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Introduction to Bitcoins

What is a Bitcoin?

We define a bitcoin as a chain of digital signatures. Each owner transfers bitcoin to the next by

digitally signing a hash of the previous transaction and the public key of the next owner and adding

these to the end of the coin. A payee can verify the signatures to verify the chain of ownership.

—Satoshi Nakamoto, Bitcoin Whitepaper

The above definition from the original whitepaper might appear a bit confusing. We will break it

down to try to understand the essence:

We define a bitcoin as a chain of digital signatures.

Bitcoins basically do not have any physical existence. There are no physical bitcoins anywhere—not

on a hard-drive, or a spreadsheet, or a bank account, and not even a server somewhere. Bitcoin is

just a chain of transactions authenticated through cryptography and proof of work (explained later).

“Owning a Bitcoin” will mean having access to the private key associated with the previous

transaction (that is, when the Bitcoins were received).

Each owner transfers bitcoin to the next by digitally signing a hash of the previous transaction and

the public key of the next owner and adding these to the end of the coin.

This is the mechanism of a Bitcoin transaction, or in fact the very basis of cryptography. Every crypto

currency (or transaction) uses the mechanism of digital signatures and public-private key

infrastructure to authenticate ownership and secure transactions. Explained in detail later.

A payee can verify the signatures to verify the chain of ownership.

“Chain of ownership” – this is what makes Bitcoins unique. Every transaction of bitcoin is irreversible

and recorded and made public. This is what makes it a peer-to-peer network and more secure than

what it would be by using just cryptography. Blockchain and proof of work concepts are explained in

detail later.

So in essence, Bitcoin is a consensus network that enables a new payment system and a completely

digital money. It is the first decentralized peer-to-peer payment network that is powered by its users

with no central authority or middlemen. From a user perspective, Bitcoin is pretty much like cash for

the Internet.

Now, that we have covered the definition and the basic introduction to Bitcoins, let us take a step

back and understand why there was a need for Bitcoins and what problem it actually addresses:

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Bitcoin – The beginning

It all began when a person (or a group of persons) calling himself Satoshi Nakamoto (probably a

pseudonym, still untraced) released a white paper “Bitcoin: A Peer-to-Peer Electronic Cash System”

back in 2009. So what did Nakamoto want to do with bitcoins? Let us have a look at the introduction

to his whitepaper:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as

trusted third parties to process electronic payments. While the system works well enough for most

transactions, it still suffers from the inherent weaknesses of the trust based model.

Completely non-reversible transactions are not really possible, since financial institutions cannot

avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum

practical transaction size and cutting off the possibility for small casual transactions, and there is a

broader cost in the loss of ability to make non-reversible payments for nonreversible services. With

the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers,

hassling them for more information than they would otherwise need.

A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can

be avoided in person by using physical currency, but no mechanism exists to make payments over a

communications channel without a trusted party.

What is needed is an electronic payment system based on cryptographic proof instead of trust,

allowing any two willing parties to transact directly with each other without the need for a trusted

third party. Transactions that are computationally impractical to reverse would protect sellers from

fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper,

we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp

server to generate computational proof of the chronological order of transactions. The system is

secure as long as honest nodes collectively control more CPU power than any cooperating group of

attacker nodes.

We break down the above introduction to make further sense of it:

The problem

We have come to rely exclusively on financial institutions to act as trusted third parties for

internet commerce. This system suffers from the inherent weaknesses of a trust based

model.

Non reversible transactions are not possible since these institutions cannot avoid mediating

disputes.

Cost of mediation increases transaction costs, limiting the minimum practical transaction

size. The possibility of reversal requires more trust which leads to these institutions

requiring more information about their customers.

All these problems can be avoided in person by using physical currency, but no mechanism

exists to make payments over a communications channel without a trusted party.

The requirement

We need an electronic payment system based on cryptographic proof instead of trust.

This system should allow two willing parties to transact directly with each other without the

need for a trusted third party.

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Transactions that are computationally impractical to reverse would protect sellers from

fraud and routine escrow mechanisms could easily be implemented to protect buyers.

The solution

We propose a solution to the double-spending problem using a peer-to-peer distributed

timestamp server to generate computational proof of the chronological order of

transactions. The system is secure as long as honest nodes collectively control more CPU

power than any cooperating group of attacker nodes.

While the problem and requirement are pretty straightforward, we will need to delve deeper into

the solution to make sense of it. Now, after having dealt with the WHAT and WHY of bitcoins, let us

have a look at the HOW of bitcoins:

“Bitcoin” encompasses two related but distinct concepts. First, individual bitcoins (lowercase-­­b) are

units of (fiat) digital currency. Second, the Bitcoin (uppercase-­­B) protocol governs the decentralized

network through which thousands of computers across the globe maintain a “public ledger”—known

as the blockchain—that keeps a fully transparent record of every authenticated transfer of bitcoins

from the moment the system became operational in early 2009. In short, Bitcoin encompasses both

(1) an unbacked, digital currency and (2) a decentralized, online payment system.

How a transaction works:

Bitcoin transactions are messages, like email, which are

1. Digitally signed using cryptography and

2. Sent to the entire Bitcoin Network for verification.

Transactions are public and can be found on the digital ledger known as the blockchain. The history

of each and every bitcoin transaction leads back to the point where the bitcoins were first produced.

