Understanding Bitcoins - 10th Grader Version

It had been long since Apurva and I had a chat. Last time it happened, it was after the announcement of implementation of GST by the government of India. But I received a call from her recently, curiously asking about the new Buzz words “Bitcoin” and “Blockchain” and how suddenly everyone wished that they had invested Rs. 100 in 2007 that would have made them Rs 2 Cr now. Is it the name of new currency? Who prints this new currency? How does it look like? Where can one buy this currency from? I was flooded with questions after a long time. “Woah, wait !! First of all, the terms “Blockchain” and “Bitcoin” are not synonyms. Let’s understand them slowly”, I started explaining her.

“Bitcoin” is so called Digital Currency and “Blockchain” is the underlying technology behind Bitcoin . Don’t get boggle down by these jargons, I am here to simplify them for you, I could see question on Apurva’s mind immediately. Let’s first understand how world operates currently when it comes to trades and transfer and then move to Bitcoins.

Take a simple example, you order a new mobile phone on Amazon with an online payment. When you make payment you are acquiring an Asset which is mobile in this case. When you make a payment online, you have payment gateways which encrypts the payment information you entered then transfers it to the bank based on information you entered, bank then verifies if you have the required the balance, validates the password/pin you entered and then approves the transaction. When everything goes smoothly the payment is done and you get a confirmation.

Take a another example, you want to transfer the Rs.10,000 which you owed to your friend from your ICICI bank account to your friend’s HDFC account using NEFT. In this case there are 2 different bank involved with RBI (NPCI) as the intermediary who verifies and validates the transaction and confirm whether the transaction was successful or not.

If you want to send $1,000 to your friend in US then it is again done through intermediary Banks who verifies the transaction using internationally defined standards.

In each of these examples you needed an intermediary which is typically a Bank or Government entity to validate/verify the transaction. Only sender, receiver and the intermediary are aware that transaction happened. How about if everyone in the universe knew about every transaction that happened in the universe?? Sounds interesting right?

That’s blockchain technology for you. “Blockchain” technology as per its architecture, when the transaction is made digitally over the internet, would create a copy of every transaction and it will be available for everyone. This will make world more transparent isn’t it? It will be difficult for people to cheat or do frauds since everyone knows what’s happening in the world.  Currently every country has its own set of regulation and limits for trades/transfers and with block chain that will no longer be required.

If you are still finding it difficult to imagine then you can closely relate it to torrent download you would have done J. They work on peer to peer transfer principle where you are downloading content which other people have on their PC. Similarly block chain works on distributed and decentralized approach and allows you to transfer/trade between peers without need of intermediary.

What about the verification/validation of these transactions? and what about Bitcoins ? , I wanted to know about Bitcoins and you are explaining blockchain here. Apurva was running out of patience.

“Your questions have the answer hidden in them”, I told her, I could see confusion on her face.

The verification of the peer to peer transaction can be done by anyone. And anyone who does this gets a bitcoin as a financial reward. “Oh!! Even I can verify the transactions and earn bitcoins?, asked Apurva. The answer to that question is Yes and No. Let us understand why.

To verify the transaction you will need a decryption key (Hence the name crypto currency) which is similar to a password or a pin which can be decrypted after solving a complex math problem associated to it. To solve this problem you need to have super computer with tremendous processing power. Since this is not everyone’s cup of tea, the term associated with it is called as “Mining of Bitcoin”. The one who solves the problem faster will verify the transaction first and will mine bitcoin as a financial reward. Imagine that many transactions happening and miners competing with each other to verify the transactions and find the key and mine bitcoin.

Obviously not everyone will be able to set up a strong processing system. So people like you and me can buy it from miners or people who would have bought it from miner. You can relate this to “Gold” which is also mined and you buy it using current currency you have. Hence more than currency you can consider Bitcoin as an Asset. In ancient time when barter system existed, people used gold and other commodities as currency and now we have moved on from them to current paper based currency. Bitcoins would be moving back to the ancient time with the difference being there is no physical presence and is available only digitally.

Currently the surge in the price is because of the demand of the Bitcoins and everyone wants to be part of the party. And as per the economic principle of supply and demand, if the demand is more compared to supply then price will increase and that’s what happening with Bitcoins.

“Is Bitcoin a bubble that is going to burst sooner than later?” question mark seemed to have gone away from Apurva face. The answer to that is, Could well be!! There are only 21 million bitcoins that can be mined and they are estimated to be mined by 2140, still 120 years to go. No one controls it currently. It is supposedly created by Japanese person whose identity could not be confirmed yet.

But any currency would derive its value from acceptance. Rs 500 note is just piece of paper if not backed by government/central bank and we all witnessed that on 8^th Nov 2016 on account of demonetization. Acceptance and regulatory backing universally are the factors that will decide future of Bitcoins and other crypto currencies. We ended the chat we a promise to come up with more frequent chats in future.