Bitcoin, Blockchain Technology: A Detailed overview
Context: This topic is important for UPSE Prelims and GS Paper 3.
El Salvador, a small coastal country in Central America, became the first in the world to make Bitcoin, a digital currency, legal. Let’s understand all about it in detail.
What Is Bitcoin?
It is the first decentralized digital currency (Cryptocurrency) that allows peer-to-peer transfers without any intermediaries such as banks, governments, agents, or brokers, using the underlying technology of blockchain.
Anyone around the world on the network can transfer digital currency to someone else on the network regardless of geographic location; you just need to just open an account on the Bitcoin network and have some bitcoins in it, and then you can transfer those bitcoins.
How do you get bitcoins in your account? You can either purchase them online or mine them.
It can be used for online purchases and can be used as an investment instrument. Primarily it’s used to buy goods and services.
What is Blockchain technology?
Blockchain is the underlying technology of bitcoin. Blockchain is a public distributed ledger in which transactions are recorded in chronological order. Any record or transaction added to the blockchain cannot be modified or altered, meaning transactions are safe from hacking. A block is the smallest unit of a blockchain, and it is a container that holds all the transaction details.
What is Bitcoin mining in Blockchain?
Bitcoin mining is the process by which its transactions are validated digitally on its network and added to the blockchain ledger. It is done by solving complex cryptographic hash puzzles to verify blocks of transactions that are updated on the decentralized blockchain ledger. Solving these puzzles requires powerful computing power and sophisticated equipment. In return, miners are rewarded with bitcoin, which is then released into circulation hence the name bitcoin mining.
Hardware such as GPU (graphics processing unit), SSD for crypto mining, ASIC (application-specific integrated circuit), or the latest FPGA (Field Programmable Gate Array) chips. When purchasing mining hardware, it is important to consider two factors, their hash rate (performance) and electricity consumption.
Mining software such as ECOS, BeMine, and Kryptex Miner .
A digital currency wallet from which an individual performs bitcoin transactions.
Preferred mining pool (if one chooses pool mining option instead of solo mining).
Difference Between Bitcoin and Traditional Currency
While both Bitcoin and traditional currency are similar in that both are a store of value, they differ in many ways. First things first, Bitcoin is the first and most recognized cryptocurrency - a digital currency that is secured by cryptography. The traditional currency also referred to as fiat money, is a government-issued and regulated currency. Some differences are illustrated in the table below.
It is a virtual currency and can only be used in its digital form
It is a physical currency in the form of notes and coins. However, we can use it in both physical and digital forms
Issued through mining and controlled by a decentralized distributed network of computers
Issued and controlled by central government authorities, i.e., central banks. Owing to this, the traditional currency is the legal tender in the country governed by the issuing authority.
Governed by a consensus mechanism in which the majority rules
Purely governed by the central bank
Value is backed by the trust of its users. The more users are willing to transact with Bitcoin, the more stable it becomes.
Value is determined by forces of supply and demand and is thus vulnerable to inflation
Capped at 21 million bitcoin
Fiat currency has no supply limit
Validation of transactions
Bitcoin transactions are validated using blockchain technology and so do not require an intermediary for validation
Transactions involve an intermediary such as a bank or a payment provider
Minimal or no associated fees as intermediaries have been eliminated
Transactions attract considerable charges
Transaction time and speed
The transaction is almost always instantaneous or greatly depends on the network speed
Transactions may take time before verification or before they reflect on the system
The concepts of decentralization, cryptography, and consensus guarantee a secure network and security of bitcoin transactions
Less secure as it can be negatively affected by fluctuations in government policies
Bitcoin transactions cannot be charged back, reversed, or canceled
Chargebacks, reversals, and cancellations are commonplace with traditional currency transactions
Because Bitcoin (BTC) transfers don’t require a transaction fee, this digital currency is often used for international transfers.
You can easily store and hold coins in your favourite digital wallet. (Although the supply of Bitcoin is limited, with only 21 million coins).
That means that if demand continues to increase over the long term, the value could rise (although people should lose their wallets with Bitcoin in it).
The Blockchain technology used is decentralized and transparent. Further hacking is difficult in this technology.
The Blockchain that supports this technology is known for its tremendous energy consumption and slow processing speed. That makes it difficult for consumers who want a fast-trading time at a low cost.
Some people say that cryptocurrencies should not be used as value storage because they are more volatile than traditional currencies such as gold and US dollars and cannot guarantee long-term value.
