Bitcoin and Blockchain Basics

The basics of bitcoin are quite complicated. In our introduction, we will get into advanced technology, economics, politics, and psychology. So get a cup of hot tea and get prepared to learn about a fascinating new world of revolutionizing technology, a banking industry that may be redundant and a lot less impoverished people.

 

What is Bitcoin?

Bitcoin is digital money. Because of its numerous benefits, many people believe bitcoin will soon replace national (fiat) currencies. Today, some people use bitcoin as a currency while others use it as a security for investment purposes. You can buy it online from exchanges or directly from individuals.

The most important benefit of bitcoin is that it is much cheaper, easier, faster and should become safer to transfer than fiat money. More about all the other benefits of bitcoin here, but for now, on to what bitcoin is and how it works.

 

Bitcoin Uses Code Instead of Paper

Bitcoin is money, but instead of printing national heroes on pieces of paper, as we do with fiat money (national currencies), one can think of bitcoin as a piece of programming code that has monetary value (even though the mechanisms behind are far more complicated). The main benefit with code instead of paper is that it is faster, cheaper and, in the future, safer to transfer.

The problem with a system where a piece of code holds a certain monetary value is, of course, that anyone who knows how to program could just copy the code and by doing that make a lot of new money for themselves. So, in order for bitcoin to work, it’s crucial to have a robust safety system that surrounds the bitcoin code. And there is such a system in place…

 

Bitcoin Uses a Security System Called Blockchain

There is a robust safety system surrounding the bitcoin code. The security system is called blockchain and is built upon decentralization.

It works like this:  a log of every bitcoin transaction is added to a long list of bitcoin transactions (a so-called ledger) that is encrypted and stored in blocks.

The blocks are linked to each other and form the so-called blockchain. The blockchain is public to everyone and, therefore, a copy of it exists on thousands of computers all over the world. Because there are so many copies of the blockchain in so many locations, it is virtually impossible to hack or manipulate it.

 

Every Transaction is Verified Several Times

The transactions on the ledger (transaction list) are not considered valid until they have been verified. Computers automatically run the verifications via a mathematical process. For a transaction to be valid, it must be verified by several computers.

Anyone is welcome to do the verifications. All you need to do is get special hardware or use a cloud service that uses your computer to run verifications. The people/companies who run verifications are called miners and are paid a small sum of bitcoin for their efforts. Hashflare Mining provides cloud mining services and you can read more about how it works on their website.

 

How a Bitcoin Transaction Works

Let’s make an example:  Björn gives Ebba 0.008 bitcoin, so he transfers 0.008 bitcoin from his wallet to Ebba’s (a wallet is like a bank account for bitcoin - it’s where the bitcoin is stored). When Björn presses the Send-button, the ledger on the blockchain gets a new line of information, namely that 0.008 bitcoin has been transferred from the wallet owned by Björn to the wallet owned by Ebba.

Because the ledger is on the blockchain, there are now thousands of encrypted copies of Björn’s transaction to Ebba - on computers all over the world.

Gloria in Wisconsin, USA, has mining hardware installed on her computer which verifies Björn’s bitcoin transaction. Seven other miners in other places in the world also verify Björn’s transaction.

Once the verifications are finished, the 0.008 bitcoin appear in Ebba's wallet and she can go buy the app-controlled Star Wars R2-D2 robot she has always wanted. 

 

Areas of Use – Why do We Need Bitcoin?

We already have a functioning monetary system, and in the West, we currently have a multitude of different ways to pay and transfer money.  So why do we need bitcoin?

If bitcoin works the way it is intended to, then the world really, really needs it! However, bitcoin is not fully developed yet, or rather, some areas are under improvement. You can read more about them here. Now on to why we need bitcoin.

 

Putting Things into Context

In our current monetary system, we are highly dependent on central- and commercial banks. The banks have a lot of power, and we rely on their systems to work and their employees to do the right thing.

 

Bitcoin Makes Payments Faster, Cheaper and Safer

Because bitcoin and the blockchain are more efficient, and because there is no bank making money off it, transferring bitcoin is much faster, cheaper and could be safer than the current systems of wire transfers, credit card payments and so on.

Bitcoin can be transferred in seconds from one part of the world to another. Today, domestic wire transfers take at least 24 hours, and international transfers take several days!

Transferring bitcoin is also much cheaper than transferring fiat (government issued) money. Banks are known for being good at hiding their fees, so trying to understand how much you pay for a transfer can be difficult.