Let us tackle the above points one by one:

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Step 1: Digital signing using cryptography

Sending bitcoin requires having access to the public and private keys associated with that amount of

bitcoin.

When we talk about someone “having bitcoins” what we actually mean is that person has access to a

key-pair comprised of:

A public key to which some amount of Bitcoins was previously sent.

The corresponding unique private key which authorizes the Bitcoins previously sent to the

above public key to be sent elsewhere.

Public keys, also called as bitcoin addresses, are random sequences of letters and numbers that

function similarly to an email address or a social-media site username. They are public so you are

safe sharing it with others. In fact, you must give your bitcoin address to others whenever you want

them to send you bitcoins.

The private key is another sequence of letters and numbers. However, private keys—like passwords

to email or other accounts, are to be kept secret.

Your bitcoin address is basically a transparent safe. Others can see what’s inside but only those with

the private key can unlock the safe to access the funds within.

For Example, John wants to send some Bitcoins to Janardan. To do this, he uses his private key to

sign a message with the transaction-specific details. This message is then sent to the blockchain and

contains an:

Input: the source transaction of the coins previously sent to John’s address (the private key

associated with the public key to which this money was sent)

Amount: some amount of Bitcoins to be sent from John to Janardan

Output: Janardan’s public address. (Which again will have a corresponding private key which will be

required to transfer these funds further).

Step 2: Sending the transaction to the entire Bitcoin Network for verification

Step 1 described above might appear clever but, it’s actually a long-running solution to the digital

signature problem, and not the key innovation Bitcoin brought to the table. Digital signatures,

described in Step 1 above, ensure that you can prove a transaction was really authorized; they stop

an outsider from spending someone else’s currency. But what if someone signs two transfers of the

same money to two different people (remember, Bitcoins do not have a physical existence)? After

all, even if John (example) can correctly generate signatures for his addresses to prove that he

genuinely issued a command to transfer bitcoins to another person, the community needs a way to

check whether the specific bitcoins are John’s to give in the first place! In other words, we also have

to guard against a legitimate owner from spending his or her own currency more than once. This is

known as the “double-spending problem.”

The solution to this problem is where the true innovation of Bitcoins lies.

Let us go back to Nakamoto’s whitepaper to understand what the solution to the “double spending”

problem is. This is the conclusion of the whitepaper:

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We have proposed a system for electronic transactions without relying on trust. We started with the

usual framework of coins made from digital signatures, which provides strong control of ownership,

but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-

peer network using proof-of-work to record a public history of transactions that quickly becomes

computationally impractical for an attacker to change if honest nodes control a majority of CPU

power. The network is robust in its unstructured simplicity. Nodes work all at once with little

coordination. They do not need to be identified, since messages are not routed to any particular place

and only need to be delivered on a best effort basis. Nodes can leave and rejoin the network at will,

accepting the proof-of-work chain as proof of what happened while they were gone. They vote with

their CPU power, expressing their acceptance of valid blocks by working on extending them and

rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced

with this consensus mechanism.

So, after step 1 the transaction is broadcast to the bitcoin network where miners verify that John’s

keys are able to access the inputs (i.e. the address(s) from where he previously received the Bitcoins)

he claims to control. This confirmation process is known as mining because it requires resource-

intensive computational labor and rewards miners, in bitcoins, per block solved. This is also the

process by which new Bitcoins are ‘created’.

So how do the ‘miners’ verify the transaction and how does the entire network come to know that

a particular transaction has been verified?

This is how it works: miners with specialized computers compete to solve mathematical puzzles with

other computers, and once they solve a puzzle they are awarded with some Bitcoin, but they also

add a “block” of completed transactions to the blockchain for future viewing and verifiability. Once a

block is added to the chain the cycle repeats itself, and the computers continue to compete to solve

these difficult problems. Every transaction on the blockchain is completely transparent and

accounted for in its log. Anyone can see the public keys of any transaction they want (although there

are no names associated with transactions). One could go all the way back and view the very first

transactions ever made on the first block ever created. This block was unironically called the Genesis

Block.

For new transactions to be confirmed, they need to be included in a block along with a mathematical

proof of work. Such proofs are very hard to generate because there is no way to create them other

than by trying billions of calculations per second. This requires miners to perform these calculations

before their blocks are accepted by the network and before they are rewarded. As more people start

to mine, the difficulty of finding valid blocks is automatically increased by the network to ensure that

the average time to find a block remains equal to 10 minutes. As a result, mining is a very

competitive business where no individual miner can control what is included in the block chain.

The proof of work is also designed to depend on the previous block to force a chronological order in

the block chain. This makes it exponentially difficult to reverse previous transactions because this

requires the recalculation of the proofs of work of all the subsequent blocks. When two blocks are

found at the same time, miners work on the first block they receive and switch to the longest chain

of blocks as soon as the next block is found. This allows mining to secure and maintain a global

consensus based on processing power.

Bitcoin miners are neither able to cheat by increasing their own reward nor process fraudulent

transactions that could corrupt the Bitcoin network because all Bitcoin nodes would reject any block

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that contains invalid data as per the rules of the Bitcoin protocol. Consequently, the network

remains secure even if not all Bitcoin miners can be trusted.

