The most famous crypto assets, also called cryptocurrencies, are well known – some believing it to be the future of economic transactions. Among these cryptocurrencies is the most famous, Bitcoin. But what is Bitcoin? This article takes a deep dive into the main cryptocurrency.
Before we go further, let’s go over some characteristics to help better understand the operation.
Differences between cryptocurrencies and fiat currencies
History classifies currencies in three monetary systems: commodity currency, representative currency, and fiat currency. People’s need and willingness to negotiate have triggered new and easier ways to trade goods and services – rather than transport a product as a means of exchange between two other goods.
Currently, paper money has no stability, as in, no guarantee of real assets since the United States ended the direct convertibility of the US dollar to gold in 1971. In addition, more and more transactions are being done digitally, but in general, currencies linked by the national government are used.
Cryptocurrencies, unlike fiat currencies, exist only in electronic format and have no connection with any bank, government, or authority. Therefore, there’s no monetary authority that can create more cryptocurrencies due to government pressure.
The amount produced will depend on the rules of each cryptocurrency. This allows investors to buy the ones they consider safest, most likely to increase in value or any other purpose. The argument of independence is one of the characteristics that draw the attention of investors.
However, not all cryptocurrencies necessarily follow this logic. For example, you can create an asset of this category linked only to the dollar or a set of fiat currencies.
Cryptography and Bitcoin
One of the main problems is encryption. Since these assets are created only electronically, we must make sure that they cannot be duplicated as you would with a photo or file. If it’s copied and shared with another person, the digital asset would lose its value. Bitcoin, as the main cryptocurrency today, is the entry into the Blockchain, which records all transactions that have already occurred in bitcoins.
During a transaction, you’re not sending a file, but “writing” the transaction in a large “digital ledger”. For this, there’s a decentralized system that evaluates whether transactions are occurring correctly and ensures system security.
Simply put, the process occurs as if we were writing all transactions on sheets of paper, but only on digital sheets. To ensure the authenticity of transactions, a great deal of computational effort from other users is required.
All transactions are written in what is known as a ledger. For example, Sarah sent 1 Bitcoin to Hilary. Here comes the first part of encryption: digital signatures. With this, we don’t want any user to go through another and perform improper transactions.
Digital Signature: An Advantage of Cryptocurrencies
Each person who makes transactions with Bitcoins has identification numbers. The idea is that in the case of a transaction, a person “signs” attesting that the transaction is correct. If each subscription matches a number, wouldn’t it be possible to use someone else’s number to execute a transaction?
The answer to this question is no, this lack of system security would make its existence impossible. There is a pair of keys called private key (or secret key, SK – from Secret Key) and public key (PK) that have an important connection.
Although each individual has their keys, they are not placed directly as their signature: the person doesn’t sign directly – it’s generated – and for each message recorded in the ledger, it’s different. Your signature on a specific message is generated as a function of the sent message and its SK: each new message is linked to your secret key, so only your ID can produce a specific signature.
Since it also depends on the message you send, it doesn’t allow someone else to use the same signature in a different message. After signing, a check should occur. Imagine that we need to verify every signature. The signature is a function of the SK and the sent message, while verification is a function of the same two variables plus the PK. The scan, using the message and PK, would produce a true or false result, indicating whether a given SK could have generated that message.
The Bitcoin Validation Process
The path to the validation process of the cryptocurrency is, given the PK, to find the corresponding SK by trial and error. If the assumptions were completely random, there would be 2 ^ 256 secret key possibilities. It’s hard to imagine such a large value, but it’s worth trying: 2 ^ 40 represents approximately one trillion and 100 billion signatures.
We would still have to multiply the same number by 2 another 200 times to get the number of total possibilities. The person who received the assets can sign the transaction with their SK, but without revealing it.
It takes very powerful hardware for the whole process, which goes beyond the described above, and some were designed only to solve the related mathematical problems. Some machines cost thousands of dollars, consuming a lot of electricity. In short, the system verification process is what generates new cryptocurrencies for users.
Therefore, with so many users competing for verification, it’s becoming increasingly difficult to make a considerable profit from the process (there are online calculators in which you can enter the hardware, the price of electricity, and more to check if it can be profitable).
The Main Cryptocurrency As A Reward for Miners
Also, in the case of the main cryptocurrency, the Bitcoin values that miners earn in the process fall over time, and more checks are needed to obtain the same amount of assets. However, the process in which miners are rewarded with Bitcoins is more complex than just guessing the keys cited. This example gives an initial idea of the size of the “problem” that must be solved at the computational level.
Since every message in a ledger has a unique signature, we’ve seen that no one can copy transactions for the purpose of stealing. Another security in the system is that it doesn’t allow the transfer of more bitcoins than the user has. This is possible because all purchase and transfer history is stored.
In the case of the main cryptocurrency, each new ledger is added to a chain of ledgers, called Blockchain. Therefore, the main cryptocurrency is just part of a large notepad with all transactions already carried out. The difference is in the system of decentralized direct transactions between two users (peer-to-peer). For this to work, some users (miners) need to verify transactions.
An important question that still needs to be answered is how the system knows that the blocks and information that users receive are exactly the same. For this, we need some concepts, such as the function called cryptographic hash function and proof of work, discussed in the next article. It’ll explain the basis of what the system does to protect transactions and thus how bitcoins are mined.
When asked about cryptocurrency, it’s common for monetary authorities to be skeptical. One example is U.S. Central Bank President G. Powell. One of the points raised is the greater risk for fraud, because there’s no regulation or mapping of where crypto assets are, and whether this electronic asset may be being used for illegal activities.
With concerns on the part of the authorities, the investor should be aware of the changes in the legislation. In the U.S., for example, the IRS treats all encryption operations such as bitcoins, ripple, tokens, ether, and others as capital assets and taxes them when they’re sold at a profit. That means it’ll have to be declared to the IRS by the exchanges that trade them.
For example, let’s say you purchased $10,000 worth of Bitcoin in early 2019 and held it until late 2020, it would be worth something around $40,000 – which you take out to buy a Tesla. It means you would owe capital gains taxes on the $30,000 profit you’d realized upon transferring that amount of Bitcoin to Tesla. You may believe that you simply spent your Bitcoin—but for tax purposes, you sold your Bitcoin to Tesla at a profit (in exchange for a car).
No one is sure how cryptographic asset development will occur. However, announcements from famous companies and central bank discussions have drawn attention to the subject. Understanding how each of these assets work is the basis for decision-making in this investment class.
In this article, we covered the fundamental concepts of Bitcoin, the main cryptocurrency. Follow the Vector blog to learn more!