ELI5 Cryptocurrency: Understanding Bitcoin as a Layman

This article is Part 1 of the GenZ Money Explain Like I’m 5 (ELI5) Cryptocurrency series. This series was created with the intent to:

  • Help you understand cryptocurrency;
  • How you can make money from having cryptocurrency in your portfolio.
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Firstly, there are many cryptocurrencies you can buy today. The cryptocurrency space has evolved that anyone can build their own digital currency. This openness allows for interesting and innovative cryptocurrencies to be created.

Asides from Bitcoin, there are other cryptocurrencies like Ethereum and Litecoin! Each cryptocurrency has its own inherent benefits and features. Some cryptocurrencies are designed for the financial system or purely for memes.

For this article, we will be focusing on the first cryptocurrency ever created – Bitcoin.

Bitcoin has become more mainstream these days. Furthermore, I often see people and companies create fluff content about this topic with no actual value for their audience.

You have most likely seen people posting about Bitcoin hitting all-time highs, how this altcoin is the next Bitcoin, or how Bitcoin will replace all money, etc.

It’s great seeing this hype, and it’s an exciting opportunity we get to witness in our lifetime.

But, does anyone actually know what Bitcoin is?

ELI5 Cryptocurrency: Bitcoin is essentially electronic Monopoly money based on supply and demand; albeit, built with unhackable technology.

Yes, I know the statement above is an overly simplified statement. But, let’s go into a bit more detail…

What is Bitcoin?word image 1

As previously mentioned, the Monopoly money is essentially Bitcoin (BTC) used to buy and sell goods. However, Bitcoin is not denominated into various bills ($1, 2, $5, etc.) like regular cash but instead divisible to eight decimal points (e.g. 0.00000001 BTC).

One unique feature of Bitcoin is its limited and finite supply of Bitcoins in circulation. This feature is essential, as this is why some experts claim BTC can be worth up to $100,000! A fixed supply with increasing demand hugely drives up prices, which essentially follows the economic theory of supply and demand.

As of writing this article, approximately 88% of BTCs are in circulation or 18,500,000 BTCs out of a total possible 21,000,000 BTCs!

To give you a quick rundown of how BTCs are created, every time a Bitcoin miner mines a new block for the blockchain, BTCs are made.

What the heck are miners, blocks and blockchains, you might ask?

These buzzwords are what give cryptocurrency its distinctive advantages over fiat currency, which include:

  • Decentralization – no governing body to manipulate the cryptocurrency
  • Anonymity – all anonymous transactions are encrypted in an unbreakable code (hash)
  • Increased Efficiency and Speed – transactions are stored electronically and automated

This leads to the question…

How are Bitcoins Created?

To understand how Bitcoins are created, let’s take a step back and understand the technology behind Bitcoin.

What is Blockchain?

Blockchain is simply a public ledger containing blocks, which contain transactions.

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Simple, right? But what’s so special about these blocks? And how is this any different from any other ledger containing transactions?

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First of all, all of these blocks have been chained together with a hash. Each block is signed with a hash, a complicated formula applied to a string of input. In Bitcoin’s blockchain, blocks are signed with an SHA-256 hashing algorithm.

This SHA-256 hashing algorithm is essentially what makes Bitcoin unhackable. Not going into too much detail, but when a block is signed with a hash, the hashing algorithm is applied to the input. Reversing the output will render many different inputs, so hackers cannot manipulate previous blocks.

For example, we can create a blockchain with a hashing algorithm: word image 4

  • Block 1
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  • Transaction Details: “Stephen gives Deborah 10 BTC”
  • Signature Hash: 8463393894552f3118ce2bb3ad5ab0a9d78235ecf8497a8f787ddf61678c41e7

For the next block, the signature hash from Block 1 will be included with the transaction details rehashed for a new signature hash. This is how blocks are chained.

  • Block 2
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  • Transaction Details: “Stephen gives Bryson 2 BTC”
  • Previous Hash: 8463393894552f3118ce2bb3ad5ab0a9d78235ecf8497a8f787ddf61678c41e7
  • New Hash: 00374436d965b733a4605f193084fd84d0df120c22cf8d89647ad07e98197d25

Lastly, who hashes the blocks in Bitcoin’s blockchain?

Bitcoin’s clever programming has automated the signature hashes, and the block only needs to be verified with a nonce.

What’s a nonce?

A nonce is an entirely random string of numbers within the block. Therefore, individuals only need the previous hash, the transaction data, and the end hash to solve for the nonce.

The process of Bitcoin mining involves solving a nonce is called mining and done by Bitcoin miners. Miners use their computers to change the nonce until they have solved the puzzle. This requires a lot of trial and error.

Once the nonce is solved, the Bitcoin miner is rewarded with a number of Bitcoins and the block is added to the blockchain.

It’s a win-win for the Bitcoin miner and for the individuals needing transactions to be verified. word image 7

What Drives Bitcoin’s Value?

