Bitcoin: Questions & Answers

Bitcoin: Questions & Answers

You ask us a lot of questions about bitcoin. Here are some answers!

What is the difference between bitcoin and blockchain?

Don’t get confused with these two terms. While bitcoin is a cryptocurrency, the largest one in the world, blockchain is a technology that allowed bitcoin happen.

How is bitcoin’s value guaranteed?

The currencies we are used to – the USD, the EUR and so on – are referred to as the “fiat” currencies. It means that these currencies represent the debt of a national government. Cryptocurrencies, however, are not issued by any government. As a result, these currencies have no intrinsic value and are valuable only when exchanged with other currencies.

How does bitcoin mining work?

Bitcoins and other cryptocurrencies are produced through an operation called “mining”. In very simple terms, it involves the decentralized verification of bitcoin transactions.

Bitcoin is digital. People can send bitcoins to each other all the time. If there was no register of the transactions, it wouldn’t be possible to know who paid what. All transaction in bitcoin network during a set period of time are gathered in blocks and blocks are organized one after the other – in chains. This is where the word “blockchain” comes from. The function of miners is to confirm the transactions and put them in a public ledger.

This is a typical ledger people and companies use for accounting – it tracks money given and received by one entity.

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Now imagine a leger where all transactions of all people who use bitcoin are written – this is the public ledger.

For example, Peter buys a car from Mary with a bitcoin. In order to make sure Peter’s bitcoin is a real one, miners verify this transaction. So, to make sure Peter has his bitcoin, it’s necessary to look at the blockchain and see where did Peter get this bitcoin from.

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To make sure that the information in the chain of blocks is correct and no one messed with it, it is encrypted using the so-called “hash function”. The principle of hash works like this: all strings of data of any lengths are transformed into a sequence of letters of a fixed length called hashes.

Have a look at the picture below: there’s some info as the input. After going through bitcoin hash function called SHA-256, this input turns into hash. If we change the input a bit (ex. Add a dot at the end), the hash will change completely. This is how the information is encrypted in blockchain networks.

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To decipher the original data, it’s necessary to come up with a key that was used to create that hash. In other words, computers of miners (also known as “nodes”) have to discover a mathematical operation used to create hashes in a blockchain. To do that, nodes try various solutions until they find the right one. This is called “proof-of-work”: a system requires efforts from the participants in order to deter frivolous or malicious uses of computing power.

As soon as the key is found, it validates all transactions within the block and the block is pushed to the network and added to the blockchain. The participant whose software has found the key first gets to place the next block on the blockchain and claim the reward. All nodes receive the new block and continue producing proof-of-work for the next block (with the new transactions).

The amount of the reward for the discovery of a new block is agreed-upon by everyone in the blockchain network. Currently, it equals to 12.5 bitcoins. This value will halve every 210K blocks. A miner is also awarded the fees paid by users who send transactions. The fee acts as an incentive for miners to include the transaction in their block. 

As the number of miners increases, the time to make a new block declines. To make the speed of block’s mining more of a constant, there’s such thing as “mining difficulty”. A special target is introduced in the system and a hash used by a miner should be below this target value. Mining difficulty is a measure of how difficult it is to find hash which fits this rule. This parameter is recalculated every 2016 blocks to a value such that the previous 2016 blocks would have been generated in exactly two weeks had everyone been mining at this difficulty. It leads, on average, to one block being created every 10 minutes. So, every 10 minutes all the Bitcoin transactions in the world, no matter where they took place, get recorded into the public ledger and the next block is added to the blockchain.

Is Bitcoin a bubble?

As the price of bitcoin keeps skyrocketing, more and more people start wondering whether it is a bubble or not. By financial bubble one usually means an asset, the price of which shoots up by multiple times exceeding its real intrinsic value. Such disparity can’t last indefinitely, so the bubble inflates to some point and then a crash comes.  

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Usually, 4 stages of a financial bubble are distinguished: stealth, awareness, mania, and blow-off. During the stealth phase, the asset is cheap. Only so-called “smart money”, who well-informed and can understand the asset’s potential, invest in it. Then comes awareness: more and more investors start to notice the asset and buy it. Slowly the media starts to pay the asset greater attention. Mania means that the asset starts being everywhere. The asset’s price is high and it keeps growing, so even those who don’t normally engage in trading, decide to jump on the train. Yet, the fundamentals don’t actually justify the asset’s appreciation. Investors lose the ability to understand the market. At the final stage, the market, which has been racing, suddenly comes to a halt. Some trigger arrives and there’s massive attempt to get out of the market. A fall starts. Not everyone believes that it’s an end of an uptrend, so they try to buy when the price declines. Yet, these buyers get slashed and the asset’s price collapses dramatically to the levels close to those of the first stage.

Does this resemble what’s currently happening with bitcoin?

It’s quite easy to see the similarities. One just needs to have a look at BTC/USD chart and realize that bitcoin is on everyone’s lips now.

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Never the less, we would recommend you not to run to conclusions – and here’s why: bitcoin is a cryptocurrency, an entirely new class of assets. Given its nature, one can’t say with certainty that it will behave like the common assets we are used to.   

