In one of our previous blogs
, we described how blockchain came to be. Today, we are going to go more in depth of why bitcoin, the cryptocurrency, was conceived and how it is leveraging Bitcoin, the network, to achieve a trustless money system. Let us first define Bitcoin, the network, upper case “B” and bitcoin, the cryptocurrency, lower case “b”.
Bitcoin, the network, is the network of computers, also known as nodes, that run the Bitcoin software and participate in verifying transactions and adding new transactions to the Bitcoin blockchain. Bitcoin software ensures that no one can create new bitcoins outside of the network parameters and that only users who truly own bitcoins can transfer them to other users. This is ensured through the Proof-of-Work consensus algorithm mentioned in the previous blog.
Satoshi and his predecessors ran into a practical problem while designing digital cash: why would someone run this software on their computer and invest their money and energy to repeatedly solve the cryptographic puzzles. Satoshi’s solution was to offer bitcoins, the cryptocurrency, as a reward to the nodes that create new blocks - groups of transactions. On average, Bitcoin, the network, creates a new block every 10 minutes. Only one node can create a new block by solving the cryptographic puzzle first. That node is rewarded with newly created (minted) bitcoins in the amount of block reward. Block reward was initially 50 bitcoins, but every 4 years the block reward is automatically halved. This process is known as the Bitcoin halving. At the time of writing, the block reward is 6.25 bitcoins. This means that the amount of bitcoins in circulation is increased by 6.25 approximately every 10 minutes.
Difference between traditional currencies such as the United States dollar or the Euro is that the inflation of bitcoins is programmatic, predictable, unchangeable and public so bitcoins have a limited total supply. There is no central entity that can decide to create new bitcoins, censor or block users from using the Bitcoin network or to manipulate the block reward. Block reward being halved limits the total amount of bitcoins that will ever exist to 21 million. Limited amount and predictability of inflation of a currency is what makes people compare Bitcoin to gold or other so-called, store-of-value assets.
“It might make sense just to get some in case it catches on. If enough people think the same way, that becomes a self fulfilling prophecy.” - Satoshi Nakamoto
These features of bitcoin, the cryptocurrency, caused early adopters to hold on to their bitcoins with expectations of future rise in value. Simple law of supply and demand states that if the supply of bitcoins decreases every 4 years and demand stays the same or increases, the price will go up. On May 22nd, 2010 first known real world use of bitcoins was recorded. Laszlo Hanyecz purchased two pizzas in Florida with 10 000 bitcoins. Pizzas cost about 40 US dollars at the time making bitcoins worth around 0.004 US dollars per bitcoin. Single bitcoin is worth around 16500 US dollars at the time of writing, meaning Laszlo paid 165 million US dollars for two pizzas in today’s valuation. May 22nd is famously known in the Bitcoin community as the Bitcoin pizza day.
Initially, bitcoins were valued with regards to the cost of electricity that was required to solve the cryptographic puzzle and receive the block reward, but as the network grew and more use cases were created, investors and financial speculators became interested in bitcoins.
Price of one bitcoin in US dollars over time
Price rise attracted new enthusiasts thus creating a positive feedback loop. To this day, the price of bitcoins is very volatile, meaning it can radically change in a short period of time and every investor should educate themselves and do their own research prior to investing in bitcoin or any other cryptocurrency.
As time went by, new blockchains were created with their own native cryptocurrencies. In most cases, a batch of new cryptocurrency is initially created (pre-mined) and sold to investors. This money is then used by a central entity to develop the new blockchain and its ecosystem. Usually, the goal is to eventually decentralize the control of the blockchain when the ecosystem is stable enough.
Most of these newer cryptocurrencies do not aim to create a replacement for the traditional currencies, but are rather aiming to utilize their native cryptocurrencies for some services provided by the underlying blockchain. This idea has been first put forward by Ethereum. Ethereum blockchain was launched in 2015 funded by a crowdsale or an ICO (initial coin offering) of Ethereum’s native cryptocurrency ether. Ethereum team led by Vitalik Buterin promised the idea of a programmable currency and “smart contracts”. These smart contracts would eventually enable additional functionality and decentralize not only the value transfer, but mediation between parties as well. Ethereum team raised 17 million USD in their ICO selling ether at a price of around 0.3 USD which enabled initial development of the project. Similarly to bitcoins, the price of ether coins skyrocketed in the following years and is currently valued at 1100 USD. Idea of ether coins is to be the fuel that runs the Ethereum network and enables smart contract functionality and all other transactions.
Huge success of Ethereum attracted the attention of many investors and financial speculators. People were looking for the following ICOs to invest in hopes of replicating Ethereum’s success. This culminated in 2017 when hype around cryptocurrencies was at its highest. This was the peak of the so-called “bull market” meaning the prices of cryptocurrencies soared higher than ever before. New projects sprung up every other day, it seemed, multi-million dollar ICOs were a common thing. Absolute record holder was a project named EOS which raised 4.2 billion USD in its ICO.
Unrealistic hype also opened space for many malicious projects and scams. Investors were simply catching a huge opportunity, or at least that’s what they thought. Late 2017 and 2018 was the time of severe losses for many projects and investors as the market deflated. Contrary to the bull market, cryptocurrencies were now in a “bear market” where prices are low and stagnating. Another bull market happened in 2020 and 2021, driven by innovations in decentralized finance protocols and non-fungible tokens, driving up prices of cryptocurrencies unrealistically high again.
At the time of writing, cryptocurrencies are in a bear market, as well as most other asset classes following the macroeconomic situation of the world. Nevertheless, blockchain space is bigger than ever, projects are being built out and new technologies are being developed every day. Most of the people see the crypto market as a speculative place to earn money quickly and easily and they disregard the potential that the blockchain technology holds.
In our next blog we will be discussing some of that potential, mainly newer consensus algorithms such as Proof-of-Stake.