Bitcoin Cash was established in 2017 with the belief that some parts of the world of Bitcoin are dissatisfied with high processing fees and need the latest iteration of Bitcoin to handle these issues while preserving all other qualities such as confidentiality and data integrity.
Digital currency is largely emerging as a new challenge due to its links with terrorist financing, drugs, and human trafficking, arms sale, money laundering, etc.
Editorial-The crypto conundrum
Cryptocurrencies possess no significant use value or exchange value to sustain their current high prices
Bitcoin and other private cryptocurrencies have been on a bull run recently. Unlike previous rallies, the current rally in bitcoin has witnessed the increasing participation of retail investors in India. Since 2020, when the Supreme Court overturned an order by the Reserve Bank of India dated April 6, 2018, restricting the use of cryptocurrencies, traffic in domestic cryptocurrency exchanges in India has grown many-fold. Yet, the future of bitcoin and other cryptocurrencies is unlikely to be as bright as many believe it to be.
A case of speculative mania?
The most important feature of cryptocurrencies that is flaunted by their enthusiasts is their limited supply.
In a world where central banks create a lot of money out of thin air, it is natural for investors who are looking to protect their wealth to seek abode in alternative assets whose supply cannot be cranked up as easily.
Money creation by central banks causes the price of all goods to rise and also tends to accelerate the adoption of alternative assets as currencies. When central banks create a lot of money, it leads to an increase in the prices of not just goods such as food and cars but also that of commodities such as gold and silver, considered to be alternative forms of money.
Yet, for various reasons, the rally in bitcoin may be no more than a case of speculative mania.
For one, scarcity alone is not sufficient to facilitate the adoption of cryptocurrencies as money.
Any asset must have either use-value or exchange value in order for it to possess any fundamental value.
This fundamental value, in turn, is reflected in the price of these assets in the long run.
Stocks and bonds, for instance, possess exchange value that is based on the expected future cash flow from these assets.
Commodities such as oil and steel possess use-value because these assets are used to run vehicles and build real estate.
Bitcoin and other cryptocurrencies may be scarce but it is questionable whether they possess any use-value or exchange value.
Gold and silver have traditionally served as hedges against inflation because they possess fundamental value derived from their use as jewelry and money.
But bitcoin and other cryptocurrencies neither offer direct use value nor possess significant exchange value — bitcoin can buy you very few real goods and services. In short, cryptocurrencies possess no significant fundamental value to sustain their current high prices.
Yet, many believe that the rising prices of cryptocurrencies reflect their likely future value as a currency.
It is possible that investors are bidding up the price of bitcoin because they foresee a future in which private currency is widely accepted as money. After all, all investments are forward-looking.
One may also grant that the extreme volatility seen in the price of cryptocurrencies, which seems unrelated to any similar fluctuations in their fundamentals, maybe due to the nascent, illiquid nature of the cryptocurrency market.
However, the more cryptocurrencies are accepted in exchange for goods and services, the greater the chances of governments cracking down on them.
Issuance of money
The monopoly that governments (and central banks) possess over the issuance of money is at the root of their power and influence.
This allows governments to fund their budget deficits, particularly during times of crises such as the current pandemic when tax revenues have taken an unprecedented hit.
It also allows central banks to tinker with the money supply under the mandate of managing aggregate demand in the economy. In essence, monopoly control over money allows governments to indirectly tax citizens by increasing the supply of currencies, thus devaluing them.
If cryptocurrencies like bitcoin are going to challenge fiat currencies like the U.S. dollar as a medium of exchange, they would essentially be challenging the authority of the government to print and spend.
This is not an assault that governments will tolerate for long. They will allow cryptocurrencies to exist only as long as these currencies remain speculative assets and not a medium of exchange.
This is not to say that governments are justified in their crackdown against cryptocurrencies.
China recently imposed a complete ban on all cryptocurrencies and plans to issue its own central bank-issued digital currency.
Private alternatives to fiat currencies offer people greater choice in what currencies they choose to use as a medium of exchange.
The benefits of free-market competition in money were elaborated by economist Friedrich Hayek in The Denationalization of Money.
Most notably, competition between currencies to cater to the demands of customers would ensure that fiat currencies that are printed indiscriminately simply go out of use.
This is the outcome that governments fear and would fight to avoid at any cost.
While deliberations continue in India on the monetary and financial regulations around cryptocurrency, it is important that attention be paid to incentives for India’s developers working on key innovations in the space.