is a public record of all transactions in chronological order. Keeping the block chain operating is the bitcoin network community. The network is a collection of pooled computer resources that keeps the block chain operating. To incentify third parties to provide resources to operate the block chain, Nakamoto’s algorithm created the distribution of bitcoins to volunteers. According to the formula, a total of 21 million bitcoins will be dispersed over a period of every 10 minutes until 2140. However, as time passes, the rate of bitcoin creation slows, with every four years the amount decreasing by 50 percent.

So there we have it. The mathematical formula was built to create new bitcoins into circulation, record transactions, and identify who is the owner of each bitcoin.

Identity

As mentioned above, each user and bitcoin is identified on the bitcoin network. When the block chain creates new currency, each bitcoin is issued its own identifier string. Users on the other hand aren’t ID’d on the block chain (sorry Jack and Jill). Rather than individuals being recorded on the block chain, users create bitcoin wallets, with each one having its own identifier alphanumeric string. Wallets are free and easy to create, and are available as downloadable products, mobile apps, or cloud based.

To receive bitcoins, users send each other their wallet address. In the sender’s wallet, they enter the receiver’s wallet ID, and amount of bitcoins to send. The transaction is sent to the block chain, and within 10 minutes becomes confirmed. At that point the payment becomes irreversible.

Its really not backed by anything?

Ok, so this sounds cool and all, but how can they be worth anything? I understand the block chain, and irreversible payments and all, but what’s the deal with bitcoins?

Providing an intrinsic value to bitcoins is a little tough. Yup, they aren’t backed by anything. But, they are a different type of currency. You can look at it this way, they are bottom-up instead of top-down. A fiat currency can be described as top-down. It’s created by this central authority and the use, value, and methods of transfer are affected by various other factors. With bitcoins, it’s a bottom-up currency. When Nakamoto created bitcoins, he did so with the goal of creating an electronic payment system that solved problems that with existing technology. Therefore, the foundation of bitcoins are P2P transfers and the universal block chain ledger. Working from the bottom, bitcoins were created to facilitate the electronic payment system.

So yes, they aren’t backed by anything, but they don’t need to. The value of bitcoins is that they facilitate the ability for a technological advance in internet based payments to take place. Therefore, the greater the demand for a P2P payment network is, the value of its entire network (including bitcoins) becomes.

Still not convinced? Well, you aren’t the only one. Believing in the value of bitcoins takes a leap of faith in the future of this technology. Also, as it is mathematical based, there is no reason to believe that a competing currency or payment network won’t exist that will prove to be better than bitcoins.

Bottom line, don’t value bitcoins in their worth being a separate currency, but as a key component of an entirely new payment technology structure. Will there be other better currencies and systems created? It’s too early to tell. But, regardless of that answer, the foundation that the bitcoin electronic payment system created will be the influence of future products.

This is part one of our look at just what bitcoins are, in part two we discuss security, where to get a wallet, and just who is Satoshi Nakamoto. Part three will focus on bitcoin firms such as merchant suppliers, exchanges, and trading firms.

Before we conclude, some food for thought.  Bitcoins were created to solve inefficiencies with internet based payments.  Therefore, they wouldn’t appear to be an alternative for face to face cash transactions.  In such a transfer, the payment is irreversible and there is no lack of trust leading to higher transactional costs.  Second, as bitcoins become more widely used, they will ultimately lead to more competition to existing payment networks and cause them to become more efficiently.  In theory, this would lead to bitcoin’s electronic payment benefits to become less desirable. Or, perhaps not; the closer existing payment methods come to resemble a P2P network, it can lead to greater adoption of bitcoins.

One last thing…The best way to learn about bitcoins is to try them out.  You don’t have to fork down $110 or so for a whole bitcoin, and buy them in fractions.

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