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So, what makes one BTC worth $10 or $1,000,000?

BTC can be of any value. However, its price is hugely driven by the market, and more specifically, supply and demand.

There is no accurate way to value a BTC, but increasing usage in our daily lives seems to be the true driver for the demand for BTC, and ultimately its price. I’ll be excusing mainstream media and their hype-driven headlines as another reason why BTC price is volatile.

In the graph below, the Number of Bitcoin Transactions is plotted against the Bitcoin Price. One insight from this plot is as Bitcoin is used more for transactions, the price of Bitcoin may increase.

Note, comparing the number of merchants accepting Bitcoin to Bitcoin price would be more representative of this theory. Unfortunately, there is not much data for the number of merchants using Bitcoin.

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Figure 1. Data Source: https://www.blockchain.com/

Again, I want to emphasize “Bitcoin’s price driven by usage” (represented by the number of transactions) is mere speculation, and this theory would need further research to confirm.

This theory is based on the US dollar strengthening in the early 1970s. The US dollar was strengthened after the US standardized oil sales in US dollars with Sauda Arabia, essentially forcing any country to sell oil to use their currency.

Similarly, Bitcoin may be strengthened if usage increases for more goods and supplies.

2. Inherent Benefits

Quoted from Warren Buffet, “Cryptocurrencies basically have no value and they don’t produce anything. In terms of value: zero.”

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Yes, Bitcoin is not a tangible or productive asset like a farm that produces cows or eggs. However, it has an inherent value that is beneficial to the economic system as it is a store of monetary value.

Cash is currently a store of monetary value for most transactions. But, irresponsible fiscal and monetary policies have heavily manipulated these currencies. For instance, Bitcoin usage has soared in Venezuela due to hyperinflation of the local currency.

What was the Motivation for Creating Bitcoin?

Before Bitcoin

To truly understand the motivation for cryptocurrency’s creation, it’s essential to understand the current monetary system and how it works. Before we had cash to buy and sell goods with, bartering was used for trading goods with people.

For example, if Sally, the sheepherder, wanted to buy some bread, she would have to trade one of her sheep for bread. But this is hugely inefficient, as what if the bread-seller didn’t want her sheep? The bread-seller would have multiple options. They could refuse to trade their bread for sheep, or they could sell the sheep for something else they wanted.

Extremely inefficient.

With time, people pegged gold as a form of monetary value to be stored. Instead of Sally paying the bread-seller with one sheep, she can sell her sheep for gold and then buy bread with that gold. Therefore, the markets evolved to use gold as a universal form of payment.

But this is still inefficient, as gold is not easily held.

Due to this issue, governments centralized gold reserves and issued currencies based on gold. As governments back their currencies by gold, they realized a new issue.

The global gold supply grows slowly.[1]

This issue hinders governments as they cannot increase the amount of money in circulation without increasing their gold reserves. In 1971, Richard Nixon took the US off the gold standard by declaring the US government would no longer convert dollars to gold at a fixed value[2].

Not going into too much detail, but taking the US off the gold standard has had many implications for the economic world and perhaps the main reason why Bitcoin has been created today. Many economic issues are prevalent in our economic system due to irresponsible fiscal and monetary policies. In the past several years, there have been countries that have gone through extreme economic collapses:

  • Venezuela’s annual inflation rate reaching an astounding 200,000% in 2019.[3]
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  • Zimbabwe’s relaxed approach in spending, while dealing with an inability to raise taxes due to angry protests, led to a currency crisis in late 1997.[4]

Fast Forward Today – The Need for Decentralization

With most currencies today run by irresponsible government fiscal and monetary policy, Bitcoin (the first cryptocurrency) has removed the central authority (government) currently in place of our economic system.

Thus, using blockchain technology, a decentralized monetary system has been created. This industry is extremely ripe with opportunity, as there is still much more development needed for us to use cryptocurrencies in our daily lives. For instance, you still can’t go to the grocery store and tap with your phone to pay with cryptos.

However, with the pace at which cryptocurrencies are being used, this may be sooner than expected.

Conclusion

Cream Beach Photo Pinterest Graphic 1 1

Well, that wraps up the first part of GenZ Money’s ELI5 Cryptocurrency Series, and I hope you have learned what cryptocurrency is, why it was created, and how it has a place in our economic system.

The next few parts will be much more interesting, as it will focus on how you can make money with cryptocurrency and a passive investment strategy you can employ. Stay tuned!

  1. Mental Floss. Why Did the U.S. Abandon the Gold Standard?
  2. History. FDR Takes United States Off Gold Standard.
  3. Statista. Venezuela: Inflation rate from 1984 to 2024.
  4. Reuters. TIMELINE: Chronology of Zimbabwe’s Economic Crisis.

Author

  • syao scaled

    Stephen Yao is a writer, ex-Deloitte financial engineer with expertise in the life insurance, pension, and capital markets industry. He lives in Toronto, Ontario, and writes about personal finance and career fulfillment.

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