Bitcoin Explained

Properties of a Bitcoin

A bitcoin is an encrypted, pseudo-anonymous, open source, decentralized, digital currency, capable of adaptive scaling, that uses a proof-of-work system. We explain each property of bitcoin below.

Pseudonymity

The idea that bitcoin is “anonymous” is a myth. Bitcoin is not anonymous – it is pseudonymous. In other words, rather than using your “real life” identity, you use a pseudonym (a fake name) in the bitcoin network. In the bitcoin network, your identity is a sequence of numbers called your bitcoin address. There is no limit on the number of bitcoin addresses you can have – for the sake of anonymity, you can even have a different bitcoin address for each transaction you make. For those with an understanding of cryptography, your bitcoin address is also your public key in bitcoin’s public/private key cryptography system.

However, it’s important to note that the system itself does not promise anonymity. Due to the public nature of the ledger (the transaction block chain), anyone can see the network in its entirety at any given moment. This opens up opportunities for independent researchers, market analysts, and intelligence agencies alike to use network and cluster analysis on the bitcoin network. Using this, they may be able to find information about you and your real life identity.

Open Source

Bitcoin is an open source network. This means that anyone is welcome to join in, everyone has access to all of the information they need to participate in the network, and the bitcoin protocol is available to all. There is no secrecy in the mechanics that drive the bitcoin system, there is no company or group who has control or a patent on the ideas behind bitcoin, and there is no agency that controls or holds the transaction block chain. For developers, the API that lets you develop applications that interact with the bitcoin network is also open source.

Decentralized

This is related to bitcoin being open source as above. This means that there is no third party that regulates bitcoin or mediates between you and the person you’re trying to transfer bitcoin to. In fact, bitcoin is the first decentralized electronic payment system. Consider other digital payment systems. If you pay someone online with a credit card, the credit card mediates your transaction, keeps detailed records of the sender and receiver, and takes a small percentage of the payment as their brokerage fee. PayPal works similarly.

Bitcoin still allows you make digital payments, but the transaction is not brokered. Making a bitcoin transaction is a lot more like handing cash to someone than it is like paying them via PayPal – this is why bitcoin is often considered to be digital cash. This also means that bitcoin is not regulated by a government or nation. For example, while the US government can issue or create US dollars, there is no government or financial institution that can create new bitcoins. Bitcoins can only be created through the process of mining (as described above).

Capable of Adaptive Scaling

The bitcoin protocol was built with a number of measures that enable it to scale to work at both small and large scales. The most notable example of this is how the difficulty of the Proof of Work puzzle changes based on the total computational power of all the miners. Every 2,016 blocks that are mined, the bitcoin system makes a note of how long it took for that number of blocks to get mined.

Bitcoin was designed to have a block mined every 10 minutes, so it should take approximately 2 weeks to mine 2,016 blocks. If mining 2,016 blocks took significantly less than 2 weeks, the proof of work protocol is made easier. If mining 2,016 blocks took significantly longer than 2 weeks, the proof of work protocol is made more difficult. This design automatically regulates the rate at which bitcoins are mined, such that the bitcoin system will function about the same despite changes in of the number of miners and their computational capabilities.

Another example of this adaptive scaling is the finite limitations placed on the bitcoin money supply. A currency would be almost useless if there were an infinite supply of it available. As such, bitcoin was designed so that there could only ever be 21,000,000 bitcoins. The way this adaptation is implemented is that the number of bitcoins that is awarded to the miner who “wins” each block (by being the first to solve the proof of work puzzle) is cut in half every 210,000 blocks.

Based on the bitcoin standard of mining one block every 10 minutes (on average), 210,000 blocks should be mined approximately every four years.For example, in January 2009, a miner received 50BTC every time it successfully added a block to the transaction chain. However, on November 28th, 2012, the 210,00th block was mined, and the reward for successfully mining a block was halved to 25BTC.

This adaptation is based on the assumption that, as time progresses, there will be an increasing number of transactions and thus an increasing significance of transaction fees. It is estimated that the last Satoshi (0.000000001BTC) will be mined into existence in the year 2140. However, it is worth noting that, even though there is a cap on the total number of bitcoins, the bitcoin money supply could exceed 21,000,000BTC through fractional reserve banking.

Capable of Positive of Negative Use

One of the most common bitcoin misconceptions is that bitcoin is a purely “bad” technology that’s only used for money laundering, funding terrorist organizations, and purchasing illegal drugs on the deep web. While all of these applications of bitcoin are very real concerns, this is not the fault of the technology itself. Bitcoin is just a technological tool which, as with any tool, is capable of being used for good or for bad.

Later, when discussing the pros and cons of bitcoin, we’ll delve into both the positive and negative applications of bitcoin. In the mean time, just be sure that you don’t write off bitcoin based on the negative applications listed above without also considering its positive applications in enabling cheaper international remittances, combatting poverty and oppression, and stimulating financial and economic innovation.