How does a Bitcoin work?
- The origin of Bitcoin is unclear, as is who founded it. A person, or a group of people, who went by the identity of Satoshi Nakamoto are said to have conceptualised an accounting system in the aftermath of the 2008 financial crisis.
- Nakamoto published a white paper about a peer-to-peer electronic cash system, which would “allow online payments to be sent directly from one party to another without going through a financial institution”. According to Bitcoin.org, a website originally co-owned by Nakamoto, Bitcoin from a user’s perspective is “nothing more than a mobile app or computer program that provides a personal Bitcoin wallet and allows a user to send and receive Bitcoins with them”.
- Bitcoins are generally identified with a Bitcoin address, which comprises 26-35 alphanumeric characters starting with either “1” or “3”. This address, which remains anonymous, represents the destination of a Bitcoin, or a fraction.
- Originally, the Bitcoin was intended to provide an alternative to fiat money and become a universally accepted medium of exchange directly between two involved parties. However, after Bitcoins picked up momentum, some entities started establishing exchanges — on lines of stock exchanges — for people to buy and sell Bitcoins against fiat money such as dollars or euros or pounds.
- Early proponents of the cryptocurrency argued that once an exchange was established, all the strengths of a Bitcoin went away, considering a third party institution was involved once again for money to change hands.
Are records of Bitcoin transactions maintained?
- Nakamoto mooted an idea for a publicly available, open ledger that would contain all the transactions ever made, albeit in an anonymous and an encrypted form.
- This ledger is called blockchain. Considering the public and open nature of the ledger, proponents of this currency system believe it could help weed out corruption and inefficiencies in the system.
- In a traditional financial deal in which two parties are using fiat money, a third-party organisation — usually a central bank — assures that the money is genuine and the transaction is recorded. With Bitcoin, a chain of computers is constantly working towards authenticating the transactions by solving complex cryptographic puzzles.
- For solving the puzzles, these systems are rewarded with Bitcoins. This process is called Bitcoin mining.
How does one acquire a Bitcoin?
- One can either mine a new Bitcoin if they have the computing capacity, purchase them via exchanges, or acquire them in over-the-counter, person-to-person transactions.
- A Bitcoin exchange functions like a bank where a person buys and sells Bitcoins with traditional currency.
- Depending on the demand and supply, the price of a Bitcoin keeps fluctuating. Miners are the people who validate a Bitcoin transaction and secure the network with their hardware.
- The Bitcoin protocol is designed in such a way that new Bitcoins are created at a fixed rate. No developer has the power to manipulate the system to increase his profits.
- One unique aspect of Bitcoin is that only 21 million units will ever be created. However, transactions can be denominated in sub-units of a Bitcoin. A Satoshi is the smallest fraction of a Bitcoin.
What investment opportunity does Bitcoin present?
- The first advocates of Bitcoin did not intend it to be used as an asset, but the mushrooming of exchanges turned it into one. Traditional investment experts are wary of Bitcoin as an investment. “We are not offering advisory on Bitcoin investment. I don’t see any underlying fundamental that drives its price and I think it’s mostly driven by supply and demand and on technical factors and hence we are not offering our advice. It is an alternative currency which is digital in form and one has to be careful while going for it,” said Surya Bhatia, founder of Delhi-based financial services and investment advisory firm Asset Managers.
- It is important to note that the price of Bitcoin fell sharply from over $18,000 in December 2017 to around $3200 in December 2018. It then went up to over $10,000 in July 2019, then fell to around $5,500 in March 2020. It has had a sharp rally since then (see chart). Market participants say the huge volatility in the price without any major fundamental reason should make retail investors cautious.
Is there a case for Bitcoin to be regulated?
- People in the investment fraternity point out that there is no underlying asset in case of Bitcoin, and the value is “fictitious”. Before investors can look at it as an asset, several things need to fall in place. If the cryptocurrency is regulated, it could result in the volatility reducing, and its acceptability and monetisation needs easing up.
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