Bitcoin: A Complete Guide
Bitcoin has seen a rise of 250% between March 2020 and December 2020. At present Bitcoin is trading at its all-time high of $28,000. So, why is Bitcoin raising so much, and more importantly what exactly is Bitcoin, How does it work, Is it even legal in India? All these questions and many other questions regarding Bitcoin are answered in this article. Read the article till the end to get a complete understanding of the concept of Bitcoin/Cryptocurrency.
What is Bitcoin?
Bitcoin (denoted as BTC) is a cryptocurrency. Obviously, this much you would already know. So, let’s answer again.
Bitcoin is a digital currency that works on the idea set out in the white paper (basically, a document, released on a cryptography mailing list at metzdowd.com, which described the idea of Bitcoin) by a mysterious person or group of persons “Satoshi Nakamoto”. It was introduced on 31 October 2008. One Bitcoins can be divided up to 8 decimal places and the smallest unit is called ‘a Satoshi’. The main idea behind Bitcoin is that it won’t be controlled by a centralized authority and would be less costly. It has a decentralized network of computer nodes (detailed explanation in further paragraphs) that operates Bitcoin.
What is Bitcoin Mining?
The concept of Bitcoin mining is essential to understand the working of Bitcoin. Unlike any other traditional currency (i.e. paper notes or coins), Bitcoin is not supervised by any central authority and it works on the decentralized network of computer nodes. Now, if any transaction takes place in traditional currencies (like you pay to amazon for buying products online), an intermediate independent third party (i.e. banks) verifies that you own that much money (meaning you have sufficient balance in your bank account) and then approves the transaction and your money gets transferred to the bank account of the supplier (Amazon in our example). Also, the bank charges a small amount (i.e. transaction fees) for this whole process. This whole process gets completed within seconds.
Now, since there is no intermediary in the case of Bitcoin, who will perform the tasks, which banks were performing in the case of Traditional Currency. Here comes the concept of Bitcoin Miners. Bitcoin Miners are basically computer nodes that could be set up by anyone who has computer hardware of sufficient capacity needed to solve complex problems attached to Bitcoins. These computer nodes verify the transaction happening in Bitcoin and in return the owners of computer nodes get rewarded in form of Bitcoins only. Like the bank records transaction in files and when a File reaches its full capacity, a new file is started. In the same way, Bitcoin transactions are recorded in Blocks, and when that block reaches its full capacity, a new block is started and a reference of the previous block is given in the new Block. In this way, a chain of blocks is formed. That’s why this is known as Blockchain. For every period of 4 years, the reward of Miners gets halved for completion of 1 Block. For example, in 2009 50 BTC were rewarded for completion of 1 Block, in 2013, 25 BTC were rewarded for completion of 1 Block and in the same way, in 2020 the BTC reward is again halved and now 6.25 BTC are being paid to complete 1 Block.
So, how does the computer node verify the transactions happening in Bitcoin? The computer nodes are not normal CPUs, in fact nowadays, CPUs are not used, and GPUs and other high-capacity chips are being used. Every Bitcoins transacted have a complex problem attached to it, which needs to be solved before recording the transaction in Block. This also has addressed the problem of double-spending (i.e. verifying whether a Bitcoin owner is using a particular Bitcoin only once). The whole process works in this way:
- Whenever any transaction is initiated, the transaction is broadcast to all the computer nodes.
- Then, computer nodes work to solve the problem attached to Bitcoin.
- Whichever computer node solves the problem first; it broadcasts the proof of work to all other nodes in the system.
- If the majority of nodes accept the proof of work, then the transaction is completed.
- The node which solved the problem records the transaction in Blockchain and gets rewarded when a block is completed.
Computer nodes start working on the next block by giving a reference to the previous block in the new block. This creates the Blockchain.
How do Bitcoin works?
Having understood the concept of Blockchain and Bitcoin Mining, let’s now understand how does Bitcoin works.
To understand the operation of Bitcoin, you have to understand three concepts (viz. Gold, Server, and Algorithm).
