Bitcoin

Bitcoin, Cryptocurrencies and Blockchains

I plan to write about cryptocurrencies and blockchains every now and then in my weekly insights. I could not do that without starting with Bitcoin. There are many reasons for this. Bitcoin is not only the first. The true innovation or, as some would say, revolution. It is also the most important, and, very importantly, it is different from every other cryptocurrency. There is Bitcoin and then there’s crypto/blockchains. Anyone who lumps the two together is doing a disservice to anyone trying to understand these topics.

So my goals with this article are:

• To provide a reasonably comprehensive, yet layman’s understanding of what Bitcoin is and how it works.
• Why it is different from crypto.
• And why it is one of the most important inventions (some say discoveries) in human history.

I’ll do my best to lay out everything I think you need to know and understand in less than a 20 minute read. I will refer to some other materials that I think complement the topics well, if you’re interested in delving deeper.

So, what exactly makes Bitcoin so special? Let us take a closer look…

What is Bitcoin?

What is money?

To understand what Bitcoin is, we first need to look at what money is, because Bitcoin is money. Money makes the world go round and accounts for half of all commercial transactions. Most people do not understand what their money is though. In its purest form, money is a commodity. It is hard to produce and counterfeit. And it is durable, so it can be used as a store of value. Money has taken many forms in the past. But in all these forms it has been difficult to counterfeit and produce. And when that reality changed, that commodity stopped being money.

Thousands of years ago, tribes used ornaments or equipment, which required a lot of time, effort and skill to produce, as a means of payment and transferring wealth, knowing well that those pieces took time, effort and skill to produce. You couldn’t just counterfeit one without being noticeable that it wasn’t the real thing. A good read on this subject is Nick Szabo’s “Shelling Out — The Origins of Money”.

Shells were used as money once. Not in areas near the sea, but high in the mountains where shells were hard to come by. People eventually chose gold as their money, due to its characteristics. And gold was used throughout the world during what has become known as the gold standard era. Even countries that stubbornly stuck to silver as money, long after everyone else had adopted the gold standard, eventually had to accept that they could not use inferior money when there was a better form of money, as it was against their interests. I am thinking of China, Mexico and Germany, but there are a few others.

Characteristics of money

So why did gold win? Quite simply, the more a commodity is used, the higher its price. And the higher its price, the more we dig/mine it; in the case of gold. The more we dig for it, the more of it we extract and become available. And the more of it that is available, the more the price goes down. Since we can extract much more silver than gold for the same cost, more silver will be extracted and the price of silver goes down compared to gold. Basic economics, supply and demand.

So money is a good that is difficult to produce, that is durable and can be used as a store of value. Is that it? Essentially yes. But apart from durability, limited supply and difficulty or cost to forge, there are a few other characteristics that are important for money to be used as a currency.

• Portability: we need to be able to transport money easily across space, especially large sums. Salt or wheat, for example, were poor money in this capacity.
• Fungibility: Every unit of money must have the same value. This is regardless of who owns or owned it, where it came from, etc. 1 ounce of gold is an ounce of gold. Every 10-euro note is worth the same, even if it has been used illegally before, for example.
• Divisibility: We need to be able to divide money into smaller denominations. For example, one problem with live cattle that were used as money at some point was that they could not be divided. Gold can be divided into very small pieces. That process is not as easy or practical as one would like though.
• Cognizability: we need to be able to easily tell if the money is good or fake. It can be quite expensive to check the purity of gold. While there are machines to check fiat money these days, they are not ubiquitous. Speaking of fiat currency.

What is fiat currency?

The introduction of paper money was an important milestone in the development of money. Paper notes allowed governments to more easily control their economies and finances. Make payments quickly and efficiently without relying on coins or bartering for goods.

In 14th century China, the government created paper notes that were backed by silver or gold reserves. These paper notes could be exchanged back for those metals when needed. This form of paper money eventually spread throughout Europe. Most of the world used paper money backed by a commodity, mainly gold, at some stage in its history.

So is this fiat money? No. Fiat comes from the Latin word “fieri” which means “to be done or made”. In other words, the term refers to something that has been declared legal tender by a government or authority. So it is money by decree. Fiat money includes paper notes and coins that are issued by governments and must be accepted as payment for goods and services in an economy.

