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Fintech

What's in a bitcoin?

Bitcoin is by far the most well-known cryptocurrency. It has paved the way for smart contracts and related applications. Here we look at bitcoin's birth, mechanics, characteristics, legal status and economic impact.

Bitcoin is – as of today – by far the most prominent cryptocurrency. It was introduced under the pseudonym of Satoshi Nakamoto in 2008, preceding its release as open-source software in 2009. This open nature explains its far-reaching acceptance, the existence of numerous applications and implementations, and the prospect of many more to come.

Conventional currencies rely on a third party or an intermediary, such as a central bank, that is exclusively entitled to issue new currency units. This gives that currency its validity.

In contrast, bitcoin uses the decentralised, open and cryptographic nature of blockchain technology. This allows people to transact peer-to-peer, rendering third parties obsolete. 

Blockchain is also trustworthy as a complete and up-to-date copy of the bitcoin blockchain (as a file containing all previous bitcoin transactions) is stored with every user and updates are distributed globally without delay. Thus, it is nearly impossible for the history of bitcoin transactions to be manipulated.

Of course, bitcoin can be 'stolen', for example by obtaining access to a 'digital wallet'. This is a software program that, like a normal wallet, contains the amount of bitcoin held by the wallet's owner. The digital wallet is accessible through its private key, which is only known to the owner. Gaining unauthorised access to this private key allows bitcoin to be stolen.

How do payments with bitcoin work?

Like cash payments, bitcoin payments are made peer to peer, ie they are conducted directly from one person to another without an intermediary like a bank. The bitcoin blockchain records all payments made by any 'bitcoin participant'. New transactions are updated on the bitcoin blockchain, and an update is sent to all other participants immediately after a transaction.

To participate in bitcoin trading, a receiver of payments needs a digital wallet. To receive bitcoin payments, the receiver has to provide the public key of its digital wallet to the payer. In practice, such public keys are sent through an instant message or email to the other party, or – for example, when paying with bitcoin in a store – in the form of a QR-code, which can be scanned by the payee's mobile phone and is then automatically imported into their digital wallet app.

Transactions of bitcoin from one digital wallet to another are updated to the bitcoin blockchain and distributed globally in a matter of seconds, and are usually settled within about an hour.

Bitcoin, as with any other traded asset or currency, is subject to the laws of supply and demand so can be as volatile as traditional currencies, if not more so.

How can bitcoin be bought?

Despite its digital nature, bitcoin can be bought in physical shops where buyers often also get a physical wallet, ie a keycard containing all necessary information, for the purchased bitcoin, unless they already have one.

Bitcoin can also be bought online at a cryptocurrency exchange or via a cryptocurrency trading platform by:

  • 'trading' established currencies or other cryptocurrency into bitcoin; or
  • selling (digital) goods or rendering services with bitcoin as the payment currency.

Where do new bitcoin come from?

As well as being bought or traded, bitcoin can also be obtained by creating new ones, a process known as 'mining'.

To mine bitcoin, a challenging mathematical puzzle must be solved, a process that requires ever increasing amounts of computing power. So 'mining' is effectively trading electricity for bitcoin.

After solving the puzzle, the miner is rewarded with a pre-defined amount of sub-units of bitcoin (according to the computing power they contributed to solving the puzzle). The computing power invested for mining new bitcoin also verifies previous transactions, so mining incentivises the validation of transactions.

The maximum amount of available bitcoin is limited to 21 million units. So the reward for mining reduces over time, until someday there will be no reward for solving the puzzle at all.

As bitcoin's only function is being a trading good, the value attributed to bitcoin is essentially a result of being a limited resource and the ever-increasing energy costs needed to create it.

The legal status of bitcoin

In most jurisdictions, bitcoin and other cryptocurrencies are intangible, digital goods representing a certain value.

But some legal systems also consider them as a taxable good. Japan, the second most important bitcoin market after China, was the first country to pass a law (on 1 April 2017) granting bitcoin the status of legal tender.

The legal status of bitcoin has been subject to various reports and studies by financial regulators, such as the European Banking Authority, the Federal Reserve Banks in the United States and the Bank of England.

The economic impact of bitcoin

Bitcoin has a reputation for being used on the 'dark web' for illegal purposes. But it also has many positives.

For example, with only marginal transaction costs and no need for intermediaries, bitcoin embodies the concept of 'be your own bank'. Therefore, it can (in theory) be used for underbanked and economically underdeveloped regions, helping millions of people to access the globalised economy.

There are several million participants using a digital wallet and trading in cryptocurrencies. Bitcoin and other cryptocurrencies will surely only become more popular.

First steps towards smart contracts

The bitcoin blockchain provides for a rather simple scripting language. The payee may set certain attributes for the bitcoin amount paid. The attributed amount is then called a 'coloured coin', which may represent a certain asset, eg a software license, diamonds or a car.

Yet as the bitcoin blockchain is limited to the exchange of bitcoin, ie it cannot be used for the direct exchange of other assets, the use of coloured coins is not yet widespread.

Although rudimentary in nature, bitcoin has paved the way for smart contracts and related applications.