As we saw in part one of the cryptocurrency series Bitcoin is the first mainstream example of cryptocurrency. Cryptocurrency enables a financial system and a money supply without the need for a centralised bank. Therefore the obvious question is: How are Bitcoins created? The answer is Bitcoin mining.
Decentralised banking system
As we saw in part one ‘What is Bitcoin and what is cryptocurrency?’, in the cryptocurrency open source system there is no need for a bank. Today, when a transaction is made the bank acts as a middleman to verify that the trade did indeed occur. In a cryptocurrency system every user has access to and participates in the verification of transactions. As such, there is no need for a bank. Consequently, no transaction fees, no regulation, no restrictions, and most importantly, anonymity.
In a centralised banking system where the bank acts as the middleman the bank also controls the supply of money. This means that overtime the bank can ‘print’ and introduce new money into the system. This has the effect of devaluing the currency over time.
The effects of monetary devaluation over time
Let’s say that you and I live in our own economy with our own currency supply. Unfortunately for you the supply of money is controlled by me. Our whole financial system consists of 100 GDBs (GreenDollarBills – like the name?!). Currently, I have half of the GDBs and you have the other half. However, you also have a job whereby you grow and pick apples and then sell them. Apples are sold for one GDB each. The only asset in our economy is apples and currently you have 100 of them. You can hold apples as a store of value over time. Each apple being worth one GDB.
Let’s say that a few weeks go by and you have sold me fifty apples. I now have zero GDBs and you have 100 GDB. However, I have 50 apples and you have 50. Currently in our economy one apple equals one GDB and measuring the whole economy 100 apples equals 100 GDBs. However, I decide to double the money supply by printing an additional 100 GDBs. What does that do to the value of your assets?
The introduction of 100 GDBs into the economy changes the dynamics. The whole economy now has 200 GDBs but the assets in the economy are still 100 apples. Therefore, one apple is now the equivalent to two GDBs where previously only one GDB was required. The price of each apple has doubled with my arbitrary introduction of 100 GDBs. Hence, the value of one GDB has in halved. Where previously, one GDB would have purchased an apple, now you need two.
Consequently, my actions and the additional GDBs has reduced the value of the GDBs that you currently hold. Whilst, this was through no fault of your own you have lost out.
Why Bitcoin mining is better than the current system of money supply
Quite simply, the Bitcoin currency supply is limited by its nature such that it isn’t possible to continually devalue the currency. Therefore, no one person has the ability to destroy the monetary value for other people.
Bitcoin mining is the ‘discovery’ of Bitcoins by computers solving complex mathematical equations. However, the mathematical equation isn’t simply for fun. It has a purpose.
Users of Bitcoin make transactions as explained in part one of this Bitcoin series. In Bitcoin mining the miners use computer programs to track these transactions within a pre-defined time period. This period of time is called a block. The mathematical problem confirms the transactions and writes the transactions into a shared ledger, another way of putting this is to say that the block is added to the existing ledger i.e. the blockchain. All miners have access to the blockchain.
Why would anyone start Bitcoin mining?
Bitcoin mining is paid work. The miners are paid for the work that their computers do.
What is the mathematical equation that Bitcoin mining solves?
The mathematical formula converts the transactions in the latest block into a code. This is a series of letters and numbers called a hash. Additionally, the creation of the latest hash related to the most recent block includes the previous hash as a starting point. Therefore, every hash is related to a previous hash.
The hash cannot be easily solved in order to identify the original transaction details. Furthermore, every single hash is unique. Any attempt to change any details in any of the transactions would affect every hash thereafter. As such, it is very easy to spot if someone has tried to alter something in the code as the latest hash will be wrong. Furthermore, all other miners would immediately be able to spot such tampering.
Bitcoin mining gets increasingly more complex upon each iteration. This is to create a natural limit such that there is a limit to the number of miners working. More powerful computers and software are required upon each iteration. A final natural limit on the number of Bitcoins that can be in existence ever is 21 million. This adds a natural fix on the money supply. Whilst, Bitcoins can be divisible up to 100,000 times, there is no risk of the currency being devalued by excess printing of money as in the existing monetary system.
The race to create the Bitcoin hash
All Bitcoin miners compete to create the hash to complete the recording of a particular block. As a result, the winning miner receives 25 Bitcoins. Furthermore, Bitcoin ledgers worldwide are updated for the new hash. Bitcoin mining keeps the blockchain truthful and regularly updated.