1. Gold: The concept of Bitcoin is very similar to Gold and that’s why Bitcoin is also sometimes referred to as “Digital Gold”. Let’s understand why Gold is being highly valued and why its value keeps increasing over time. There are many reasons for that but the fundamental reasons which will enhance our understanding of Bitcoin are:
- Limited Supply: Gold is limited in supply. No doubt, it is being continuously mined even today but sometime in future, all the goldmines in the world will run out of Gold. This is one of the reasons, gold is being valued and people store gold.
- Mining Cost: Gold is not available on the top of land nor it is being raining from the sky. Gold has to be extracted out of land and it involves a cost. Also, the cost of mining increases as we go deeper into the land. As more and more extraction is being carried out, the cost to mine further gold increases as miners have to go deeper into the land. So, the cost of mining gold determines its value and as mining cost increases, value also increases.
- Demand: The demand for gold has increased and that’s also the reason for the increased prices of gold.
- Now let’s link the above points to Bitcoin. Bitcoin when first introduced in 2008 has specified the number of Bitcoins that would be generated in the future. It was fixed that only 21 million Bitcoins would be generated/mined. So, it made the supply of Bitcoin limited.
Now, who will generate the Bitcoin as unlike traditional currency, there is no central authority to issue new Bitcoins into the system. Now, at this place concept of Bitcoin mining comes into play. New Bitcoins are released into the system by way of mining only. So, to mine Bitcoin, one needs to set up some computer hardware with the specific computational ability and run it on a continuous supply of electricity. So, if new Bitcoins are to be mined, there would be some cost attached to it (in form of computer hardware and electricity cost). Also, as more and more Bitcoins will be generated, more complex calculations will need to be done to record the transactions and they need to be done faster than others as more people start mining Bitcoin; hence the cost of hardware will also increase (same as in case of Gold).
Also, the demand for Bitcoins has increased in the youths and speculators (because of its exceptional high returns) and that has a major impact on the price of Bitcoin.
2. Server: As already mentioned, Bitcoin is a digital currency, so obviously it will need some servers where the data is being stored and customers get a response as per their demand (for example, if you search anything on Google, the response is sent from the Google Servers and the Google servers contain the codes which do the computations on the back end). In the same way, servers are needed for Bitcoins. So, where are the servers of Bitcoin? Well, it could possibly be at your neighbors’ house. Any person can set up a server for Bitcoin and mine the Bitcoins from it. Yes, you read it right. Even you can set up a Bitcoin server and do the Bitcoin mining. All you need to do is buy the required computational ability (i.e. Graphics Card, GPUs, ASICs, etc.) and set up the PC and install software on your PC to do the required computations for the recording of the transactions. As you will record the transactions, you will get rewarded in form of Bitcoins. In short, Bitcoin miners are the servers of Bitcoin and they can be anywhere in the world and in this way Bitcoin runs on a decentralized network.
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3. Algorithm: Bitcoins run on a predefined algorithm which if understood in simple terms says that in total, only 21 million Bitcoins will be released into the system. And, over a period of 4 years half of the remaining Bitcoins will be released in form of a reward to miners. For example, in 1–4 years 50% of the remaining Bitcoins (i.e. 50% of 21 million = 10.5 million) will be rewarded to the miners. In 5–8 years 50% of the remaining Bitcoins (i.e. 50% of 10.5 million = 5.05 million) will be rewarded and so on for next years. In this way, all the Bitcoins (i.e. 21 million) will be released into the system by the end of the year 2140. As of 2020, around 18 million Bitcoins are released into the system.
Who owns/invented Bitcoin?
No one knows about the inventor of the concept of Bitcoins. A pseudonymous person/group of persons known as “Satoshi Nakamoto” is known to be the inventor of Bitcoin. As far as ownership is concerned, Bitcoin is not owned by anyone as it is managed by a decentralized network of computer nodes (and computer nodes could be owned by anyone). Although, if the majority of such computer nodes will be owned by a single person or a group of persons then he could hack the system and record the transactions in its favor. But, the system of Bitcoin is designed in such a way that is very less probable to happen. But nevertheless, there is a possibility to hack the whole system of Bitcoin by owning the majority of the computer nodes. Also, talking about hacking, Bitcoins are stored in name of the public key of a person buying them and the public key is being secured by a private key. So, if a person buys Bitcoins and does not safely secure the private key itself then it is possible to hack the wallet and make an unauthorized transfer of Bitcoins.
