Figuring Out How Bitcoin Works – Learn To Invest Safely


People are thinking of a positive and thought‐provoking way because of what they are perceiving about Bitcoin. The seed of doubt has been planted in a lot of people’s minds and has made them think about money differently. Remember that, because of the financial crises experienced in the past decade, it causes some people to think out of the box trying to come up with new and creative solutions for a better economy. With the transparency and decentralization of Bitcoin, it has proven to be a powerful tool in achieving that goal.

Bitcoin bypasses the current financial system and it could, therefore, provide potential services to unbanked and underbanked nations around the world.

A cashless society is now on the rise, society has been evolving toward a cashless ecosystem for a while now: The use of bank and credit cards to pay for goods and services both online and offline are increasing every day. Paying for stuff with your phone (Mobile payments) is now on the rise, and as time goes on this may become a threat to card transactions. For years now, bitcoin has been available on mobile devices.

The nature of cryptocurrency

Cryptocurrency in its purest form is a peer-to-peer version of electronic cash. It allows online payments to be sent directly from one party to another without going through a financial institution. The network timestamps transactions using cryptographic proof of work. The proof-of-work Bitcoin protocol is basically a contest for decoding and an incentive to reward those who participate. For Bitcoin, the first participant to crack the code will be rewarded with the newly created coins. This contest will form a record of the transactions that cannot be changed without redoing the proof of work.

Cryptocurrency is a subset of digital currency. Examples of the many digital currencies are air miles issued by airlines, game tokens for computer games and online casinos, Brixton Pound to be spent only in the Brixton local community in the Greater London area, and many other forms that can be exchanged for virtual and physical objects in a closed system and, in the case of an open system, exchanged for fiat currency.

The beginning: eCash

Commercially, it all began with DigiCash, Inc.’s eCash system in 1990, based on two papers by its founder (Chaum, 1983; Chaum et al., 1992). Payments were transferred online and offline using cryptographic protocols to prevent double-spending. The cryptographic protocols also used blind signatures to protect the privacy of its users.

8 Handbook of Digital CurrencyAs the first cryptocurrency, the eCash system was available via various banks and smart cards in various countries like the United States and Finland. It slowly evolved into the current form of cryptocurrencies with many refinements by various software developers over the last 20 years.

eCash was a centralized system owned by DigiCash, Inc. and later eCash Technologies. However, after it was acquired by InfoSpace in 1999, eCash and cryptocurrency faded into the background.

Pioneering Internet payments with digital gold

The digital gold currency came into the limelight between 1999 and the early 2000s. Most of these new forms of electronic money based on ounces of gold are stored at the bullion and storage fees are charged. We have seen the growth of e-dinar, Pecunix, iGolder, Liberty Reserve, gBullion, e-gold, and eCache. With a couple of exceptions, most have ended up in the graveyard due to either compliance issues or regulatory breaches.

e-Gold was a pioneer for Internet payments. As the first successful online micropayment system, it pioneered many new techniques and methods for e-commerce, which later became widely used in other online aspects. These techniques and methods include making payments over a Secure Sockets Layer-encrypted connection and offering an application programming interface to enable other websites to build services using e-gold’s transaction system. However, its Achilles heel was its failure to fulfill know-your-customer (KYC) and suspicious transaction reporting requirements. With the introduction of the US Patriot Act, compliance has been a major issue for money transmitters. Furthermore, it has to contend with hackers and Internet fraud. Before the motion to seize and liquidate the entire gold reserve of e-gold under asset forfeiture law in 2008, e-gold was processing more than USD 2 billion worth of precious metal transactions per year. There are clear lessons to be learned by the cryptocurrency community.

Revival of cryptocurrency – Bitcoin

At the onset of the global financial crisis in 2008, interest in cryptocurrency was revived.