This is the true innovation embedded in Satashi Nakamoto’s elegant white paper on Bitcoin. In a

sentence, the way that Bitcoin gets everyone to agree on a ledger is to have one rule in the protocol,

what can be described as:

Bitcoin's central trick: Of all the valid ledgers, use the one with the most proven work invested in it.

Now let us tie it all together with a simplified transaction flow:

1. Whenever users (Example John) want to transfer their bitcoins over to someone else, they

broadcast a message describing the transfer and sign it with their private key.

2. Whenever a user (Miners) receives a message indicating a transfer, he or she first checks

that the signature is valid, and that the address doesn’t spend more than the latest

“confirmed” ledger shows it as having. If it checks out, the user keeps the message and

propagates it to others.

3. All users wishing to claim the reward for a solution (aka “miners”) bundle up all transactions

they know of (i.e., new ones plus those in the latest confirmed ledger), and convert it into

the “crypto guessing game” problem for that transaction set. They then work on solving

that problem.

4. When someone finds a solution, he or she broadcasts it, with the bundle of known

transactions (new latest ledger), to all other users. Like with individual transactions, anyone

who receives one of these checks it, and if valid, broadcasts it to others.

Miners who receive a new valid solution quit their current search for a solution, and then take the

latest ledger as definitive. Again, as in point 3, they bundle up new transactions they hear of, add

them to this new ledger, and try to solve a new math problem unique to the new transaction set,

and the process begins anew.

This set-up is the first workable solution to one of the more nagging problems of the digital realm:

how to transfer something of value from one person to another without middlemen having to make

sure that the item is not copied or, in the case of money, spent more than once? And Bitcoin does

the trick while being open (unlike conventional payment mechanisms, which aim for security by

shielding themselves from outsiders). This means that third parties can make use of Bitcoin’s

features without having to ask anyone for permission—as is the case with the internet.

Now that we have had a look on the what, why and how of Bitcoins, lets us take a look at some FAQs

on these to further enhance our understanding:

How Is the Blockchain Different from Banking Ledgers?

Banks and accounting systems use ledgers to track and timestamp transactions. The difference is

that the blockchain is completely decentralized and open source. This means that people do not

have to rely on or trust the central bank to keep track of the transactions. The peer-to-peer

blockchain technology can keep track of all the transactions without the fear of having them erased

or lost. Furthermore, the blockchain, because of its open source nature, is more versatile and

programmable than central banking ledgers. If programmers need new functionality on the

blockchain, they can simply innovate on top of already existing software through consensus. This is

difficult for central banks because of all of their regulations and central points of failure.

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Why Trust Bitcoin?

Bitcoin is a network operating by the three foundational principles of technological freedom:

Decentralization, Open Source code, and true Peer-to-Peer technology. Bitcoin’s trust is based on

the subjective valuations of human faith in mathematical algorithms, encryption and numbers. With

the three pillars of technological principles Bitcoin’s blockchain is a peer-reviewed system of

integrity.

Much of the trust in Bitcoin comes from the fact that it requires no trust at all. Bitcoin is fully open-

source and decentralized. This means that anyone has access to the entire source code at any time.

Any developer in the world can therefore verify exactly how Bitcoin works. All transactions and

bitcoins issued into existence can be transparently consulted in real-time by anyone. All payments

can be made without reliance on a third party and the whole system is protected by heavily peer-

reviewed cryptographic algorithms like those used for online banking. No organization or individual

can control Bitcoin, and the network remains secure even if not all of its users can be trusted.

Is Bitcoin anonymous?

Participants in Bitcoin transactions are identified by public addresses – those are the long strings of

around 30 characters you see in a person’s Bitcoin address, usually starting with the numerals ‘1’ or

‘3’. For every transaction, the sending and receiving addresses are publicly-viewable.

Since these numbers are virtually incomprehensible, difficult to remember without a computer and

don’t contain a person’s name or identifying information, it is often claimed that Bitcoin is an

“anonymous currency”. This is also often used as an argument to attack Bitcoin as a currency for

illegal transactions and tax evasion.

But it’s not as simple as that. If you publish your address anywhere, it can be linked to your real-life

identity. Even if you don’t publish it, simply re-using the same address many times can show a

pattern that an analyst with basic skills could link to your identity by looking at transaction times,

amounts, location and regularity – and connecting it to other data sources like receipts, exchanges,

and shipped items.

It’s recommended for privacy and security that you use a new address for every single transaction,

and most modern wallet software is designed to do just that. But even though this increases the

amount of effort and skill required to uncover your identity, it doesn’t make you 100% anonymous.

Freely available blockchain explorers and analytical tools have been used to link addresses with only

single transactions to other addresses, forming a chain or pattern that eventually reveals its owner.

These have been useful in investigating cases of theft at companies like Mt. Gox and Bitcoinica, but

can potentially be used to identify anyone.

Due to all of this, it’s more accurate to say Bitcoin is “pseudonymous” and not anonymous. Think of

it as a less memorable email address or online handle. Even if it’s not your real name, someone out

there can potentially find out who the real person behind the pseudonym is.

What Can Bitcoin Do?

