What is Bitcoin?
Before we talk about Bitcoin I want to take a moment and talk about money. What is money exactly? At its core, money represents value. If I do some work for you, you give me money in exchange for the value I gave you. I can then use that money to get something of value from someone else in the future. Throughout history, value has taken many forms and people used a lot of different materials to represent money. Salt, wheat, shells and of course gold have all been used as a medium of exchange. However, in order for something to represent value people have to trust that it is indeed valuable and will stay valuable long enough for them to redeem that value in the future. Up until a hundred years ago or so we always trusted in something to represent money. However, something happened along the way, and we've changed our trust model from trusting something to trusting in someone. Let me explain. Over time, people found it too cumbersome to walk around the world carrying bars of gold or other forms of money, so paper money was invented. Here's how it worked: a bank or government would offer to take possession of your bar of gold. Let's say worth $1000, and in return, that bank would give you receipt certificates, which we call bills, amounting to $1000. Not only were these pieces of paper much easier to carry, but you could spend a dollar on a cup of coffee and not have to cut your gold bar into a thousand pieces. And if you wanted your gold back, you simply took $1000 in bills back to the bank to redeem them for the actual form of money, in this case that gold bar, whenever you needed And so, paper began its use as money as an instrument of practicality and convenience. However, as time progressed, and due to macroeconomic changes, this bond between the paper receipt and the gold it stands for was broken. Now, to explain the path that led us away from the gold standard is extremely complex, but suffice to say that governments told their people that the government itself would be liable for the value of that paper money. Basically we all said let's just forget about gold and trade paper instead. So people continued to trade with receipts that are backed by nothing but the government's promise. And why did that continue to work? Well, because of trust. Even though there is no actual commodity backing paper money, people trusted the government and that's how fiat money was created.
Fiat is a Latin word that means by decree. Meaning the dollars, or euros or any other currency for that matter have value because the government orders it to. It's what is known as legal tender - coins or banknotes that must be accepted if offered as payment. So the value of today's money actually comes from a legal status given to it by a central authority, in this case, the government. And so the trust model has changed, from trusting something to trusting someone, in this case, the government.
Fiat money has two main drawbacks:
1. It is centralized: You have a central authority that controls and issues it. In this case the government or central bank.
2. It is not limited by quantity: The government or central bank can print as much as they want whenever needed and inflate the money supply on the market.
The problem with printing money is that because you're flooding the market with more money the value of each dollar drops, so your own money is worth less. When you see prices rising throughout the years it's not necessarily that prices are rising as much as that the purchasing power of your money is dropping. You need more dollars to buy something that used to cost less. Once fiat money was in place, the move to digital money was pretty simple. We already have a central authority that issues money, so why not make money mostly digital and let that authority keep track of who owns what. Today we mainly use credit cards, wire transfers, PayPal and others forms of digital money. The amount of physical money in the world is almost negligible and is getting smaller with each year that passes.
So if money today is digital, how does that even work? I mean, if I have a file that represents a dollar, what's to stop me from copying it a million times and having a million dollars? This is called the double spend problem. The solution that banks use today is a centralized solution; they keep a ledger on their computer which keeps track of who owns what. Everyone has an account and this ledger keeps a tally for each account. We all trust the bank and the bank trusts their computer, and so the solution is centralized on this ledger in this computer. You may not know this, but there were many attempts to create alternative forms of digital currencies, however none were successful in solving the double spend problem without a central authority. Whenever you give a anyone control over the money supply you're giving them enormous power and this creates three major issues:
The first issue is corruption; power corrupts, and absolute power corrupts absolutely. When banks have a mandate to create money, or value, they basically control the flow of value in the world, which gives them almost unlimited power. A small example of how power corrupts can be seen in the Wells Fargo's scandal where employees secretly created millions of unauthorized bank and credit card accounts in order to inflate the bank's revenue stream, without their customers knowing about it for years.
