BITCOIN: what is it and how does it work?

Online shopping is faster, easier and more efficient than ever, and it’s a group of payment systems that facilitate these transactions: banks and credit card companies have payment systems like Visa, Mastercard and PayPal. What is their role and how do they make money?

In an online transaction, three main parties are present: the buyer, the seller, and a financial intermediary that makes sure its legitimate. These intermediaries are payment systems (Visa, Mastercard, PayPal etc) that solve the ‘double spending problem’ when you’re transferring money online as a digital file. Like a photo saved on a PC, it doesn’t automatically delete itself when you send it to someone else. There is a replica remaining on your end, meaning that in theory you can spend that money again and again. Hence, a third party like PayPal must be employed: using a ledger (a collection and record of financial accounts), when I spend $50 online, PayPal deducts $50 from my account and adds $50 to the seller’s. At the end of the day, all of the accounts on the ledger must reconcile to zero.

Let’s also consider how these financial intermediaries make money. When consumers pay for something using a credit card, a percentage of the payment goes to these intermediaries in the form of 1) merchant fees, and 2) consumer fees. Sellers have to apply and pay a membership fee to credit card associations, and they have to pay around 3% of every transaction that takes place. The reason that financial intermediaries can charge so much is because they provide secure financial transfers and also monitor for any fraudulent activity. This is how your credit card company is able to refund your purchase if you were misled by the seller, or if your credit card details are stolen and used.

So where does bitcoin come into this? Bitcoin is an alternative to these payment systems – it eliminates the intermediary, whether that’s Paypal or Visa or Mastercard, meaning that transactions can take place directly between buyer and seller, making the process cheaper and faster. It is even accepted as payment by companies like Steam, Microsoft, Tesla, Wikipedia and Virgin Galactic.

Bitcoin is the world’s first decentralized digital currency. Unlike previous cryptocurrencies, it is decentralized. This means is that there is no central bank that *prints* or issues bitcoins out. This means that there is a higher degree of freedom in payment: there is no central authority in the bitcoin network. You do not have to worry about crossing borders, a limitation when conventionally transferring money. Furthermore, bitcoin protects against identity theft because a user’s personal information is not tied to the transaction, and it can be backed up and encrypted to ensure the safety of your money.

How does it work with online transactions? Bitcoin employs a ledger (called blockchain) like the other financial intermediaries mentioned, but now everyone can access it on their computers. All transactions that take place are recorded in it and it can’t be cheated. Bitcoins also mean that the transactions are directly between buyers and sellers.

Instead, they are said to be ‘mined’ (we will explain this later).

However, bitcoins do face shortfalls today. As a currency, bitcoins are not as good a store of value as something like the US dollar, for example. This is because the value of bitcoin is very volatile because the market is relatively small. Its market cap today is 65 million dollars. Due to its size, every time a relatively large transaction takes place, it has a profound effect on the market and therefore bitcoin’s value.

On the other hand, another advantage of bitcoin is that it is censorship-free, something that proved to be significant during WikiLeaks’ famous Cablegate. I’ll talk about this in another blog post because it’s something that deserves attention.

Going back from our digression: What exactly is bitcoin mining?

At the heart of bitcoin mining, mathematical problems are put in place. These problems can be solved by users using high-end computer parts (CPUs, GPUs, ASICs) and every time a solution to a problem is found, it is rewarded with bitcoins. On average, solutions are found every ten minutes. Bitcoin rewards are such that minable bitcoins halve every 4 years, with the upper limit being 21 million bitcoins. Today, we have a circulating supply of 16.5 million (https://coinmarketcap.com/). Once we reach 21 million, the idea is that bitcoins will become more expensive as they become rarer.

Drishti Rai

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