This edition discusses the features of Bitcoin, a cryptocurrency that lets us exchange money without any intermediaries.
In the modern world, the most accepted form of money is ‘fiat’ money or the money declared as legal tender by State. We can keep the currency notes in our wallet and then exchange it with someone else for goods and services. We are able to do this because of our faith in the promise of our country’s central bank that issued it. Now, if we need to send money to a distant client, we use electronic money.
For this, we enlist the service of an intermediary- mostly a commercial bank. Money in electronic form is kept in the bank’s database and the bank keeps a register to store details of your money transactions. When you send a certain unit of money to a distant client, the banking system will deduct this amount from your account and credit it to the client’s account. So, in the current monetary system, for most of the operations, we depend on the banking system as an intermediary, a third party trust system.
An issue with the fiat currency based monetary system is that it is controlled by the whims and fancies of a set of people or the political powers that be. The current demonetization (and the miseries caused by it to the public) is an apt example. Fiat money is no more a good store of value. There is no guarantee that today’s 100 rupee note would fetch me the same value after a week.
So, this waning confidence in fiat money prompts many to seek alternative forms of money. One such alternative gaining traction among the tech savvy people across the globe is cryptocurrency, a digital currency system based on cryptographic methods.
Unlike the physical currency, we cannot bring the electronic currency from the bank and keep it in our PC or mobile device and send some money to the client directly to a distant client. Money in electronic form, like any other electronic file, can be copied easily. This means if you get some money in electronic form, you can copy and send it to as many people as you wish. Let us assume that you have one unit of e-money and you send it to three people.
Now, all of a sudden, where you started out with just one unit of money, now you have 3. You have simply created 2 new units out of thin air! And, technically, you could do this as many times as you wanted. Naturally, nobody will have trust in this system. So, how can we send money in electronic form without an intermediary like a Bank and still control double spending (or spending the same money more than once)? Bitcoin, the first cryptocurrency, solves this problem meticulously.
In the Bitcoin scheme of things, a unit of currency is called bitcoin (BTC). The currency lives on the Bitcoin network, which is a peer-to-peer network of computers. Being a peer-to-peer network, users can directly communicate with one another. The participants in the network use BTC to store and transmit value among them. Bitcoins are generated within the Bitcoin network as per a mathematical algorithm and transactions are recorded using cryptographic techniques. A full ledger with all the Bitcoin transactions hitherto made is available to all the participating nodes. Any fresh transaction gets transmitted to all the nodes and through a verification process, gets appended to the ledger.
To get started with the system, all you need to do is to download/install the Bitcoin software appropriate to your platform. Once installed, the software provides you with an e-wallet, which can be used to send/receive bitcoins. To send/receive bitcoins, you need something called a bitcoin address — similar to your bank a/c number (e.g.: ‘16VNpCo9acCTHHGbQinVbtu7KaGkATqug7’). The wallet software will provide this too. Along with the public address, you will get a private key also (this is similar to your bank password). These two numbers (the public address and private key) are mathematically linked and if you lose one of them you will lose your money completely.
When someone sends you bitcoins, she needs to send it to your Bitcoin address, which can only be redeemed by using your private key. When someone initiates a transaction, it gets transmitted all over the bitcoin network. Nodes in the bitcoin network, undertake the task of verifying the integrity of the transactions — this process is called mining in the bitcoin parlance. Each of these nodes collects a set of transactions, assembles them into a block with some administrative data and starts the verification process. As part of the verification process, the node has to solve a mathematically intensive puzzle. The block (of transactions) from the node that solves the verification puzzle first, gets accepted as the next block to be added to the ledger. Now, every node in the network has to add the block to its database. Being a ledger with a chain of confirmed transactions, it is aptly called a Blockchain.
The successful node gets rewarded with a token of the cryptocurrency. In the Bitcoin case, currently, the reward is 12.5 BTC. This is how new money gets generated in the Bitcoin system. The reward gets halved every four years (in the beginning, around 2009, this amount was 50 BTC and then it was reduced 25 BTC) and the total number of bitcoins will reach a maximum of around 21million BTC by the year 2140. This means that the money supply in the Bitcoin economy is fixed. Being algorithmically controlled, unlike fiat currencies, this amount cannot be arbitrarily adjusted or devalued.
Though Bitcoin is still popular among many tech-savvy entrepreneurs and merchants (like online retailer Play-Asia, it is still not a mainstream product. The most significant aspect is that the technology that made Bitcoin possible is being harnessed to create new products. Apart from Bitcoin, several other digital currencies based on cryptographic tools are emerging. Even many banking institutions are planning to create their own cryptocurrencies.
The real innovation of Bitcoin is the Blockchain, the decentralised transaction recording and verification system. In the Bitcoin system, the Blockchain is used to track the exchange of money. But why should Blockchain be limited to the exchange of money alone? Why not use it to track exchange of stocks, land titles and so on. Many new ventures that intend to tap into the potential of Blockchain are surfacing. We will take up this exciting phenomenon in another edition of this column.