Bitcoin: Decrypted!

Launched hardly over a decade ago, Bitcoin today finds itself more lustrous than ever. Despite being declared dead for precisely 389 times, this cryptocurrency has now surged to an all-time high-price of approximately $34,000 per bitcoin. Its highly controversial and volatile nature makes it difficult for us to classify it clearly as a currency, an asset class or a mere store of value. But before we attempt to do so, let’s first understand what the idea behind bitcoins is.

The Origin

The first-ever mention of bitcoin was made in a whitepaper, written by a pseudonymous Satoshi Nakamoto, released in the year 2008. They consequently launched the Bitcoin software in January 2009. The identity of the author(s) remains a mystery to date. The probable reasons for Satoshi being anonymous are privacy (from the media, governments and banks) and protection (since the idea threatens the globally existing banking and monetary systems).

What is Bitcoin?

Bitcoin is the world’s largest cryptocurrency (digital money) by market capitalisation. As explained in Bitcoin's whitepaper, its meaning is deceptively simple- “A peer-to-peer electronic cash system”, i.e. bitcoin is a software-based currency that facilitates instant payment between two parties, not necessarily humans.

(Top 10 Cryptocurrencies by Market Capitalisation; Source: Coindesk)

But digital-wallets and instant money transfer options already exist, so why Bitcoin? Because the existing widely-used online payment platforms require a third-party, i.e. the banks or credit/debit card companies, that ensure smooth and secure transactions, maintain a record of the same and charge us a cut as transaction fees.

Conversely, the whole idea behind bitcoins is to not involve any third party, be it a bank or the government. It only requires two parties willing to transact. It promises lower transaction fees and is operated in a decentralised manner, unlike the government-backed currencies, and is therefore not accepted as legal-tender currency. But its revolutionary nature, the ease of transactions offered and the opportunities unfurled in the world of ‘Fintech’ and ‘Internet of Things’, have led to its popularity.

Additionally, bitcoin offers a much larger degree of divisibility, contrary to other fiat currencies. A bitcoin is divisible up to 8 decimal places. The smallest unit of a bitcoin, equal to 0.00000001 bitcoin is called a Satoshi. This enables quadrillions of individual units of bitcoins to be circulated throughout the world economy.

Who makes/releases bitcoins?

Firstly, there are no physical bitcoins. There is no central regulatory authority involved in pumping bitcoins into the economy. Instead, Bitcoins are released into circulation through a process called Bitcoin Mining. In layman’s terms, mining involves solving computationally complex puzzles to discover new bitcoins, which then get added to the network. Miners, i.e. the people who solve these puzzles to discover new bitcoins, are rewarded with a certain number of bitcoins as an incentive. Thus, miners are seen as the decentralised authorities that hold up the credibility of the bitcoin network.

(Racks of Bitcoin Mining Rigs run the length of 7 warehouses in Ordos City, China)

According to the whitepaper, the total supply of bitcoins is restricted to 21 million; as of July 2020, about 18 million bitcoins have been mined and approximately 3 million remain unmined. However, with each new bitcoin mined, the complexity of the puzzles increases and it is estimated that all of 21 million bitcoins will be in circulation by the year 2140, post which miners will continue to be incentivised by fees that they will collect from the network users. The limited supply and ever-increasing demand have resulted in a manifold increase in the value of this cryptocurrency over the years; as per the economic principle of scarcity.

How are bitcoin transactions recorded?

Every ongoing bitcoin transaction gets recorded in a public ledger through a unique digital signature or hash (a long string of letters and numbers). This public ledger is nothing but the blockchain, which stores data related to all these transactions in several blocks. Together, these blocks form the blockchain. The records of transactions on the blockchain are unchangeable and require computational proof to sign, thereby eliminating the possibility of fraud or double-spending of a bitcoin. Further, to maintain transparency, these transactions are publicly available, 24/7.

How do transactions take place in the bitcoin network?

In order to transact, every bitcoin user requires two sets of numbers - a public key and a private key. The best analogy here would be a username and a password. A hash of the public key is called an address. This address gets recorded on the blockchain.

Each owner transfers coins to the next by digitally signing a hash of the previous transaction and adding the public key of the next owner. These contents are added at the end of each coin, with each new transaction. Every recipient can thus verify these signatures to verify the chain of ownership. This makes bitcoins a ‘chain of digital signatures.’

