Understanding Bitcoins

What is a Bitcoin?

Introduced in 2009 as a peer-to-peer payment system, the bitcoin developed into a digital currency (BTCs).  Today, the BTC is a financial network able to both transfer and create money. BTCs issuance and use is decentralized (see below), and loosely regulated by the Bitcoin Foundation, a non-profit organization. As BTCs are administered over a shared computer network, cryptography is essential to protect and secure communication, via untraceable transactions.

Users can purchase BTCs either at a BTC ATM or through numerous websites. These websites (e.g.:, ‘coinbase.com’ or ‘bitbargain.co.uk’) act as brokers among BTCs users – and between banks and BTCs users. By supplying their bank account information and transferring money at the going conversion rate (i.e. buying BTCs), users open a “BTC account”. For identification purposes, the acquired BTC balance is associated to a unique sequence of numbers and letters, called “block” (see below). First-time BTC users receive two numbers: the first is a public-account number, called “public key”, and enables them to ‘receive money’; the second is private number, called “private key”, and is used to ‘send money’.

Users can then spend their BTCs at online retailers that accept them as a ‘means of payment’. Merchants accept BTCs because transaction fees are extremely low, as opposed to the 2–3 percent typically charged by credit cards.  BTCs can also be exchanged into main global currencies – the US dollar (USD), the Euro (EUR), the Swiss Franc (CHF), the Chinese yuan renminbi (RMB) – on exchange websites (e.g.:, ‘avatrade.com’). Investors can invest in BTCs through several dedicated funds.

BTC prices are extremely volatile. After jumping above USD 1,100 in early December 2013, and following a 30 percent year-to-date decline, on April 2, 2014 1 BTC was worth USD 480. Because of its volatility, the BTC has not been able to fully play the three essential roles of money at the international level: 1) unit of account; 2) medium of exchange; and 3) store of value. Indeed, extreme volatility is severely hampering the BTC ability to “store value” and weakens its effectiveness as a system to process payments (“medium of exchange”).

Supply of BTCs

The issuance of BTCs – referred to as “mining” – is decentralized. In other words, BTCs are not issued through a single authority such as a Central Bank; they are issued by BTC users themselves – currently amounting to about 20,000 anonymous (unless they choose to be identified) individuals called “miners”.

Put it simply, “miners” try to solve complicated puzzles and – if they obtain the right answer – are awarded a payment in BTCs. Concurrently, they validate previous BTC transactions, for which they receive a smaller payment. In essence, “miners” are both a decentralized monetary authority, responsible for issuing new currency and a clearing house for the transactions denominated in BTCs.

How does it work? Once a BTC unit is created, its information gets recorded in a “block”. For illustrative purposes, let us imagine that – initially – ‘Mr. A’ owns 10 BTCs, and on April 2 2014, he uses them to buy goods from ‘Ms. B’.

A “block” contains four sets of information:

(1)    A reference to the previous “block” in the “block chain”;

Example: 0001xyz – i.e.:, the code recording “how 10 BTCs were originally issued to ‘Mr. A’ ”.

(2)    A timestamp, such as the transaction date;

Example: 2April2014.

(3)    Information about the current transaction;

Example: Mr.A_gives_10BTC_to_ Ms.B.

This way, a string of numbers and letters, in (1)-to-(3) sequence, is created.

Example: 0001xyz/2April2014/ Mr.A_gives_10BTC_to_ Ms.B

All “miners” simultaneously receive this transaction, and start their search for:

(4)    A “nonce” – an arbitrary number (used in security engineering for cryptographic communication).

Finding the “right” (4) is critical. Concretely, “miners” take the (1)-to-(3) sequence and add a random (4). The resulting sequence of numbers and letters is the “alphanumeric” tested by “Miner X”.

Example: “Miner X” tries the number 230; his “alphanumeric” is:

0001xyz/2April2014/ Mr.A_gives_10BTC_to_ Ms.B/230.

Now “Miner X” puts his “alphanumeric” into a specific “hash function[1]. The goal is to obtain a number that starts with three zeros.

The “hash function” random result is: “1b2a0dc”. It does not start with three zeros.

Miner X” tries again, with another random number – i.e.:, a different (4) – until he finds the solution. To find “the right number” and earn their compensation, “miners” use powerful computers and run millions of iterations. Every iteration is recorded as “proof of work”. In our example, “Miner X” tries for a second time with 111. His “alphanumeric” is:

0001xyz/2April2014/ Mr.A_gives_10BTC_to_ Ms.B/111.

