Bitcoins are increasingly in the news. If you were an unfortunate victim of a ransomware attack (like WannaCry, which hit computers worldwide two weeks ago), chances are you were asked to pay in bitcoin to regain your data. Bitcoins are also famous for their large value fluctuations, having just hit an all-time high of over INR 1.5 lakh, or USD 2400, per bitcoin. Compare this with its (nonexistent) value in January 2009, when the first bitcoins were being mined! This article aims to understand this sudden rise in their value. This requires some understanding of the bitcoin system itself, which is undertaken below.
Background & Intention: What is a bitcoin?
The proposal for bitcoins was put forward in October 2008 in a white paper by Satoshi Nakamoto (interestingly. this is a pseudonym whose real-world identity is as yet unknown). It was born out of a desire to create a form of electronic payment system, one that did not require validation by a third party. This was important to Nakamoto because of the increasing prevalence of electronic transactions, all of which (at the time) involved third parties such as banks. According to him, mediation by a third party led to all sorts of problems: transaction fees, loss of privacy, and possible fraud. He wanted a way for two people to directly exchange money online. Out of this was born the bitcoin.
A bitcoin can be divided into a hundred million parts—which might seem impractically small, but is actually rather useful. The smallest unit is individually identifiable, which allows payments over a large range of denominations; it is no longer infeasible to pay small amounts online. Much like paper money, and unlike online payments, bitcoin payments cannot be undone or cancelled: the only way to get back spent bitcoin is for the receiver to return it.
Computer scientists are far more excited about the Bitcoin concept, and further applications of its technology, but its future as a monetary system is also one worth considering.
And now, on to the question that today’s college students might well be asked by their children: where do bitcoins come from?
The easiest way for you and me to obtain bitcoins is to buy them with our own government-issued and honoured currency (INR, USD, what-have-you). Bitcoins can be stored in virtual wallets, and can be used to pay for various online and real-world services. In this sense, bitcoin can be understood as another currency, which currently has a whopping exchange rate. However, in keeping with Nakamoto’s vision for peer-to-peer payments, there is no issuing body or third party for bitcoins. So how are new bitcoins generated? Through a (mathematical) process (carried out by algorithms) called bitcoin mining.
Bitcoin mining involves complex mathematics, which can be (very crudely) explained thus: a miner has to generate a unique hexadecimal number within a number of constraints. These constraints are imposed and tweaked automatically by the bitcoin network, depending on how quickly new numbers are generated. Based on current global processing power, the constraints are fixed such that one such number is generated roughly every ten minutes, or 2016 numbers are generated in roughly two weeks. Thus, as the number of hopeful miners increases, the difficulty of mining bitcoins increases. According to the math that runs the system, each successfully-calculated number is a way of verifying a transaction. Thus, the miner(‘s computer processors) keep the network running. To put it another way, the running of the network is incentivised by being paid in bitcoin.
Behind the rise
All this leads to the conclusion that, like any other market commodity, the availability—thus, the ‘price’—of bitcoins is determined by that good old law, supply and demand. The reason for the bitcoin’s rapid value rise in recent months is, simply put, more demand. Both bitcoin buyers and miners contribute to this demand, and the ‘price’ that expresses it includes the global processing power that miners need to use to generate bitcoins. The algorithms that control the constraints mentioned above are essentially a mechanism for supply to keep pace with demand.
Satoshi Nakamoto has managed to create the world’s first decentralised, open-source, peer-to-peer system of electronic cash. Its mechanisms are still being proven, and are (so far) holding firm. Being a form of cryptocurrency, the value of a bitcoin is not linked to anything in the physical world—which is perhaps why it’s a bad idea to convert all your savings to bitcoin. However, it is growing in value, and offers many online benefits—and is being accepted in an increasing number of real-world stores. As many people of the bitcoin community suggest, it’s probably a good idea to develop technical literacy on the subject, and maybe even invest in bitcoins.
Some resources you might want to check out to learn more:
Satoshi Nakamoto’s white paper on Bitcoins bitcoin.org.
A list of places that accept payment in bitcoin.