There has been a lot of attention paid to bitcoin and crypto currencies lately, but may people do not fully understand how they work and why they are worth money. I was actually one of those people, so I decided to dig into this and setup a wallet and miner and see what all the fuss is about.
So what exactly is it?
Crypto currencies are a peer 2 peer network, similar to what napster and filesharing programs used to be. However instead of being used to share mp3s and movies, all computers running the p2p software connect together to create, maintain, and secure a public ledger for the currency known as a blockchain. That blockchain contains highly encrypted transaction records that must be confirmed and approved by other peers on the network. So in a sense the users help to keep the other users honest.
So what is all the talk about mining?
Mining may not be the best term for what is happening here, mining is essentially the approval process for transactions to be entered into the blockchain. Say my friend sends me 20 dogecoins, a broadcast is made to all peers on the network that a new transaction has been made. All of the peers on the network that are mining will work to verify this transaction by determining it is valid by unlocking its encryption and verifying the contents. Once a worker can show proof of work that they verified the block it is broadcast to all the peers on the network, once all the peers accept the transaction and proof of work it is added to the blockchain and everyone moves on to the next transaction.
So in a way the mining is a verification system to make sure someone can’t just go give themselves a bunch of bitcoins or undo previous transactions in the chain, as the community of peers will not approve it.
So how do you get coins by mining them?
As transactions are entered into the blockchain, the first portion of each block is the generation of a new set of coins, as a reward for helping secure and verify the transaction you get those coins.
But I heard that mining gets more difficult, less coins are given as a reward, and there will eventually be no new coins, What then?
Mining is essential to the system, without it there is no verification and the system will fail so there must always also be an incentive for people to mine the coins. The original bitcoin documents state that the idea is to create a transaction fee, and eventually convert fully to where that fee is the reward and incentive to the miner.
So what makes these coins worth money?
There are exchanges where you can buy and sell bitcoins using other currency, much like you can exchange US dollars for Euros. While anticipating success in the platform people are paying more money for a bitcoin in anticipation that their value will go up. Currently a bitcoin is valued around 640 US dollars, that is simply what people are willing to pay for a bitcoin today.
Are there dangers with using bitcoins?
Yes, because it is digital it is your responsibility to secure your digital wallet. If its stored on your hard drive you have to have it backed up in case your hard drive dies. If you store it online with a web service that web service could fail, and both platforms can be susceptible to hackers.
How is this different than standard economies?
Bitcoin is decentralized, so there is no backing by a central bank, and it is unregulated by governments. It is very difficult to trace transactions witch make it able to be used for money laundering and crime. Think of it this way, the US federal reserve is the centralized bank that controls the US dollar. They employee many well trained people that control the US dollars value and the amount of money printed based on economic factors such as unemployment rates and economic growth. With bitcoin there is no central bank, there is only a static algorithm that determines how many coins are released to miners and that is already set through 2140 when new bitcoins will no longer be produced. It is not able to adjust to factors like unemployment rates, economic depressions, or population changes.
The design of the system was originally to take the power of creation of money out of the hands of centralized banks and governments, thinking that it can create a more stable economy. Since inflation and the amount of currency in circulation is predefined the system should be able to avoid financial crises. However opponents to the system say that an economy can not be based only on a static rate of money creation, and that a system that can not inflate and deflate to adjust to unpredictable human behavior will ultimately fail, and eventually create the exact financial crises that it is hoping to avoid.
What does the government think of this?
Some governments like China and Russia have banned the crypto-currecies in their countries. In the US the government has given several warning to deter people from investing in this system. The IRS has determined that they will treat bitcoins like property and not like currency in regards to taxes. So its more like owning a stock than owning money, but you will still be required to report and pay taxes on any capital gains from it. Though as I said before that is is hard to trace bitcoins, I am not sure how they could effectively audit and enforce accurate reporting of gains from bitcoins to the IRS.
So should I try to mine or buy some coins and get in on the action?
Like any other investment you should do your research and decide if this is correct for you. Is there a possibility for profit, yes there is. A bunch of people mined or purchased bitcoins when they were around $10 each, and they are nos worth $650 each. Those people made money. However the price could also drop if you buy now and you could lose just as much. The harder thing to determine is what to research. If you buy stock in a company to can research that companies profits, free cash, debt, etc and try to make a wise choice. As bitcoin is a peer to peer network it does not have these things. It is probably more tied to government acceptance, strength of the p2p network (how many miners there are, and how diverse they are), and its acceptance from retailers.
Mining is at this point not very profitable. I did it for a few days and earned about $0.16 worth of crypto currency. It cost more than that to power the pc that was doing the mining.
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