Sometimes bank fees come in the form of slow service (every hour your money is in their system they make interest on it). Sometimes the fees are baked into other things, for instance, the fee for exchanging money to other currencies is usually baked into the exchange rate. When you use your debit card abroad you pay 1.5-1.65% for the foreign exchange. Other times the banks are transparent about their fees. For instance, Nordea charges 75 SEK to transfer money to a bank account in another bank, when done at a branch office.

The price of monetary transactions is important. If transaction prices are low, even very small payments are worthwhile and make economic sense. If transaction prices came down, it would help the developing world a lot, which we discuss here. However, it can also benefit people in the West.

For example, online newspapers can make more money if they can charge a small fee for accessing a specific article. Today the newspapers are leaving money on the table because some customers are willing to pay for individual articles but not willing to sign up for binding monthly subscriptions.

 

Bitcoin Can Remove Our Dependence on Banks (and the Problems They Sometimes Cause)

Because bitcoin and it’s blockchain security system is decentralized (members of the network provide the security by mining), there is not as much need for commercial banks to provide security and have control/power over the monetary system. Bitcoin and its blockchain just works on its own and is run by the people who use it.

Most of the time the banks use their power in a good way, but there are times when they don’t. When that happens, it’s devastating for society as a whole. Here is an example;

Greed in banks can cause recessions. In 2008 we had a worldwide recession where many people lost their jobs. The recession was set off by greedy bankers who messed things up in their quest to make more money for themselves.

There is a lot to be said about how the 2008 recession happened, but this is the basic outline:

Banks lent money to people who couldn’t afford to buy houses. Banks also created fraudulent financial products with excessive risk built into them - which the customers were not aware of. => (this led to) Some large banks went bankrupt (Bear Stearns, Lehman Brothers, Fannie Mae etc.) => In fear that other banks had similar problems and may also go bankrupt, banks stopped lending to each other => The customers (companies and individuals) suffered because they couldn’t get loans or run their businesses. => Some companies went bankrupt and fear spread in society. => In order to be prepared for possible layoffs, people spent less money and companies didn’t hire. => A recession kicked in.

People can lose their money if banks are badly run and turn to bankruptcy. Fortunately, many governments have policies in place to protect savers from these kinds of scenarios. In Sweden, we have ‘insättningsgarantin’ where the government promises to repay individuals up 950 000 SEK if their commercial banks go bankrupt. Ultimately though, it’s the taxpayers who pick up the tab for bad management on behalf of the banks.

 

Bitcoin Can Ease International Trade

If Bitcoin truly became a world currency, no company would have to worry about fluctuating foreign exchange rates, which is a big headache for the industry and adds additional costs to businesses.

Most of the products we buy today are not only produced in countries other than our own, but also the different components that they are made of are too.

For example, when you buy a shiny new Volvo car, it’s not only shipped from the final assembly plant in Malaysia, but the different parts have been produced and shipped from all over the world. In order to make just one Volvo vehicle, there are countless components shipped back and forth over the globe.

For each international sale of a component, an international monetary transaction takes place. These transactions are costly, take days to clear and usually come with huge foreign exchange rate risk. The cost for all this is pushed onto us, the end consumers.

For example, a company that sells China-produced eyeliners in Sweden may have placed their order on February 1st, 2017, when the exchange rate was 1.27 CYN/SEK. According to common practice, the products were paid for when they start being produced, on April 10th, 2017, when the exchange rate was 1.31 CYN/SEK. In this example, because of the change in the exchange rate, the products were 3% more expensive the day they were paid for compared to the day the order was placed. This may not sound like much, but it is. The average net profit margin for retail companies is 1.5-3%, so fluctuating exchange rates are a big problem.

 

Bitcoin Can Help the Developing World Prosper

With bitcoin and blockchain, it is easier for people in the emerging world to access financial services, such as taking loans. The bitcoin blockchain makes it cheap and easy to lend small amounts of money globally, across borders.

Being able to take loans is important because without them it’s much harder to start businesses, buy toilets for shanties, and in other ways get ahead financially. In the developing world, identity verification is complicated because a large portion of the population isn't officially registered as citizens. Also, most people want to borrow a very small amount. These two factors make it too expensive to provide financial services to the world’s poorest. There are Microfinance Institutions (MFI’s) that provide some financial services, but the costs are still too high to offer good solutions for international money transfers.

The good news is that bitcoin can solve all of this! With bitcoin, investors in the rich world can lend small amounts of money to individuals in the developing world and still earn a high-interest rate. Because the transaction cost for bitcoin is so low, the costs won’t eat away the profits.

And this is not a future dream-scenario. You – personally - can do this right now! You can lend money to someone in the developing world who is trying to set up a business. Bitbond gives investors this possibility, their minimum investment is 5 USD and their average investors earn 13% interest on doing this great favor. Here is how it works.

