What Is Bitcoin?
Crypto, Bitcoin, Blockchain, Miner, Stablecoin… you have surely come across many terms in the field of cryptocurrencies and decentralised finance. The number of cryptocurrencies available increases, and a lot has happened in this sector in recent years, partly due to the hype surrounding it.
What Are Cryptocurrencies
Cryptocurrencies are characterised by the following:
- they are digital
- they do not necessarily have to be linked to an official currency, such as the euro or dollar
- they are transferred electronically
- they are decentralised, meaning that they are not managed by central banks
Cryptocurrencies also don’t have the legal status of an official currency. You can look up the exact definition of cryptocurrencies here (§ 27b Abs 4 EStG).
Bitcoin (BTC), the very first cryptocurrency, was developed in 2008 under the pseudonym Satoshi Nakamoto. Its mode of operation, which is described in more detail below, was revolutionary. The system of Bitcoin is designed as an open source software. The source code of this kind of software is freely accessible and modifiable, which means that people who use it can make changes to it. The term “Altcoin” is often used for all cryptocurrencies that were developed after Bitcoin.
Some people confuse digital centralised with digital decentralised currencies, but, in fact, these two kinds of currencies are very different. All in all, der are three types of currencies:
- Fiat currency, also called fiat money, is controlled by central banks such as the FED or the ECB. These currencies are not linked to commodity prices, like gold or silver, which means they don’t have any intrinsic value. Their value can be determined – and changed – by governments. Almost all countries in the world have been using fiat money since 1971. These currencies are the money, for example cash, as we all know it.
- As mentioned before, cryptocurrencies are decentralised digital currencies, effectively the exact opposite of fiat money. Their value is not determined by governments or central banks, but purely by supply and demand.
- Digital central currencies are currently in the development phase. They have something in common with cryptocurrencies in that they are digital, but the important difference between those two types of currencies is that digital central currencies are controlled by central banks. In contrast to fiat money, banks are not necessary for this type of currency, as anyone can open an account directly with the central bank. This has both advantages and drawbacks: Without banks and cash, most fees and transaction costs could be omitted. However, critics of digital currencies are sceptical and see them as a threat to democracy as states could theoretically link political conditions to the account at any time.
How does Bitcoin work?
Bitcoins are “mined”, meaning created, using mathematical processes. Bitcoins are created by adding another block to the existing blockchain, the network on which this cryptocurrency is based. At first, this was possible using normal computers, but today you would need increasingly powerful ones, and it might take years before you get a single Bitcoin.
Blockchain
The blockchain is like an endless line of blocks that represent transactions, i.e. Bitcoin trades. These need to be verified by other network users to be validated, which is where so-called “miners” come into play: They validate 1MB worth of transactions as well as solve a numeric problem, also known “hash” to add the block of transactions to the blockchain. Once they are part of the blockchain, every user in the network is able to see the transaction and track it back to the user who initiated it.
Hashing
A ”hash” is a 64-digit hexadecimal number that is attached to the transaction block. The hash of a new block is based on that of the previous block. Because of this, it is not possible to simply change earlier blocks in the chain since it would be visible that all the hashes associated with the blocks afterwards no longer match.
Public Keys & Private Keys
Another safety precaution in the blockchain network is the encryption with so-called “public keys” and “private keys”. Public keys are like an account number that other users can see. A private key serves as a password. The keys are used to encrypt and decrypt information in order to transfer data securely from A to B. Private keys are stored in a computer software, the Bitcoin wallet.
Why is Bitcoin so successful?
Mining is a competition: The first miner to find the right hash is rewarded with Bitcoin. As this is a difficult task, the only viable way to do it is to calculate as many combinations as possible and wait until a match is found. This means that the miner with the most powerful setup, i.e. the highest hash rate or hash-per-second, is the most likely to win this competition. This explains the high computing costs of mining.
An important aspect of Bitcoin is that, in contrast to many other cryptocurrencies, the number of Bitcoins was limited to 21 million Bitcoins from the outset. This is meant to preserve the value of this cryptocurrency and is the reason why many consider Bitcoin to be valuable.
The fact that Bitcoin is completely decentralised is also appealing to many investors. The network runs on the computers of all users in the Bitcoin network, i.e. tens of thousands of computers worldwide. Because of this, Bitcoin is not dependent on any single individual or group, such as an institution or bank. This means that the system cannot simply be shut down unless one shuts down the entire internet.
Apart from its advantages, decentralised systems also have its drawbacks and risks.
Possible Use in the Future
Digitalisation and technology are constantly evolving, and so are digital cryptocurrencies. New developments and innovations in this area will certainly be interesting.
The blockchain system was invented to create a self-regulating system in which users’ trust is not based on laws and regulations, but on codes. This system can be used not only for crypto transactions, but also for electronic contracts, so-called "smart contracts". The flow of crypto money and the transfer of ownership for these openly visible, transparent contracts is documented in the blockchain.
The cryptocurrency Ethereum makes it possible to store and operate apps via its blockchain. The computing power for this is provided by the network participants. This could possibly lead to the decentralisation of the entire internet.
Risks
Many people are alarmed when they hear “Bitcoin” or “cryptocurrency”. Like any other speculative form of investment, it does, of course, also pose its risks.
- Total loss: Let’s start with the biggest risk: the risk of total loss. Although cryptocurrencies are decentralised, governments could pass legislation on trading or completely ban them. Legal problems might also occur, for example, if crypto investors are accused of money laundering.
- Fluctuation: The value of Bitcoins and Altcoins has heavily fluctuated over the years. Not everyone has the nerves for that. Furthermore, people or groups who own a large number Bitcoins, so-called Bitcoin Whales, can strongly manipulate the price by selling large amounts of this currency.
- Responsibility: Investing in cryptocurrencies comes with great personal responsibility. As mentioned before, no third party or institution is responsible for controlling and managing Bitcoin etc. Reputable trading platforms do have support teams that can reset forgotten passwords if the user can prove their identity. However, if you enter an incorrect transaction number and the recipient does not want to send back the Bitcoins you transferred to them by accident – tough luck! Worst case scenario: your money is gone.
- Not anonymous: You should also bear in mind that Bitcoin isn’t anonymous, but pseudonymous. When you register on a trading platform, you usually need to provide and verify personal information. The registration process is quite time-consuming as most platforms wish to offer users the best possible protection and avoid terrorism or money laundering. Your personal information is not automatically visible to the entire network. However, there are companies which’s whole purpose it is to identify the people and institutions owning Bitcoin wallets.