The second issue of a centralized system is mismanagement. If the central authority's interest isn't aligned with the people it controls there may be a case of mismanagement of the money. For example, printing a lot of money in order to save a certain bank or institution from collapsing, as what happened in 2008. The problem with printing too much money is that it causes inflation and basically erodes the value of the citizen's money. One extreme example for this is Venezuela, where the government has printed so much money, and the value of it has dropped so much, that people are no longer counting money but are weighing it instead.
The last issue is control. You are basically giving away all control of your money to the government or bank. At any point in time the government can decide to freeze your account and deny you access to your funds. Even if you use only cold hard cash the government can cancel the legal status of your currency as was done in India a few years back. This was the state of things until 2009. Creating an alternative to the current monetary system seemed like a lost cause. But then everything changed.
In October 2008 a document was published online by a guy calling himself Satoshi Nakamoto. The document, also called a whitepaper, suggested a way of creating a system for a decentralized currency called Bitcoin. This system claimed to create digital money that solves the double spend problem without the need for a central authority. At its core Bitcoin is a transparent ledger without a central authority.
But what does this confusing phrase even really mean?
Well, let's compare Bitcoin to the bank. Since most money today is already digital, the bank basically manages its own ledger of balances and transactions. However, the bank's ledger is not transparent, and it is stored on the bank's main computer. You can't sneak a peek into the bank's ledger, and only the bank has complete control over it. Bitcoin on the other hand is a transparent ledger. At any point in time I can sneak a peek into the ledger and see all of the transactions and balances that are taking place. The only thing you can't figure out is who owns these balances and who is behind each transaction. This means Bitcoin is pseudo-anonymous; everything is open, transparent and trackable, but you still can't tell who is sending what to whom.
Let's explain this with an example. You can see on your screen certain rows from Bitcoin's ledger. We can see that a certain Bitcoin address sent 10,000 Bitcoins to another Bitcoin address in May of 2010. This specific transaction is the first purchase that was ever made with Bitcoin, and it was used to buy 2 pizzas by a guy named Laszlo. Laszlo published a post back in 2010 asking for someone to sell him 2 pizzas in exchange for 10,000 Bitcoins. Well, someone did, and now the price of these two Pizzas is worth well over 100 million dollars today.
Bitcoin is also decentralised; there's no one computer that holds the ledger. With Bitcoin, every computer that participates in the system is also keeping a copy of the ledger, also known as the Blockchain. So if you want to take down the system or hack the ledger you'll have to take down thousands of computers which are keeping a copy and constantly updating it. Like most money today, Bitcoin is also digital. This means there's nothing physical that you can touch in Bitcoin. There are no actual coins, there are only rows of transactions and balances. When you own Bitcoin it means that you own the right to access a specific Bitcoin address record in the ledger and send funds from it to a different address.
Why is Bitcoin such big news?
Well for the first time since digital money came into existence we now have an alternative to the current system. Bitcoin is a form of money that no government or bank can control. Think about the time before the Internet, how centralized the flow of information was. Basically if you wanted information you could get it from a few major players like the New York Times, The Washington Post and others like them. Today, thanks to the Internet, information is decentralised, and you can communicate and consume knowledge from around the world with the click of a button. Bitcoin is the Internet of money, and it's offering a decentralized solution to money. Bitcoin has several advantages over the current system. First, it gives you complete control over your money. With Bitcoin, you and you alone can access your funds. No government or bank can decide to freeze your account or confiscate your holdings. Bitcoin also cuts a lot of the middlemen from the process of transferring money. This means that in many cases Bitcoin is cheaper to use than traditional wire transfers or money orders. Also, unlike fiat currencies, Bitcoin was designed to be digital by nature, this means you can add additional layers of programming on top of it and turn it into smart money. Finally, Bitcoin opens up digital commerce to 2.5 billion people around the world who don't have access to the current banking system. These people are unbanked or underbanked because of where they leave and the reality that they have been born into. However, today, with a mobile phone and a click of a button they can start trading using Bitcoin, no permission needed. Today there are several merchants online and offline that accept Bitcoin. You can order a flight or book a hotel with Bitcoin if you like. There are even Bitcoin debit cards that allow you to pay at almost any store with your Bitcoin balance. However, the road toward acceptance by the majority of the public is still a long one.
