What is bitcoin and how does it work?
Can you imagine a thing — the value of which was zero around ten years back and today its value has touched almost 15 lakhs. I’m talking about bitcoin, that has recently touched its all-time high price point due to which it is being talked about in the market and the media again. So, I thought this would be the right time to make a blog on it and explain to you what Bitcoin actually is what and its history. Merely 12 years ago, on 31st October, 2008, a person named Satoshi Nakamoto published a paper on the internet. Satoshi’s main motive was clearly evident from the first line of the paper. “A version of electronic cash that would allow payments to be sent directly from one party to another party without going through a financial institution.” Cryptocurrency is a digital asset over which central banks or financial institutions have no control or regulation. For instance, the US dollar is controlled by the central bank of US. The Indian Rupee is controlled by the RBI but there is no central bank or any main financial institution that controls the bitcoins/cryptocurrencies. Back then, cryptocurrency was merely an idea in the mind of that person. But now, there is trading worth lakhs and crores on its crypto exchange just like shares are traded on the normal stock markets. In order to understand the paper of Satoshi and the context of cryptocurrency we will have to understand some concepts of our economic history.
Our financial systems are based on trust. The currency notes and coins have value in our society because they are guaranteed by the government and the central bank. Take a look at any note in the wallet. For example, a 200 hundred rupee note. It reads- “I promise to pay the bearer a sum of 200 hundred rupees.” This is a promise made by the Governor of the Central Bank, that is, the Reserve Bank. There is his signature right below. This note holds no value without this promise/guarantee, this note will be reduced to an ordinary paper if it does not carry this signature. There is a small, but interesting story in this context. After the second World War, America became the most powerful country in the world and the rest of the countries had to align their currency with the US dollar and what was the US dollar aligned with/guaranteed by? A reserve of gold. The actual value is that of gold or silver. But it is not practical to carry gold or silver around in your pocket. The currency notes were printed for convenience, but US did away with this gold standard back in 1971. After that, the central banks of the rest of the counties could print their notes as per their wishes. But what do cryptocurrencies ad bitcoin have to do with this. It helps you to guess how powerful the government and the banks especially the central banks of the country are as far as monetary policy is concerned. The fact of the matter is that when you deposit your money in the banks, you give the banks permission to play with that money, in one sense. Making use of these deposits, the banks give loans to companies and individuals. This is what fetches returns, that is, interest on the money that you have deposited. Very recently, we have seen that these banks use these savings and deposits in a very irresponsible manner. It happens quite often that banks give loans to big industrialists without performing adequate checks and then these loans become bad debts/NPAs and who becomes the victim in such cases? Depositors like US. In the last 15 months, three deposit taking institutions have failed — Yes Bank, PMC Bank and Laxmi Vilas Bank but even the decisions of the government can put the common man in danger. Do you remember November, 2016? Demonetization! The government laid to waste the 500 and 1000 notes in one single strike 86% of Indian currency became unusable. Those in favour of the Bitcoins and cryptocurrencies are so because they do not want the government or the central banks to exercise so much control over their money or currency. Do you understand the original idea/vision of Satoshi? Satoshi imagined Bitcoin as an alternate financial system which would be based on software technology and would be outside the control of third parties. You might be able to recall the Global Economic Meltdown of 2008 mega investment bankers like Lehman brothers had become bankrupt. Cryptocurrencies were born right after this scenario. Bitcoin was the first to arrive. And then many other crypto currencies surfaces — Ethereum, Litecoin and Ripple, in fact in the beginning of the year, more than 2000 cryptocurrencies were available on the internet. Let us move on to the main point now. How does crypto-technology work? If truth be told, in order to understand this, one needs to have knowledge of advanced mathematics and computer science — which I don’t have. But if you want to start investing or trading, then basic knowledge would suffice let us take the example of Bitcoins. There is one public account in digital form, of all the bitcoin transactions this is called a ledger. A copy of this ledger exists on all the systems that are a part of the Bitcoin network. Those that run this system are called “miners”. The job of the miners is to verify transactions. Say A has to transfer 2 Bitcoins to B’s account. Miners will have to confirm whether A actually does have 2 Bitcoins in his account or not. To complete the transaction, miners will have to solve a complicated mathematical equation. You might have studied about variables back in school. Every Bitcoin transaction has a unique variable. The job of the miners is to calculate it, it’s not that they sit with a pen or paper to solve the equations, all these calculations are carried out on the computers automatically because they are extremely complicated and their combinations run in crores which is why these miners require computers with very complex and high processing power. Once the equation is solved, the other computers within the network confirm it and this transaction is added to the chain. A block of transactions gets created and hence, the technology is called ‘block chain’. And what do miners get in exchange for this? They get the most valuable thing — bitcoins. This system is called ‘proof of work’. The miners have to prove the computation work they do in order to get awarded the Bitcoins in return. If all this explanation went straight above your head like a bouncer, then do