Now, the “hash function” result is: “000erg1”.

As this solution begins with three zeros (i.e.:, fits the required criteria), “Miner X” sends it to all other miners, with his “proof of work” – showing that his computer went through 2 iterations to find it.  When the other miners confirm the validity of his solution, “Miner X” gets compensated in newly issued BTCs (the current rate is 25 BTC, approximately USD 12,000). By doing his computation, “Miner X” also validates the authenticity of the transactions within the block (i.e.:, that Mr.A_gave_10BTC_to_ Ms.B) and gets a smaller return.

A “new block” is formed, and added to the “block chain – recording: 1) the transaction the 10 BTCs were used for; 2) all previous transactions these 10 BTCs – now owned by ‘Ms.B’ – were involved in, as they were changing hands; 2) the validation by the “miner”; and 3) the compensation of the validating “miner”. The information is created and added to the existing “block chain”.

The process can start again. When ‘Ms. B’ spends her 10 BTCs to buy services from ‘Mr. C’, the same process applies: “miners” receive the “block” of historical information (including all transactions, validations and compensation fees), rather than just information about one single transaction; the fastest ”miner” validates the “block” by running his computer algorithm, and gets compensated for it. This new information is added into the “block”, and a new “block” is created. And so on: when ‘Mr. C’ spends his 10 BTCs to buy flowers from ‘Ms. D’, the “block” is further enriched, via the same process.

In other words, a “block” refers to a series of transactions within the “block chain”. In the BTC system, the “block chain” is an electronic ledger that contains information about: a) every BTC ever issued; and b) details on every BTC transaction.

BTCs issuance grows at a declining rate. As time passes and BTCs are mined, the pre-determined number of required zeros at the beginning of each “block” steadily rises, and it becomes harder and harder to find outputs that fit pre-determined criteria. Additionally, the supply of BTC is capped at 21 million, of which about 12.1 million have already been issued. The reward for discovering these blocks declines every four years by half – to ensure that by 2040 only 21 million BTC will have been issued. Currently, given the high number of “miners” and the powerful computers they use, it takes about 10 minutes to initiate a new “block”; as a result, the annual supply totals about 1,314,000 BTCs. Because of the rising challenges, “miners” are increasingly teaming up, pooling computing power and sharing the rewards. With time, finding solutions will take longer and pay-offs will decline.[2]

Demand for BTCs.

There seems to be two types of demand for BTCs, as:

a)      Saving instruments: savers, investors, and speculators demand BTCs for saving purposes rather than as a ‘means of payment’. About 60-65 percent of BTCs issued to-date is estimated not to be in circulation, used for hoarding purposes (however, some of these BTCs might have been lost).

b)      Payment instruments, for:

  1. Illegal operations: Due to its non-traceability, BTC usage quickly rose – led by illegal activities such as payments on ‘Silk Road’, a website that sold illegal drugs. BTCs have also been used in Iran to circumvent sanctions, and in Cyprus – and other crisis-struck countries – as a tax-evading mechanism to smuggle wealth abroad. Some analysts fear that BTCs are used as a ‘means of payment’ by drug-dealers, arms-dealers and terrorists.
  2. Legal operations:   thousands of online retailers – from small travel-agencies to e-Bay (the largest online auctioneer) – accept BTCs as a ‘means of payment’: ‘coinmap.org’ lists about 3,500 companies, while ‘spendbitcoins.com’ lists almost 6,000. There are even gift certificates issued in BTCs and luxury websites, such as ‘bitpremier.com’. To date, the largest transaction was the purchase of a villa in Bali for 800 BTCs or USD 500,000. Going forward, Virgin Galactic announced it will accept BTCs.

Advantages:

  • Decentralized, standardized issuance: The birth of BTCs in 2009 coincided with the global financial crisis, and the efforts of global Central Banks – US Fed, European Central Bank (ECB), Bank of Japan (BoJ), Bank of England (BoE), People’s Bank of China above all – to devalue their respective currencies. Satoshi Nakamoto, the mysterious founder (a man – or group of persons – nobody has ever met face-to-face and who disappeared in April 2012) was well-aware of the declining market trust towards global hard currencies. Indeed, savers fear devaluation and inflation. By decentralizing issuance, no single institution is given power over the currency’s fate.
  • Independence from politics: Even though most Central Banks are said to be independent from their respective Governments, a simple look at budget deficits versus policy rates shows that they are not. When deficits rise, Central Banks usually ease interest rates to let Governments borrow more easily. Moreover, in many countries the choice of the Central Bank governor is a political decision with major consequences for the economy. The BTC divorces monetary policy from politics. There is no single monetary authority, no central bank, no governor. Also, the issuance calendar is known.
  • Openness, growth: The BTC creates opportunities for new businesses to flourish. There are already hundreds of start-ups catering to the BTC concept and making BTCs more accessible. As a result the BTC can have a positive impact on growth and employment, although the impact is rather small for now.
  • Divisibility: Unlike most world currencies, BTCs are almost infinitely divisible. While 1 USD can only be broken down into 100 cents (1 cent is the smallest denomination), there is no such floor for BTCs.
  • Low transaction fees: This is probably the first and real reason of BTCs success. As mentioned, unlike other online payment systems (such as Mastercard or Visa), Bitcoin’s transaction fees are extremely small. On most websites, paying in BTCs can reduce any item’s price by 2-3 percent. However, as the issuance of BTCs will decline in the future, transaction fees will have to rise to give an incentive to “miners” to continue to validate transactions.

Disadvantages:

  • A deflationary currency: The biggest strength of BTCs (a decentralized, standardized issuance) is also its biggest weakness. If the demand for BTCs were to outpace supply, the currency would appreciate against other currencies. All goods or services priced in other currencies – USD, EUR, CHF, etc. – would decline in value when expressed in BTCs, i.e.:, a deflationary impact. In other words, as the BTC would increase in value in terms of goods and services as time goes by, people would tend to hoard BTCs rather than spend them. Thus, BTCs are likely to be used as a savings instrument – not as a ‘means of payment’.
  • Not linked to the business cycle: In general, Central Banks adjust money supply to the needs – and shifts – of the business cycle, to sustain aggregate demand and growth. Not the BTC. As BTC issuance is completely divorced from the business cycle in any single economy, BTCs are likely to bring about high demand in expansionary periods and low demand in contractionary ones. This might result in higher volatility – even in the long term.
  • Volatility: The BTC is an experiment few people believe in – but many people want to invest in. As a result, compared to other asset classes, the BTC is “7 times more volatile than gold and 8 times more volatile than the S&P 500”. Given abundant global liquidity and a relatively small supply, BTCs are bound to remain volatile. In the past, a big retailer’s announcing “we accept BTCs as a means of payment” saw the daily value of BTCs jump by 30 percent; during the same day, the issuance of a Government regulation made it plummet by 30 percent. Such volatility discourages speculators from investing in BTCs but also hamper its use as a ‘means of payment’. According to the Bitcoin Foundation, BTC volatility is due to scarce liquidity, attributable to a mathematically defined supply and insufficient popularity.
  • Lack of risk-infrastructure: There are not enough market-based instruments to hedge against BTC exposure. Thus, retailers/producers who accept BTCs as a ‘means of payment’ run an FX risk. They buy/produce goods in hard currencies but sell in BTCs. The trade works as far as the BTC appreciates against all major currencies. However, a depreciating BTC might cause financial losses, bankruptcies and/or retailers pulling out of the BTC market.  Currently, to avoid running FX mismatches, most retailers switch immediately their BTCs revenues into hard currencies.
  • Technical vulnerability: Many people keep their BTCs in online “wallets”. However, these “wallets” run the risk of being hacked. Indeed, most “e-wallet” sites do not assume the risk of theft, and pass it to BTC users. Usually, BTC users are not tech-savvy, and are likely to leave security gaps in their “e-wallets”. If BTCs are stolen, it is impossible to retrieve them – due to their non-traceability. Such thefts have already occurred and will likely continue to occur, undermining the trust in BTCs. In February 2014, the collapse of the largest and most prominent BTC exchange (Mt. Gox, launched in 2010, by 2013 was handling 70 percent of all BTC transactions – see below) provided plenty of evidence of the existence of technical vulnerabilities.
  • Loss of BTCs: In the early days of BTCs, many people bought BTCs just for fun or as an experiment. Analysts believe that many of the early buyers of BTCs have either lost access to their “e-wallets” or misplaced their unique BTC address. Losing an “e-wallet” is equivalent to burning cash: the money cannot be replaced unless the wallet is found.

Does Bitcoin have a real value?

