Creator of Kelp trading bot (https://kelpbot.io) & SEP-0007 at Stellar
Bitcoin confuses a lot of people because they get lost in the jargon (decentralized, validator, etc.).
In truth, you only need to understand the high-level idea behind why Bitcoin exists. In this blog post, I break it down into a few fundamental questions with simple answers.
Note: When I say Bitcoin, I refer only to the Bitcoin cryptocurrency (BTC). There are many cryptocurrencies created after Bitcoin, these are collectively called “altcoins”. Altcoins is short for alternative coins. As a group, including Bitcoin, you refer to them as “cryptocurrencies”.
What is wrong with traditional money?
Governments back traditional fiat currency, which requires them to propose changes to how money works. Governments exercise this control by adjusting interest rates and money supply. This can be a good thing or a bad thing since sometimes government intervention is required. Either ways, this gives the masses less control over money they have earned.
Today, you could have worked hard for 20 years to save up $300,000 in the hopes of buying a house. This is a lot of money. When the government prints $3,000,000,000,000 of new money out of thin air it “dilutes” your money because of inflation.
The $300,000 you had saved up to buy a house can no longer buy you a house because your money is worth less. This is because of supply and demand. This is unfair.
How does Bitcoin solve this problem?
Bitcoin is not backed by any single person or entity, or a group of people or entities.
Bitcoin is not backed by anything, so nobody can manipulate it.
If nobody is backing Bitcoin then how does it have any value?
Bitcoin will always have 21,000,000 units only. That’s it! No matter what happens, it can never have more.
If the economy crashes or booms it doesn’t matter, only 21,000,000 units of bitcoin will exist. The Bitcoin Whitepaper describes why the incentives are aligned for this limit to remain constant.
Bitcoin uses a new decentralized approach to agreement on who owns how many bitcoins. This allows people to check for fraud payments which keeps the bitcoin network secure. Cointelegraph explains the proof-of-work consensus algorithm well. It is formally described in the Bitcoin Whitepaper.
The fixed supply and built-in fraud protection is why people trust Bitcoin.
What does it mean to trust Bitcoin?
If you are willing to accept Bitcoin as payment for goods or services then you “trust” Bitcoin.
If enough people trust Bitcoin then you can conduct your business using Bitcoin. This will help Bitcoin reach mainstream adoption.
A shopkeeper would accept Bitcoin if their supplier accepts Bitcoin. In turn, the supplier would accept Bitcoin if their own supplier accepts Bitcoin, and on and on. This is already starting to happen.
In this manner, Bitcoin could serve as a “stand-in representation of economic value” that you can exchange for equal goods or services. In other words, this means that you can use Bitcoin as a currency.
Has Bitcoin reached Critical Mass?
Bitcoin has reached Critical Mass but not mainstream adoption yet. This is why informational blog posts such as this one are still needed.
The reputation of Bitcoin has shifted from “niche underground money used by drug dealers” to “banks will hold your Bitcoin and cryptocurrencies”. This means we have reached critical mass and are moving towards mainstream adoption.
USA has very stringent laws related to money. Yet, Coinbase and Gemini operate with the required licenses and compliance. These trading exchanges are well-funded from top VC firms such as Andreessen Horowitz. There are many more well-reputed exchanges around the world such as Binance. These exchanges make Bitcoin and other cryptocurrencies easy to access by almost anyone. Cryptocurrencies have become a lot more accessible since 2017 because of these exchanges.
Here are some of the most notable developments in the Bitcoin space since 2017:
These are all signs that we are past the point of critical mass. There are many more such examples that I’ve left out to keep this section short.
If you want to buy Bitcoin today, you can do so in a safe and secure manner, which was not as easy in 2013 or 2017.
The price of Bitcoin keeps changing. How can I transact in it?
The activity on trading exchanges determines the price of Bitcoin. The price of Bitcoin keeps changing because of market volatility on exchanges. This happens to all currencies. People trade foreign currencies on the foreign exchange market (FOREX), causing volatility.
