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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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In the last video, I talked about how Bitcoin transactions are really incorporated into a global and a publicly accessible ledger of sorts that we call the transaction block chain. And this work is actually carried out by nodes in the Bitcoin network that are known as Bitcoin miners. And as a reward for all that effort, especially since some of the computational heavy lifting is done by these Bitcoin miners, they're basically awarded a certain number of Bitcoins for their efforts. And this happens by the miners effectively constructing what's called a coinbase transaction, and then basically assigning themselves Bitcoins within that transaction. So in a sense, then-- and this is kind of intriguing-- Bitcoins are effectively generated almost out of thin air during this process. And of course, if you see something like that, that might raise in your mind the question of whether there is ever an upper limit to the Bitcoin money supply. And fortunately, the answer-- or maybe not so fortunately, depending on your viewpoint-- the answer to that question is actually yes. And the Bitcoin system is actually designed so that there can be at most 21 million Bitcoins ever generated. OK, so that's the maximum number of Bitcoins that can ever come up in the system. Beyond that point, no more new Bitcoins will ever be accepted or generated, or allowed to be generated. And so as a result, nodes at that point-- from that point onward, once 21 million Bitcoins have been generated-- nodes will no longer get a reward for augmenting the transaction block chain. The Bitcoin miners who do all this effort are not going to get a guaranteed award for doing that effort. And keep in mind that, because every transaction in the Bitcoin system is public, and the nodes in the system actually know how many coins have been generated, it's possible to really enforce these limits on the total number of Bitcoins created. Now there are actually two points I want to make regarding this particular limit. So first of all, even after it's reached, we're still going to need nodes to do what Bitcoin mining nodes do today. So that involves things like incorporating transactions into transaction blocks, and incorporating these transaction blocks into transaction block chains, and so on and so forth. But if you think about it for a moment, once the 21 million coin limit is reached, these nodes don't get that automatic reward of Bitcoins for performing this extra effort. And now you might be wondering, well, what incentive is there for these nodes to engage in this additional effort? I mean, why are they doing this sort of thing if they're not going to get Bitcoins as a guarantee for doing that work? And really at this point, the hope is that, when we reach the 21 million Bitcoin limit-- or as we get closer and closer to it-- that actually transaction fees will play a more prominent role in a node's decision to be a Bitcoin mining node. And in particular, the idea here is that we hope the transaction fees will be enough of an incentive, and more and more people will-- in general, I think, hopefully, by this point-- will be using Bitcoin. And so as a result, I think there is an expectation-- or it's not unreasonable to think-- that as more and more people use Bitcoins, there will be more and more transactions, and as a result, more and more opportunity to make money off of transaction fees. And it turns out that in the context of Bitcoin mining, a lot of the heavy lifting is in this proof-of-work piece, not in being able to incorporate all these transactions into a transaction block. So even if there's a lot of transactions in the transaction block, it's not that much more effort for the miners to really incorporate those extra transactions. But if they're getting all these extra transaction fees, then that might be an incentive for them. It's also worth noting that transaction fees are actually set by the payer in Bitcoin. The payer, then, is going to have the onus of setting the fee appropriately, so that the nodes in the Bitcoin network are incentivized to add that payer's transactions to their transaction blocks. So hopefully that makes some sense. The second point I want to make, regarding this limit of 21 million Bitcoins, is that really Bitcoin does allow for fractional coins. And I haven't really talked much about that in this video series. I've really implicitly talked only about the idea of coins being these whole entities, like Alice transferring 10 coins to Bob, or 25 coins to Bob, and so on. But it turns out you can actually have coins that are fractional. And in fact, the smallest possible unit in Bitcoin-- it's a very small number-- it's 0.00000001 Bitcoins. And this is 1/100-million of a Bitcoin. And this actual-- this unit, by the way, just as an FYI-- is known as a Satoshi. And this name actually comes from the name Satoshi Nakamoto. And Satoshi Nakamoto is the pseudonym of the inventor of Bitcoin. Nobody actually is sure that there is somebody actually named Satoshi Nakamoto, but as far as anybody can tell, the only person who's ever taken credit for the invention of Bitcoin is this Satoshi Nakamoto name. And it's unlikely there's actually a person behind that name, but it's more likely maybe some type of a group, or something of that nature. Now, aside from that, there are actually a couple of other additional controls that I want to mention, that are built into Bitcoin for keeping the growth of that money supply in check. So first of all, the reward provided to Bitcoin miners actually decreases over time. And if you were aware-- when