The price of bitcoin is currently around $4,000 US (~£3,124), higher than it has ever been. But how can a currency that remains completely over most of our heads be worth so very much? How is it even generated? There are a lot of questions to answer, with some of these answers so complicated that it is making my head hurt trying to explain them (let alone understand them). But I’ll do my best.
I’m just going to focus on one specific area of Bitcoin today, and that is the bitcoin mining process. So, take a deep breath and make a strong coffee… let’s go down the rabbit hole.
First, the basics:
The process of bitcoin mining involves compiling recent transactions into the blocks in a blockchain and trying to solve a rather difficult computational puzzle. This puzzle isn’t, however, solved by humans, who’d be thoroughly useless at the task.
Working out the answer to each puzzle has been likened to trying out billions of combinations of numbers on a safe in order to crack it. The human mind is simply too slow. So, Bitcoin mining is done by machines.
Every ten minutes or so, the mining machines are issued a new maths problem to solve. The first machine to solve it gets a certain number of bitcoins as a prize. This reward is set by the Bitcoin software and is completely untamperable, as it’s part of a blockchain. The solving of the problem is essentially the ‘discovery’ of a block in the chain. Obviously, the more mining machines you own, the more Bitcoin you’re going to earn. Bitcoin miners are currently making around $7 million (£5.5 million) a day.
This is how the currency is generated. Unlike normal currency, Bitcoin isn’t the property of one state or another. It’s a global currency with no borders. Because it doesn’t have a central government, and is essentially virtual, there is no mint for churning out paper notes and coins. So the mining process is the smart way to issue the currency in a way that provides an incentive for more people to mine, and thus create more Bitcoin.
The miner (owner of the machine) is also awarded fees paid by Bitcoin users sending transactions. This fee is another incentive, this time to encourage the miner to include the transaction in their block.
As time goes on, the number of new Bitcoin that miners are permitted to include in each block will decrease. At this point, the fees from the transactions will form the greater percentage of income from Bitcoin mining.
[clickToTweet tweet=”The no of new Bitcoin in each block will go down over time. Then, fees from transactions will be greater % of income.” quote=”As time goes on, the number of new Bitcoin that miners are permitted to include in each block will decrease. At this point, the fees from the transactions will form the greater percentage of income from Bitcoin mining.” theme=”style4″]
So, why’s it called mining?
Well, in a way, Bitcoin mining resembles the mining of other commodities, such as gold or oil, for example. It requires a lot of effort and exertion, and is a slow, gradual process. This is deliberate; clearly it should not be easy to generate new Bitcoin, otherwise it obviously brings the value of the currency down. Also, the difficulty of solving the puzzle means that the rate of bitcoin generation remains steady from day to day.
How does the Bitcoin software prevent cheating?
Well, Bitcoin works within a blockchain. Each transaction that occurs creates one block in the chain. Individual blocks must contain proof of work to be considered valid. This is kind of like when you have to show your working out in a Maths exam. This proof of work is verified by other Bitcoin nodes every time a new block is received. The proof of work function used by Bitcoin is called ‘hashcash’, which is mega complicated. To learn more about hashcash and other proof of work functions, look here.
So what makes Bitcoin so great?
Firstly, as I mentioned, Bitcoin is a digital currency and thus requires no physical production or storage space in itself. It’s the mining machines that take up storage. The number of bitcoins that the algorithm will permit to be produced is limited, and – because it functions as part of a blockchain – is untamperable, irreversible, and anonymous.
It’s worth noting, however, that bitcoin is – of course – not the only cryptocurrency. What’s more, it’s not invulnerable to demise. Though it’s the kingpin of cryptocurrency right now, if a competitor currency, such as Litecoin, Peercoin, or Primecoin, develops a better algorithm than the Bitcoin one, any of those could take the lead instead.
Another downside comes with the anonymity factor. An anonymous currency is clearly going to facilitate illegal transactions, including tax evasion. It’s doubtful that this will be permitted by the powers that be!
It could go either way for Bitcoin. Those who invested before the cryptocurrency hit its current high are reaping monetary rewards, simply by hitting ‘Sell Bitcoins’ on the trading platform. But is the apex of value still ahead? And will cryptocurrency really be the currency of the future? Time will tell…