The Bitcoin protocol can change the financial landscape we see today. The protocol can act as a

currency, voting mechanism, global identification and reputation application, a micro-tipper,

crowdfunding platform, initiate trusts, wills and contracts, decentralized domain names, future

markets, and basically everything the financial system of today can handle plus so much more. The

currency application is just the beginning of this evolution of world's finances.

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Who Is In Charge Of Bitcoin?

Nobody is "in charge" of Bitcoin – at least in the sense that Bitcoin is not a company or organization,

has no governing body and no organizational structure. Bitcoin is simply a software protocol, like

HTTP (aka the Internet and SMTP (aka email). This has been the case since Bitcoin’s creator, the

person (or persons) calling themselves Satoshi Nakamoto, released their creation into the wild in

2009. There are, however, certain groups who can exert influence over the way Bitcoin functions

through various means. Again, though, there are no individuals who can claim to speak for these

groups and they contain a plethora of opinions and incentives within. Examples of such groups are:

Developers: These are the people who write and maintain the software the Bitcoin network runs on.

Although Satoshi Nakamoto released the first version of Bitcoin himself in 2009, the code has since

been re-written and updated by subsequent programmers. The developers choose what updates to

make to the protocol, and consider ways it can be improved. Miners: These are the people (and

companies) that own the machines that generate new bitcoins and keep the network secure by

validating transactions. As a result, they have the power to "vote" with their hardware and choose

which Bitcoin software to support. Developers may create and release radical revisions to the Bitcoin

protocol, but they'll have no effect unless the Bitcoin miners choose to adopt them. Users: That's

you. At the end of the day, if regular users decide Bitcoin no longer fulfils their needs, then it will

have no value. You can see the user effect in action just by looking at alternative cryptocurrencies

collectively known as ‘altcoins' – there are currently about 700 different altcoins of varying degrees

of popularity. They have risen and fallen in favor as users decided whether to buy, hold, sell, or

simply abandon. Merchants have made individual decisions as to whether to accept them as

payment or not. Bitcoin faces the same market conditions, and there's no shortage of new projects

claiming their protocol is superior. So far none have knocked Bitcoin from its position as the most

popular cryptocurrency, but there's no guarantee this will always be the case. Large holders, venture

capitalists and influential figures in the "Bitcoin community" could also affect Bitcoin's future path,

though their influence is less direct. And again, there is rarely a consensus of vision among them.

Is Bitcoin useful for illegal activities?

Bitcoin is money, and money has always been used both for legal and illegal purposes. Cash, credit

cards and current banking systems widely surpass Bitcoin in terms of their use to finance crime.

Bitcoin can bring significant innovation in payment systems and the benefits of such innovation are

often considered to be far beyond their potential drawbacks.

Bitcoin is designed to be a huge step forward in making money more secure and could also act as a

significant protection against many forms of financial crime. For instance, bitcoins are completely

impossible to counterfeit. Users are in full control of their payments and cannot receive unapproved

charges such as with credit card fraud. Bitcoin transactions are irreversible and immune to

fraudulent chargebacks. Bitcoin allows money to be secured against theft and loss using very strong

and useful mechanisms such as backups, encryption, and multiple signatures.

Some concerns have been raised that Bitcoin could be more attractive to criminals because it can be

used to make private and irreversible payments. However, these features already exist with cash

and wire transfer, which are widely used and well-established. The use of Bitcoin will undoubtedly

be subjected to similar regulations that are already in place inside existing financial systems, and

Bitcoin is not likely to prevent criminal investigations from being conducted. In general, it is common

for important breakthroughs to be perceived as being controversial before their benefits are well

understood. The Internet is a good example among many others to illustrate this.

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How does mining help secure Bitcoin?

Mining creates the equivalent of a competitive lottery that makes it very difficult for anyone to

consecutively add new blocks of transactions into the block chain. This protects the neutrality of the

network by preventing any individual from gaining the power to block certain transactions. This also

prevents any individual from replacing parts of the block chain to roll back their own spends, which

could be used to defraud other users. Mining makes it exponentially more difficult to reverse a past

transaction by requiring the rewriting of all blocks following this transaction.

“The Bitcoin network is enormously wasteful in terms of energy.”

The “competition” between miners to find solutions the fastest, far from being pure waste, is an

artefact of it being a trustless protocol, in which the fact of having found a solution must convey that

a significant portion of the overall computing power of the network was spent on it. This requires, in

turn, that greater total investment in faster hash computations will be followed by a larger number

of hashes per mined bitcoin, no different from how gold tends to require a greater investment per

ounce to mine over time.

Isn't speculation and volatility a problem for Bitcoin?

This is a chicken and egg situation. For bitcoin's price to stabilize, a large scale economy needs to

develop with more businesses and users. For a large scale economy to develop, businesses and users

will seek for price stability.

Fortunately, volatility does not affect the main benefits of Bitcoin as a payment system to transfer

money from point A to point B. It is possible for businesses to convert bitcoin payments to their local

currency instantly, allowing them to profit from the advantages of Bitcoin without being subjected

to price fluctuations. Since Bitcoin offers many useful and unique features and properties, many

users choose to use Bitcoin. With such solutions and incentives, it is possible that Bitcoin will mature

and develop to a degree where price volatility will become limited.

How much will the transaction fee be?