not worry. Because understanding the philosophy, vision and future of crypto-technology is far more important than understanding the working of crypto technology. Now comes the question of how to use crypto currency and bitcoins. It is extremely important to understand that as well. Because on one hand, some people use bitcoins as an investment while on the other hand, some people use cryptocurrency as an alternative currency. A lot of people want to replace it with currency and use bitcoins in place of rupees and dollars but the main use of crypto currency at present is like an investment. We invest money in cryptocurrency hoping for a higher return in the future and hence get more money in return. This, then becomes a “store of value”, just like Gold. Just like we don’t use gold in our daily transactions but instead buy it and store it in the bank lockers like a guarantee to get more returns in the future because the price of gold keeps rising gradually. People do the same with Bitcoins and this is why bitcoins are also called “Digital Gold”. But just like any other investment, this too, entails risks. And those who criticize this as a form of investment say that bitcoin is a digital currency. It has no inherent value of its own, for example, you can physically touch the gold in your hands. If you buy a house as an investment, it will be physically available to you. Bitcoins, on the other hand, are not physical. Everything is happening on the computer. It could still be referred to as a ‘niche product’ that does not have a widespread acceptance in the society. Cryptocurrency is not yet a medium of exchange, that is, you cannot go to the nearby shops and buy bread and eggs with bitcoins but this trend might change in the future because there are several restaurants and hotels in the Western countries that have begun to accept Bitcoins as an alternative form of payment. This is a technical challenge here that makes it difficult to use bitcoins as a medium of in daily transactions. The Bitcoins transactions on the block chain take time to get confirmed. One block process takes around 10 minutes for the computers to calculate. So, you can understand that it is not practical to wait for 10 minutes for a transaction to get completed in daily life. But at the same time, there are some present-day cases for bitcoins where they work better than our traditional ways. The best example of this is our Foreign Funds transfer, when you have to transfer money from one country to another, the banks deduct a lump sum of foreign transfer fees, they charge a lot of fees and take a lot of time to transfer money from one country to another. The Bitcoins are more economical in this case. Bitcoins do not charge any transfer fees and ten minutes in a much lesser time as compared to the 1 to 2 days that the banks take. A similar thing applies to the credit card fees. Cryptocurrency can be more economical than credit card fees. This is why banks; credit card companies and remittance companies have been against the cryptocurrencies and are so even today because cryptocurrency can become a rival to their business model. In the last few months, especially due to the Covid pandemic, situations have changed. While several industries and mutual funds have been struggling the value of cryptocurrencies like bitcoins and Ethereum has been on the rise. From the 1st of March until November 30, the value of Bitcoin has risen more than 120%, that is, it has more than doubled in value. PayPal, the world’s biggest digital payments company, has introduced the feature of crypto transactions in November. JP Morgan Bank used to be the biggest foe of Bitcoins. When bitcoin was on a bull run in 2017, that is, when its price was rising exponentially, the CEO of JP Morgan had said that it was a fraud and now just a few months ago, JP Morgan has opened corporate accounts for famous crypto exchanges like Coinbase and Gemini trust. So, you can see how the doors that had earlier been shut for cryptocurrency have now been opening up. An open mindedness is being observed with regard to cryptocurrency in the general public and the financial industry. Talking about India, a change of attitude has been observed this year in India as well. In April 2018, the RBI had frozen out the crypto industry from the banking system. The RBI has instructed the banks via a circular to desist from dealing in crypto related platforms or transactions. The mainstream media had claimed that RBI had placed a ban on cryptocurrency but it was technically inaccurate to say so cryptocurrency had never been directly banned in India. RBI had merely blocked the banking access of the crypto ecosystem the result of which was that the public could not deal in INR that is, in Indian Rupees on the crypto platforms. The banks treated the crypto platforms with lot of harshness. With the problem accounts frozen, they were not able to pay their employees or pay rent to their landlords. So, a question arises: Why did the RBI do this? The reality is that the cryptocurrency has some negative points as well that are mainly related with money laundering and security. In the dark web on the internet, the people had started accepting payment in Bitcoins for buying weapons and drugs. It became very difficult for the law enforcement agencies to track transactions because they were outside the traditional financial system. Issues related to hacking also surfaced. Another reason is that any one can come up with their own cryptocurrency. This is why, a lot of bogus and fraud companies took money from the public with a promise that once trading started in that particular currency, the value of their money would double/triple so they claimed that the money invested would double/triple. A person named Amit Bhardwaj came up with a similar fraud crypto scheme by the name of “Gain Bitcoin”. There is an allegation of a fraud of 2,000 crore against Bhardwaj. Bhardwaj claimed that he had “mining farms” in China. That is, a place where several computer servers were solving equations and said that the bitcoins that were earned as a result of mining operations would be given to the investors as returns. But all his promises were hollow. He took money from a lot of people and fled India, there were such allegations on him. Finally, on April 2018, he was arrested. As per the latest update, he is out on bail and the case is pending in the courts.
