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Unraveling Bitcoins, bit by bit
January 6, 2018, 3:58 pm
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Love it or hate it, crypto-currencies are clearly here to stay. In the not too distant future, if these virtual currencies can evolve from their current free-wheeling form into more structured, regulated entities, they could very well pose a challenge to traditional financial sectors.

One of the biggest monetary trends to emerge in 2017 was a shift in perception about crypto-currencies. In the year gone by, Bitcoin, the leading digital currency, which had since its inception in 2009 hovered on the fringes of fiscal respectability, gained increased acceptance among the mainstream financial community.

As the year drew to a close, there was an almost frenzied rush to grab bitcoins as its value soared meteorically from less than US$11,000 per coin in early November to almost $20,000 on 19 December. Anecdotal online social media stories of million-dollar fortunes being made by early-adopters, and prophecies that Bitcoin would continue to keep rising, fueled the buying frenzy.

Bitcoin, which was priced at one US Cent when it launched in 2010, has no doubt gained a cult status among crypto-currencies, nevertheless, its sudden surge in December came as a surprise even though the rise was viewed as a bubble by most investors. In line with predictions by pundits, Bitcoin tumbled and sank by nearly 50 percent to reach a little over $10,000 per coin on 22 December. However, it bounced back and ended the day at around $14,000 per coin.

Whether you were a Bitcoin investor or not, there was no denying the huge international attention and interest that crypto-currencies garnered within the space of a week in December.  Together with popular interest, the growing credibility of crypto-currencies within the global financial community is probably an indication that virtual currencies are fast becoming a monetary force to reckon with.

But, as with any other force that challenges existing status-quo, crypto-currencies could be crushed by coordinated action from international monetary regulatory authorities. However, at least for the moment, the authorities have chosen to take a ‘wait and see’ approach that has allowed various crypto-currency brands to establish and gain popularity around the world.

So, what exactly is a crypto-currency?

Well, for starters, it is not a paper currency that you can hold in your hand, or fold and place in your wallet, or a coin that you jingle in your pocket. It is also not something that you can easily use to buy anything at your local grocery store, mall or even at most High-Street stores. More importantly, it is not issued or supported by any government, nor is it supervised by any regulatory authority.

At its core, crypto-currencies are software protocols that run on a decentralized peer-to-peer network and generate digital tokens. Transactions on the network are registered using an intertwined online ledger called a blockchain, which is basically a database of all transactions ever made on the network. The algorithms and complexity of the system makes counterfeiting or tampering with the digital tokens phenomenally difficult.

Using simplistic analogy, digital currencies are like any ordinary online bank transaction where you first open an account with a bank, transfer money to that account, and then conduct transactions from one account to another. Throughout the online banking process, you do not physically handle any currency. Once you enact a transaction, the bank enters details of the deal in their ledger by debiting your account and crediting the other account.

In the Bitcoin world, a decentralized network stands in place of your bank, a personal Bitcoin wallet represents your account, bitcoin is the currency that you use to conduct transactions from one account to another and the blockchain database denotes the traditional ledger where transactions are recorded.

How are bitcoins created?

Each single bitcoin is created by a process called ‘mining’, which basically involves a competition among ‘miners’ on a peer-to-peer (computer-to-computer) network. The miners attempt to find a random number based on the latest batch of bitcoin transactions and other specific criteria. The first miner who manages to solve the number is rewarded with a pre-determined number of new bitcoins.

Huge computer resources are needed to crunch the numbers involved and the process involves repeated trial-and-error attempts by miners. Usually, several miners join together and pool their computer resources to increase the computational power available to find the solution. The first miner or group that manages to solve the encrypted data in the transaction batch gains the right to add the batch to the blockchain, and, once the transaction details are verified and authenticated by other miners on the network, the successful miner is rewarded with a set of new bitcoins.

Though mining is how new bitcoins are generated, the primary job of miners, and the reason they get rewarded, is for processing transactions on the network and successfully adding them to the blockchain.

The Bitcoin software sets specific criteria for generating the random numbers and periodically adjusts the difficulty of the competitions so that on average only six competitions are solved every hour. The software ensures that the more computers there are on the network trying to mine bitcoins, the harder it becomes to win the competition and to get rewarded with bitcoins.

In addition, the amounts of bitcoins generated and given as reward per competition is cut in half after every 210,000 competitions, or roughly every four years. In 2016, the reward per successful competition was cut to 12.5 bitcoins from the earlier 25 bitcoins. Calculations show that by the year 2040, the reward amount will become zero, and that by then the amount of bitcoins in circulation will have reached the maximum permissible number of 21 million. Currently there are about 11 million bitcoins in circulation.

The security of each transaction is vouchsafed by its interlaced complexity, as each block contains data that is intricately linked to the previous block. Any attempt to spend the same bitcoin twice or corrupt the transaction in any other way would entail having to revise multiple anonymous links in the chain. Moreover, any attempt at fraud would have to be done while under the scrutiny of other miners who are continuously monitoring and verifying each other’s work each step of the way.

[Next week, we will look at how Bitcoin transactions work, and how you go about buying and selling bitcoins.]


 

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