How Does Bitcoin Work? Bitcoin is a disruptive technology that’s worth the attention!

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How Does Bitcoin Work? In 2020, Bitcoin returned to the spotlight in the financial world and beyond. It has increased from below $10,000 over a year ago to near $70,000 today. This over 270% annual increase is incredible, but the public remains rather uninformed about Bitcoin. Let’s dive right into it.

What is Bitcoin?

It must be heard in the news very often that Bitcoin is a cryptocurrency. What does that mean? It is also a currency, which means that just like cash. Bitcoin can be used to store value and be exchanged for certain goods and services. However, Bitcoin has three unique characteristics: virtual, decentralized, and international.  

  1. Bitcoin belongs to the virtual currency group as it exists only in electronic form. Digital wallets store the bitcoin. And transacted over the internet. 
  2. Unlike the United States dollar that is regulated by the Fed. Bitcoin is decentralized. There is no central bank or government that controls its issuance and exchange; instead, Bitcoin is transacted on a peer-to-peer basis without engaging any intermediate institutions. 
  3. As Bitcoin is transacted solely over the internet. Bitcoin’s transactions circulate beyond borders, around the world.  
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Mining & Transaction

Bitcoin comes to birth through the process called mining. Powerful computers solve complicated math problems, or “puzzles”, that create the bitcoins. In addition, the miner that solves the puzzle is rewarded with new bitcoin.

The transferring of bitcoin from its holder to somewhere else is a bitcoin transaction. Miners document the transactions by putting them together into “blocks” and recording them on a public ledger, called “Blockchain”. To ensure that the transactions are safe, network nodes that use cryptography verify the transactions. Bitcoin’s underlying cryptographic principles make it a cryptocurrency.

The Value behind Bitcoin’s huge price surge

I will explain Bitcoin’s value from three different perspectives: infrastructure, commercial usages, supply and demand 

Bitcoin delivers a cheap, fast, and safe solution for transactions by its design. As Bitcoin takes away the intermediary of a bank, transactions between peers almost cost none. Only when the sender wants to prioritize the transaction, usually large ones, will one pay a small fee. It is therefore overall cheaper than transactions that engage banks. Also, using Bitcoin for cross-border transactions is very efficient. International exchange through Bitcoin is faster than that through banks: while wire transfer or electronic check takes a day or two to process, payment made through bitcoin takes seconds or minutes––it only requires that the receiver picks the “wallet” (platform to which the sender will deliver the payment).

Some skeptics question that its transaction speed is slow. When multiple levels of confirmations are needed.

Although the process is admittedly decelerated by more confirmations. Each additional confirmation adds ten more minutes, give or take. The total time it takes for a transaction through Bitcoin is still much shorter. Furthermore, it is the confirmation that makes large transactions via Bitcoin secure. Having multiple machines to verify a transaction prevents double spending. The same tokens being spent more than once. Bitcoin’s features build a good foundation for this crypto asset to surge in value, as what actually happened over the past 10 years and especially in 2020.

Step by step, Bitcoin has also gained more and more usages across the world, and this trend continued. After its first appearance in the 2008 crisis, Bitcoin stayed humble for two years: only in 2010 did the first transaction occur––programmer Laszlo Hanyecz bought two pizzas with 10,000 Bitcoin (only $30 equivalent then). For a couple of years until 2013, Bitcoin’s use is primarily in the black market, such as the Silk Road.

The closure of Silk Road seemed to end Bitcoin.

This caused fear in the market, with Bitcoin dropping to $109.7 immediately. Yet with an economy system independent from the Silk Road, Bitcoin soon rose from darkness to light. In 2014, it was first accepted by game company Zynga and the D Las Vegas Casino Hotel, and then got an allowance of payment by giant tech companies: Dell and Microsoft. Soon, it attracted more and more big corporations as well as businesses to accept it as an option of payment, with its underlying technology blockchain even rising to the cover of the Economist in 2015. 

