Bitcoin is a digital currency created in 2009. What is a digital currency compared to paper currency? Unlike government issued paper currency, it is operated by a decentralized authority. Bitcoin, being a cryptocurrency, isn’t physical, therefore the balances are kept on a public ledger everyone has access to, transparently. Bitcoins are not issued by any banks or governments, nor are individual bitcoins valuable as a commodity. Although Bitcoin is not considered legal tender, it has soared in popularity, and has triggered hundreds of other cryptocurrencies, collectively known as altcoins. As of today, Bitcoin is the largest form of cryptocurrency on the market.
How Does Bitcoin Work?
When first working with Bitcoin, it can be confusing. Trust me, I know, I’m just beginning to learn myself. Most of us were taught how money works when we first started in school. We could physically hold money in our hands and count it, so it was easy to see how it worked. You can’t do that with Bitcoin. So is it money? Is it really an asset? Is it a payment network?
It’s easier to define what it is first than how it works. Bitcoin is software. Sure, stock images show a shiny coin, but at the heart of it all, it’s a program, a set of protocols and processes. When you keep that in mind, it’s easier to understand. It uses cryptography, the science of making and breaking codes.
Bitcoin is a network that runs on a protocol known as the blockchain. A 2008 paper written by a person or people called Satoshi Nakamoto first described both the blockchain and Bitcoin for the first time. Bitcoin is really just a list. Person A sent X amount of Bitcoin to Person B. By adding these transactions, everyone knows where each person stands. These transactions do not need to be done from human to human. Anything can access and use the Bitcoin network. This creates vast possibilities for the internet of things. Imagine, self driving Ubers or taxis having their own blockchain wallets. The vehicle would be sent cryptocurrency from the passenger and would not begin the trip until funds were received. It could refuel itself.
Why Does Bitcoin Have Value?
Let’s start by asking, why does any currency have value? Currency, of any sort, is only usable if it has what’s called a store of value. Meaning, it can be counted on to maintain its value over time. In most societies throughout history, precious metals and commodities were used as methods of payment. Think spices and gold.
But rather than expect their citizens to carry around heavy quantities of cocoa beans or gold, most governments switched to minted currency. They were usable because the government maintained a store of the commodity the minted currency represented. In the US, this usually meant stores of gold.
When most countries left the gold standard, we switched over to what’s called fiat money, which has no physical backing. Instead, it’s backed by faith that our government will stand behind the paper currency and that they and individuals will accept it in exchange for goods and services.
Besides value, a successful currency must also meet qualifications of scarcity, divisibility, utility, transportability, durability, and counterfeitability.
Scarcity- The key to the maintenance of a currency’s value is supply. Too much and the cost of goods will skyrocket, too little, and the economy will collapse.
Divisibility- Successful currencies are divisible into smaller amounts.
Utility- Burdensome precious metals and commodities don’t easily meet this stipulation.
Transportability- See above.
Durability- Coins or notes made out of materials that can easily be mutilated, damaged, or destroyed, or which degrade over time to the point of being unusable, are not sufficient.
Counterfeitability- Just as a currency must be durable, it must also be difficult to counterfeit in order to remain effective. If not, malicious parties could easily disrupt the currency system by flooding it with fake bills, thereby negatively impacting the currency's value.
How does Bitcoin hold up? Under scarcity, quite well, as it was created from the beginning to only hit 21 million coins before ending. Divisibility, excellent, it can be divided down to exceedingly small numbers and traded in the smallest increments. Utility, it’s a cryptocurrency, so no worries about it being burdensome. Same with transportability and durability, it doesn’t physically exist. There is a mild concern about counterfeiting, but it’s minimal. It’s a lot more difficult to counterfeit Bitcoin than it is paper money.
Like fiat currencies, Bitcoin is not backed by any physical commodity or precious metal. Throughout most of its history, the current value of Bitcoin has been driven by speculative interest. It has shown characteristics of a bubble, with drastic price run-ups and a craze of media attention. This is likely to decline as it sees more mainstream adoption. The future is uncertain.
well thought out and simple explanation.