Another important distinguishing feature of fiat money is that Richard Nixon temporarily suspended the convertibility of the dollar into gold in 1971. This affected the whole world for many reasons. Mainly because the US held most of the gold reserves of most of the countries affected by World War II and the fact that the dollar was already the world reserve currency. The whole world effectively went out of the gold standard after this decision. This is a good website to take a look at on this topic. It shows some of the impact of this decision on the world https://wtfhappenedin1971.com/

So the “money” we use today is fiat currency.

Characteristics of fiat currency

Is it portable? Absolutely. At least in the developed world. Here, we can send “money” from Europe to Asia within a few days, for example. And we can also easily carry banknotes and coins with us.

Is it divisible? Yes. We can divide it as much as we want. Even if we had to create new denominations to achieve that. That’s not a problem we have though, since fiat currencies never go up in price.

Is it fungible? Yes, undoubtedly, it is by law.

But is it cognizable though? Yes. Fiat currency has evolved greatly in this area. There are many marks on banknotes and coins that are very difficult to counterfeit nowadays. Anyone who wants to can get access to tools to check the authenticity of a currency.

So it is hard to counterfeit, then. The answer is not so simple. On the one hand, it has become increasingly difficult for criminals to counterfeit currencies that are widely accepted in commerce. On the other hand, governments create new currencies at the push of a button and out of thin air. So for me it is quite clear that fiat currency is easy to counterfeit.

And that leads to an unlimited supply. There are several reasons why the supply of money grows, which can be called inflation. But I think the most important reason is that politicians are only human. If they have the ability to just print money, they will. Every problem will seem to be solvable by throwing money at it. I think a good read on this subject is “Basic Economics: A Citizen’s Guide to the Economy” by Thomas Sowell. The book’s scope is way broader than this particular topic, but it’s such an essential read for anyone really, that I had to mention it.

So again, what is Bitcoin?

It is definitely a complex technology. By the way, money is also a technology, but I will try to explain its basic characteristics. Let me first make a distinction between bitcoin and Bitcoin to help in reading the rest of the article. When using capitalised Bitcoin, I’m referring to the Bitcoin network through which all transactions are made. And when using bitcoin, I’m referring to the token that is exchanged on the network. This distinction is important because they are 2 different things and I will use the 2 different forms going forward.

Bitcoin

It’s open source. This means that anyone can inspect, modify and improve the source code.

It is permissionless. Meaning that anyone can build on it or integrate it without asking anyone’s permission.

It’s decentralised. Meaning there is no central point of failure or control. No one owns the network and as such can make decisions about it. So you mean that developers working on the software can not make changes to it? No, the network is permissionless, anyone can make changes, but no one has to accept those changes. This leads down a rabbit hole of hard forks and soft forks and their implications. If you want to learn more about this topic, I can recommend https://www.lopp.net/transcripts/podcasts/Future_Crypto_Asset_Trading.txt.

What about the miners? Same thing. When miners include invalid transactions in a block, their block is rejected by the network. This is possible due to the transparency of the network, since everyone sees everything. No one has privileged access to any part of the information stack. If a block proposed by a miner is rejected, the cost they spent mining that block is lost.

It’s borderless. The above features mean that Bitcoin is borderless. Anyone, anywhere in the world with an internet connection, can access the network.

It is a peer-to-peer system. There is no middleman to authorise or process transactions and take a cut. Note: Bitcoin miners do take a fee for their services. However, these services are not the authorisation or processing of transactions but guaranteeing the security of the Network. And the fees paid are set by the user, not the miner. For more, see How Bitcoin works.

It’s secure. Because of its decentralisation and use of private and public cryptography, Bitcoin is the most secure network we have seen to date. The Bitcoin network has never been hacked. There have been a few serious bugs in the past. But the network has never been hacked. You probably have a different idea. This is because of the way the media reports on issues directly or indirectly related to bitcoin. First of all, the media tends to write a lot about bitcoin, but not much or anything about Bitcoin. There are numerous actors who have been hacked or acted fraudulently when using bitcoin. These hacks were always with other tools or were phishing and social engineering attacks though. And fraud, well, fraud is all around us.

