Bitcoin: Rewards and risks

Bitcoin is "a purely peer-to-peer version of electronic cash" which allows "online payments to be sent directly from one party to another without going through a financial institution".

Bitcoin is a completely digital currency which does not exist in physical form. It has no use value, but has high exchange value even though it is not recognised as legal tender in any country of the world.

Bitcoins allow for nearly instantaneous global transactions, with very low transaction costs. Unlike conventional currency, Bitcoin is not owned, issued, verified, or controlled by any central bank or financial intermediary. Instead, Bitcoin is owned by the people who use it for transactions, and who hold it as a store of value.

Bitcoins are issued by the Bitcoin network and the supply of bitcoins is designed to grow at an exponentially decreasing rate, with an upper limit of 21 million bitcoins.

A Bitcoin transaction starts with a Bitcoin wallet which allows users to send, receive, and store Bitcoins. A Bitcoin wallet is a software that can be used online, through a computer, mobile phone or tablet, or through a dedicated hardware device.

Every Bitcoin wallet is protected by a secret number or private key, which is required to authorise Bitcoin transactions just like a pin number is required for a debit card.

Once a Bitcoin transaction is authorized through the digital signature of a private key, funds are ready to be transferred to a recipient through an anonymous public key. The anonymous public key or Bitcoin address is just like a bank account number, so every Bitcoin transaction is a transfer of value between two anonymous Bitcoin addresses.

The fundamental problem, however, is that if bitcoins are transferred directly from one individual to another, then the recipient has no way to be sure that the sender did not already spend the bitcoins elsewhere and is simply offering fabricated bitcoins. This is known as the problem of double spending.

Bitcoin was the first digital currency to resolve the problem of double spending without having a third party. Bitcoin achieves this remarkable feat by utilising a decentralised worldwide peer-to-peer consensus network of people using an open source software over an innovative internet protocol.

Bitcoin advocates "an electronic payment system based on cryptographic proof instead of trust". Therefore, rather than having a trusted central authority that checks every transaction, Bitcoin has a peer-distributed timestamp server which creates computational proof of the chronological order of transactions.

The global Bitcoin network has an army of "miners" who validate each transaction in a chronological public ledger called a "block-chain". Each miner who validates a "block", or a record of transactions, is incentivised with a reward of bitcoins for expending their computing power and electricity. Validation of each transaction involves cryptography which is computationally impractical to reverse for an attacker.

As long as the majority of the miners in the Bitcoin network are honest, the entire system is secure. Moreover, it has been shown that as a block-chain becomes longer, the probability of an attacker or group of attackers being able to compromise it decreases exponentially, as long as there is a majority of honest miners in the network.

Since all Bitcoin users agree on a single chronological publicly available history of all Bitcoin transactions, each Bitcoin recipient is assured by the Bitcoin network that the sender is not cheating by double spending.

Bitcoin offers many important advantages which makes it very attractive as a currency. Bitcoins users are totally free to carry out transactions in bitcoins anywhere in the world, at any time, with anyone they want.

Since it is a single global currency, there is no need for exchanging currencies across borders. Moreover, because of the absence of financial intermediaries, the transaction costs of bitcoin are extremely low. In fact, transaction fees are optional and are only intended to speed up the transactions.

Bitcoin transactions are secure, irreversible, and permanent and all historical records are publicly available. Freezing Bitcoin addresses is practically useless since new Bitcoin addresses can be created instantaneously. The supply of Bitcoin is steadily increasing and is capped to an upper limit of 21 million bitcoins. This means that Bitcoins are immune to domestic monetary policies of countries and international financial regulations.   

In terms of privacy, there are big differences between conventional banking and Bitcoin. Firstly, each anonymous Bitcoin address is usually used for only one transaction and every Bitcoin wallet can create as many addresses as required. Therefore, a Bitcoin address does not uniquely identify any individual as a traditional bank account number would.  

All Bitcoin users can see every transaction, but they only see the anonymous Bitcoin addresses, the amount of funds transferred, and the time at which the transaction took place. This is comparable to the information released by stock exchanges, where the general public can know the time and size of each trade without knowing the individuals involved in trading. Thus, Bitcoin offers a level of privacy which is similar to cash, and a level of convenience similar to electronic money.  

Nevertheless, there are still many problems and risks associated with Bitcoin. Firstly, Bitcoin is still a relatively new currency and is therefore limited in its degree of acceptance. Therefore, at present Bitcoin cannot replace conventional currency completely. Even the most avid Bitcoin enthusiast would still be compelled to use ordinary currency from time to time, due to the limited acceptance of Bitcoin.

The price of Bitcoin is extremely volatile, and is subject to incredible booms and busts. In fact, bitcoin.org itself does not recommend saving more value in bitcoin than you are ready to lose completely. The price volatility problem of Bitcoin is a strange dilemma.

If more people accept and use Bitcoin, then the prices will eventually stabilise. However, since the prices are not stable people are reluctant to adopt Bitcoin.

Syed Yusuf Saadat is a Research Associate at Centre for Policy Dialogue (CPD)