In reality, cryptocurrencies don’t actually exist.
They are a digital currency that generates value because people accept them as a trading tool.
So how is Bitcoin created?
Furthermore, how are Bitcoins and altcoins regulated and what is the likelihood of cryptocurrencies becoming an accepted currency.?
The chime of cryptocurrencies is ringing out across cities worldwide; it’s important people understand how digital currencies work and how blockchain technology could impact the economy, the financial system and the way we buy and sell goods.
It’s all very exciting!
What Is Bitcoin?
Essentially, Bitcoin is a form of digital currency that exists in the online space.
It can be used as an investment tool and, where accepted, to buy and sell goods. Because Bitcoin can be converted into cash, digital currencies provide a solution that makes online shopping easier.
Online casinos have been using Bitcoin for a while now.
Cryptocurrencies are even starting to creep into the online retail space. As widespread acceptance of digital tokens grows, we can expect to see more online businesses providing customers with the option to buy goods with digital tokens.
Bitcoin not only offers practical benefits but will also stabilise a flawed financial system.
The current banking system functions through loans. The bank doesn’t have enough money to make this credits. Thus they use money deposited with them by account holders.
Banks, and other financial institutions that act as creditors, therefore have to rely on debtors paying back the loans. Interest is earned (or used to be) on the amount of interest the banks make on loan. If a significant debt caused by loans is not met, the bank collapses.
New laws give banks the right to take money from the accounts of stakeholders and uninsured depositors to pay off the debt.
That means if your bank goes into insolvency, they can take money from your bank account if the debt is not covered by other stakeholders that have loans – such as mortgage lenders.
The 2008 banking crisis was caused because banks loaned too many sub-prime mortgages that accrued high-interest rates over time.
Lenders inevitably failed to pay their mortgage and the housing market collapsed – taking the banks with it.
Cryptocurrencies look to negate the threat of economic collapse and the gross inflation that comes with it.
The blockchain technology that knits online transactions together is also designed to eliminate fraud and place the power of control back into the hands of the general public.
The underlying idea behind Bitcoin is to create a peer-to-peer currency that is not controlled by a central authority such as a bank.
People will be able to make electronic payments over the internet and mobile wallets for low transactions fees and store their money in a secure environment without being charged excessive bank fees.
This is why banks and governments are not in favour of backing cryptocurrencies.
So far, digital currencies appear to be working theoretically and practically.
But how is Bitcoin created and how are transactions regulated?
The Easy Bit About The Bitcoin Nature
From a user perspective, Bitcoin is a digital coin that can be used as a value of a currency to buy and sell goods online or, on rare occasions, physically.
The coins are bought and sold through cryptocurrency exchanges and stored in private digital wallets investors can save to a removable hard drive to reduce the risk of being hacked.
So far so good.
Furthermore, Bitcoin is mostly an investment opportunity. Early adopters pocketed thousands if not millions when the price of Bitcoin exploded in 2017. The tokens started the year at less than $1000 before hitting an all-time high of $19,666 on the 22nd of December.
At the time of writing, the value of Bitcoin is around €11,000, but the long-term forecast is that digital tokens could break through the $20,000 barrier.
The value could also go down of course, and with some cryptocurrencies with better technologies, the industry leader will probably be replaced.
The success of Bitcoin is well documented, but there are still doubts about its long-term future.
Authorities argue Bitcoin is unregulated and susceptible to fraudulent activity. But the blockchain community claims the technology prevents fraud and promises a secure financial future the current banking system does not provide.
The cryptocurrency ecosystem is self-regulated because it is validated by computers on the blockchain network.
Transactions cannot be manipulated. Furthermore, the encryption technology used is so secure there are no weak points hackers can exploit, and end-users can store bitcoins privately in digital wallets that are secured with private key multiple times stronger than conventional username/password methods.
So what makes the cryptocurrency community confident that blockchain provides the solutions the current economic system lacks?
Behind The Scenes Of Bitcoin
Bitcoin works because of the technology. Every cryptocurrency is shared on a public ledger that provides a record of every transaction made with any existing crypto-coin.
This ledger is available to everybody in the network and every computer housing the blockchain’s software verifies the validity of each transaction. This eliminates the risk of financial fraud and protects Bitcoin owners from cybercrime.
Bitcoin protocol ensures that transactions between parties are legitimate and protected by a digital signature in the form of public code.
Bitcoins can only be spent once, but are copied so the recipient can use them. It’s the principal factor that makes digital currency work as it prevents double-spending.
When a Bitcoin is used for a purchase, the public code reveals the name of the Bitcoin owner and the IP address they make the transaction with.
All this data is “mined” by sophisticated computers and places in the public ledger. The name of the seller is also recorded, and a bitcoin is copied to that account.
The ledger records the price of the Bitcoin moving from one account to another account.
Every computer within the Bitcoin network is consistently updated with a copy of the ledger so that transactions can be properly audited and validated.
And this is the role of Bitcoin miners, otherwise known as cryptocurrency exchanges.
Miners are independent of each other, but all work to build blockchain ledgers.
Furthermore, they create a blockchain all over the world and use complex mathematical formulas that create encrypted codes that are so secure the ledger cannot be manipulated or tampered with.
Blockchain codes are impossible to decode.
How Does Blockchain Technology Work?
When transactions are created using a cryptocurrency, data mining firms collect the data and record it in a ledger.
This ledger is also called a block.
Once miners have created a block, they apply a mathematical formula which creates an incorruptible sequence of letters and numbers which are then stored at the end of the blockchain with a date and time.