How does bitcoin work as a currency, or have any value at all?
Bitcoin wouldn't exist without a whole network of people and a little thing called cryptography. In fact, it's sometimes described as the world's first cryptocurrency. And here's how it works. Bitcoin is a fully digital currency, and you can exchange bitcoins between computers in a worldwide peer-to-peer network. The whole point of most peer-to-peer networks is sharing stuff, like letting people make copies of super legal music or movies to download. If bitcoin is a digital currency, what's stopping you from making a bunch of counterfeit copies and becoming fabulously wealthy? Well, unlike a mp3 or a video file, a bitcoin isn't a string of data that can be duplicated. A bitcoin is actually an entry on a huge, global ledger called the blockchain, for reasons we'll get to in a minute.
The blockchain records every bitcoin transaction that has ever happened. And, as of late 2016, the complete ledger is about 107 gigabytes of data. So when you send someone bitcoins, it's not like you're sending them a bunch of files. Instead, you're basically writing the exchange down on that big ledger “ something like, Michael sends Hank 5 bitcoins. Now, maybe you're thinking, But, wait. You said bitcoin doesn't have a central authority to keep track of everything! Even though the blockchain is a central record, there's no official group of people who update the ledger and keep track of everybody's money like a bank does “ it's decentralized. In fact, anybody can volunteer to keep the blockchain up to date with all the new transactions. And a ton of people do. It all works because there are lots of people keeping track of the same thing, to make sure all transactions are accurate. Like, imagine you're playing a game of poker with some pals, but none of you have poker chips, and you left your cash at home. There's no money on the table, so a few of you get out some notebooks, and start writing down who bets how much, who wins, and who loses. You don't completely trust anyone else, so everyone keeps their ledgers separately. And at the end of every hand, you all compare what you've written down. That way, if someone makes a mistake, or tries to cheat and snag some extra money for themselves, that discrepancy is caught. After a couple hands, you might fill up a page of your notebook with notes about the money movement. You can think of each page as a block of transactions. Eventually, your notebook will have pages and pages of information a chain of those blocks. Hence: blockchain.
Now, if thousands of people are separately maintaining the bitcoin blockchain, how are all the ledgers kept in sync?
To stick with our poker analogy: think of the entire bitcoin peer-to-peer network as a really huge poker table with millions of people. Some are just exchanging money, but lots of volunteers are keeping ledgers. So when you want to send or receive money, you have to announce it to everyone at the table, so the people keeping track can update their ledgers. So for every transaction, you're announcing a couple of things to the bitcoin network: your account number, the account number of the person you're sending bitcoins to, and how many bitcoins you want to send. And all of the users who are keeping copies of the blockchain will add your transaction to the current block. Having a bunch of people keep track of transactions seems like a pretty good security measure. But if all it takes to send bitcoins is a couple of account numbers, that seems like it might be a security problem. It's a huge problem with regular money “ just think about all the ways criminals try to steal other people's credit card information. And with bitcoin, there's no central bank to notice anything weird going on to shut down fraud, like if it looked like suddenly you spent your entire life savings on beef jerky. So what's stopping Hank from pretending he's me and just sending himself all of my bitcoins? Bitcoins are kept pretty safe thanks to cryptography, which is why it's considered a cryptocurrency. Specifically, bitcoin stays secure because of keys, which are basically chunks of information that can be used to make mathematical guarantees about messages, like hey, this is really from me! When you create an account on the bitcoin network, which you might have heard called a wallet, that account is linked to two unique keys:
A private key, and a public key. In this case, the private key can take some data and basically mark it, also known as signing it, so that other people can verify those signatures later if they want. So let's say I want to send a message to the network that says, Michael sends 3 bitcoins to Olivia. I sign that message using my private key, which only I have access to, and nobody else can replicate. Then, I send that signed message out to the bitcoin network, and everyone can use my public key to make sure my signature checks out. That way, everyone keeping track of all the bitcoin trading knows to add my transaction to their copy of the blockchain. In other words, if the public key works, that's proof that the message was signed by my private key and is something I wanted to send. Unlike a handwritten signature, or a credit card number, this proof of identity isn't something that can be faked by a scam artist. The who part of each transaction is obviously important, to make sure the right people are swapping bitcoins. But the when matters, as well. If you had a thousand dollars in your bank account, for example, and tried to buy two things for a thousand dollars each, the bank would honor the first purchase and deny the second one. If the bank didn't do that, you'd be able to spend the same money multiple times. Which might sound awesome, but it's also terrible. A financial system can't work like that, because no one would get paid. So if I only have enough money to pay Olivia or Hank, but I try to pay them both, there's a check built into the bitcoin system. Both the bitcoin network and your wallet automatically check your previous transactions to make sure you have enough bitcoins to send in the first place.
