Part 2: Bitcoin – The Problem it is trying to address

It is overwhelming to see people from different walks of life expressing interest in understanding the crypto-currency ecosystem. The response to the post ‘Genesis of Cryptocurrency Ecosystem’ was encouraging and I hope that today’s post lives up to the expectations set by the first one. This piece discusses the issues that Bitcoin is attempting to address and why it is relevant today. 

First, the basics – How a Bitcoin transaction works. The flow chart below is one of the simplest illustrations of how a Bitcoin transaction is made through multiple participants. The entire process is completed within minutes.

Illustration of a Bitcoin transaction:image001.png

Now, the question arises – What exactly is a Bitcoin? – Very broadly, Bitcoin is a cross-border payment network that allows you to transfer money from one country to another in a relatively quick manner with minimal transaction fees. Placing it in the local context, it’s similar to what Paytm is in India (The applicability of this parallel is limited to the payment gateway piece of Paytm’s business).

Broadly, there are three problems that we face today in case of a cross border money transfer:

1) High transaction fees: Retail remittance cost of transferring money from a G20 country is ~7.45%  (Source: World Bank)

2) Time for money transfer: If one uses regular money transfer services of someone like the Western Union, it takes a minimum of 24-36 hours to transfer money

3) Unviability of small transfers: If you transfer a minimal amount of say USD 100,  then the transaction will not be viable as the transaction fees will eat away most of your transactional money

In the light of this piece of information, the question that must be on your mind – So, what is the estimated size of the global foreign emittance market? – USD 52 Bn

image002.png 

Source: World Bank

The problem that Bitcoin is trying to address is to reduce the transaction fee charged in a cross-border money transfer which I would estimate to be ~USD 52 bn (Refer to the calculation above) and reduce the transaction completion time. The above number does not include merchant fees charged by Visa and MasterCard (Big Sharks).

Now, comparing global cost of remittances across countries vs Bitcoin Network

image003.pngNote: FY ending 31 March; Source: Worldbank, Bloomberg, Coindesk

What is the secret sauce that allows the Bitcoin Network to achieve rapid turnaround with low transaction fees? – The secret sauce lies in the technology behind the Bitcoin Network – ‘BlockChain’ or as the Bay Area Venture Capitalist call it ‘Internet 2.0’

image004.png

image005.pngThe blockchain is a shared, distributed ledger where all transactions of the bitcoin network are recorded in an open, accessible manner. The transaction is encrypted using a combination of Public and Private key. The entire network can see the Public key but will not be able to access the data till the time the Private key (which is the password) is plugged in. Since all the data is stored at one single place in a machine readable language, it becomes very easy to develop an algorithm to run a query across the entire database to yield a targeted outcome.  In case of a banking system, where a local bank ties up with a foreign bank, the transaction goes through multiple steps within the originating bank and the destination bank. This if often a long process that takes over 24 hours for completion. As a general principle, wherever there are multiple layers involved, the time taken to complete a task is much longer, and the incentive demanded by each intermediary in the process adds up to a large transaction fee.

Example – A (India) transfers USD 100 to B (US): In this case the computer algorithm will search the open distributed database to check whether 1) A’s wallet has sufficient money to pay USD 100 2) B’s address matches with the instructions given by A – If the two conditions are met, the transaction is approved. The beauty of Blockchain technology is that there is no single person approving this transaction. The transaction which passes through the entire network is authorised and approved by at least 51% of Miners (People who validate a bitcoin transaction through Algorithms) and the person who is first in the race,wins Bitcoins in return! That’s how a Bitcoin is generated.

The above procedure takes between 30-60 minutes to complete. In a nutshell, sender A incurs a minimal transaction fee (<1% ) to transfer USD 100 from India to US. The entire transaction is completed in less than 60 minutes thanks to Blockchain technology – where backend computing power helps achieve the complex tasks of verification, authentication, and final approval of a transaction in a few minutes. 

The speed at which a Bitcoin transaction is executed is made possible because all the data is stored in a centralised place in a machine readable language where algorithms solve complex mathematical problems vs. banks where data is stored in silos and no single bank has all the information required at a central, accessible place.

Closing thoughts: I would like to end by pointing out the key difference in transferring money via a Bitcoin Network vs Banking/Money transfer agent

 image006.png“Bitcoins will do to banks what email did to the Postal Industry” – Rick Falkvinge

Hope you enjoyed reading the post. Please like/share/comment. See you in my next post (Part 3) – What is Bitcoin Mining and the Economics behind the Bitcoin mining business


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