So, due to reasons like this, here was a negative bend of mind regarding cryptocurrency and bitcoins and in response, the RBI took the decision to imposing a banking ban on crypto. Crypto exchanges i.e., platforms where you can invest in cryptocurrency and convert rupees into bitcoins had been operational in India since 2013. Some exchange founders decided to challenge the banking ban in courts. In was only a matter of their livelihood, but also a matter of principles. They got a chance to explain how the crypto technology and blockchain works to the government and the RBI. They were of the opinion that the negative points pertaining to cryptocurrency are also valid on other asset classes as well. They can be money laundering over property, fake notes can be printed, there can be money laundering there as well. There are many fraud schemes that operates in a lot of other things. The software of banks or stock exchanges can also be hacked. There are chances of that as well. So, the problems that exist with Bitcoins exist with other things as well. In response for this, the reputed Indian platforms included a lot of safeguards. For example, KYC process was made mandatory during sign up. The case reached the Supreme Court. Several famous senior lawyers refused to fight the case because there was a lot of negative news regarding the cryptocurrency in the media. A lot of rumors were afloat as well. There were adjournments. Some exchanges were not able to survive during this time and consequently, they had to wind up. Finally, a three-bench judge heard the case in January 2020 and the court accepted the stance of the exchanges and conceded that the ban of the RBI was “disproportionate” because RBI was not able to prove in the court that the crypto investments and trading had negatively hampered the financial systems or banks. Under Article 19(1)(g) of the Indian Constitution, it is the Fundamental right of every citizen to indulge in any business/occupation or trade. The court said that the banking ban imposed by the RBI was interfering with this fundamental right. This is a huge thing because it is no ordinary thing to defeat the RBI in court. Therefore, it was a historic day on 4th March for the Indian crypto industry. The court clearly declared that there is no legal prohibition on cryptocurrency trading and investment. This business is legal and the RBI would have to repeal its banking ban. Overall, this is good news for all of us. We are freely invested in cryptocurrencies, if we wish to, we have this opportunity to diversify our financial investment. You can invest some money in cryptocurrency as an experiment. After the decision of the Supreme Court, several exchanges have burgeoned and this process has become extremely straightforward and easy in India. One of these is Coinswitch Kuber, an app on which you can deal in more than 100 cryptocurrencies. More than 7 lakh users have signed up on Coinswitch Kuber within 6 months and their safety measures are also extremely stringent. The Aadhar and PAN of the customers are verified and the minimum investment allowed is of 100 rupees- all without any fees. Furthermore, rupee withdrawals are instant. That is, there is no problems of lock ins. These days, crypto investment has become as easy and painless as online food ordering. This will become evident upon seeing the clutter free user interface of Coinswitch Kuber. Of course, you will have to follow some rules of common sense. For example, do not trade by taking loans from Banks or others. If there is a need for you to take loans, to invest in cryptocurrencies or bitcoins, do not do that. Then, this is not for you. Only invest that much money that you are comfortable losing because this is an extremely risky investment. The price of the cryptocurrencies fluctuates a lot and it is extremely volatile. You risk appetite and investment goals decide whether you want to play a short term or a long-term game. Overall, it can be said that cryptocurrencies and bitcoins could play an important role in the future of finance. It remains to be seen whether cryptocurrency can become a medium of exchange that will be subject to widespread use or will it remain a store of value investment? Will you be able to buy bread and eggs from your nearby shops with bitcoins in the future or will it not be possible? That day might be very far but it cannot be ruled out as impossible that easily.