The price of Bitcoin relative to USD has increased 44x in the past 5 years — that’s a 113% annualized return.
There are many factors why Bitcoin is more volatile than other (fiat) currencies. Here are some:
- Bitcoin is a new currency that introduces a new model for money which is never seen before.
- Nobody knows how to accurately value Bitcoin and price it. Nobody has ever lived to see something of this scale actually come to fruition so we are all in new territory.
- The supply of Bitcoin is pre-determined. It releases on a fixed schedule by the software, halving every four years until all 21,000,000 units are released. Halving events have a large impact on the rate of minting of new Bitcoins. The last halving event happened recently on 11th of May, 2020 and this was the third halving event.
Many people consider Bitcoin to be a hedge against fiat inflation. It also protects against failure of the local economy such as in Venezuela or Puerto Rico. You can think of it as an insurance policy and also as a store of value.
How is the value proposition of Bitcoin different from Gold?
Many consider Gold to be a hedge against inflation. There is an estimated 197,576 tonnes of gold mined throughout history. This number could very well be twice this amount and we would never know, since it is only an estimate. Bitcoin will always have only 21,000,000 units, like I’ve described above.
If you own Gold as a hedge against inflation, the government can pass an act which forces you to sell all your gold to them! They can set the price for Gold in this sale. They did exactly this with Executive Order 6102 on April 5th, 1933. They cannot do this with Bitcoin because it is decentralized. Bitcoin is cheaper to store, transport, use for payments, and is more secure when compared to Gold.
How is Bitcoin cheaper to store, transport, use for payments, and more secure when compared to Gold?
Here are some facts related to Bitcoin to explain this:
- Storage — Bitcoin is data. You can store billions of dollars worth of Bitcoin in a small amount of data. You can store this on a chit of paper if you wanted. This is a lot easier to store when compared to Gold.
- Transport — You can transfer Bitcoin over the bitcoin network. This is a transfer of data. The bitcoin network is the computers connected to form the “internet of money”. You need all sorts of physical security when transporting Gold. Bitcoin offers a much better solution compared to Gold.
- Payment Use Case — Bitcoin is divisible up to 8 decimals. This makes it a lot easier to pay with when compared to Gold. The cost of paying someone 0.01 BTC is the same as paying someone 100,000 BTC. If you want to split Bitcoin to more than 8 decimals you can do so on the Bitcoin Lightning Network. It would be very expensive to melt the exact amount of Gold to pay someone for a $5 coffee. Bitcoin offers a much better solution compared to Gold.
- Security — Bitcoin has multi-signature protection built in. This lets you choose exactly how many people, and who needs to approve a payment for it to go through. If you set up multisig correctly then your Bitcoin will be safe even if someone breaks into your house to steal your Bitcoin. With Gold, if someone steals it then you lose it.
When will the price of Bitcoin become stable?
There are still many things to figure out about bitcoin and cryptocurrencies. Here are the current challenges that people are currently working to improve:
- Scalability — How can Bitcoin scale to support the needs of real-world payments? Currently Bitcoin supports 3.5 transactions per second (i.e. 3.5 tx/s), which is very very slow. Other blockchains are faster such as Ethereum (15 tx/s), Stellar (1,000 tx/s), and Solana (65,000 tx/s). For reference, Visa’s Fact Sheet (download) mentions they have a peak capacity of 65,000 tx/s as off August 2017. There is still a lot of room for improvement in this area and has been the focus of developers in the past few years. See how Ethereum is using Reddit to find the best solution to scale their blockchain.
