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Crypto Currency 101

WHAT IS BITCOIN?

Bitcoin is a digital currency developed to trade for goods or services. A Satoshi is the smallest unit of one Bitcoin that can be sent or transmitted on any transaction. Each Bitcoin is divisible to the 8th decimal place or one hundredth of a millionth of a Bitcoin (.00000001).

The Bitcoin token is produced through custom-made computer software (platform) which uses encryption to process, verify, and validate each transaction and a ledger to maintain permanent records. Its value is derived by the shared perception of freedom, privacy, and its ability to be shared through a Peer-to- Peer network (P2P) eliminating the need for intermediaries such as banks. It is decentralized, which means, there are no servers; it is not stored in a bank, issued, or regulated by any government or agency, and it only exists on the virtual world of the internet maintained through a network of shared computers called “Nodes”.

Bitcoins are created through a process called “Mining” where participants of the Bitcoin network use powerful computers to verify the validity and authenticity of all transactions. Transactions are sent in the form of an encoded mathematical problem and the miner that solves it, and thus confirms a transaction, gets issued a number of Bitcoins. By design, the number of Bitcoins issued is decreased every four years by half, so the total number of Bitcoins that will be produced will be 21 million. The last Bitcoin will be mined in 2140.

The mechanism used to record and maintain all the information is called a Blockchain. The Blockchain is a ledger, a register, a record book of transactions executed between members of the Bitcoin network. When a transaction occurs, this ledger is changed to reflect the changes; the entire network is updated and the balance of coins is accounted for.

FINANCE

The ability of Bitcoin to serve as an efficient digital currency generated an upheaval of interest in consumers as well as developers of the financial and technology (FinTech) sectors.

Consumers saw this as an opportunity to conduct transactions directly with one another or with a vendor without the need to maintain a bank account or have credit card. This gave rise to small and large companies to contemplate its use in everyday transactions. Major companies like Starbucks, Subway, and Uber were among the first to announce that they will be accepting crypto currencies such as Bitcoin as a form of payment. By eliminating the banking system, both consumer and vendor will save on fees incurred in every transaction. For example, an individual can pay Starbucks directly from his/her digital wallet to the store’s digital wallet. An employer can pay its employees directly; sending money from the company’s wallet to the employee’s wallet in any cryptocurrency the employee chooses.

As a consequence Major banks like Goldman Sachs, Bank of America, Barclays, and Lloyds of London are threatened by the development of Bitcoin (and other cryptocurrencies) and are now confronted with the need to adapt.

TECHNOLOGY

On the technological sector, Bitcoin spurred a race to develop and expand on its technology; in particular the Blockchain component. Bitcoin is considered a first generation Blockchain; one that was designed specifically to run the Bitcoin network. But analysis of its Blockchain quickly revealed that its structure could be applied to many different fields such as legal, database design and maintenance, security, record keeping, information storage, and more. For example, The Bitcoin digital wallet Mycelium emerged in 2008 out of the idea of using Bitcoin technology as a method of mesh network for communication during the Arab spring (anti-government protest in North Africa and the Middle East). At a time when the government shut down Twitter and other social media, the model of the Blockchain nodes could be used to send encrypted information among the network. After its launch, the Bitcoin
Blockchain was soon duplicated and used as a model to use on follow up companies like Litecoin, Monero, and Dash.

A second generation Blockchain called Ethereum was proposed in 2013 by 24 years old Russian-Canadian programmer Vitalik Buterin and it went live in July, 2015. Ethereum expands on Bitcoin by the creation of a more open-source platform and the addition of smart contracts. Examples of second generation Blockchains are Ethereum, NEO, and IOTA.

Third generation Blockchains explore solutions of the scalability problems through the use of Sharding, Graphene, and the addition of Sidechains, to name a few. Examples of these are Zilliqua, Lisk, and Bitcoin Lightining.

A fourth generation Blockchain is in the works where companies claim scalability breakthroughs through the use of the cloud storage as a way to increase the volume of transactions processed through the Blockchain.

HISTORY

I first learned about Bitcoin in its early stages when I read a newspaper article that stated that a group of MIT students had been challenged by their professor to “change the world.” The students responded with the idea of digital currency to replace money or FIAT currency as is referred to now in the crypto lexicon.

The official version of how Bitcoin came into existence is myriad with mystery, controversy, and innovation. The true identity of its creator is still not conclusively known. But it is generally attributed to  a person, or group of persons, named Satoshi Nakamoto.