Transactions can be processed without fees, but trying to send free transactions can require waiting

days or weeks. Although fees may increase over time, normal fees currently only cost a tiny amount.

By default, all Bitcoin wallets listed on Bitcoin.org add what they think is an appropriate fee to your

transactions; most of those wallets will also give you chance to review the fee before sending the

transaction.

Transaction fees are used as a protection against users sending transactions to overload the network

and as a way to pay miners for their work helping to secure the network. The precise manner in

which fees work is still being developed and will change over time. Because the fee is not related to

the amount of bitcoins being sent, it may seem extremely low or unfairly high. Instead, the fee is

relative to the number of bytes in the transaction, so using multisig or spending multiple previously-

received amounts may cost more than simpler transactions. If your activity follows the pattern of

conventional transactions, you won't have to pay unusually high fees.

How are bitcoins created?

New bitcoins are generated by a competitive and decentralized process called "mining". This process

involves that individuals are rewarded by the network for their services. Bitcoin miners are

processing transactions and securing the network using specialized hardware and are collecting new

bitcoins in exchange.

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The Bitcoin protocol is designed in such a way that new bitcoins are created at a fixed rate. This

makes Bitcoin mining a very competitive business. When more miners join the network, it becomes

increasingly difficult to make a profit and miners must seek efficiency to cut their operating costs. No

central authority or developer has any power to control or manipulate the system to increase their

profits. Every Bitcoin node in the world will reject anything that does not comply with the rules it

expects the system to follow.

Bitcoins are created at a decreasing and predictable rate. The number of new bitcoins created each

year is automatically halved over time until bitcoin issuance halts completely with a total of 21

million bitcoins in existence. At this point, Bitcoin miners will probably be supported exclusively by

numerous small transaction fees.

From the question, it is evident that the Bitcoin protocol deals not only with the what, why and how

but also with the how much. Let us take a look at this aspect of Bitcoins.

The Bitcoin protocol is hard limited to 21 million Bitcoins

Now this is where all the controversies about Bitcoins being able to become a widely used currency

are created. This is where the inflationary and deflationary debate of economists comes into play.

The Bitcoin protocol is hard-limited to 21 million bitcoins, meaning that no more than that can ever

be created. This means that no central bank, individual or government can come along and simply

‘print’ more bitcoins when it suits them. In this sense Bitcoin is a deflationary currency, and as such

is likely to grow in value based on this property alone.

The proponents of Bitcoins believe that this one property of bitcoins make them superior to the

existing currencies. The opponents don’t buy this argument. We will be presenting both the cases

(verbatim) and leave the decision to you:

The proponents’ arguments:

The Promise of Bitcoin

Because Bitcoin is a private currency, widespread adoption of it would mitigate all of the evils of the

State’s monopoly on money. First and foremost, the menace of inflation would be forever

vanquished—households and businesses could make long-term plans with much more confidence

about the market value of the currency.

In this respect, note that Bitcoin is superior to even the traditional commodity monies of gold and

silver. The precious metals are obviously much more stable in their growth rate than State-issued fiat

currencies, but they too can “inflate,” and with less predictability than Bitcoin with its internal

feedback mechanism by which the difficulty of mining is periodically adjusted. Although it’s a bit

fanciful, we note that even “hyperinflation” is possible with gold and silver, if (say) humans discover a

massive new deposit (perhaps in an asteroid belt) or if scientists one day can figure out how to

cheaply manufacture gold and silver out of other elements in the lab.

In contrast, Bitcoin is the ultimate in “hard” money, even though it’s intangible. Its scarcity is not due

to empirical likelihood (as is true for gold and any other commodity money), but is mathematically

embedded in its very protocol. By design, Bitcoin will be forever capped at (just under) 21 million

units.

So we see that even a hard base-money doesn’t necessarily translate into a stable money, as held by

the public, if the commercial banking system operates on a “fractional reserve” basis and (for

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whatever reason) the banks periodically engage in wide swings in the amount of loans they pyramid

on top of their customer deposits of base money. Yet here is where another advantage of Bitcoin

comes into operation. Because Bitcoin is both a currency and a payment system, a society that used

Bitcoin as its money would be much less dependent on large banking institutions. Maintaining a

“Bitcoin wallet” is, practically speaking, the same thing as opening an online checking account (with

100% reserves). Note that as more and more merchants and employees began to accept Bitcoin, the

need for “Bitcoin exchanges” would also diminish. To be sure, there would still be commercial banks

and other “middlemen” institutions even in a world that used only Bitcoin as its money, but the

power of banks to inflate the currency would be greatly curtailed, even compared to a world where

everyone used gold as money.

Beyond stability in the value of money, the elimination of monetary inflation would also eradicate the

business cycle as we know it, as credit markets could no longer be whipsawed by the whims of

central bankers. Furthermore, by taking the power of the printing press away from the politicians,

States would have to finance their wars and welfare programs through explicit taxation or borrowing

from private lenders. This would reveal the true burden of these expenditures, thereby ushering in a

more productive and peaceful world.

The advantages of Bitcoin are most obvious when it comes to underdeveloped regions of the world

that are not served by sophisticated financial institutions. Entrepreneurs in Africa can much more

easily connect with venture capitalists in Europe if the world moves toward Bitcoin. Furthermore, it

would be quite difficult for governments to prevent “repatriation of profits” when all that the local

business owner needs is an Internet connection to transfer some of the earnings back to the foreign

investors.

