DECYPHERING BITCOIN: unlocking the concept
Bitcoin was conceived by a person (or group of people) known by the pseudonym of Satoshi Nakamoto, who published a white paper in October 2008 describing the first functional decentralised cryptocurrency and how it could open the door to value transfers without the intervention of a trusted third party such as a bank. The first transaction took place on 12 January 2009. The Bitcoin network, and its eponymous digital coin bitcoin, have sparked many intense debates. But they’ve proven resilient since their inception: bitcoin’s value just recently surged to an all-time high. But what is it, exactly? A currency? A new asset class? A new opportunity for storing value?
Chief Digital Officer at Société Générale Private Banking France.
How Bitcoin works
Bitcoin is built on blockchain1 technology, which includes encryption mechanisms2. It operates on a fully decentralised peer-to-peer network, authorising direct transactions between users with no intermediary or trusted third party. This is revolutionary, in that Bitcoin solves the double-spend problem. Unlike digital objects, such as a photo, document or sound, which can be copied infinitely, Bitcoin ensures the same value cannot be transferred twice. In this case, a bitcoin or a bitcoin fraction can't be spent more than once.
Bitcoin is built on a decentralised network of computer nodes called miners. The role of miners (now specialised companies) is to operate the network by collecting all transaction intents and verifying the validity of those transactions. If they’re accepted, the miners add them into a block of transactions that’s cryptographically chained to the previous one. These transaction blocks are added to the blockchain using a process known as “mining”. To add a transaction block, miners must solve a complex maths problem. The electricity required to solve this cryptographic puzzle is the cost of securing the transactions. Miners must carefully validate the transactions, or else they’ll have expended energy (and hence money) in vain. To do this, miners use special hardware that can run a massive number of calculations and keep a copy of all past transactions.
In exchange for work done according to the rules, miners are rewarded with new bitcoins. That’s why it’s called mining, as it’s similar to digging for gold. In addition, miners are paid transaction fees for the blocks they’ve validated.
A deflationary protocol
The protocol is designed to limit the total volume of bitcoins issued to 21 million units. Today, nearly 94% of bitcoins have already been created: once every four years or so (every 210,000 blocks, to be precise), the protocol cuts the number of newly-created bitcoins given to miners that validate transaction blocks by half. This mechanism is known as “halving”. The latest halving occurred on 20 April (CET), reducing the number of new bitcoins created by mining from 6.25 BTC to 3.125 BTC. In four years, that number will reach 1.5625 BTC. The last bitcoin will be mined in 2140. This makes a bitcoin a rare deflationary digital asset. And one that’s precious to those who understand how it works and embrace it.
Security and trust in the Bitcoin network
Participation is probably furthered by the fact that the Bitcoin network has not been hacked since it launched. Transactions are secured by an advanced encryption method, and multiple copies of all transactions chained together are available, which gives Bitcoin its value, relevance and security. This is the very principle of blockchain, which links all the transaction blocks to each other.
Transactions are not anonymous but pseudonymous, so each can be identified by its public address3. They can all be publicly identified on the blockchain, guaranteeing the authenticity and integrity of each and every one.
Today, there are powerful tools for analysing and tracking transactions, used by public authorities and institutions to identify any suspicious or fraudulent transactions. Contrary to popular belief, the rate of illegal transactions tied to criminal activity is still very limited, well below the use of fiat currencies. In fact, one of the things that defines blockchain is the transparency of transactions available to all, which can make it easier to identify criminal networks - unlike cash.
The blockades to blockchain persist
Bitcoin is up against multiple challenges: its very high volatility and scalability issues4, plus the management of bitcoins held and the public’s dim view – and understanding – of it all, especially in terms of the energy it uses.
The volatile nature of bitcoin prices, expressed in fiat currency, makes it impractical as a means of payment for merchants and consumers. Like any risky asset, it can also put off any investor taking a short-term approach.
Scalability is tricky, because each transaction is considered validated after at least six transaction blocks (about 60 minutes). “Lightning Network,” a Bitcoin-backed second-tier solution, does provide a solution by making instantaneous micropayments in satoshis5 (subdivision of bitcoin) possible.
Managing bitcoins (like any other cryptoasset) means managing your private keys carefully. If you lose or forget your private key, the bitcoins are lost forever. While there’s a variety of hardware and software solutions on the market for effectively managing and protecting private keys, it’s still complex and mysterious to much of the public.
Lastly, Bitcoin is often criticised for using so much energy. Indeed, mining – also known as “proof of work” – is highly energy-intensive, given the computing power required to validate transactions. Yet Bitcoin now uses mainly intermittent and renewable surplus energy, which would otherwise be wasted by power generators. The economic interest of miners is to minimise the cost of the energy used to validate and secure transactions, hence the search for lower-cost energy. It’s a chance to use some of that oversupply that’s become profitable for green energy producers.
Regulatory authorities and financial institutions are shifting their stance
Government regulatory issues are another factor impacting the adoption of bitcoin and other cryptocurrencies. Some countries have taken a regulatory-friendly approach to cryptocurrency (Germany, Switzerland), while others have imposed sharp restrictions or prohibited their use altogether (Algeria, Morocco, Pakistan, China). Meanwhile, El Salvador has made bitcoin into legal tender. How widely Bitcoin is adopted will depend largely on how these questions are addressed around the world.
Not long ago, Bitcoin could be seen as an attempt to challenge the monopoly of traditional banks. Now, however, it’s more likely that this decentralised, transparent alternative will join the existing financial system. The recent issue of spot Bitcoin ETFs6 in the US, by major asset management firms like BlackRock, makes it clear that adoption is happening. Companies and individuals say they’re taking more of an interest in Bitcoin and/or in owning it. The latest KPMG-ADAN research puts this growing adoption in an interesting light.
By authorising quick, low-cost cross-border transactions, Bitcoin challenges the limits of traditional payment systems and offers a potential solution to financial exclusion for populations without access to banking services all over the world. Bitcoin can also act as a medium/long-term store of value, like an alternative to gold, offering protection against inflation and monetary devaluation. Its increasing adoption by companies and institutional investors is making it more legitimate as a viable financial asset. As such, despite its peculiarities, Bitcoin could become a contender in the international financial landscape.
1 Technology used to keep track of a set of transactions, in a decentralised, secure and transparent way, in the form of a chain made up of blocks of transactions.
2 Cryptography is a field of mathematics that comes up with solutions to protect messages (by ensuring confidentiality, authenticity and integrity) using secrets or keys.
3 Every cryptoasset owner holds a private key and a public key so they can control coins/tokens and sign transactions. For the sake of simplicity, consider the private key –which should never be shared –as a password, while the public key identifies the person or entity sending and/or receiving coins/tokens. More specifically, it’s the public address which is derived from the public key. A simplistic analogy would be to compare the public address concept to an IBAN or email
4 Scalability can be defined as a system’s capacity to be deployed over a wide area.
5 Subdivision of bitcoin. 1 bitcoin = 100,000,000 satoshis.
6 An Exchange Traded Fund, or tracker, is a fund that replicates the value of a stock market index, a commodity, or any asset that is assigned a value. In the case of spot ETFs, the manager must constantly adjust the volume of assets held in order to constantly duplicate the valuation.
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