 

Concluding Remarks About the Use of Bitcoin

There are several more areas of use for bitcoin and blockchain. We have only listed some of the bigger and most obvious ones. Of course, there are also counter-arguments explaining why bitcoin won’t work in the way that many people hope it will. We discuss some of the biggest bitcoin drawbacks here.

When you dive deep and really try to understand all the pros and cons of bitcoin, you realize that things are extremely complicated. Bitcoin touches advanced technology, economics, government regulation, politics and human (psychological) reactions to everything from adapting to new technology to fear of losing out.

Bitcoin and blockchain are like economics in the sense that it’s almost impossible to make accurate predictions. You can know virtually everything about it, and yet, the field is very complicated and there are many different factors that can influence any given situation.

So, in regard to bitcoin, there is very good reason to be respectful of other’s opinions about how things will unfold. Derogatory comments are never good, but they are even more inappropriate when discussing bitcoin.

With this in mind, you are invited to discuss bitcoin’s future, and areas of use, with other readers on our live chat forum. Discussions are not only fun but also they can help people understand and develop their thinking.

 

New Technology Will Change the Banking Industry

New technology has shaken and fundamentally changed many industries including the music industry, the media industry, and the retail industry. Many now believe it's bankings turn. Bitcoin is well positioned to win the race, but there are other possible paths of development.

Just a few decades ago people bought music on vinyl records. Now people pay Spotify to stream music directly to their phones. We no longer have video stores in every shopping center; instead, we have access to a much wider selection of films through web-services such as Netflix. The same goes for retail.

In your mind, does it seem likely or not likely that banking will be disrupted (changed dramatically) by advances in technology, just like so many other industries have?

 

The Change Has Already Begun…

Bitcoin is not the geeks-only Internet currency that it was a few years ago. Today you can use it online to pay for many products and services, for example at Overstock.comExpedia.com, and Webhallen.com.

In Japan bitcoin gained legal status as an accepted means of payment (in April 2017) and in the Swiss municipality of Chiasso you can pay your taxes with bitcoin (which was announced in September 2017).

In countries where the financial systems are unstable, bitcoin is and has been widely used. In Venezuela, bitcoin is used instead of the Venezuelan Bolivar because of the country’s hyperinflation. And Cyprus saw a large upswing for bitcoin during their 2013 financial crisis.

 

…But Bitcoin May Not Be the Winning Technology

Right now, it appears to be fairly clear that new technology will fundamentally change the banking industry. However, at this point in time, it’s uncertain which new technology will be the winner.

Although most analysts believe that the future of money-transfers will be built on blockchain, it might not be the bitcoin blockchain. There are already many different blockchains. Another cryptocurrency called Ripple has their own blockchain which is built for interbank transactions, and Intel and Microsoft have built their own private blockchain with more privacy than the bitcoin blockchain.

Several commercial banks including Nordea, Handelsbanken and Swedbank are testing out different blockchain- and bitcoin solutions. According to DI's sources, more than 10 people at SEB work full time on different projects related to blockchain. Since May 2017 Skandiabaken’s Norwegian customers can see their bitcoin holdings in their online banking platform.

In March 2017, Riksbanken, the Swedish central bank, announced a project where they will evaluate the possibility of an e-Krona. According to their time-plan, they will decide at the end of 2018 whether or not we will get e-Krona.

 

Concluding Remarks About Whether Bitcoin Will Change Banking

Although central banks, commercial banks, and established big IT companies are (or might be) developing their own blockchains, many of the benefits of the bitcoin technology can only be reaped if the system is worldwide, and run by the users rather than central institutions like banks or big companies.

But then again, there is more to this equation than what makes theoretical sense. We also have to account for things like politics and psychology.

Even if governments and/or big banks make their own cryptocurrencies, it may be possible for world-wide user-run cryptocurrencies like bitcoin to exist at the same time.

Bitcoin could continue to be used in the same way it is today, for certain circumstances where it is more practical, such as international trade and internet transactions. And it could be a valuable alternative currency at times of turmoil in other financial systems.

Many interesting discussions can be had over where bitcoin and blockchain might take us in the future. Please share your thoughts and discuss on our live chat forum.

2017-09-04

Disclaimer: The information in this article, as all content on BlockBull Review, is not and should not be seen as investment advice. The information is for educational and/or entertainment purposes only, so use it at your own risk. It is possible to lose money when engaging in any investment including cryptocurrencies and past performance does not indicate future performance. Any opinions expressed are those of BlockBull Review's writers who are not broker-dealers or advisors of any kind.


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