Some skeptics try to turn Bitcoin’s ostensible advantage—the absolute ceiling on the number of

bitcoins, at 21 million—into a handicap. By its very design, the Bitcoin protocol adjusts the block

reward (how many bitcoins one may claim for finding a valid solution) to yield a constantly shrinking

“harvest” of new bitcoins over time, such that 99% of all bitcoins that will ever exist, will be in

people’s possession probably around the year 2030. This eventual standstill in new “production” of

bitcoins leads people to call it a “deflationary currency,” and they worry that it would stifle economic

growth if large numbers of people relied on Bitcoin as their primary form of money.

These fears are baseless, as we can show using both economic theory as well as historical evidence. A

baseline result from monetary theory is that in the long run, the quantity of money is irrelevant to

“real” economic variables (such as the unemployment rate, or how many hours a person must work

at his job to be able to buy a new car or a basket of groceries). For example, if the total quantity of

dollars suddenly doubled overnight—so that people who went to bed with $200 in their checking

account with wake up with $400, and so on—then in the long run, the main effect would simply be to

double all wages and prices. Sure, someone who used to make $50,000 would (eventually) make

$100,000 once things settled down, but she wouldn’t actually be better off—everything at the store

would cost twice as much, too.

Most people can recognize fairly quickly that a doubling of the money supply wouldn’t really make

society richer. But once a person admits that, then the opposite holds as well: Suddenly cutting the

money supply in half won’t make society poorer, either, at least once everything adjusts to the new

situation. Somebody who initially made $50,000 in salary would (eventually) see her paycheck fall to

$25,000, but that wouldn’t make it harder for her to live—everything at the store would be half as

expensive, too.

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Now it’s true, so far we’ve been talking about the long run—the economist’s favourite refuge where

nothing messy happens. What about in the short run? For example, if someone has a mortgage on a

house, that’s a fixed, contractual obligation quoted in dollars. Whether there is price inflation or

deflation, that mortgage payment stays the same. So wouldn’t these type of frictions cause serious

hardship during an adjustment phase, in response to changes in the money supply?

The answer is yes, and—drumroll please—it’s yet another reason that Bitcoin is so desirable as a

currency. Changes in the quantity of money only lead to short-run disturbances if they are

unexpected. But changes in the total amount of bitcoins can be predicted decades in advance, with

far more precision than fiat currencies or even commodity monies like gold and silver. If, for example,

the bitcoin - price of a general basket of consumer goods fell (say) an average of 5 percent per year

from 2030 onward, then people in the year 2028 writing long-term contracts quoted in bitcoins

would have seen it coming, and adjusted the terms of the contract accordingly.

It is a modern myth that “deflation” (referring to falling prices for consumer goods) is a bad thing

that cripples the economy. Part of the public’s fear is a confusion of correlation and causation:

Historically economic catastrophes often went hand in hand with falling consumer prices, as people

panicked and hoarded cash. Yet that doesn’t mean that consumer price deflation causes economic

depression. For example, from January 1926 through January 1928, the official Consumer Price Index

(CPI) in the United States fell a cumulative 3.4 percent. Did this gentle price deflation lead to a

sluggish economy? No, this happened smack-dab in the middle of the so called “Roaring Twenties,”

the boom period that preceded the Great Depression of the 1930s. To be sure, consumer prices fell

much faster during the early 1930s than in the mid-1920s, but it was a matter of degree, not kind.

More generally, there were long stretches in U.S. history during the classical gold standard period

when consumer prices gently fell year to year, and yet such mild price deflation was consistent with

strong economic growth. Indeed, when the production of goods and services rises faster than the

quantity of money (such as the amount of gold people hold), other things equal we would expect the

purchasing power of a unit of money to increase, as it becomes scarcer relative to everything else.

There is nothing dangerous or stifling about this development; it’s just the normal operation of

supply and demand at work.

One glib argument to “prove” consumer price deflation is bad runs like this: When people see prices

falling, they postpone purchases. Thus business sales fall off, they lay off workers, people panic and

become even more reluctant to spend, and so in a downward spiral to oblivion.

Yet that story can’t be right, at least as a general rule. First of all, we have historical examples (such

as the mid-1920s) when consumer prices gently fell amidst a booming economy. And in our own

time, try applying that narrative to the computer industry. Wouldn’t that logic “prove” that nobody

ever buys a new computer, because he can just wait six months and find better options at lower

prices? Yet casual observation informs us that despite the perpetual “deflation” in computer

hardware, that industry hasn’t been hurting.

In contrast, someone holding bitcoins would not need to “put them to work” in other financial assets;

the bitcoins themselves would appreciate (in terms of general purchasing power) over the years. But

to avoid confusion, we should clarify once again that the social function of Bitcoin is its service as a

currency (and low-cost payment system). The fact that individual bitcoins would appreciate in

“market value” over time wouldn’t make humanity richer. Rather, Bitcoin’s “hard” cap on quantity

would make its purchasing power much more predictable than that of other possible monies, and

therefore would make it correspondingly more suitable in coordinating long-term economic planning.