The cryptocurrency had the potential to counter a few problems associated with the fiat currency system, argued Szabo (2008) in a blog post just at the beginning of the global financial crisis. Given that it is cumbersome to transact using commodities, the concept of bit gold was mooted. As the name suggests, there is gold to be mined and bit recorded on a digital register. The digital record would resolve the issues of a trusted third party and in his own words,

Thus, it would be very nice if there were a protocol whereby unforgeable costly bits could be created online with minimal dependence on trusted third parties, and then securely stored, transferred, and assayed with similar minimal trust. Bit gold.

ALSO READ: Digital Currencies – The Next Generation Of Money And Payments

My proposal for bit gold is based on computing a string of bits from a string of challenge bits, using functions called variously “client puzzle function,” “proof of work function,” or “secure benchmark function.” The resulting string of bits is the proof of work. Where a one-way function is prohibitively difficult to compute backward, a secure benchmark function ideally comes with a specific cost, measured in compute cycles, to compute backward.” Despite sounding technical, what Szabo described was a simple protocol that requires participants to spend resources to mine the digital gold or bit gold, be rewarded, and in the process validate the public digital register. What differentiated his approach from failed digital currencies of the past were the timing of the financial crisis and the distributed nature of the protocol. The reward to the miners was one innovation and the free access to the digital records for the users was another. One of the reasons is that the nature of the Internet makes collecting mandatory fees much harder, while voluntary subsidy is much easier. Therefore, there must be no barrier to access content or digital record, and there must be ease of use and voluntary payments.


Ideas were discussed in the literature, and technology was developed over time by a group of cryptographers, old and new, such as Chaum (1983) on DigiCash, Back (1997) on Hashcash, Dai (1998) on b-money, Szabo (1999, 2002, 2008) on the concept of money, and Shirky (2000) on micropayments. Cypherpunk is an activist group since the early 1980s that advocates the widespread use of strong cryptography as a route to social and political changes. Finney (2004), who ran two anonymous remailers as a cypherpunk member, created the first reusable proof of work (RPOW), which is an economic measure to deter denial-of-service attacks and other service abuses such as spam on a network by requiring some work from the service requester. It means that whoever requests for the information has to incur more processing time on a computer than the provider. Hashcash, used by Bitcoin, is a proof-of-work system designed to limit e-mail spam and denial-of-service attacks (Back, 2002).

At the same time, sociopolitical interest in cryptocurrency grew. Since we abandoned the gold standard in 1971 and adopted the fiat currency system, central banks have used their discretion to print as much as they desired during a crisis. This has created an asset inflation environment and worsened income equality. The supply of cryptocurrency or coins may or may not be limited but the new coins are usually created by a predetermined rule. The loss of trust in the fiat currency system, caused mainly by quantitative easing and huge government debts, has brought attention to cryptocurrency for those who wanted to hedge their positions with a currency that has a finite supply.

Digital Currencies

The cryptocurrency was thought to possess the characteristics of a currency that can impose fiscal discipline on the government and it is perceived to be a debt-free currency with a constant growth rate with a finite supply. For asset managers who were constantly seeking for negative correlation with their core portfolio, cryptocurrency provided a glimpse of hope for a high-risk and complex asset class that enhances the returns of a portfolio with bitcoins acting as a negatively correlated alternative asset class. But the origins of Bitcoin have their roots in crypto anarchy that started as a movement in 1992:

Just as the technology of printing altered and reduced the power of medieval guilds and the social power structure, so too will cryptologic methods fundamentally alter the nature of corporations and of government interference in economic transactions. Combined with emerging information markets, crypto anarchy will create a liquid market for any and all material that can be put into words and pictures. And just as a seemingly minor invention like barbed wire made possible the fencing-off of vast ranches and farms, thus altering forever the concepts of land and property rights in the frontier West, so too will the seemingly minor discovery out of an arcane branch of mathematics come to be the wire clippers which dismantle the barbed wire around intellectual property. (May 1992)

The most common arguments against Bitcoin are (i) the lack of a central issuing authority like that of a central bank, (ii) its fixed supply and deflationary nature by design, (iii) doubts that the price is stable enough to function as a currency, and (iv) the risk associated with it.

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