What's in a Bitcoin?

Bitcoin is the name of by far the most well-known cryptocurrency based on blockchain technology. Bitcoin has paved the way towards the implementation of smart contracts and related applications. This article sheds light on bitcoin's conceptual background, how to participate in its currency trading, the cryptocurrency's mechanics and characteristics, and its legal status and economic impact.

Background

Bitcoin (BTC) is – as of today – by far the most prominent cryptocurrency based on blockchain technology. The concept of bitcoin 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 e.g. a central bank) who is exclusively entitled to issue new currency units, which, as a result, gives that currency its validity. In contrast, unlike traditional and prior digital currencies, bitcoin is not administrated and controlled by a regulated third party. Instead, bitcoin creates trust by using the decentralized, open and cryptographic nature of blockchain technology that allows people to trust each other and to transact peer-to-peer, rendering intermediaries and third parties obsolete (for more information how blockchain works see "What's in a blockchain?"). Trust is especially generated by the fact that 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, bitcoins can be “stolen”, e.g. by obtaining access to a "digital wallet". This is basically a software program which, like a normal wallet, contains the amount of bitcoins that are held by the owner of this wallet. The digital wallet is accessible through its private key, which is only known to the owner of the wallet. Gaining unauthorized access to this private key paves the way to unlawful disposition or “stealing” bitcoins.

How do payments with bitcoins work?

Like cash payments, bitcoin payments are made peer to peer, i.e. 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" and new transactions are updated on the bitcoin blockchain, with an update being distributed to all other "bitcoin participants" immediately upon a transaction being conducted (for details on blockchain technology see "What's in a blockchain?"). To participate in bitcoin trading, a payee or receiver of payments needs a digital wallet. For receiving bitcoin payments, the receiver has to provide the public key of its digital wallet to the payee. In practice, such public keys are sent through an instant message or email to the other party, or – for example, when paying with bitcoins 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 bitcoins 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.

Bitcoins, as with any other asset or currency, are subject to trade. The price is subject to traditional supply and demand, and therefore more volatile as traditional currencies.

How to buy bitcoins?

Bitcoins can be obtained in various ways: First, bitcoins can be bought in physical shops where buyers often also get a physical wallet (i.e. a keycard containing all necessary information) for the purchased bitcoins (unless they already have a wallet). Further, bitcoins can be bought online at a cryptocurrency exchange or cryptocurrency trade platform (either by "trading" established currencies or other cryptocurrency into bitcoin), or by selling (digital) goods or rendering services with the payment currency being in bitcoin. Bitcoins can not only be bought, but also obtained via "mining" (see below).

Where do new bitcoins come from?

New bitcoins can be created by everybody through a process called "mining". Mining requires solving a challenging mathematical puzzle requiring ever increasing computing power (i.e. electricity). So, mining bitcoins basically means trading electricity for bitcoins. Upon successfully solving the puzzle, the miner is rewarded with a pre-defined amount of sub-units of bitcoin (according to the computing power he contributed to solving the puzzle). The computing power invested for mining new bitcoins also serves the purpose of verifying previous transactions; hence mining provides an incentive to take part in validating transactions. However, the maximum amount of available bitcoins is limited to 21 million units. Thus, the reward for mining gets less and less over time (until someday there will be no reward for solving the puzzle at all).

As bitcoins do not have any functionality other than being a trading good, the value attributed to bitcoins is essentially a result of being a limited resource and the ever-increasing energy costs needed to create it.

Legal Status

In most jurisdictions bitcoins and other cryptocurrencies are intangible, digital goods representing a certain value. Some legal systems, however, 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 bitcoins the status of legal tender. The legal status of bitcoins has been subject to various reports and studies by financial authorities, like the European Banking Authority, the Federal Reserve Banks of various US States and the Bank of England.

Economic Impact

Currently there are several million participants using a digital wallet, trading with bitcoin or other cryptocurrencies. Bitcoins offer a way to exchange value without the control of any government and without any traditional financial institution involved. Albeit bitcoin has the reputation as being regularly used in the dark net or for potential illegal actions, it has many other applications: Requiring only marginal transaction costs and no financial institutions as intermediaries, bitcoin sort of embodies the concept of "be your own bank" (BYOB). Therefore, Bitcoins can (in theory) be used for underbanked and economically underdeveloped regions, helping millions of people to access the globalised economy.

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".A coloured coin may then represent a certain asset, e.g. a software license, diamonds or even a car. Yet, since the bitcoin blockchain is limited to the exchange of bitcoins and as other assets cannot be directly exchanged over the bitcoin blockchain, the use of colored bitcoins is not yet wide-spread.

Albeit its rudimentary nature, bitcoin has paved the way towards the implementation of smart contracts and related applications. For more information on smart contracts see "What's in a smart contract?"