- User Friendliness — Remember the part where I mentioned the jargon (validators, decentralization, etc)? These relate to the internal workings of blockchains. Most consumers of the technology should not have to deal with this. Developers are innovating to make blockchains and cryptocurrencies simpler to use. This will make it more intuitive, but is a challenging task. The internet was also faced with this challenge. The internet had complex jargon (IP Address, HTTP, HTML, TCP, UDP, etc.). With time and innovation developers abstracted away these complexities. The end user is now very happy with the internet. To learn more about abstractions in technology, see my recent blog post on this topic.
- Mass Adoption — Yes, you read that right. The price of Bitcoin will only become more stable when we reach Mass Adoption. You can think of each person who buys/sells Bitcoin as a “vote” on the price. If someone thinks the price is too low then they buy, if they think it’s high then they sell, or short it. Today, very few people are “voting” for the price of Bitcoin since most of them are “sitting out” of the market. The data shows that the volume of Bitcoin is about $27B per day. At a price of $11,700 this is 2.3 million units of Bitcoin traded per day. Compare that to the volume on the Nasdaq which is $122B per day, or 2 Billion units per day. The “sample size” of the vote that leads to Bitcoin’s price is about 800 times less than the Nasdaq (2.3 million vs 2 billion). This means that someone will need less money to move the price of Bitcoin by 10% compared to moving the Nasdaq by 10%. When more people trade Bitcoin, the number of “voters” will increase, which will bring stability to the Bitcoin price.
Once the world solves these problems, the price of Bitcoin will stabilize.
Two important points to note about this:
- This will take at least a few years or more since these are challenging technical and legal problems.
- The price of bitcoin will likely be higher when it stabilizes. This is because there is a lot of uncertainty and risk associated with Bitcoin today. Developers are innovating to resolve this uncertainty and risk. As uncertainty and risk reduces, people will understand Bitcoin better, which will increase its value as a currency.
What is the Proof-Of-Work Consensus that I keep hearing about?
The details of the consensus algorithm are complex. Cointelegraph explains the proof-of-work consensus algorithm well. It is formally described in the Bitcoin Whitepaper.
Can I contribute to Bitcoin?
Anybody can contribute to Bitcoin. You can contribute your skills such as code, knowledge, content, and marketing. You can help secure the network by running the bitcoin network software (the node).
The code is completely open-source. You can find the code on Github. On there you can take part in the active conversations and see what the developers are up to.
Bitcoin is for the people and by the people. We need everyone to pitch in.
Can I earn or invest in Bitcoin?
Yes! You can earn Bitcoin by:
- charging for products and services in Bitcoin
- becoming a bitcoin miner (investopedia guide)
Who created Bitcoin?
The best known fact about Bitcoin is that nobody knows who created it. The creator (or group) goes by the pseudonym Satoshi Nakamoto.
Nobody knows the reason why Satoshi chose to keep their identity secret. There could be any number of reasons for this. Reading more about this can make for an interesting evening!
One thing for sure is that Bitcoin has had a significant influence on our society already and is here to stay!
(08/19/2020) The limit of 21,000,000 is not explicitly defined in the Bitcoin Whitepaper. However, based on the parameters set in the bitcoin software, the total supply turns out to be 21,000,000 units. The rate of production of Bitcoin reduces by 50% every 210,000 blocks, and the first block starts off with a reward of 50 Bitcoins. Using the Sum of an Infinite Geometric Series formula, we can calculate this to be 210,000 * 50 / (1–0.5) = 210,000 * 50 / 0.5 = 210,000 * 100 = 21,000,000 Bitcoins. This wiki article explains more about the relationship between the parameters of the bitcoin network and the total supply of Bitcoin.
Disclaimer: None of the above information is investment advice, a solicitation to buy the above tokens, use specific exchanges, or factual information in any way, and should not be construed as such. Readers should do their own research. If any errors are brought to my attention I will do my best to fix them. My intention is only to provide information and spread knowledge about the topic. I work at The Stellar Development Foundation as an Engineer on the Kelp cryptocurrency trading bot and I own tokens in all projects mentioned in this post. Everything in this post is my personal opinion only.
This article was originally published here.