Bitcoin Economy Explained: What You Need To Know About Bitcoin Economics 101

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Let’s dive into the Bitcoin world. Initiated in 2008 with “Bitcoin: A Peer-to-Peer Electronic Cash System,” Satoshi Nakamoto’s paper, Bitcoin is the first crypto-currency widely accepted throughout the world as a means of exchange of value. The fear of central bank servers being hacked and the rage to the government to impulsively control the national currency made people believe in this hack-proof technology as a major medium to safely and without anyone spying on them. This is built on blockchain technology and therefore it is open, decentralized and public. Bitcoin operates on a straightforward set of rules.

We must know before we start today what determines the value of a fiat currency. In history, a nation’s currency’s exchange rate is mainly driven by the country’s gold reserve. Assume, for example, that both the United States and India have 1 kg of gold in reserve. If India prints Rs. 10,000 against its reserves, then the exchange rate between two currencies is $1=Rs.100. Similarly, any nation in the world that has its currency keeps gold in its reserve and sets the exchange rate of its currency. Printing more reserve currency to help the national economy devalues the currency. The balance is also rising, increasing the currency. Many other variables such as import-export and FDI also influence the currency exchange rate.

But when we speak about cryptocurrencies such as Bitcoin, some important questions need to be answered. Is there a fund to protect its value? If so, who’s keeping the reserve? If not, what determines the Bitcoin value? What factors lead to price changes for Bitcoin? Who decides what are the legal transactions? Who decides when to mine new Bitcoins? (Bitcoins are mined just as the money is printed. Consider bitcoin mining for the time being as printing new bitcoins).

It’s a digital platform, Bitcoin. We recognize that blockchain is a distributed network and has no central authority which can claim rights. Therefore, there is no advisory which maintains a gold reserve to support Bitcoin’s price because maintaining a reserve would essentially mean claiming currency rights. So where is the Bitcoin increasing its value? Okay, people’s trust and ability to own a bitcoin at a certain value determines Bitcoin’s price. Find Rolls Royce’s limited edition car’ Sweptail.’ There is only one of its type and has been sold to an unrevealed man for a whopping $13 million (call him X). The value of the car can, therefore, be considered as 13 million dollars. If someone named Y will buy the car from X for 15 million dollars tomorrow, the value of the car rises to 15 million dollars. The desire to acquire ownership of the car caused $2 million in an increase in the value of the car. Similarly, the price of Bitcoin increases depending on the confidence of the system’s people and their willingness to take over Bitcoin. The Bitcoin price is determined by a simple “demand and supply” model. Increasing demand and people’s confidence in the network have been two of the reasons for the sudden increase in bitcoin’s price to $19,000 between December 2017 and January 2018. Therefore, demand arises when people want to purchase more coins.

But what about the bitcoin supply? When are new Bitcoins mined and published into the network for circulation?

When explaining how a blockchain operates in the previous article, we saw that many nodes verify and include blockchain copies of the information in a blockchain network. Like the banks, these nodes verify our transactions by verifying whether we have the money that we want to pass and add the transaction to their blockchain copy (if valid). When at least 50% of network nodes verify a transaction, it is considered a transaction confirmed (i.e., the funds were transferred from the sender to the receiver’s account). Such nodes are known as miners and are mainly responsible for maintaining the Bitcoin Network through unconfirmed transactions.

But validating a transaction in Bitcoin is a heavy computational operation. A large number of computer resources (such as RAM and GPU) are used to verify network transactions. And that’s a lot of energy. The Bitcoin network rewards several bitcoins, which first confirms a set of transactions (also called a “block”) to support the expensive process of validating transactions. Such bitcoins are newly created coins that never existed previously in the network. This is how bitcoins are being mined in the bitcoin network (that is, created). Therefore, “mining” in Bitcoin means competing with other miners to verify a series of unconfirmed transactions, winning new Bitcoins. The mining rules are dictated by the algorithm “Bitcoin Consensus.” Understanding this algorithm right now is not so important, so consider it as a matter of course.

