One question that many people ask is what backs Bitcoins and gives them value. This question arises because most of our currencies are backed by something, and people assume that Bitcoin will be the same. When we are taught about currencies in school and college we are taught about currencies that were backed by different things. We all know about currencies that were backed by gold or silver. We also know that salt was used as currency once, which is why our pay is called salary (sal was the Roman word for salt).
Then we have fiat currencies, which are simply backed by the government. The US Dollar is one such currency – there isn’t enough gold to cover all of the dollars out there, they are simply being issued because the American government backs them. So what are Bitcoin backed by? The short answer is nothing. The real answer though is a bit more complicated.
Here’s something important which we all need to understand – currencies do not need to be backed by anything. Anything which can be exchanged for something else is a currency. However, currencies have always been backed by a material or an official agency because we had no other way to give currency value. We have always needed a system to determine the value of currency and its exchange rate. How would we limit the production of a currency if there was no material backing it, or if there was no government making sure there wasn’t too much supply or fake money out there?
How Bitcoin works
Bitcoin sidesteps all of these problems. Bitcoin is not backed by any material and there is no agency that produces bitcoin for others to use. Instead the users themselves can mine bitcoin and then exchange bitcoin with other people.
How does it have so much value then? That is because of a genius idea that allows bitcoin’s production to be naturally limited. A bitcoin is generated whenever a complicated algorithm is calculated. The genius is that every bitcoin generated needs to follow a certain pattern, and any value that already fits the pattern cannot be used again.
This genius idea does two things. One is that, as time goes on, it becomes harder and harder to come up with an answer that still fits the required pattern. This keeps the supply of Bitcoin limited and ensures that no one can just start mining bitcoin at a really fast speed. The more people there are mining bitcoin, the harder it is to mine one bitcoin.
The other genius thing this does is that it ensures that no one can create a fake bitcoin. Since every bitcoin has a unique number in it, once it is noted in the public ledger no one else can just copy it and use it.
Thus, without being backed by any material or any government agency, bitcoin gets value. Its value is decided by market demand – if lots of people want bitcoin the price goes up. If lots of people start selling bitcoin the value goes down. That’s all there is to it.