What is a Bitcoin and How does it work?

By Shan Balasuriya Posted Date: 2014-05-08

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The bitcoin has been quick to gain increased attention as a new form of payment and currency. The value of a bitcoin has increased from $15 to over $1000 in 2013 alone and is currently valued at about US $440. So what is the story behind this volatile currency and how does it work?

Bitcoin is a form of digital 'crypto' currency that was developed by Satoshi Nakamoto, it is a payment network that is powered by its users and has no regulatory authority or middleman - This means no banks and no transaction fees. It is often called a 'decentralized peer-to-peer' currency which basically means that there is no centralized body that controls the Bitcoin network or the currency itself.

  • How does the bitcoin technology work?

    The foundation of the bitcoin technology relies on what is known as the 'blockchain'. This is like a ledger or public record of all the transactions carried out within the bitcoin network. The authenticity of a transaction is protected by digital signatures and this 'ledger' is collectively maintained by everyone who uses the currency. These transactions can be processed by anyone using their computing power (with specialized hardware) and earn a reward in bitcoins for providing this service, so this encourages people to donate their computing power to maintain this blockchain and receive bitcoins in return.

    This process known as bitcoin mining and is how bitcoins are created; Bitcoin miners are processing transactions as mathematical problems and securing the bitcoin network (or blockchain), in return for solving the mathematical problem (that is creating a new block in the blockchain) they receive bitcoins.

    Wouldn't this depreciate the value of bitcoins if they are generated by users maintaining the blockchain? - No, the bitcoin protocol is designed in such a way that new bitcoins are created at a fixed rate; the reward for creating a block is automatically adjusted by the algorithm so that during the first four years of the bitcoin network 10.5 million bitcoins will be generated and the amount is halved every four years. Which means only 5.25 million bitcoins will be generated in the next four years and so on till eventually the maximum number of bitcoins in circulation reaches 21 million.

    Bitcoins are created at a decreasing rate, so when more miners join the network it becomes more difficult to generate bitcoin, this difficulty is related to the average computing resources dedicated to generate new bitcoins over the time it took to create the previous blocks. So the amount of bitcoin received as reward is dependent on the computer they are using compared to all the computers on the network creating blocks as well. This means that amount of bitcoin given as reward for creating a block reduces as the number of people mining increases, and the more processing power you donate to the blockchain the more bitcoins you will receive.

    It eventually becomes only profitable to mine if you can reach high efficiency where operating costs (of supporting the blockchain) is reduced while computing power is increased (usually with better hardware). Although the bitcoin network is open source, no developer has any power to control or manipulate the system to increase profits. Any miner (bitcoin node) that does not comply with rules the system is expected to follow will be rejected.   
  • How does the bitcoin get its value?

    To put it simply bitcoins have value because they are accepted as a form of payment. Bitcoin has the attributes of money - it is scarce, fungible, divisible and recognizable like cash, and these attributes are based on mathematics rather than its physical properties (like precious metals such as gold). What gives any form of money value are these mathematical attributes in combination with trust (acceptance) and implementation (its use), with bitcoins its value can be measured by its growing number of users - people and businesses. Like all forms of currency bitcoin gains its value directly from people willing to accept it as payment.
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  • How is the price of a bitcoin decided and why has it seen drastic fluctuations?

    The price is determined like most things by supply and demand. When the demand for bitcoins increases its price increases and when the demand reduces its price falls. Since there is only a fixed number of bitcoins and new bitcoins are created at a decreasing rate, the demand of the bitcoins must follow this level of inflation to keep the price stable. As the bitcoin is only currently active in a small (but growing) market and the number of people and businesses using bitcoins is still relatively small this means that seemingly small events, trades, or business activity can significantly affect the price. Although the bitcoin is volatile it will eventually begin to stabilize as its acceptance as a form of payment increases as well as its use and popularity.

As bitcoins are fairly new there is much speculation as to whether it will succeed as a form of currency. Bitcoin has many advantages in terms of freedom of payment, anonymity, security, including the control & transparency of its supply. However the future of this new and interesting form of digital currency is still uncertain.