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Also, some people worry that the market value of bitcoins would eventually rise so much that the

regular person couldn’t afford them. In the year 2050, if one bitcoin can buy (say) a new luxury car,

then won’t only the rich hold bitcoins, defeating the purpose of trying to get widespread adoption?

This objection overlooks the fact that people can own fractions of bitcoins. The protocol actually

allows the blockchain to divide ownership down to eight decimal places, meaning that the original

protocol and related software can handle purchases as small as 0.00000001 BTC. Therefore, rather

than imagining the world eventually being saturated with 21 million bitcoins, it’s more appropriate to

think of humanity ultimately holding 2.1 quadrillion units of bitcoin currency. Just as Americans use

dollars, but quote cheaper items in terms of cents, so too could merchants quote items with a

different unit of measurement (not “bitcoins”) to denote fractional amounts of the currency. For

example, a merchant might simply write “45 mBTC” on a price tag, to indicate that the item cost 45

milli-bitcoins, or 45 one thousandths of one bitcoin. This could also be written as “4.5 cBTC,” denoting

four and a half centi bitcoins. (Note that this is similar to 1 millimeter being one-­­ thousandth of a

meter, and one centimetre being one-hundredth.) Furthermore, with consensus of the userbase, the

protocol can be updated without disruption to allow even greater divisibility.

The Opponents’ argument:

BITCOIN, to its most ardent fans, is more than a useful way to pay for drugs. It is also a technological

marvel that could disrupt much of the consumer-finance industry. But is it money? The Bitcoin

economy keeps growing, despite the periodic disappearance of large quantities of currency in hacker

heists. The total value of Bitcoins in circulation has risen to $7.9 billion, from just $490m a year ago,

while daily transaction volume is up by almost 60%. If Bitcoin aspires to match dollars and euros for

money-ness, it will need to be more than just a Mastercard for nerds.

Economists reckon money is anything that serves three main functions. It must be a “medium of

exchange”, which can reliably be swapped for goods and services. It should be a stable store of value,

enabling users to tuck some away and come back later to find its purchasing power more or less

intact. And it should function as a unit of account: a statistical yardstick against which value in an

economy is measured. The American dollar meets all three conditions. Bitcoin has some way to go.

Bitcoin does best as a medium of exchange, thanks to its clever technical design (see article). Users

can quickly move holdings around anywhere in the world. Rather than relying on central clearing-

houses, verification of transactions is done by “miners”, who are compensated for their work with

newly created Bitcoin. The new money they create adds imperceptibly to Bitcoin inflation, spreading

the cost of their work over all users.

This elegant system makes Bitcoin cheap to use. Because banks are not needed to confirm legitimate

purchases, transaction fees are low. Bitcoin’s near-anonymity has also helped drive acceptance

among those who would prefer to keep their transactions secret, whether drug-dealers or money-

launderers. The combination of functionality and user interest means that people are finding it easier

to swap coins for both goods and services and for other currencies. This rising credibility as a medium

of exchange supports Bitcoin values.

Yet Bitcoin is not exactly a stable store of value. It is technically equipped to do the job: coins saved in

an encrypted wallet on a hard drive can be retrieved for later use in purchases. But the currency’s

worth is prone to wild gyrations. Massive Bitcoin heists, like the recent plunder of roughly 6% of

outstanding Bitcoins from the Mt Gox exchange, reduce confidence in the currency. Bitcoin prices

dropped by 30% against the dollar in February due in part to the Mt Gox news. In more bullish

moments, interest has attracted speculators, sending values soaring—at least temporarily. Cameron

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and Tyler Winklevoss, twin brothers known mainly for their early quasi-interest in Facebook, recently

announced plans to launch a Bitcoin tracking fund, to make it easier for amateur investors to take a

punt on the technology.

Volatile values could prevent Bitcoin from ever establishing itself as a medium of account. Even the

few retailers who accept Bitcoin use other currencies as their principal accounting unit. Prices are

given in a prominent currency (US dollars, for instance) and the Bitcoin price fluctuates automatically

with changes in the crypto-money’s exchange rate. Similarly, most Bitcoin owners work in jobs with

wages paid in traditional currencies. So long as Bitcoin buyers and sellers “think” in euros or dollars it

will fall short of money status. And until Bitcoin values are less volatile relative to the currencies that

now dominate real economies, users are unlikely to change their monetary frame of reference.

That may be for the best, given another Bitcoin quirk. The currency’s “money supply” will eventually

be capped at 21m units. To Bitcoin’s libertarian disciples, that is a neat way to preclude the

inflationary central-bank meddling to which most currencies are prone. Yet modern central banks

favour low but positive inflation for good reason. In the real world wages are “sticky”: firms find it

difficult to cut their employees’ pay. A modicum of inflation greases the system by, in effect, cutting

the wages of workers whose pay cheques fail to keep pace with inflation. If the money supply grows

too slowly, then prices fall and workers with sticky wages become more costly. Unemployment tends

to rise as a result. If employed workers hoard cash in expectation of further price reductions, the

downturn gathers momentum.

Bitcoin’s money supply is still growing; its miners are just over halfway to producing the total possible

number. New coins will be minted until around 2030. Miners may then introduce transaction fees as

compensation for their critical verification work. More worryingly, deflation is already a reality.

