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Bitcoin: Its working, advantages and disadvantages

EXPLAINERS
By Patrick Vidija | September 7th 2021

El Salvador has become the first country in the world to adopt bitcoin as legal tender.

Although real-world experiment proponents say this will lower remittance commission costs for the millions of dollars sent to its citizens from abroad, critics warned this may fuel money laundering.

The plan spearheaded by President Nayib Bukele is aimed at allowing Salvadorans to save on $400 million spent annually in commissions for remittances, mostly sent from the United States.

But what is Bitcoin?

This is a decentralised digital asset designed to work in peer-to-peer transactions as currency, without a central bank or single administrator and can be sent from user to user on the peer-to-peer bitcoin network without the need for intermediaries.

Bitcoins have the three qualities useful in a currency in that they are "hard to earn, limited in supply and easy to verify."

How does it work?

The bulk of bitcoin transactions take place on a cryptocurrency exchange, rather than being used in transactions with merchants.

Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain.

Ken Gichinga, a chief economist at Mentoria Economics says bitcoin is simply a digital currency that was developed in 2008 due to a global financial crisis.

According to Gichinga,  this can be attributed to trust issues that had cropped up in the banking sector.

The system uses blockchain technology which is simply a series of connected databases talking to each other.

According to Gichinga, the system has stronger security features in that if one feature is corrupted the information remains the same.

Bitcoin is the monetary part of the entire process where it is mined in the digital world. It is generated when computers are given complex problems to solve.  The successful computer then earns a bitcoin. In other words, it creates value through work.

Decentralization

Bitcoin is decentralised in that it does not have a central authority or central server meaning its network is peer-to-peer.

There is also no central storage with a ledger. As a result, anybody can store it on their computer.

Also, there is no single administrator where the ledger is maintained by a network of equally privileged miners. Anybody can become a miner.

The additions to the ledger are maintained through competition. Until a new block is added to the ledger, it is not known which miner will create the block.

The issuance of bitcoins is decentralised meaning they are issued as a reward for the creation of a new block.

Anybody can create a new bitcoin address (a bitcoin counterpart of a bank account) without needing any approval.

Anybody can also send a transaction to the network without needing any approval the network merely confirms that the transaction is legitimate.

Regulatory warnings

Governments across the world have, in warnings emphasised, that trading in any cryptocurrency is often speculative and there is a risk of theft from hacking and fraud. 

In May 2014 the US Securities and Exchange Commission warned that investments involving bitcoin might have high rates of fraud and that investors might be solicited on social media sites.

The European Banking Authority issued a warning in 2013 focusing on the lack of regulation of bitcoin, the chance that exchanges would be hacked, the volatility of bitcoin's price, and general fraud.

The Central Bank of Kenya (CBK) has maintained bitcoin is a form of unregulated digital currency that is not issued or guaranteed by any government or central bank.

According to CBK, no entity is currently licensed to offer money remittance services and products in Kenya using virtual currency such as Bitcoin.

“This is to inform the public that virtual currencies such as Bitcoin are not legal tender in Kenya and therefore no protection exists in the event that the platform that exchanges or holds the virtual currency fails or goes out of business,” a circular from CBK reads.

CBK says transactions in virtual currencies such as bitcoin are largely untraceable and anonymous making them susceptible to abuse by criminals in money laundering and financing of terrorism.

Such virtual currencies are traded in exchange platforms that tend to be unregulated all over the world and consumers may therefore lose their money without having any legal redress in the event these exchanges collapse or close business.

Another risk highlighted by CBK is the fact that there is no underlying or backing of assets and the value of virtual currencies is speculative in nature. This may result in high volatility thus exposing users to potential losses.

Experts commend the bitcoin system for its security features that lockout fraudsters and middlemen.

Gichinga points out concern has been raised about the environmental implications due to the amount of electricity that is required for computers to process to mine the coins.

“The fact that the coin has a global acceptance through the digital wallet operations outside the banking sector where institutions like CBK cannot regulate imprest rates and its supply has seen volatility,” he said.

According to him, placing the production limit of the coins to 20 million is also another concern.

“As we speak, the production has hit over 16 million coins, so what happens when we hit 20 million. You cannot limit production of money where the population is still growing,” he says.

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