Timeline

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Diagram

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At this point, Bitcoin has transformed from a mysterious new concept to a widely adopted and recognized currency by the industry, with large companies in different sectors including Subway, BMW, Apple Music, PayPal, and Goldman Sachs. The strong corporate endorsement and wide commercial adoptions created strong bullish market sentiment that has driven Bitcoin’s price to skyrocket.

In addition to the Bitcoin infrastructure and usages. The limited supply and huge demand also together drive Bitcoin’s price up.

Unlike USD which central banks could keep printing more and more, Bitcoin has been fixed to 21 million since its creation.

This limited supply creates an opportunity for Bitcoin to surge in value as it becomes more and more scarce in the future, and also limits the downside for Bitcoin by ruling out the possibility of inflation due to over-printing. At the same time, Bitcoin has been adopted by more small and large businesses across the world. Even the world’s most respected funds like Ark Invest are considering Bitcoin.

Bitcoin does not have a listing on major exchanges such as CME, NYSE, or Nasdaq. But, an ETF is coming out and more brokerages are offering the ability to trade Bitcoin. Furthermore,it has attracted large numbers of retail and institutional investors––including funds with above 30% annual return in the last 7 years like Ark Invest. Therefore, the demand for Bitcoin is already huge and keeps growing. As with any good in an economy, when limited supply met with an enormous and increasing market demand, Bitcoin’s price surged.

Table

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Bitcoin has had an exceptional annual return during the last ten years. The table below tracked its year-to-year annual return. except in 2014 and 2020, Bitcoin all gained positive and huge annual returns, with six years of more than 100% and three years of more than 1000%. This tremendous price growth has made it the fastest growing asset over the past ten years. It has far outperformed the growth of major indices and most equity returns.

What should investors be careful about when considering Bitcoin investment

Despite the tremendous growth in the past and potential in the future, it is important to acknowledge that investing in Bitcoin bears a considerable amount of risk as well. The over-reliance on technology and high market volatility together make it important that one should consider Bitcoin cautiously.

Technology behind Bitcoin makes it an effective medium of exchange, but it’s over-reliance on technology––bitcoin mining, digital wallet, blockchain––may limit Bitcoin’s development. First of all, as like any technology, Bitcoin faces the risk of hacking. It is possible for Bitcoin investors to lose their coins and fail to retrieve them as a result of cybertheft and online fraud.

Also, as a crypto-currency, Bitcoin lacks a physical entity to back up its value. But, the private keys are replicable. In addition, easily backed up in the physical world. This differentiates it from scarce precious metals like gold and silver. Once society does not recognize the technologies that Bitcoin relies on, Bitcoins’ value will diminish immediately. Furthermore, as technology is not  without borders, different countries might hold different attitudes toward Bitcoin’s technology development.

Although Bitcoin posted a high positive return, it is one of the most volatile assets.

Bitcoin (and crypto currencies) usually has considerably higher volatility than currencies, commodities, precious metals, US Equities, and real estates.

While its high volatility on one hand suggests potential high return (which was proven especially in 2020), it also suggests that Bitcoin players must be able to handle the drawdowns due to Bitcoin’s volatility. While rewarding those who buy it early and keep it long, Bitcoin’s fluctuation has certainly blown off trading accounts and scared too many participants away.

This question––is Bitcoin a bubble? Has risen time and time again. At this time, it is difficult to recognize it as a bubble, but we don’t truly know that one is a bubble until it bursts. As analyzed in the last section, there are underlying reasons of infrastructure, commercial usages, supply and demand that explain Bitcoin’s price surge. Still, in order to make the best decision before one moves, bearing the risk that Bitcoin investing has in mind is crucial.

How Does Bitcoin Work?

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How Does Bitcoin Work? Edited by Jules Hirschkorn

How Does Bitcoin Work?
How Does Bitcoin Work?
How Does Bitcoin Work?