Side Note: Anyone on Earth can become a miner by simply installing Bitcoin core software and receiving the block reward. All you have to do to become a miner is run the “Proof-of-work” algorithm by a computer.

Therefore, when new bitcoins are produced, the supply of bitcoins increases. That, however, leads to unlimited supplies of coins as new transactions will always be made waiting to be validated when and when people use the network. And the law of basic economics dictates that something with an unlimited supply never has value for long. Satoshi has come up with a brilliant solution to solve this problem that has inflation in the value of bitcoin over time: the number of bitcoins awarded for mining a block must be halved every four years. This rule was implemented in Bitcoin software. In 2008, 50 BTC (Bitcoin symbol) is awarded to the miner for a block mining. In 2012, this award was halved to 25 BTC. 12.5 BTC have been awarded for each mined block since 2016. This year, in 2020, the award will be reduced to 6.25 BTC. This technique ensures that the supply of bitcoins remains limited. Knowing the consensus algorithm and using some math can verify that there can ever be around 21 million bitcoins in the system. As the demand for bitcoins continues to increase, the limited supply of bitcoins ensures that the currency’s value increases.

Half the price of verifying new transactions can however de-motivate miners to pursue the costly mining process. Continuing mining even with reduced rewards could result in losses for miners who joined the network to create more money. Satoshi has given the option of each transaction to include a transaction fee to avoid destabilizing the price of the currency and encourage new miners to join the network. For their transactions, users may include an optional transaction fee. These fee costs are close to the taxes we pay on credit cards. Miners earn these transaction fees for authentication of the transactions as an extra incentive.

But don’t forget that all this is sole because people trust and want to buy more, though it has no reserves to support the value of the currency as in the case of fiat currencies. Some economists argue that we can not trust the currency for this reason. You agree that any day could be a damning day for Bitcoin and there will be no authority or reservation to refund Bitcoin users that day. But it is people’s confidence in blockchain technology that helps preserve Bitcoin’s value.

Certain players such as the government, the payment gateway and the investors, to sell the currency in the future, as prices increase, also have an impact on the value of bitcoin. We’ve already covered a lot today so we’ll continue our conversation in future posts.

Something to think about: without a responsible authority for Bitcoin and no reserve to support the value of the currency, why do people still trust the system and invest heavily?

Is Bitcoin Legal?

Notice that no matter who claims that you can not use Bitcoin, its decentralized existence means that no one can stop you from using Bitcoin. As a general response, Bitcoin can be used everywhere with equivalent network access, while you have internet and electricity in some places, thanks to new satellite systems.

Nonetheless, countries have not stopped trying to limit bitcoin use within their borders. Several countries, including India, Bolivia, and Ecuador, have declared Bitcoin completely illegal. Some of them have also issued their digital currencies. Many countries, such as China, have over recent years changed their opinions on bitcoin, restricting and banning currency in various ways. China limited digital currencies only to private use by October 2018, banning any digital currency transaction for any financial institution.

The problem with banishing something like Bitcoin from a geographical region (which can not easily be censored) is that it is very hard to enforce such a ban. It is possible to try and discourage people from using Bitcoin by threatening them with some sort of consequences, but because Bitcoin is decentralized they can not prevent them. But in general, it is legal to send, receive, mine and use Bitcoin generally in most countries around the world.

Is Bitcoin Legal Tender?

The legal tender is defined as money that must be recognized as debt payment in the jurisdiction in which the payment is made. As Bitcoin is not accepted by any government as a legal tender, it can only be used as a currency if both parties agree to its use as a method of payment in a transaction.

New technology is often misrepresented and confused as in the early days of the Internet. Many countries in the first world, such as the USA, Canada and most of Europe, have taken the Bitcoin approach by not banning it outright but reluctant to regulate it as a legitimate financial technology.

Bitcoin is considered the gray line in these legal classifications. Regulatory bodies around the world have their legal definition based on what they think Bitcoin is. The problem arises when each regulatory body has its own opinion on the classification of the digital currency.

All these organizations have their reasons for classifying the digital currency as they are, but the fact that it is so many times classified differently shows one thing: none are willing to agree to define exactly what Bitcoin is.

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