Bitcoin – A Beginner’s guide

Part Two of a new weekly blog on the rise of cryptocurrencies

Before I delve into the effect cryptocurrencies such as Bitcoin have had on treasury functions and currency trading, it is worth stepping back and looking at how cryptocurrencies work. For this blog I will concentrate on bitcoin, the original and most successful currency.

At its most basic level, bitcoin is simply a digital currency, and someone using bitcoin to buy or sell products online would not notice any great difference to using pounds or euros. You just download a wallet onto your phone or computer via an app, and you can send and receive coins just like you would do with cash. You can buy bitcoins with normal currencies.

Behind the scenes, however, bitcoin is a world away from physical currencies or ‘fiat’ currencies as they are often referred to.

Why bitcoin?

Bitcoin was created by the elusive Satoshi Nakamoto (Read more about the mythical Nakamoto here) because he believed the existing methods of financial transactions were heavily reliant on trust, which made them inherently unstable.

He wrote: “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes.”

His desire was to create a system that allowed transactions to take place without the need for any third party, and was also safe and secure.

The challenge

The biggest challenge facing a digital currency was how to stop people spending the money more than once. With a banknote it is impossible to pass the same note to someone twice, but for online currencies it was a big dilemma.

Nakamoto solved this issue through his supreme mastery of Cryptography, a method of protecting information and communications through the use of codes (“crypt” means hidden” or “vault” and “graphy” stands for writing.). Such is his mastery of coding, that it is seen as  virtually impossible to break bitcoin’s source code and manipulate the currency’s supply.

Central to the success of bitcoin is its use of a global community (Miners) who allow their computers to join together to create a huge processing network. When a transaction takes place an encrypted code is published and verified by the global network of computers.

The verification is achieved by Mining – a process of making computer hardware undertake mathematical calculations to confirm transactions.

Everyone in the network can witness that a bitcoin has moved and that a transaction has taken place, although the buyers and sellers retain their anonymity.

Should someone try and spend money twice, two transactions would be generated and the network, via the mining process, would come to a ‘consensus’ about which of the two transactions should be confirmed and be considered valid.

All the new transaction data is stored in a ‘block’, which is tacked onto to all the other blocks already created. The resultant Block Chain is a publicly distributed ledger of all prior and new bitcoin transactions and is shared across the network. A bitcoin transaction hasn’t technically occurred until it’s added to the block chain, at which point it becomes irreversible. The block chain holds all the information about movements of bitcoins.

Rewarding the miners

For bitcoin to be robust and secure, the currency needs to call on the support of large numbers of miners. As keepers of the block chain, they keep the entire bitcoin community honest and indirectly support the currency’s value.

There is a price to pay – mining uses eye-wateringly high levels of computer processing power and electricity. So how do you build this all-important network? Simple – reward the volunteers or miners with transaction fees and free bitcoins!

The bitcoins issued to reward the miners, who offer up their computer processing capacity, represents the only way that new coins are released. But if new coins are distributed as payments, how does bitcoin hold its value? The answer is that the rate at which coins are released becomes slower as time goes on and the processing power needed to earn becomes prohibitively higher. Most of the processing now takes place in remote farms, kitted out with highly powered hardware.

Additionally, the original bitcoin source code specifies that only 21 million bitcoin units can ever be created. This scarcity cannot be matched by fiat currencies, with governments often resorting to printing more money when times get hard.  The latest projections suggest that the 21m will be achieved in around 20 years time. After this, the miners will be rewarded solely with transaction fees.

If 21 million Bitcoins sounds rather limited, another advantage of bitcoin comes into play. As it is digital, there is the option of trading in tiny fractions of whole bitcoins. Currently, the smallest unit is the Satoshi (named after Satoshi Nakamoto) – there are 100 million satoshis to a bitcoin! If needed, an even smaller derivative could be created. Although, even with the dramatic growth in Bitcoin value, I’d expect it will be a very long time before we need a smaller unit than a satoshi!

I hope this whistle-stop layman’s tour of Bitcoin has been useful. Should you wish to delve deeper, I’d recommend the website, which explains the workings of the currency in far greater detail.

You can also check out the original paper released by the currency’s founder Satoshi Nakamoto, entitled ‘Bitcoin: A Peer-to-Peer Electronic Cash System‘, the pronouncement which started it all off!

The rise of cryptocurrency – The blogs

1 – The mysterious birth of bitcoin

3 – The dark side of bitcoin

4. Will the volatility ever end?

5. Can block chain technology make elections foolproof?

6. Bitcoin and the Elon Musk Effect

Guy Middleton is a Treasury Associate Director at Harvey John.

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