PYMNTS Blockchain Basics Series: What’s Bitcoin, and How Did It Get That Way?

by admin May 25, 2022

So, what is bitcoin?

By this time, most people know at least a little about bitcoin, the first cryptocurrency, and that there is also Bitcoin the blockchain.

And while we’ll get into the basics about both of those, there’s a lot more to Bitcoin’s story than how it works.

If you listen to Bitcoin’s many boosters, it is the progenitor of the biggest new industry since the World Wide Web, destined to transform finance, replace fiat currency, return personal and financial privacy, reinvent the way people socialize (see “metaverse”) and even provide the infrastructure for a new internet free of censorship and Big Tech’s control (see “Web3”).

There’s something to some of those claims — Wall Street is very interested in decentralized finance, governments are terrified of stablecoins, and the metaverse is attracting hundreds of top brands, as well as social media networks like Meta, which bought in hard enough to abandon the name “Facebook.”

But the fact is, Bitcoin has so far failed to live up to its core purpose, which pseudonymous creator Satoshi Nakamoto described as a “purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”

It’s important to remember that description, as it not only summarizes the goals of Bitcoin, but it also gives a great deal of insight into its shortcomings.

Trustless

The core of Bitcoin’s uniqueness is the solution it provides to what Nakamoto called “the double-spending problem” that requires transactions to be made through a trusted third party, like a bank, credit card network or broker.

Bitcoin is what cryptographers call “trustless,” as it requires no trust. It achieves that by building a distributed ledger network in which all the ledgers (called “nodes” in the blockchain) must agree on the accuracy of a transaction both before it is validated, timestamped and written onto the ledger in an order that cannot be changed without creating a very visible break in the ledger.

More here: PYMNTS Crypto Basics Series: What’s a Blockchain and How Does It Work?

Blockchain got its name from the comparison to a chain onto which new links are added. Any disagreement causes a “fork,” which is essentially a new ledger at that point — think of adding two links to the end of a chain and adding new links to each.

So, to make a change to any existing transaction anywhere in the past would require changing all the following links as well. Each “link” in the chain is a block of validated transactions. This process is kept honest through a process called proof-of-work, in which the operator of a node competes to solve a math puzzle, with the winner getting a reward in newly minted bitcoins when the rest of the node operators agree that the block is properly validated and add it to the blockchain.

In this way, the trusted intermediary isn’t needed because there is no way for one party to double-spend their bitcoins — transaction records cannot be changed, and the process of spending a bitcoin requires the use of a single-use password code which is burned in the process; a new one is generated for the next possessor of that bitcoin.

And, the theory goes, with enough nodes distributed around the world, there’s no way for individual governments or bad actors to seize control of the network.

Yes, But …

There’s a couple of problems here, starting with the reality that there are plenty of reasons to want to reverse a transaction, ranging from buying a defective product to having sent it to the wrong person to learning that you’ve bought something stolen.

Additionally, the reliance on complex, one-time-use codes make bitcoin transactions “pseudonymous” — meaning that while the bitcoin itself can be traced along the publicly viewable blockchain, the owner is hidden behind a code.

That’s great from the libertarian philosophical perspective Nakamoto espouses, but it causes problems when that cryptocurrency is used by drug dealers, ransomware hackers and the like to get paid in a currency that is almost as hard to trace as physical cash but can be sent, received and spent instantly and anonymously around the world.

But there’s a hole within that hole: While bitcoin has value anywhere, very few merchants actually accept it directly. As such, spending it generally requires “off-ramping” it via a payments processor, bank or other financial institution. The main way of spending bitcoin — and any other cryptocurrency — at retail is to run it through a Visa- or Mastercard-issued debit card that lets the owner pay in bitcoin but gives the merchant dollars.

And while some merchants are beginning to accept it, change is slow, and made slower by the wildly volatile price of bitcoin and other cryptocurrencies, which rise or fall by 5% or even 10% daily on a fairly regular basis. In just the past year, bitcoin has seen its price doubled and halved twice.

Bitcoin enthusiasts, who call themselves “hodlers” as they “hold on for dear life,” are happy with the long-term view. However, merchants don’t really want to use a currency that fluctuates wildly. Companies with cash flow to manage can’t afford that perspective.

Store of Value?

As a currency, bitcoin is still in its infancy 13 years after the Bitcoin Genesis Block was minted on Jan. 3, 2009. It’s use so far has been as an investment, which has confounded more than a few investors as there is literally nothing behind bitcoin other than people’s belief that it has worth — no yellow metal usable as jewelry, no stock in a company that produces something, no commodity that can be used to build or feed, and no “full faith and credit” of a sovereign government like fiat currency.

Berkshire Hathaway CEO Warren Buffet recently said he wouldn’t buy a half trillion dollars worth of bitcoin “for $25.”

There is, he said at his annual shareholder event, “all kinds of frictional costs that are real, that somebody has paid to a bunch of people who facilitate this game. There’s no more money in the room. It’s just changed hands.”

Buffett was referring to financial intermediaries like cryptocurrency exchanges.

The embrace of bitcoin by Wall Street bankers and investment firms that began in earnest in late 2020 was based on the idea that it is a store of value — meaning an investment that, like gold, will retain its value in the face of inflation.

This was based on the fact that no more than 21 million Bitcoins can ever be minted, making it, the argument goes, noninflationary.

That was a great idea, right until it started rising and falling with the broader markets as the current financial situation got more sticky.

And bitcoin has some technical disadvantages: it takes 10 minutes to finalize transactions; fees are unpredictable; and with about five transaction per second, it’s not close to scalable enough to act as a real currency.

See more: Bitcoin’s 10-Minute Block Time Batches and Fluctuating Transaction Fees Give RTP a Leg Up

There are ways around this — Layer2 blockchains like the Lightning Network are a good example, as the transaction takes place off Bitcoin’s blockchain, and are simply written onto it in batches after being completed.

But Bitcoin has a long road to walk ahead if it is to become a “purely peer-to-peer version of electronic cash” that people prefer to dollars and cents.