Soaring demand for the currency is partly responsible for boosting its price (therefore reducing the

price of everything else in Bitcoin terms, generating deflation). But the knowledge that supply is

ultimately finite is also a factor.

Digital fetters

That other currencies remain the medium of account has so far been the Bitcoin economy’s saving

grace. If Bitcoin matured into a complete currency, with large numbers of workers using it as their

medium of account, then its inflexibility could bring economic havoc. Money-supply “shocks”, like the

disappearance of Mt Gox, could set off a systemic collapse. Given a loss of faith in exchanges, users

might withdraw their coins in a panic, leading to a dangerous decline in transaction volume. Such

hoarding could threaten Bitcoin’s status as a medium of exchange, leading to its complete demise as

a currency.

Reputable exchanges with large institutional holdings could help stem such panics by advertising a

willingness to sell their Bitcoins to meet liquidity demand. Yet because Bitcoin reserves are finite,

users may not find the promise credible. By contrast, central banks with the inexhaustible resources

of the printing press face no such inconvenient constraints.

We will end this brief introduction with some FAQs related to bitcoins hard limit of 21 million:

AKASH CHATURVEDI

Won't the finite amount of bitcoins be a limitation?

Bitcoin is unique in that only 21 million bitcoins will ever be created. However, this will never be a

limitation because transactions can be denominated in smaller sub-units of a bitcoin, such as bits -

there are 1,000,000 bits in 1 bitcoin. Bitcoins can be divided up to 8 decimal places (0.000 000 01)

and potentially even smaller units if that is ever required in the future as the average transaction

size decreases.

Why Mining was incorporated

In principle, the developer(s) of Bitcoin could have released all 21 million units of the currency

immediately with the protocol. Yet that would have almost certainly killed the project in its cradle.

With the current arrangement—where the “mining” operations needed to keep the system running

simultaneously yield new bitcoins to the machines performing the calculations—there is an incentive

for people to devote their machines’ processing power to the network (and for them to raise

awareness of the new currency). If people want to pay fees on the side to expedite the verification

of a Bitcoin transfer, they can do so, but (in this initial phase) the network eventually will get around

to processing a transaction even if the parties involved have attached no extra fee. Such a feature is

an ingenious way to encourage the widespread adoption of Bitcoin and help it “get off the ground.”

What happens when 21 million bitcoins are mined?

Two things would happen: Bitcoin(BTC) mining would become reliant on transaction fees, and the

value of Bitcoin will start to deflate

Currently, there are two things that miners make money off of: Minted Money and Transaction Fees.

Within the Bitcoin protocol, every ten minutes 25 BTC are created, and most importantly, are given

to people who calculate which transactions are valid vs. which aren't. The task of mining is extremely

vital to the integrity of the Bitcoin protocol, so the task has to be incentivized to ensure the network

works. However, every 4 years the amount of BTC being made halves, and so the profits from mining

will get lesser and lesser. However, mining is not solely dependent on minting, as there are also

small transaction fees whenever a transaction is made, which also go to miners. Currently, these

make up a small portion of profits, however, as the number of minted BTC gets smaller, transaction

fees will start to play a more prominent role in the BTC network.

The second thing that will happen as a result of the limit being hit, is that the currency will become a

deflationary currency. Currently, thousands of BTC are made daily, which causes inflation, however

once BTC stops getting mined, the currency will stop inflating. It is a regular occurrence for someone

to gain a few BTC and then to forget about their account, causing that person to have destroyed a

few BTC, or at least a few thousand Satoshis (a subdivision of BTC equal to ten nanoBitcoins, or

1/100,000,000th of a bitcoin). This act, while insignificant as a singular act, is a somewhat regular

occurrence, and as such will result in the number of BTC in circulation to decrease, causing the value

of BTC to rise in the long term. This deflation, in combination with increasing popularity, will mean

that what will seem cheap to us in 10 years (now), will seem incredibly expensive in 100 years.

Compare this to the American Dollar (USD), as any American who listened to their grandparents

would remember that what used to cost 1 cent back then, would now seem incredibly cheap to our

modern economy. The point is, instead of governments being able to print more money and make

things cost more, Bitcoins get destroyed over time, making things cost less. Whether or not this is a

good thing depends on what you consider good, and how you view the economy.

AKASH CHATURVEDI

Sources:

https://www.bitcoin.com/you-need-to-know

https://www.bitcoin.com/info/how-bitcoin-transactions-

work?utm_source=bitcoindotcom&utm_medium=website&utm_campaign=getting_started

https://www.bitcoin.com/info/what-is-the-blockchain?utm_source=get-

started&utm_medium=post&utm_campaign=info&utm_content=how-bitoin-transactions-work

https://www.bitcoin.com/faq

https://bitcoin.org/en/faq

https://www.bitcoin.com/bitcoin.pdf

https://www.quora.com/What-happens-when-21-million-bitcoins-are-mined

http://www.investopedia.com/news/what-happens-bitcoin-after-all-21-million-are-mined/

https://www.economist.com/news/finance-and-economics/21599053-chronic-deflation-may-keep-

bitcoin-displacing-its-fiat-rivals-money

Understanding Bitcoins book – Robert murphy