Bitcoin began, which was around January of 2009-- at that time, the reward for a Bitcoin miner to do their effort was 50 Bitcoins. Now, the way that the reward structure is set up is that every 210,000 blocks-- so when you get to a 210,000-block period, every time 210,000 new blocks are generated-- the reward size actually gets cut in half. And so what that means is that once 210,000 blocks are generated, the reward goes from 50 Bitcoins to 25 Bitcoins, and from 25 to 12 and 1/2, and so on and so forth. Now, it does take approximately 4 years to generate 210,000 blocks, and I'll talk a little bit later about where this 4 years numbers come from. But as of right now, I'm recording this video-- it's May 2013-- the current reward is actually no longer 50 Bitcoins. The current reward now is actually 25 Bitcoins per mining operation, and it's going to go down half in approximately 4 years. And that's just going to keep happening, until-- the estimate is around the year 2140. So in the year 2140, we will expect that the entire Bitcoin supply will have been generated. So we're not going to-- it's unlikely we'll be generating Bitcoins after 2140. 2140 is the point at which all Bitcoins will have been generated. Now, the last way to limit the generation of Bitcoins is to actually calibrate the difficulty of solving that proof-of-work protocol at a global level. And so I also want to point out that another functionality that Bitcoin has built into it is that for every 2016 blocks that are generated, the network basically estimates the time that it took to generate those blocks. It looks at how long did it take to generate the first of these blocks, and how long did it take to generate the last of these blocks, and it measures that amount of time. And if that amount of time is-- let's say it's something that's significantly bigger than 2 weeks. So if it's significantly bigger than 2 weeks, then the proof-of-work protocol will be simplified. But we're going to calibrate it so it's easier to generate blocks. On the flip side, let's say it took a lot less than 2 weeks to generate these 2016 blocks. In that case, the proof of work will be again calibrated to be made more difficult. And the goal is that we want it to be the case that, of 2016 blocks, we want it to be the case that it takes about 2 weeks to generate these blocks-- about 14 days to generate 2016 blocks. And to get a better sense for why that number is the way it is, you could see that-- let's say it takes about 2 weeks to generate 2016 blocks. What that actually will imply is that it takes about 10 minutes before the proof of work is actually solved, and a new transaction is-- or a new transaction block, rather-- is folded into the overall transaction block chain. And you can actually work out that if you-- if it took 10 minutes to validate, or to come up with one new block in the system at a global level, and you multiply that by 6 to get the number of blocks generated per hour-- so you'd get 6 blocks per hour, or really 6 new proofs of work per hour, which in turn would lead to 6 new transaction blocks per hour-- you multiply that by 24 hours per day. And then you multiply that by 14 days, and you'll actually find that when you multiply these things together, you will get the number 2016. And so you can get a sense for where this number comes from. And I want to make one last, final clarifying remark regarding this proof of work. Since solving the proof of work actually requires a Bitcoin mining node to come up with the proof string-- which it currently does through some type of exhaustive search-- as you increase the number of Bitcoin mining nodes on the network, then really, all else being equal, the proof of work will be solved faster. But I don't mean faster for a particular node. I mean faster at the level of the entire network. In other words, it'll take less time before at least one node comes up with a solution, because these nodes are all working on that same problem concurrently. And actually, on that note, I do also want to mention quickly maybe a more subtle point, which is that-- even though the different Bitcoin mining nodes are all validating either the exact same set of transactions, or maybe a largely overlapping set of transactions-- they actually are all solving entirely different proof-of-work protocols when they're doing this sort of thing. And the reason for that is that each node, remember, inserts its own coinbase, or generational transaction, into the block that it's working on to award itself coins. And this generational or coinbase transaction is actually unique to each node. So as a result, the challenge string for which, let's say, each Bitcoin mining node is seeking a corresponding proof of work-- well, that challenge string will be different for each Bitcoin-- each Bitcoin mining node, rather. And so essentially, what you have is that, because you have a cryptographic hash function that's being used in the process, just this one difference-- the fact that just this one piece is different-- that actually completely randomizes the proof-of-work problem that results. And that makes it likely that across the entire network, the solutions are likely to be widely distributed, and we can expect that if we have enough nodes, one node will come up with a solution in about 10 minutes. At least one of the nodes will. They won't all do it, but at least one will, and once one node comes up with a solution, everyone else can proceed from that point onward with the new chain. So as you can see, the Bitcoin protocol takes a number of measures-- implements a number of mechanisms-- to both limit the total number of Bitcoins, as well as the rate at which these Bitcoins are ultimately generated.