During my semester abroad last spring, I took a course called Business Presentations, for which we had to pitch a new or existing product to the rest of the class. The class would act as investors and decide the fate of the product. Now, while the rest of the class came up with their own versions of products that will change the world, a female student claimed that she was going to pitch about an existing service that has started to “revolutionize the way people trade on the internet.” Bitcoin – she called it. She was so passionate while presenting, that I began to believe that she was not doing this for just an A in the assignment. Surprising, right? On the other hand, being a finance student, I was little embarrassed that I knew nothing about what she was talking about – which still, did not stop me from zoning out during the presentation. How typical, Sana! Later when I interviewed for a leading financial services company and was asked about Bitcoin, I realized that I should have paid attention to that student’s presentation. Have I convinced you why you should read further? Awesome!
Now let me be clear, this article is not going to be a sales pitch about how Bitcoin is the next big thing in the finance industry – I leave that up to you to decide. The objective of the article is to give you a little insight into what Bitcoin is, how it works and to present both sides of the “The Great Bitcoin Debate” going around the world.
What is Bitcoin?
Bitcoin is the world’s first decentralized digital currency which are created and held electronically. In other words, it is a purely peer-to-peer version of electronic cash that allows online payments to be sent directly from one party to another without going through a financial institution. Created by Satoshi Nakamoto, Bitcoin can be used to buy things electronically.
However, Bitcoin’s most important characteristic that makes it different from conventional money is that it is decentralized. No single institution controls the bitcoin network. The important question is: Why does this matter? But in order to answer this question, we need to first take a look at how Bitcoin functions.
How does it Work?
At its core, Bitcoin is just a digital file that lists accounts and money like a ledger. A copy of this file is maintained in every computer in the Bitcoin network. There’s no government-issued money backing these numbers, just people’s beliefs that the numbers mean something and a system that prevents unfair changes. Here’s how the system functions:
- People transfer money by sending messages to the network describing where and how much money should move.
So what stops a thief from creating a message to transfer money from someone else’s account? Bitcoin requires a kind of signature on each message to prove that it was created by the true account owner. The signature works in the same way as a handwritten signature but it relies on math rather than handwriting. The math comes from the world of cryptography used to hide secret messages. In addition to not relying on handwritten analysis, these math-based signatures cannot be copied or reused on other transactions, since the signatures are unique to each transaction.
- The network makes sure that the messages are coming from the true account owners by checking digital signatures
So if a financial institution is not backing these transactions, who exactly is checking the signatures and maintaining the ledger? Surprisingly, anyone who wants to! Every time someone sends money, a transaction message is passed around to all people who want to help maintain a ledger – these people are called miners. Each miner keeps a personal copy of the ledger and updates it whenever they receive a new transaction with a valid signature.
- Miners reach consensus with each other through a math-based voting process.
With ledgers spread all over the world, traffic delays and occasionally fraud, can lead to differences in these ledgers. So how does the world decide which version to use? Miners ‘vote’ for the right version by trying to solve a puzzle based on their ledger. The first one to solve the puzzle, announces their solution and everyone updates to that version. So the vote turns out to be a mathematical race but it is designed to favor the majority’s version because the more people there are working on a version, the faster it will be solved. Thus mathematics enables a fair vote in a decentralized system.
- More money is printed!
Every time a puzzle is solved, a small amount is added to the solver’s balance – effectively creating money ‘out of thin air.’ This award acts as an incentive for people to help in maintaining the ledger and is in addition to the small fees that senders attach to transactions. The voting system basically acts as a way to randomly distribute money around the world and as a fact, after the year 2140, no more money will be created!
The Great Bitcoin Debate
The introduction of Bitcoin has sparked a great controversy on whether this service is as liberating, as it claims to be, or does it ignore important issues that deserve attention.
The most basic criticism about bitcoin is also the most severe: It isn’t money—yet. Money must serve at least three basic functions: as a medium of exchange, store of value, and unit of account. At the moment, bitcoin is a good medium of exchange, but a lousy store of value. The reason is erratic price fluctuations. During the last year, it has gone through several major crashes, often losing half of its value (or more) over the course of a day or two before clawing its way back. Its most recent correction, beginning earlier in November 2015, has driven its price down by more than 20 percent. This volatility poses serious liabilities for anyone using the crypto currency. Making long-term contracts, keeping your books in order, or simply trying to figure out whether you will made a profit by the close of business become monumental challenges (Bier & Patterson).
On the other hand, supporters of Bitcoin speak about how Bitcoin has finally freed trade on the Internet from the old systems. Since its launch, Bitcoin has seen explosive growth averaging around 70,000 transactions per day in recent months. The reason why supporters feel that this growth will continue is because nation-states and their central banks derive significant benefits from issuing fiat currency and forcing citizens to use it. Now anyone in the world with Internet access has another alternative, and this currency cannot be devalued through the printing presses or seized from bank accounts to pay for governments’ excesses. Additionally, accepting bitcoin is cheaper for merchants than using other payments systems, with fees typically at or below 1 percent compared to the 3 percent to 5 percent typical for credit cards. There is no permission required to use bitcoin unlike banks or credit card networks, which require standards that billions of people in the world cannot meet or do not have access to. Since this system relies only on mathematical solutions and not ‘trust’, it might solve quite a few problems that the current system faces (Bier & Patterson). So which side of the debate are you on?