Winklevoss twins spent $11 million to buy bitcoins. Back then a bitcoin cost $120. Their wealth is estimated by 100K bitcoins. The brothers are considered the first to earn a billion dollars on bitcoin. In 2015, Cameron Winklevoss said that they had never sold bitcoin, it’s their long-term investment.

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How does bitcoin’s price form?

Bitcoin is traded on the market, so its price is based on supply & demand.

Bitcoin supply is limited. The total number of bitcoins in existence is not expected to exceed 21 million. According to bitcoin generation algorithm, the number of Bitcoins generated per block is set to decrease by 50% approximately every 4 years. Finite supply is one of the reasons why the asset’s price is going sky-high.

Demand is another big driver. A lot of bitcoin investors became such out of fear of missing out (FOMO). Many websites contributed to the rush with posts that a person who bought 250 Bitcoins in 2010 would have by now become a millionaire.

News flow is a great engine of the demand for bitcoins. If well-known companies and businesses start accepting bitcoins as a means of transaction, the cryptocurrency’s quotes move up further. Negative news can be about government regulations in various countries, bankruptcy or hacks of bitcoin exchanges, related websites, and services. In addition, Bitcoin falls when large players need fiat money and sell large quantities of Bitcoins to get it.

The most recent wave of interest in cryptocurrencies was driven by Initial Coin Offerings (ICO). ICOs are a new form of crowdfunding. Various types of ventures raise money by selling tokens for Bitcoins or other cryptocurrencies. Often an idea is enough to collect millions of dollars. These tokens grant investors access to a product or service that will be built with the money raised in the ICO. This option based on Ethereum – a cryptocurrency, but also a platform for apps – has broadened horizons for a lot of projects, but also gave scammers a way to attract funding and disappear. It seems that ICOs, which have gone rogue on a global scale, represent the main risk for cryptocurrencies’ ecosystem.  

How safe are investments in bitcoin? Can computer fraudsters create new bitcoins?

The fact that bitcoin is digital doesn’t mean that it’s easy to fraud. Actually, the situation is quite the opposite.

As we have pointed out before, bitcoin is based on the blockchain technology, which allows building systems of distributed ledgers, which are based on peer-to-peer networks of computers and do not have a central authority.

Even if someone creates a fake bitcoin, no one will simply accept it. The software is checking all the transactions and coin creation. In other words, it tracts history of every bitcoin. Technically it works like this: each block’s hash is produced using the hash of the block before it confirming that this block is – and every block after it – is legitimate. As a result, if you tried to fake a transaction by changing a block that had already been stored in the blockchain, the block would be instantly spotted as a fake.

Conclusion: to trade or not to trade?

If you decide to trade cryptocurrencies, you’ll need to take into account the fact that they are highly illiquid and extremely volatile. Low liquidity is what makes the market vulnerable to speculation: large players can easily manipulate the price. Cryptocurrencies have low correlation with other asset classes but are highly correlated among themselves. As the price of Bitcoin climbed, investors got interested in other cryptocurrencies.

In addition, it’s necessary to understand that buying a cryptocurrency is not like buying a stock or commodity futures. There’s something of a Wild West in the cryptocurrencies market. Dealing with cryptocurrencies involves a whole bunch of risks: risk of systemic & flash crashes, centralized exchange hacking, fork risk, mining concentration risk, regulatory risk, compliance & due diligence risks and many other risks.

As Bitcoin’s price is still more than 300% up from the start of the year, concerns that such surge is a bubble are shared by the majority of market players. According to the famous anecdote, American businessman Joe Kennedy once said: “You know it’s time to sell when shoeshine boy gives you stock tips.” And now you can hear about Bitcoins everywhere. The current situation is often compared to 17th-century Dutch tulip bubble or the weeks before the dot-com crash.

On the bright side, crypto market cap varies between $100 billion and $147.1 billion, which is commensurable to the market cap of McDonald’s. It’s a drop in the ocean compared with other financial markets, so a scope for further growth exists.

There are several things that may drive bitcoin “to the moon”. Blockchain technology is a revolution, which will lead to a better and a more efficient economy. Some experts compare it with the Internet and say that now that it is here it won’t go away. As cryptocurrencies are at the moment at the front side of the blockchain, it’s hard to believe that they will go down. The negative talk about bitcoin and its brothers and sisters comes mainly from banks and governments, which of course can’t welcome something that will deprive them of control over money supply and circulation. Yet, it’s not likely that cryptocurrencies will be banned in the entire world. The Bank of Sweden has already started investigating a possibility of turning national currencies into cryptocurrencies. 

That said, one has to understand that the market may be currently pricing in more than bitcoin has to offer. As a result, short-term investment horizon is a most sensible option when dealing with bitcoins – for now. Don’t be in a hurry to swap all your fiat currencies for bitcoins – nothing should be done in a hurry except catching fleas. At the same time, it would be bitter to miss all the fun and great profit opportunities bitcoin can offer. That’s why the best thing would be to set aside some of your money for trading bitcoin and other cryptocurrencies – this is the future!

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