It’s immutable. Once recorded and buried under a couple of blocks, you can be sure that history cannot be rewritten on a whim. Or at all, it’s immutable.

bitcoin

Supply is limited — There will never be more than 21 million bitcoin tokens, which is very scarce.

It is costly to forge — Bitcoin is either created through what is called mining or acquired through payment. Due to the dynamics of supply and demand, the price has risen exponentially over the last 12 years, making it more expensive to acquire. And as the price rises, so does the number of miners who want to generate bitcoins. The more miners there are in the network, the more expensive it is to generate new bitcoins. For more on this, see How Bitcoin Works.

It’s portable — Because of its digital nature, bitcoin can be sent anywhere in the world in minutes. Not days like fiat currencies (intercontinental transfers take days, not domestic). And it’s open 24/7, 365 days a year.

It’s durable — We know that nothing lasts forever, but right now it is probably the closest thing we have.

Is it fungible? — This is a contentious issue because the network is open and transparent. It is argued that governments will succeed to impose the same nonsensical laws they impose on fiat currencies. I will try to stay away from politics and geopolitics in these weekly insights. What I will say in this matter is that at this moment bitcoin is fungible. And, it looks very unlikely that governments will be able to sanction the Bitcoin network.

It’s cognisable — unlike anything else out there, bitcoin’s authenticity is easy and fail-safe to verify. If you use a bitcoin wallet and have 3 or more blocks confirmed, you can be sure that your bitcoin is real.

It’s divisible — 1 bitcoin is divisible to 8 decimal places. Each unit is referred to as a satoshi, in recognition of Satoshi Nakamoto’s contribution to society by inventing/discovering Bitcoin. No one knows who Satoshi Nakamoto is. Whether he is a man, a woman or a group, nobody knows and it doesn’t matter. Similarly, it doesn’t matter that we don’t really know who Socrates was or Archimedes or Euclid. What matters is what they left us.

How Bitcoin Works

It is not easy to explain in simple terms how Bitcoin works. I will not get into cryptography and private and public keys here. I do believe this is an important topic to fully understand how Bitcoin works but the subject is too complex to explain in this article. Also, I’m not even confident enough to explain it clearly and in simple terms. I think I have a good enough grasp to understand how Bitcoin works though. If you want to go deeper into this topic, I recommend “Grokking Bitcoin” by Kalle Rosenbaum. I will focus on the mining aspect of the network. And even here I will only scratch the surface and try to explain it in very simple terms.

The Bitcoin network consists of 3 main players

The Developers — Although there are many programmers directly or indirectly involved with Bitcoin, I will refer to the developers who work directly on the Bitcoin Core software. These are not just programmers, but also cryptographers with a good knowledge of cryptography so they can apply it in their code.

The Users — This is everyone who downloads a copy of the software and runs it. Some would argue that anyone who owns a bitcoin wallet is a user. For the purposes of this article I will stick with my definition.

The Miners — These actors run machines that perform complex computational processes to validate bitcoin transactions.

Although much can be said and discussed about developers and users, I will focus on the miners. I believe this is the best way to explain how Bitcoin works.

What is mining?

When a user makes a transaction, that transaction is sent to a pool of pending transactions waiting to be validated and included in a block.

The process of validating a transaction is first done by a miner and after it is included in a block, it is again validated by users.

Each miner is in a race with all the other miners to be the one to create a block. A block is simply a list of transactions from the pending pool.

How does the miner determine which transactions to include in a block? The free market and the rules of the Bitcoin network determine which transactions are included in a block. The transaction must be valid, i.e. the sender must have the Bitcoin he is sending. And the fee the user is willing to pay affects their place in the queue of transactions to be included. If you pay less, it takes longer for you to be included. Pay a little more, and your chances of being included in the next block increase. There are tools that tell users the minimum fee required to be included in the next block.

The mining race

So what does this race consist of? Are miners marathon runners? No, quite the opposite. Each race takes an average of 10 minutes.

The software creates a 67-digit number starting with a certain number of zeros. The number of zeros determines the difficulty. Difficulty is set so that it takes on average10 minutes for the number to be found considering the number of participants (miners) in the race.