How to deal in Bitcoins?
Dealing in Bitcoins could be in two ways:
- For investment purposes: To invest in Bitcoins, there are multiple Bitcoin exchanges running in India and a person could easily invest in Bitcoins through such exchanges. Nowadays, it is as simple as investing in any other stock.
- For payments in return of goods/services: To pay in the form of Bitcoins, the supplier has to accept Bitcoins as a form of Payment. In India, there is no acceptability of Bitcoins as a method of payment but it is expected that it will increase in the future.
Should I invest in Bitcoins?
Bitcoins are highly volatile and unpredictable. Also, these are not being governed by any authority. But, it does not mean that one should not invest in Bitcoins. An investor can invest in Bitcoin if he:
- Has some extra money at his disposal, and
- Has the risk-taking capacity to lose that money completely.
Since Bitcoins are highly risky investments; return from Bitcoin could also be exceptionally high. So, high returns can attract a lot of investors towards investing in Bitcoin but if an investor does not fulfill both of the above characteristics then he should not invest in Bitcoin because its value may even reduce to zero. I am not saying it will reduce to zero, but yes, there are some chances of it happening.
Is Bitcoin legal in India?
As of the date of publishing this article, Bitcoins are not banned in India but they don’t have any legal backing also. In 2018, RBI banned crypto transactions in India due to a number of frauds taking place in cryptocurrencies. The Cryptocurrency exchanges filed a suit against that decision and won the case in March 2020. Since then, the value of Bitcoins has increased by 250%. So, as of now, Bitcoins are allowed to be traded in India but they are not given any legal backing so Bitcoins cannot be safely accepted as a mode of payment (which was the main objective of Bitcoin).
Also, there is news that India is working on a new law to ban cryptocurrencies.
Bitcoin v/s traditional Currency
Bitcoins differ largely from the traditional currencies in the following ways:
Opinions that matter
“In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending. If I could buy a five-year put on every one of the cryptocurrencies, I’d be glad to do it but I would never short a dime’s worth.”
— Warren Buffet (2018)“Cryptocurrencies basically have no value and they don’t produce anything, I don’t own any cryptocurrency and I never will.”
— Warren Buffer (2020)“As an asset class, you’re not producing anything and so you shouldn’t expect it to go up. It’s kind of a pure ‘greater fool theory’ type of investment, I agree I would short it if there was an easy way to do it.”
— Bill gates (2018)“Gold will suffer for years because of Bitcoin.”
— JP Morgan (2020)“Widespread cryptocurrency adoption is absolutely inevitable.”
— CEO of Standard Chartered (2020)PayPal recently announced that PayPal users in US can buy, sell and hold select Cryptocurrencies directly through PayPal.
— PayPal (Largest Digital Payment Company) (2020)
A growing number of major banks have started offering cryptocurrency services, including Standard Chartered Bank, BBVA, and DBS.
Overall, there are mixed opinions about the future of Bitcoins (or Cryptocurrencies in general) but it is being accepted by many that Blockchain technology is having great potential in the future. So, even if we may not trade in Bitcoins in the future, the technology running the Bitcoins (i.e. Blockchain) is probably going to affect our lives in the future.
Frequently asked questions
What are Risks in investing in Bitcoin?
What about Taxation of Bitcoins in India?
What are Public Key and Private Key?
What is the problem of Double Spend and how does Bitcoin addresses it?
I hope you got most of your doubts about Bitcoin solved. Also, some of the questions would still be going at the back of your brain. Go ahead and post the questions in the comments section below and I will answer them as soon as possible.
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Thanks for Reading!
CA Umang Agarwal
