For the past few years, bitcoin – the original cryptocurrency launched in 2009 – has been on a roller-coaster ride of note, says David Lerche, senior investment analyst at Sanlam.
After dipping below $5,000 in March last year, bitcoin reached over $52 000 on 17 February following increased publicity after a tweet by Elon Musk that his car firm Tesla had bought around $1.5 billion worth of the digital currency.
Its current market capitalisation is around $960 billion. For many investors, what exactly bitcoin is and how it works remain an enigma – here’s what you need to know.
In our view, understanding bitcoin creates a foundation upon which to understand the rest of the cryptocurrency environment.
While different cryptocurrencies have varying characteristics, the first thing to know is that bitcoin is a decentralised currency, but unlike traditional currencies, it isn’t backed by any government.
Invented as a new way to transfer value over the internet without intermediaries like banks, bitcoin is backed by a decentralised ledger database and limited supply.
Bitcoin uses peer-to-peer technology, via an open network, to create an unalterable record of which account owns how many bitcoins. Unlike banks with different systems, bitcoin is a single, global ledger system, synchronised across the internet, where any participant can view the ledger at any time.
Bitcoin’s rules are set out in its source code, which, although freely available, is only understandable to software engineers. By having a distributed ledger, no single entity or group is able to alter the ledger.
Today, over 40,000 computers around the world independently verify every bitcoin transaction. So, in effect, bitcoin is a way to transact.
Blockchain technology is what underpins bitcoin and while bitcoin’s source code remains static, people are continually inventing new use cases for blockchain technology.
Eventually, we expect blockchain technology to underpin all global banking and financial transactions. The blockchain facilitates high-speed, low-cost, round-the-clock settlement of transactions. You can send bitcoin anywhere in about 10 minutes, while it takes days to transfer normal money internationally.
Perhaps the best way to think about it is as a form of digital gold. Bitcoin shares some key characteristics with gold: it’s untraceable, almost infinitely divisible, rare and not controlled by governments.
Like gold, bitcoin pays no dividends or interest, nor do you earn interest on your holdings.
Where it differs is that there is a clear, finite number of bitcoins that will ever come into existence: 21 million. After that, no more can be created. Currently, around 18.6 million bitcoins have been ‘mined’, or 89% of the eventual total.
Unlike gold, which has a 5,000-year history as a store of value and a medium of exchange, bitcoin has 12 years of history, during which prices have fluctuated widely.
New bitcoins are created through ‘mining’ when someone completes a successful authentication of a ‘block’ of valid new transactions.
In plain English, this means that the people (computers) who work to keep the distributed ledger system running and trustworthy earn a small transaction fee (paid in bitcoin) for verifying a block, in much the same way that the bank charges you when you transact in normal currency.
As the number of coins mined increases, so the rewards for doing so decline. The reward halves every 210,000 blocks, or about every four years. This means that the final bitcoin will likely only be mined around 2,140.
We know that the number of bitcoins in circulation will grow at a slower rate than that of ordinary US dollars, for example, so theoretically, the US dollar value of bitcoins should rise over time.
On top of that, just like gold that’s buried and lost, a material portion of all the bitcoins mined to date has been lost. More than 20% of the bitcoins in existence have sat unmoved in a…
Read More:Bitcoin: an investor’s guide