Bitcoin #1

What Bitcoin is and how it works

By Chris Sutton - 22.08.14

In July, The Three-thinkers business club hosted a fantastic event on the ‘online’ currency Bitcoin. The evening was really well attended, attracting a wide variety of local experts and interested business owners.  

Our guest speaker, Graham Lally from the Bitcoin Brighton group gave a thought provoking presentation that included a whistle-stop tour of how the currency actually works, a practical demonstration of a Bitcoin transaction in action, and an introduction to the potential implications of the currency to the global financial system. As usual with Three-thinkers debates, there was also some fascinating discussion focusing on the implications of Bitcoin and similar cryptocurrencies on people, planet and profit.

What follows are my key takeaways from the event, as ever taking a three-thinking approach that looks holistically at the financial, environmental and societal implications of the technology in the second blog in the pair.

What is Bitcoin?

Bitcoin is a digital currency and payment system. It shares many of the characteristics of more familiar forms of money in that it can be exchanged for goods and services and held as a store of value. Like most mainstream currencies today, its value is reliant on widespread confidence in the currency by its users rather than being backed by a physical commodity, for example gold.

The currency was supposedly devised by a mysterious Satoshi Nakamota who, in a 2008 paper[i], described a digital currency that replaced the need for a trusted central financial authority to oversee the currency with a complex system of cryptographic algorithms which would ensure the integrity of financial transactions.

Bitcoin is an open source project so it effectively doesn’t have an owner. A group of core developers maintain and develop the system, and thousands of enthusiasts contribute through various online forums. Many aspects of the currency including the core principles of how new Bitcoins are issued and the protocol for validating transactions were set when the currency was created.

How it works

1. I can purchase Bitcoin from one of the various online exchanges, exchanging them with pounds sterling or some other widely accepted currency. The alternative to buying Bitcoin is ‘mining’ Bitcoin – of which more below. However mining is a complicated process which involves powerful computing equipment, and so isn’t practical for your casual user.

2. I hold my Bitcoins (chains of zeros and ones), in a ‘wallet’ on my computer managed by a software application.  The person who I want to give Bitcoins to also has a similar ‘wallet’. The two applications record the transaction, ensuring security via the use of secure keys. From a user perspective this is pretty much all I need to worry about – but it’s good to know a bit more about what’s going on behind the scenes.

3. The two software applications (one on my computer and the other on the computer of the person I’m giving Bitcoins to) broadcast the proposed transaction to a large number of ‘nodes’ or computers on the internet announcing the proposed transaction. Every 10 minutes the ‘nodes’ or ‘miners’ gather up the proposed transactions and try to add them to the ‘block chain’, which is basically a universal ledger of all Bitcoin transactions.

3. In order to be added to the ‘block chain’, Bitcoin requires that a complex mathematical problem is solved by the miners. The problem is very difficult to solve and near impossible to guess but is easy to verify once solved, and this makes at a useful tool for validating the currency without needing a central body like a bank.

4. The first ‘miner’ to find a solution to the problem broadcasts it to the other miners who verify it and the new block is added to the ‘block chain’. As a reward for the effort expended the miner who solved the problem receives a new block of Bitcoins. The whole process takes about 10 minutes, which is the time it takes for a Bitcoin transaction to be completely validated.

5. The value of the blocks of Bitcoins generated from the transaction and the timing of when they are released is automatically adjusted to regulate the system. The original value of new blocks of Bitcoin was 50 Bitcoins, but this value is halved for every 210,000 Bitcoins circulating, and so will not exceed 21 million. The system also regulates to keep the blocks being added six times an hour. If more miners join the network and computing power is increased the difficulty of the problem increases to compensate.

6. Mining will become less profitable over time. As such there is an additional incentive to miners built into the system. Users of the currency can choose to pay a transaction fee of any amount they choose, to ensure that their transaction is included in the next block added to the block chain which then also accrues to the miner who solves the mathematical problem.