This piece of data is known as a “hash”.
Hashers are made freely available to the blockchain network. But the code is impossible to work out.
Part of the encryption is entirely random, and the other part is taken from the hash of the previous blockchain which acts as a digital wax seal.
The hash confirms the block is legitimate and that every previous transaction in the blockchain is authentic.
Blockchains are essentially policed by cryptocurrency exchanges that mine Bitcoin. For every blockchain that is sealed, miners are rewarded with Bitcoins.
The reward not only gives exchanges an incentive to mine Bitcoin but to make sure they do not step beyond the boundaries of the protocol.
Any attempt to create a fraudulent transaction will be identified immediately.
Although miners are forbidden or incapable of tampering with data in a block, they are obligated to apply different data to create a hash.
This is performed using a random piece of data called a ‘nonce’.
The nonce and the blockchain data have to fit the required hash format before the block is sealed.
Bitcoin protocol will not allow a hash to be created if the sequence of numbers does not fit the formula.
This is determined by a series of complex mathematical equations. It can take miners several attempts to seal a block.
Nobody knows what the hash will look like before it is produced which is what makes blockchain incorruptible.
The easiest way to understand how a blockchain is created is to imagine a spreadsheet which is duplicated thousands of times and shared among a vast network of computers.
Every time somebody uses Bitcoin to make a purchase, the transaction is recorded in the spreadsheet.
Furthermore, the spreadsheet is not kept in any one location and is updated by multiple people. Literally millions of people.
As a result, transactions are peer-to-peer monitored rather than controlled by any one organisation. The competition between miners is who can dig out the information first and seal the data in a block with a hash.
This system gives blockchain some distinct benefits:
- Interested parties autonomously regulate online transactions within a network, and not a bank/government appointed auditor
- Bitcoin is owned by the users and not by a sole business or agency
- Blockchain cannot fail thus creates a stable financial system
- The blockchain ecosystem is self-auditing
- Data is transparent and available to everyone on the network
- Blockchains cannot be corrupted
How Does Bitcoin Work?
Bitcoin works because it has developed a trustworthy ecosystem people are willing to accept and use as a currency for trade.
Essentially, it works the same way as any other currency. Its value is derived from supply and demand.
The idea of Bitcoin was floated in 2008 when an unknown developer using the pseudonym Satoshi Nakamoto published a whitepaper stating the case for a cryptocurrency.
Bitcoin went public for the first time. Ten years later it has matured into the fastest growing investment available in the current market and looks set to change the way we buy and sell goods on a grand scale.
Bitcoin works because people buy digital tokens with traditional currencies.
Investors go to an exchange and pay a sum of money to buy bitcoin or a fraction of bitcoin. Say $100 worth. The value of your $100 of Bitcoin can be more or less by the end of the day depending on how many people are using Bitcoin and affecting the price.
When buyers purchase something with Bitcoin, the seller can convert it back to cash.
While central banks back fiat currencies, and precious metals are valuable in themselves, Bitcoin is slightly different.
Digital coins don’t have government backing. They don’t need to because when people are prepared to use them as a trading tool, they have real-world value.
Cryptocurrencies will only fail if governments pass legislation to ban them or stunt their growth.
Given the cryptocurrency market is a multi-billion pound industry, this is unlikely to happen because any attempt to shut it down will be met with a backlash governments will not be able to wriggle out of.
It will also be nonsensical to ban a digital currency in the digital age.
That hasn’t stopped some countries trying to prevent cryptocurrency trading.
As far as the general public is concerned, cryptocurrency is already too big to fail and is here to stay.
How Is The Value of Bitcoin Calculated?
It’s important to note that the price of Bitcoin is not equal to its value.
The value of virtual tokens is determined by how much people are buying and selling goods with Bitcoin and the price they are setting for products.
The value of Bitcoin is not the same as the price used to pay for something with Bitcoin.
Transactions in bitcoin tokens are indexed.
Cryptocurrency exchanges then work out an average price the tokens traded for. This includes how much people are prepared to buy shares in Bitcoin.
The more people agree to pay the price for goods in Bitcoin the higher the value of a bitcoin becomes.
The price of a bitcoin is decided by the two parties trading goods for tokens. This works in the same way as buying goods from a shop with traditional money.
So if one seller charge $2 and one seller charges $4 for the same item, the value of Bitcoin is $3.
At the time of writing, the value of Bitcoin is about €11,000. If you bought one Bitcoin in 2011 when they were €20, you would now have a substantial amount of Bitcoin to spend.
If you buy €20 of Bitcoin in today’s market, you would only own a small fraction of Bitcoin.
When you make a purchase, a fraction of Bitcoin is calculated to buy goods just as you only use a portion of the money in your bank account to do your weekly shopping and pay your bills.
Sellers calculate the cost of an item by converting Bitcoin in the local currency.
The transaction is all recorded in the digital space, so no money actually changes hands. Buyers lose some of their Bitcoins and sellers gain it.
But because of the volatility of the crypto market, it’s quite feasible to go on an online shopping spree and still make a profit by the end of the day.
You can’t do that with your monthly pay cheque.
The concept of Bitcoin is no different from existing currencies or commodities such as gold and silver.
Essentially, this fact works in its favour.
The significant difference is that Bitcoin, and altcoins, promises to create a financial system that can not be manipulated by financial institutions and covered up by an inadequate audit trail.
The digital audit trail is airtight.
If you’re fascinated by how Bitcoin is created, you should read more about the process in our proof-of-work vs proof-of-steak article.