But there's another problem that might happen with timing: Because lots of people are keeping copies of the blockchain all over the world, network delays mean that you won't always receive the transaction requests in the same order. So now you've got a bunch of people with a bunch of slightly different blocks to pick from, but none of them are necessarily wrong. Okay, bitcoin. How do you solve that problem? Turns out, it's by actually solving problems. Math problems. To add a block of transactions to the chain, each person maintaining a ledger has to solve a special kind of math problem created by a cryptographic hash function. A hash function is an algorithm that takes an input of any size, and turns it into an output with a fixed size. For example, let's say you had this string of numbers as your input And our example hash function says to add all of the numbers together. So, in this case, the output would be 10. What makes hash functions really good for cryptography is that when you're given an input, it's really easy to find the output. But it's really hard to take an output and figure out the original input. Even in this super simple example, there are lots of strings of numbers that add up to 10. The only way to figure out that the input was 1-2-3-4 is to just guess until you get it right. Now, the hash function that bitcoin uses is called SHA256, which stands for Secure Hash Algorithm 256-bit. And it was originally developed by the United States National Security Agency. Computers that were specifically designed to solve SHA256 hash problems take, on average, about ten minutes to guess the solution to each one. That means they're churning through billions and billions of guesses before they get it right. Whoever solves the hash first gets to add the next block of transactions to the blockchain, which then generates a new math problem that needs to be solved. If multiple people make blocks at roughly the same time, then the network picks one to keep building upon, which becomes the longest, and most trusted chain. And any transactions in those alternate branches of the chain get put back into a pool to be added onto later blocks. These volunteers spend thousands of dollars on special computers built to solve SHA256 problems, and run their electricity bills up sky-high to keep those machines running. But why? What do they get out of maintaining the blockchain? Is it just community service? Well, bitcoin actually has a built-in system to reward them. Today, every time you win the race to add a block to the blockchain, 12 and a half new bitcoins are created out of thin air, and awarded to your account. In fact, you might know the bitcoin ledger-keepers by another name: miners. That's because keeping the blockchain updated is like swinging a proverbial pickaxe at those hash problems, hoping to strike it rich. When bitcoins were first created in 2009, they didn't really have any perceived value. Tens of bitcoins would have been worth the same as a bunch of pennies. As of November 10th, 2016, though, one bitcoin is worth 708 US dollars. So 12 and a half bitcoins are worth 8,850 dollars. That's a nice chunk of change!
Every single bitcoin that exists was created to reward a bitcoin miner. Besides the big payout when they add a new block of transactions, miners are also essentially tipped a very small amount for each transaction they add to the ledger. It's also worth noting that every 210,000 blocks, the number of coins generated when a new block is added goes down by half. So what started as a reward of 50 bitcoins decreased to 25, then 12 and a half. It'll only be around 6 bitcoins in a couple more years, and keep decreasing. Eventually, there will be so many transactions in a block, that it'll still be worthwhile for miners to mostly be paid in tips. According to current projections, the last bitcoin “ probably around the 21 millionth coin “ will be mined in the year 2140. This decreasing number of bitcoins is actually modelled off the rate at which things like gold are dug out of the earth.
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