The ingenuity of the Bitcoin system is recognised by many in the financial world. For example, Francois Velde, Federal Reserve Bank of Chicago writes:

“…the Bitcoin protocol provides an  elegant solution to the problem of creating a digital currency—i.e., how to regulate its issue, defeat counterfeiting and double-spending, and ensure that it can be conveyed safely—without relying on a single authority.”

Why the fuss about Bitcoin?

Bitcoin is a small player in the payment systems market place, let alone as a currency. About 70,000 transactions are made in Bitcoin each day[ii], which is just over 7.5% of paypal’s daily 9.3 million transactions[iii], which in turn is dwarfed by the hundreds of millions of visa and mastercard transactions made each day. How then has it managed to percolate into the public consciousness?

  • Scandal -  Bitcoin is more famous for the scandals that have surrounded it, rather than for the impact it’s had in the financial world.  The most prominent of these have been its association with Silk Road, the underground virtual marketplace closed down in November 2013 by the FBI due to its association with the illegal drugs trade, and the theft of millions of dollars worth of Bitcoin leading to the collapse of the Mt.Gox, at the time the largest Bitcoin exchange.
  • Regulation - As a virtual currency, Bitcoin has been largely unregulated. While that this has its attractions for those who want to be free from the power of the state it also leaves users vulnerable as the state isn’t there to protect users, as the Mt.Gox experience shows. As its popularity has grown, governments have become more interested in regulating it.
  • The Bitcoin protocol -  The jury is out as to whether Bitcoin will establish itself as a significant currency or whether it will be a short lived phenomenon soon to disappear. However the fundamental principle of ensuring the integrity of a system by distributing that task to large numbers of participants rather than an overarching central authority may have wide reaching implications.

Bitcoin – FAQs raised from Three-thinkers event

1. Bitcoin takes 10 minutes to confirm a transaction. Does this cause a problem for retailers in terms of fraud?

From reading around on web forums, the answer to this seems to be that it could be, but the situation seems far from clear. In order to be properly validated Bitcoin requires 100 confirmations of a transaction but many merchants set up their payment systems (for example with bitpay) to accept a transaction at 6 confirmations or even 0 which is much quicker. The situation is complicated by the option the person paying (or ceding the Bitcoin) has to add a fee to the transaction as an incentive to the Bitcoin user group to solve the resulting algorithm and validate the transaction. How risky the confirmation process is to the retailer probably depends a lot on the value and number of transactions that they’re dealing with. 

2. How are transactions in Bitcoin taxed?

HMRC issued a briefing on March on Bitcoin and similar cryptocurrencies.[iv] The short answer is that transactions are liable to tax in the same way as any other currency.
 

 

Also in this blog series:

Bitcoin #2 - Financial, societal and environmental implications

 

References:

[i] Nakamoto, S. (2008) ‘Bitcoin: A Peer-to-Peer Electronic Cash System’. Available at: https://bitcoin.org/bitcoin.pdf (Accessed 15th August 2014)

[ii] Note this statistic came before the recent scandals so volumes could now be lower. Source is“Bitcoin needs to scale by a factor of 1000 to compete with Visa. Here’s how to do it.” Timothy B.Lee, Washington Post, November 12th 2013.  Available at: http://www.washingtonpost.com/blogs/the-switch/wp/2013/11/12/bitcoin-needs-to-scale-by-a-factor-of-1000-to-compete-with-visa-heres-how-to-do-it/ (Accessed, 2nd August 2014)

[iii] Paypal’s published quarter 2, 2014 financial metrics available at:
https://www.paypal-media.com/about (Accessed, 2nd August 2014)

[iv] “Tax treatment of activities involving Bitcoin and other similar cryptocurrencies”.Revenue and Customs brief 9/14. HMRC website. Available at: http://www.hmrc.gov.uk/briefs/vat/brief0914.htm
(Accessed 7th August 2014)

 

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