Bitcoin – How does it work and why has it shot to the moon!

Written By Rebant Patodi (Grade 9)

Money is very confusing and has taken different forms as we have progressed in the future. Money is something that represents value. In ancient times civilisations traded, but without money. In those times, there were no coins or notes. They traded through the barter system, where if I take something from you I give something to you in return. For example, if I take a goat from you I will pay you back by giving you a sheep in return. Trading “things” for “things”, but not cash or coins. As time progressed it became tough carrying objects from one place to another to continue trading through the barter system. So, we came up with the concept of money. 

Today, we pay using notes and coins but what if I told you that this system might get replaced with a virtual currency: “Bitcoin”. Bitcoin is a cryptocurrency. Some other cryptocurrencies including Dogecoin, Ethereum and NEO. A cryptocurrency is a digital currency based on a ledger system. It is decentralized and secured by cryptography. Cryptocurrency is entirely virtual and eliminates the use of physical cash. 

The current value of one Bitcoin is approximately 28 lakh. This in itself is a lot but what is insane is that in the past month, the value of one Bitcoin has halved. From peaking 40 lakh INR it has fallen to 28 lakh INR. So how and why has Bitcoin become so insanely expensive?

Bitcoin works on the basis of a ledger. A ledger is a huge spreadsheet that holds all the information about every transaction. The Bitcoin ledger has data going back to, January 2009, when it was first introduced. For better understanding let’s assume you and 4 other friends went to the movies and say you bought everyone’s ticket. They would eventually pay you their share of the tickets. These 5 transactions (you buying the ticket and your 4 friends paying you back) are documented on the ledger. However, on the Bitcoin ledged the 4 friends have not actually transferred Bitcoin to your account. The ledger just keeps track of who owes who how much. Now that you have this ledger in front of you, there is proof of how much money someone owes you. Each ledger entry can be thought of as a “block” connected to the next entry using a “chain” giving the name blockchain.

Now let’s say you have to pay some money to your roommate because he paid for your lunch. He adds it to a ledger where he is keeping track of both of your finances. In this case, you trust him to ensure that he’s added the correct amount. But on the Bitcoin ledger, you wouldn’t trust a stranger not to change the value you owe them. For security, every Bitcoin user has their own copy of the spreadsheet. A hacker can only access his copy of the Bitcoin spreadsheet. The Bitcoin software compares everyone’s spreadsheet regularly. If there is an anomalous transaction it detects it and changes it back. This way it is impossible to hack Bitcoin since there are millions of people who are maintaining and managing their spreadsheets. This ensures that Bitcoin is decentralised and safe from fraud or forgery.

To further secure the system, Bitcoin is built on cryptography. Well what is cryptography? Cryptography is a branch of science and mathematics that uses codes to keep all our communications “encrypted”. For example, you text a message to your friend on WhatsApp. The message is encrypted which means that an employee of WhatsApp cannot read the message himself. Only you, your friend and the computer (which does not understand the message) can read it. This is called end-to-end encryption where a message is encrypted on both, your device as well as your friends. Similarly, Bitcoin also uses cryptography using SHA-256 a common encryption key. This solves the issue of trust and centralization and does not let any 3^rd party interfere in your work. 

There are over 40 million Bitcoin users in the world now. No one had heard of cryptocurrency until recently and there have to be some reasons for the growing popularity of cryptocurrencies especially Bitcoin.

 Reasons for popularity: 

1. Security – The biggest advantage of cryptocurrencies is that they are decentralized. The ledger system and the cryptographic encryption ensures that no 3rd party can view or change your transactions. This is a huge advantage.
2. Mining – Bitcoin mining is the process by which new bitcoins are entered into circulation. It is a critical component of the maintenance and development of the blockchain ledger, to prevent hackers from hacking the system. The Bitcoin miners solve complicated problems using their computers to generate new Bitcoins. This makes Bitcoin very safe and ensures that no one can create their own Bitcoins.

With the rapid growth of Bitcoin, many famous people have become have started investing in Bitcoin. Elon Musk’s company Tesla in February disclosed that they have invested in 1.85 billion bitcoins, and all of a sudden the bitcoin market mooned by 10%, but then on May 13^th, Tesla revealed that they would stop taking Bitcoin as a mode of payment as it was causing pollution to the environment. Since mining Bitcoin requires huge computing power fossil fuel emissions increase. Because of this Bitcoin saw a drop of 20%, but a week later he retweeted saying that they plan on using renewable energy which was potentially promising. This saw a growth of 4% in the price of Bitcoin. But on June 3rd he again tweeted a meme about breaking up with Bitcoin which saw a drop in price of 5%. Now in his most recent tweet, he tweeted that Tesla would once again accept Bitcoin when the Bitcoin miners (people who sit behind computers and maintain the bitcoin system from any hacks or scams) start to use clean renewable energy. It is comical to see how Elon Musk has been driving the price of Bitcoin up and down only increases the popularity of cryptocurrencies.

Since Bitcoin is not managed by any Central Bank or the Government the basic rules that are applied in investing in stocks do not apply here. For example, the inflation rate and monetary policy don’t apply here. So what determines the cost of bitcoin? The competition with other cryptocurrencies, the supply and demand of Bitcoin and the cost of production are the main reasons that determine the price of Bitcoin. Investing in any cryptocurrency can be very risky. Even in Bitcoin investing is really risky as the market fluctuates a lot. The reason for the fluctuation of bitcoin is because of the supply and demand chain. Bitcoin has a fixed limit of 21 million bitcoins. So when someone buys Bitcoins in bulk the price increases and as a result when people see this they decide to buy Bitcoin (FOMO being a big reason for this) and as a result the price increases. But when people decide to sell Bitcoin the price reduces attracting buyers, and the cycle repeats. 

All of this makes Bitcoin a very successful cryptocurrency. The Bitcoin network processes on an average 300,000 transactions daily. There are approximately 400,000 to 800,000 active Bitcoin addresses daily, which means that there are approximately 300,000 to 500,000 bitcoin users either sending or are receiving bitcoins per day. In America, 8% of the population own Bitcoin or any other cryptocurrency, and in Turkey, 18% of the country’s population own cryptocurrencies. This shows the rapid growth of cryptocurrencies across the world. Bitcoin is also considered as the best cryptocurrency since it is the oldest and most developed of them all.

Featured Image Courtesy – India Today