  • NO: currencies run on trust – “trust” is the real value of any currency. The value of 1 USD is mostly determined by people’s trust in the US Fed honoring the payment that every USD issuance entails. Because investors trust the Fed (and indirectly the US Government and the US economy as a whole), the USD is a global currency. In that respect, the BTC has no value. There is no national economy, no real production, no BTC-based wages and no institutions behind the BTCs.
  • Yet, YES: The trust in BTCs is not based on a national economy, it is stemming from the existence of the internet and clear rules. Investors trust the mathematically defined issuance calendar of BTCs and its independence from politics. They also believe in a rising demand for goods and services acquired over the internet and in BTCs as a mean to purchase them. In this respect, the BCT has a value, because it offers a “trust” that cannot be found elsewhere.

Can Bitcoin become a bubble? The demand for BTCs as a ‘means of payment’ is real. The BTC trend value is rising, and a sudden crush back to the original value of 0.3 USD is unlikely. As its supply is fixed, the demand becomes the main factor to determine its value. As more and more retailers accept payments in BTCs, demand is up. However, the BTC value will not rise to infinity as there are clear holdups, such as Governments’ regulation and security.

a)      Government regulation: Recently, Lamborghini announced that they would accept payments in BTCs. Inevitably, some of the demand for Lamborghini cars could come from not-legitimate businesses. Allowing payments in BTCs would permit unlawful buyers to bypass the scrutiny of regulators and tax authorities. As a consequence, Governments and regulators from various jurisdictions are starting to think about BTC supervision – hence limiting the upside for BTC valuations. A key area is the provision of rules on how to integrate this new technology with the formal, regulated financial system. The Financial Crimes Enforcement Network (FinCEN), a bureau of the US Treasury Department, recently issued a non-binding guidance on virtual currencies. Some jurisdictions (e.g.:, Argentina) severely restrict virtual currencies. Other jurisdictions (e.g.:, Thailand) limit the licensing of BTC exchanges. Recently, China curbed banks’ usage of BTCs. Yet, BTCs have not been made illegal in any jurisdiction.

b)      Security: Until early 2014, BTC thefts had been limited in amount. Yet, in February 2014, the Tokyo-based BTC exchange Magic: The Gathering Online Exchange” (Mt. Gox) announced that about 850,000 BTCs (about 6 percent of total BTC supply) belonging to customers and the firm, valued at the time more than USD 450 million, were “missing and likely stolen”. The reasons for BTC disappearance are still unclear; speculations point to theft by internet hackers and mismanagement. As a result, Mt. Gox suspended trading, closed its website, and filed for bankruptcy. Such events severely undermine the confidence in BTC; were they to continue, investors would lose trust in the currency and demand – and hence value – would decline.

Can Bitcoin become a global currency? Not in the short term. The BTC is still limited by its own design. First, its decentralized, standardized issuance makes the BTC a deflationary currency, limiting its use as a ‘means of payment’. Second, its limited issuance compared to a rising – although erratic – demand makes its value very volatile. Third, its non-traceability makes it attractive for illegal activities thus boosting the likelihood of Government’s intervention and regulation. Finally, BTCs are solely used for payments or investments. To date, there are no companies that pay salaries in BTCs. Without BTC based wages, independent value formation is not possible, and BTCs’ value will always be relative to other currencies.  In other words, the BTC is unlikely to become a mainstream currency (replacing the USD, EUR, etc.) due to design-limitations. However, it is unlikely to be a short-lived phenomenon and might become an alternate payment mechanism. In the medium term, developments in: a)government regulations”; b)ease-of-use”; and c) proof-of-security” will influence its future role and value – and need to be closely monitored.



[1] In computing, information security applications (e.g.:, passwords, digital signatures, authentication codes) use a “hash function” – a pre-determined algorithm that maps data of arbitrary length into data of a fixed length – i.e.:, “a fixed-size bit string”.

[2] As of December 11, 2013, miners – as a whole – run operating losses of USD 13 million (USD 4 million in revenues – USD 17 million in costs, mostly due to computing and electricity bills). In simpler words, mining has become a loss-making business. The value of BTCs needs to significantly rise for mining to become profitable again.

2 Responses to "Understanding Bitcoins"

  1. Tejas552   April 2, 2014 at 6:18 am

    It is interesting to note that the (obviously very smart) creators of Bitcoins modelled their currency on gold. Looks like that in (smart) peoples' minds the ideal currency should be like gold. The question is why not use gold straight away. Gold seems to have all the advantages of Bitcoins, while at the same time eliminating some of the disadvantages (trust, theft through hacking, limited supply).

  2. HermanFoster   April 7, 2014 at 4:13 am

    So many discussions about Bitcoins. For myself, I prefer USD.