On August 18, 2008 the name Bitcoin.org was registered. Three months later, a paper titled “Bitcoin: A Peer-to- Peer electronic Cash System was published and in January 2009 the Bitcoin software was implemented on SourceForge (a web service that offers software developers a place to manage free and open source software projects). The first block of the chain (Block chain) was mined then as well. It’s been referred to as the Genesis Block. The mysterious creator of Bitcoin, Satoshi Nakamoto, worked on the ‘Bitcoin Project’ but then dropped out in 2010 and left its development to others.

PURPOSE

Bitcoin was created as an approach to the problems presented by traditional banking and the existence of money in itself. It was designed to overcome four particular problems: 1. high costs associated with banking transactions, 2. the length of time required to complete monetary transactions, including all the legalities, protocols, and conventions associated with it, 3. the risk of operations created by toxic investments, and 4. counterfeiting.

Traditional banking incurs massive fees on the customers and operating costs. Bitcoin was envisioned as a way to eliminate fees as every transaction would be conducted online and Peer to Peer, which means, an individual (person, business, organization, etc.) to another, thus removing the need for a middle men and all associated fees. However, this has not come to fruition as the theory has not functioned in practice. In reality, fees are charged by crypto currency exchanges and by Bitcoin miners. The miners fee comes in the form of Bitcoin and it is due to the high cost of validating transactions which require dedicated mining hardware, huge amount of computing power, and large use of electricity. In addition, the production of Bitcoin itself; it is estimated that it costs $1000 per every Bitcoin produced.

Another major drawback in the current fiat market is the inability to transfer money from one entity to another in a timely manner, especially in the international arena. It is said that it is faster to take a flight to another country carrying a suitcase full of money than to wire money from one bank in one country to another in another country. Bitcoin proposed to solve this problem by conducting digital transactions in seconds. Unfortunately, this also has not happened. Per design, the Proof-of- Work process of every transaction block on average takes ten minutes to validate. This in part is a security measure to ensure that it will cost a lot of time, money, and effort to duplicate or attack the Blockchain network. And also due to the complexity of the encryption used, it takes the entire network’s computers approximately ten minutes to decipher the code on each block.

In addition, the popularity of Bitcoin has overwhelmed the decade old infrastructure and its capacity to handle transactions. This has forced users to incentivize miners to prioritize the validation of some transactions over others. In other words, well positioned investors offer to pay higher fees to have their transactions validated first while the average user can wait hours for a transaction to be completed.

One of the key pressing problems Bitcoin creator/s meant to address is the ever present problem of bank failures. It is said that Satoshi Nakamoto was disillusioned by the financial collapse of 2008 and was determined to provide the world with a decentralized system not dependent of banks and their short sighted views of investing in toxic products. The purchase, sales, and altogether distribution of high risk subprime mortgages and collateralized Debt Obligations (CDOs) caused a chain reaction failure in the interlinked global banking system, almost causing a global financial catastrophe. By decentralizing the Bitcoin network, the failure of one party not to pay another, however large the amount, would not affect the rest of the users and compromise the integrity of the entire network.

The fourth problem Bitcoin was supposed to solve is “Double Spending” or Counterfeiting. In the real world, paper monies can be duplicated in an infinite number of ways forcing world governments and banks into a perpetual struggle against this crime. Bitcoin significantly reduces this problem through the use of its Blockchain encryption and its procedural confirmation process.

When a transaction enters the Blockchain, it goes into an unconfirmed transactions pool; there it is checked for validity by verifying the information through a series of tests. For example, when an amount of Bitcoin is being sent, the Blockchain ledger’s history is checked to make sure that the sender has indeed in his possession sufficient Bitcoin to complete the transaction. If the transaction passes all the checks, it is found to be valid and it’s confirmed. This creates a new block in the chain and the transaction is approved. If a duplicate transaction were to be made simultaneously, this would be considered as double spending. While double spending can pass the same initial validation test, as the transaction moves forward on the chain, the duplicate transactions would race each other to the next confirmation block. The transaction that is checked first will be validated, while the second will be detected as a duplicated and it will be declined. That is why a minimum of six confirmations are required to approve a transaction. Six confirmations equal .01% probability of cancellation and 99% verification that double spending does not occur.

Example: Party A sends Party B an X amount of Bitcoin. Assuming Party A sent the same amount to Party C, double spending could occur. Both transactions enter the Blockchain and they go into the unconfirmed transactions pool. If both transactions are checked for validity simultaneously, by two separate nodes, they are both approved and sent forward. So long as the transactions continue to be approved at the same rate, they will continue to move through the chain. However, the instant that one transaction is checked before the other, that first one will move forward, and when the second one arrives, the system will identify the duplicate and cancel the second transaction.

While the Bitcoin network is not totally immune to double spending, the number of measures to prevent it such as the high number of nodes available makes the network highly resistant to this and many other problems like hacking.

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