Understanding the Dynamics of Bitcoin
On October 31st, 2008, an anonymous figurehead, Satoshi Nakamoto, released a promising proposal for a Peer-To-Peer Electronic Cash System entitled “Bitcoin”. The system’s primary value proposition was the creation of a digitally scarce currency that could be traded with anyone in the world, at any time, without the control of a third party. Over the past decade, many arguments have been made whether or not Bitcoin’s current uses are still in line with Satoshi’s original proposal. Despite the community’s conflictions, the value of the currency has drastically outperformed every other asset class since its inception. Early quotes suggest Bitcoin was trading at an average price $0.003 on BitcoinMarket.com back in 2010. Today, even after enduring almost an 75% decline, Bitcoin has dwarfed it’s previous all-time-highs (ATHs) as it currently sits around $5,000 per BTC in April 2019.
Bitcoin has been one of the best investment opportunities within the past decade and continues to be so for keen investors. However, it’s an emerging asset with a laundry list of nuances which can take a significant amount of time to understand. As such, throughout this article we will explore some of the driving dynamics behind Bitcoin, the economic incentives within the system and what exactly makes it “work”.
What is Proof of Work?
In order for a decentralized system to function properly, the network must achieve consensus on all transactions that have occurred over the course of a specific period of time. With Proof of Work, “miners” provide computing power to solve cryptographic problems based on an underlying hashing algorithm (in the case of Bitcoin, SHA-256). All miners compete with one another to be the first to find a solution which can only be solved with an immense amount of calculations and a “trial-and-error” process. When a problem is solved, the first miner proposes the solution to the network while every other miner continues to solve it until a significant amount of the network returns the same solution. Once this occurs and the network achieves consensus, a block is created and transactions which have been validated during that time are recorded on a distributed ledger. A block records some or all of the most recent Bitcoin transactions that have not been stored in any previous block. Therefore, a block is like a page of a ledger or record book.
In short, Proof of Work is necessary for 3 reasons:
- To secure the network
- To validate the legitimacy of transactions (to avoid double spending)
- To incentivize actors for providing resources to the network
What Are Block Rewards?
To reward miners for providing computing power and securing the network from malicious actors, the network provides an autonomous incentive for good behavior. When solutions are agreed upon, they are publicly published in the form of a new block. The entity responsible for solving the problem is then rewarded for their efforts in the form of the blockchain’s native asset, which in this case is Bitcoin.
This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In (Bitcoin’s) case, it is CPU* time and electricity that is expended. -Satoshi Nakomoto
Block rewards are crucial for the long term security and stability of the network. Without block rewards and the incentives they provide, miners would operate solely out of good-will, a merit that can only go so far in a capital-driven society in which we live in today. In short, virtually all permissionless blockchains utilize some form of an incentive for participants to reach consensus and autonomously distribute a digital asset in return for securing the network.
*It’s important to note that nowadays, with the proliferation of ASICs and the rise in difficulty rate, CPUs are largely ineffective at providing hashing power to Bitcoin.
Difficulty Rate
Now that we’ve discussed some of the core tenants of how transactions are formally recorded on a distributed ledger in a decentralized fashion, here’s where things get interesting. A blockchain’s “difficulty rate” determines how hard it is to solve the cryptographic problems proposed by the network. Taking this a step further, the difficulty rate is adjusted relative to the network’s hashrate in order to have consistent block times (10 minutes for Bitcoin). As more computing power is added, the average number of calculations needed to solve and create a new block increases, ultimately increasing the difficulty of receiving a reward.
As difficulty rates increase, so does the cost of creating a block, and thus the value of the underlying reward.
In short, as the difficulty rate increases, the cost of production for miners increases. This process forces miners to improve the efficiency of their systems in order to return a net profit on the energy costs and the hardware they are providing.
The “Store of Value” Proposition
As the first widely recognized digital asset, Bitcoin has dominated in terms of value creation thanks to the first mover advantage. Despite this high level recognition, Bitcoin’s value proposition is inherently stronger than the majority of other crypto assets due to its substantially higher security, in the form of hashing power, relative to all other blockchains. Bitcoin has also been exceptional in value creation largely to due to its fixed supply and disinflationary monetary policy. As it is stated on the Bitcoin website:
“Bitcoins are created at a decreasing and predictable rate. The number of new Bitcoins created each year is automatically halved over time until Bitcoin issuance halts completely with a total of 21 million Bitcoins in existence. At this point, Bitcoin miners will probably be supported exclusively by numerous small transaction fees.”
Ultimately, Bitcoin as a disinflationary fixed-supply asset paired with its robust security creates an enticing argument for Bitcoin as a global Store of Value.
Conclusion
Understanding the driving factors behind Bitcoin and the surrounding economics can be tough. Here at Fitzner Blockchain Consulting, we want to help newcomers (as well as old) have a firm grasp of what’s going under the hood for the most prominent digital asset in existence today.
In our next article, we’ll be taking a deeper look at how changes to block rewards have affected Bitcoin’s price. While it’s difficult to draw direct correlations to what has caused increased demand for Bitcoin in the past, analyzing historical events such as block reward reductions allows us to draw some degree of indication for future performance.
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Writers: Cooper Turley — https://twitter.com/Cooopahtroopa
Lucas Campbell — https://twitter.com/0x_Lucas
