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Understanding Bitcoin

Block chain based crypto-currencies are coming into fashion with governments, investors and the general public. For many, they nature of such currencies is challenging to understand because these forms of exchange do not have a tangible backing like metal or paper. Crypto-currencies are free of governments, bank fees and prying eyes. That is what truly gives these currencies value.

So the question is really: How do they work?

 

Core Mechanics

Crypto-currencies are just 1s and 0s of data. To be effective as a currency, they cannot be able to be copied or easily replicated. This is done by using an algorithm that encrypts the currency.

The core of crypto-currencies is a mathematic equation (algorithm) that must be solved to verify any currency exchange. The solution is called the BLOCK CHAIN and is used in successive solutions. This solution is verified but multiple computers, and once validated the best (shortest) solution is awarded some of the crypto-currency as a reward for the use of the computing power.

Every previous exchange of the currency is contained within the block chain. This encryption algorithm, such as Bitcoin uses, started small enough that it could be solved on a laptop. Over time, the block chain increased and more computing power was required to solve the equation. The size has grown so large that massive servers and unique hardware is sold to try to solve this equation and reap the rewards. Solving the equation is known as MINING.

The cost of mining is what defines the underlying currency fundamentals.

Currently, for Bitcoin, hardware has been developed for miners to keep up with the block chain. This is because inline dedicated hardware is the fastest way to solve the equation. Large teams of miners all try to solve the equations, pooling resources (computer power) and sharing the rewards. Any computer can solve the equation, but it is unlikely a slow computer will be able to solve it and win the reward. As the block chain increases, the old hardware becomes obsolete (too slow). Mining is a race, and the best hardware is most likely to win.

Bitcoin’s design has roughly 10 minute solution time per event. This means that the turnaround between the old solution and new one is roughly 10 minutes. This ensures that there is not sufficient time for dodgy dealing but there is enough time to challenge people mining.

Mining requires resources. This is the combination of computer power, electricity and a fast internet connection. Hardware quickly becomes obsolete, so calculations of feasibility are based upon computing power. This determines how long hardware will be competitive by estimating how probable it will be to find a solution.

The electricity costs become an issue at these speeds. These computers have to run constantly to increase their probability of solving the equation. These dedicated computers are using high levels of power (over a kilowatt - like a space heater). Faster computers require more power, and if that power is expensive it will offset the risk-reward spread. This is the spread between the reward, such as a single Bitcoin, to the effort and time required to yield a single solution.

As the price of Bitcoin relative to local currencies increases, then it is more feasible to mine the block chain. But as price drops, then the cost of hardware investment and power required are at best a break-even risk.

In some cases, even at a loss, it can be still worth mining. These could be people that want to laundering money by paying for electricity and yielding Bitcoins. Or someone that is using the computer as a heater that occasionally yields some return. There are also wildcat speculators with out of date hardware just taking a punt in the hopes of striking a reward.

 

 

 

Functionality

To use data as a currency it must be able to move from person to person. To utilize the currency, a storage system is required, referred to as a WALLET. Currency is then moved from wallet to wallet.

For Bitcoin, this wallet has a private key-code (SEED) that is unique to that wallet. The wallet has two address for money in and money out. These addresses are used to transfer the coins (data). That wallet’s seed number is then sent to the algorithm to be coupled with the exchange data into the block chain.

There is a high likelihood of the currency leaving the market over a long timeline. If a person loses their wallet, then those coins are gone from the market because it is unlikely that someone else will be able to crack the passwords of any found wallets. If the hardware holding the data is destroyed, there is no way to recover the data from another source (wallets are not designed to be copied).

 

Market Fundamentals

The thing that truly gives these coins value is their widespread use by the people of the world. As more people use Bitcoin, it will become more widely accepted as a medium of exchange. This will create a higher level of price stability relative to goods and services. This will encourage more people to utilize this currency which will create more stability.

Any currency is a faith based exchange. The faith is because a person must believe that the currency has a value. The value for gold is the effort to mine and refine that gold. The value for paper currencies is the faith that someone else will want that currency. Paper currency also has the problem of governments printing in excess and thus devaluing that currency.

For Bitcoin, the devaluation (currency expansion) is done by releasing coins to miners that have solved the equation. Bitcoin has also defined a maximum amount of coins to be released in the future, so eventually the Bitcoins will not be generated, only be leaving the market (strengthening the value of individual coins).

When the Silk Road was in operation, Bitcoin was widely used as a safe medium of exchange because it was easily moved and not able to be tracked. When that site on the Darkweb was shut down, Bitcoin lost much of the tangible value as an exchange. Other sites were started to continue the exchange of illegal dealings, and they use a wide variety of crypto-currencies including Bitcoin. Bitcoin is often used in these dealings as a safe medium of exchange and the most widely accepted crypto-currency.

Bitcoin is also a way to secure your wealth away from governments. As governments print money (devalue currency), citizens flock into Bitcoin as a safe haven play against such money printing. Because this currency can be transferred with only a cell phone, there is no way for governments to confiscate the funds in transit. Unlike crossing a border with cash or gold, transferring Bitcoins carries less risk. Because governments cannot track such exchanges, they also cannot tax such exchanges. Banks cannot skim percentages and handling fees from such exchanges, unlike a funds wire or simple foreign currency exchange. The most disadvantaged and impoverished use Bitcoin to transfer money and avoid excessive fees. This makes crypto-currencies useful as an every-man currency.

For now, fear of governments, collapsing markets and poor international exchange access will continue to create volatility in Bitcoin. This volatility is really just a gauge of fear in the markets but at a faster speed than a move in the gold price. For investors looking to secure wealth against governments in a very liquid form, Bitcoin will likely be the first choice.

 

Getting Started

The easiest way to get started is to download a Bitcoin wallet to your cellphone. This can then be filled through buying Bitcoins from a merchant. If you are trying to avoid being tracked, you can also buy bit coins from a dodgy guy in a park off of Craigslist. Once you have Bitcoins, then you can spend them at various places online or in the real world that accept this kind of payment.

 

References

Wallets:

http://www.coindesk.com/information/how-to-store-your-bitcoins/

https://bitcoin.org/en/how-it-works

Block Chain:

https://en.bitcoin.it/wiki/Block_chain

https://blockchain.info/wallet/bitcoin-faq

https://blockchain.info/

Mining:

https://en.bitcoin.it/wiki/Mining

https://www.weusecoins.com/en/mining-guide/

http://www.coindesk.com/information/how-bitcoin-mining-works/

Mining feasibility calculator:

http://blockchained.com/profit/

http://www.coinwarz.com/calculators/bitcoin-mining-calculator

https://bitcoinwisdom.com/bitcoin/calculator

http://www.bitcoinx.com/profit/

Bitcoin Wallet:

https://bitcoin.org/en/choose-your-wallet

https://play.google.com/store/apps/details?id=de.schildbach.wallet&hl=en

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