All the mining machines (ASICs) have to do is find the hash that corresponds to this number. And that is what they do. They try random hashes per second until they find the one that matches the random number generated. It’s a guessing game. Is it this one, this one, this one? Over and over again until someone finds the one that matches and wins the race.

The performance of Bitcoin mining hardware is measured by the hash rate. Current new generation ASIC miners produce 100 TH /s (100 trillion hashes per second, that’s 100 trillion guesses per machine, per second). And now imagine that there are estimated to be over a million miners on the Bitcoin network. Mind boggling numbers.

Difficulty adjustment — A stroke of genius

So the miner guesses the right number. Like any other miner, they have their block ready to send to the network, and they do.

The network, made up of rival miners and self-interested users, validates the block and the race begins again.

When there is an influx of miners to the network, a guessing that should take 10 minutes on average to be solved, as more hashes are now produced per second by adding these machines, will take less time. An adjustment to the difficulty is made every 2016 blocks, which is about every 2 weeks.

If the average time it took to guess the random numbers was less than the target of 10 minutes, the difficulty is increased so it can get back up to 10 minutes on average. This adjustment is achieved by reducing the number of zeros in that arbitrary 67-digit number. And vice versa, if the 2-week average is higher. So a 67 digit number starting with 60 zeros is easier to find than a 67 digit number starting with only 6 zeros. You get the point.

As a result, the number of bitcoins that come into circulation always remains constant. No matter how many new miners enter the race, blocks are produced every 10 minutes on average.

Bitcoin halving — Arbitrary settings? Genius nonetheless

Another adjustment that takes place regularly is the bitcoin halving. Every 210,000 blocks, or about every 4 years, the coinbase, or bitcoin reward for miners, is halved. In 2009, when Bitcoin was launched, 50 new bitcoins were created in each block. Today, only 6.25 bitcoins are created in each block. The next expected halving will take place in early 2024 and the coinbase reward will drop to 3.125 bitcoins per block. Around 2140, the last coinbase reward will be issued and bitcoin supply will never increase again. This is assuming the majority of the network, i.e. its users, don’t agree to change it. Miners will be rewarded with transaction fees only.

The decentralisation of Bitcoin, the mining process with the halving and difficulty adjustments are amazing solutions to a problem that has plagued cypherpunks for decades.

Another recommendation I can confidently make is “The Internet of Money” by Andreas M. Antonopoulos.

Why is bitcoin different from crypto?

The blockchain

The blockchain, as it is popularly known, is simply a chain of blocks. Computer scientists might well disagree with me here, but that is my understanding. There are many other technologies used by the myriad of different blockchain projects. Ultimately though, what constitutes a blockchain is a chain of blocks. I concede that a blockchain is only a blockchain if it is encrypted using cryptography. But that is the one technology that ALL blockchains must have. In some, the tokens are mined with special machines. In others the tokens are simply brought into existence by programming it, which is no different from our current fiat system.

The main difference between Bitcoin and all other cryptocurrencies is its decentralisation. There is no company or authority behind Bitcoin. There’s no one to complain to. There is no CEO to whom regulators can send cease-and-desist letters. The same cannot be said of any other cryptocurrency, including Ethereum. Do not get me wrong, I believe that blockchain technology will have a huge, positive impact on society. But let us not confuse Bitcoin and all other cryptocurrencies, because they are different in nature and have different goals.

Do you still doubt that Bitcoin is one of the most important inventions (some say discoveries) in the history of mankind?

Why is Bitcoin one of the most important inventions (some say discoveries) in the history of mankind?

I realise that this article might not be enough to convince anyone of this bold claim, but I believe that if you read the additional information I have sparingly sprinkled throughout the article, you will come to the same conclusion. Bitcoin allows us to be sovereign and hold our wealth in a way that cannot be confiscated. Transactions without gatekeepers. Save for the future in a non-inflationary money. It is a way to escape the fiat currency system that is robbing us of our wealth.

Final recommended reading: 2 books by Saifedean Ammous, “The Bitcoin Standard” and “The Fiat Standard”. Both are essential reading in my opinion, but the latter is a real eye opener that I think everyone should experience.

PS: And Bitcoin II is now written so you can head there now if you think you can handle another 25m read.