Crypto Chronicles: Bitcoin 101 for Community Bankers

May 19, 2021

By Brian Laverdure

The payments industry is abuzz with excitement as one topic continues capturing headlines, with profound implications for community banks: Bitcoin.

As the original digital currency, Bitcoin has steadily climbed from obscurity to reach a total market capitalization of over $1 trillion. The lofty valuations, however, often come with precipitous declines—it is not uncommon for Bitcoin’s value to rapidly plummet in a matter of hours.

With digital currencies reshaping the U.S. payments system that community banks and their customers depend on, what exactly is Bitcoin and where did it come from?

Origins of Bitcoin

The story of Bitcoin started in the murky corners of the internet on Nov. 1, 2008. On that date, a person or group called Satoshi Nakamoto uploaded the original white paper that laid out the vision for a “purely peer-to-peer version of electronic cash” that would permit people to send payments without using financial institutions as intermediaries.

This new form of digital money depends on cryptography to secure transactions—thus the word cryptocurrency was born.

Bitcoin launched on Jan. 3, 2009 when Nakamoto created the first transaction block, now known as the genesis block. The block contained a message reading “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” that both serves as a time stamp and a criticism of the traditional financial system and the Great Recession.

Shortly thereafter, the first transaction occurred on Jan. 12 when Nakamoto sent 10 bitcoin to Hal Finney as a test.

Nakamoto continued to support the development of Bitcoin until posting a final entry on the Bitcoin Forum on Dec. 12, 2010, and final communications to the crypto community in April 2011. Nakamoto, whose identity remains a mystery, has estimated holdings of 1.1 million bitcoin, which have never been spent or transferred.

How Does Bitcoin Work?

Unlike the electronic payments that bank customers initiate with ACH or cards, Bitcoin transactions do not flow over traditional payment rails or require any processing financial institutions to complete the transactions.

New Bitcoin are not created by any central bank. Instead, they are generated through a process called mining.

Bitcoin does not exist as a physical object. Images of golden coins stamped with various Bitcoin symbols are simply artistic representations to help viewers understand or visualize the abstract concept of cryptocurrency.

Miners are engaged in a 24/7 race to bundle unprocessed transactions into blocks to add to the public ledger of all Bitcoin transactions, known as the blockchain, to receive transaction fees and newly minted Bitcoin as compensation for their efforts to maintain the network. The network relies on miners to process and validate all pending transactions and, most important, prevent users from spending the same bitcoin twice.

Nakamoto devised a clever solution to achieve consensus across the decentralized network and ensure that transaction processing requires enough resources to disincentivize miners from confirming false records. Miners must successfully complete challenging proof-of-work calculations that consume tremendous amounts of electricity to sustain sufficient computing power.

The proof-of-work equations become increasingly difficult over time, necessitating more powerful computers and more electricity. Bitcoin’s use of electricity is now controversial, with many critics, including Treasury Secretary Janet Yellen, calling it wasteful and harmful to the environment.

To initiate a Bitcoin transaction, an owner needs access to a Bitcoin address and a private key. The Bitcoin address, a hashed version of the public key, is like a bank account number that can be shared publicly. The private key is like a special password.

These are critical elements of a process called public-key encryption that cryptographically secures all transactions. All the “electronic coins” associated with a particular address are a “chain of digital signatures” because the number of bitcoins contained within any address always derives from the outputs of previous transactions.

A new transaction happens when the owner digitally signs a transaction message with their private key, which proves ownership of bitcoin associated with the address and secures the message before it is broadcast into the network for confirmation.

A private key should never be shared and should always be protected—losing a private key means losing access to bitcoin. Likewise, forfeiting one’s keys to someone else risks surrendering control of one’s bitcoin.

There are many stories of lost fortunes due to forgotten passwords, lost hard drives, or hackers obtaining private keys to steal cryptocurrency. Researchers estimate that 20 percent of all Bitcoin created to date may be permanently lost.

The Evolution of Bitcoin

Bitcoin has expanded beyond its mysterious origins to become a complex force for innovation in financial services that will ultimately have a dramatic impact on community bank operations.

There were an estimated 101 million unique cryptoasset users as of the third quarter of 2020, with 4 in 10 planning to use cryptocurrency within the next year. Other announcements, such as Coinbase’s initial public offering and PayPal’s expanded cryptocurrency services, signify that the digital currency industry is advancing toward a new level of adoption and acceptance.

However, important questions remain unresolved, including whether Bitcoin possesses the attributes to qualify as money or is instead a speculative store of value. Resolving this question directly affects the development of cryptocurrency policies and regulations.

Crypto Chronicles will examine this question more closely next month along with more on cryptocurrency’s direct implications on community banks. Meanwhile, don’t forget to follow me on Twitter for more news and perspective on cryptocurrency.

Brian Laverdure, AAP, is ICBA vice president of payments and technology policy.