(screenshot of the whitepaper)

Bitcoin Exchanges and Wallets

Individuals can enter the bitcoin network through Bitcoin Exchanges, which are online platforms that facilitate transactions (buying, selling and holding) in bitcoins and other cryptocurrencies. To access bitcoins, individuals use Bitcoin Wallets, which are in the form of third-party web applications or QR codes printed on a piece of paper. Wallets connected to the internet are called hot-wallets, which are vulnerable to hacking, hence preferred for low-volume transactions. Another is the cold-wallets, which are not connected to the internet. These are in the form of paper-wallets or hardware-wallets, preferred for high-security transactions and long-term investments.

Bitcoin as an Investment

Given that regulators do not view bitcoin as a currency, a large number of businessmen and traders perceive bitcoins as a lucrative investment asset rather than a medium of exchange. This is mainly because digital currency is perceived as the future. However, bitcoin was not originally designed to be an investment asset and therefore, there are no equity shares issued for bitcoins. Yet, myriads of speculative investors and day traders have been attracted to bitcoins after the prices appreciated rapidly in November 2013, repeatedly in December 2017 and recently in December 2020.

A boost in bitcoin trading eventually led to the creation of a multi-billion dollar industry. But the unpredictable price fluctuations and anonymity are prime reasons why it still lacks credibility. Mr. Barry Silbert, CEO of Digital Currency Group, has appropriately described bitcoins to be “pretty much the highest-risk, highest-return investment that you can possibly make.”

(a few tidings of Bitcoin naysayers)

As per the Internal Revenue Service, all the virtual currencies are to be taxed as property in the US and not as currencies, i.e. gains and losses on bitcoin transactions shall be taxed under Capital Gains or Losses. In India however, the government is in talks to impose 18% GST on Bitcoin transactions, by recognising bitcoins as an intangible asset. This is estimated to generate at least 7,200 crore INR of additional revenue to the government.

Bitcoin’s Price Overview

Bitcoin prices have been tumultuous in their fairly short trading life. In the initial years after launch, bitcoins traded for just a few dollars. The first-ever bitcoin price rally was seen in October-November 2013 when the price went from $100 per bitcoin in early October to over $1,075 per bitcoin by the end of November. This rally was caused due to the entry of new bitcoin exchanges and miners in China. However, this bubble burst in the following December and the next four years saw some minor fluctuations in the prices.

The latter half of 2017 was characterized by a meteoric rise and fall in the bitcoin prices. December 2017 was marked with record-high prices when a single bitcoin was trading at close to $20,000 in some exchanges. However, prices soon tumbled down to approximately $3,500 per bitcoin by November 2018.

Things again took a turn in 2020. On March 4, 2020, the Supreme Court Of India passed a landmark decision, lifting the ban on crypto trading in India. (An RBI circular earlier in April 2018 had barred all banks from allowing cryptocurrency transactions to their customers.)

Due to the pandemic, bitcoin prices plunged from about $9,000 to $5000 per bitcoin in mid-March, therefore striking out the asset’s allure as a safe-haven investment. Later in October, Paypal, the online payment giant, announced that it will enable all its customers to buy, sell and hold cryptocurrencies. Alongside, institutions began to recognise bitcoin as an effective store-of-value and dollar-inflation-hedge given stimulus from the COVID-19 spending. The price of bitcoins has shot up ever since and sprinted over the all-time-high mark of $20,000 per bitcoin on December 16, 2020. The price rally continued as prices hit approximately $34,000 per bitcoin on January 3, 2021. The past 9 months have roughly seen a 600% jump in bitcoin prices (from $5,000 to $34,000).

(Source: Coindesk)

The June 2020 Crypto Research Report has predicted that the price per Bitcoin could go up to $397,000 by 2030; whereas some experts believe it can even touch $500,000 within the same timeframe.

Throwing caution to the wind!

However vibrant it may seem at the moment, investing in bitcoins comes with its own set of risks and drawbacks. The decentralised and deregulated nature of this digital currency has attracted innumerable criminals, dark-web and grey-market miscreants. Numerous scams, frauds and Ponzi-schemes have been linked to Bitcoin. Bitcoin Mining is said to pave the way to environmental deterioration as the process requires an extensive amount of power. Further, we are all witness to the wild price swings that the currency experiences over short periods.

For the nonce, it is safe for us to treat bitcoin as a speculative asset - Choose to move cautiously or not at all and never invest funds that we cannot afford to lose!

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