What is Bitcoin?
Most of us have heard about Bitcoin by now. Alas, constantly hearing about Bitcoin doesn’t mean that we actually know what Bitcoin is.
Fear not, after reading this post you will learn what Bitcoin is. You may still dislike it, but you will know more about it than 99% of its detractors.
And no, I will not include a price chart to convince you that Bitcoin is important [this is how you can tell we are not in a bull market].
Bitcoin, the protocol
Bitcoin, the protocol, is a constantly updating database. The database consists of a series of entries which describe transfers of tokens from some bitcoin addresses to others, or new tokens given as a reward to bitcoin miners. It is updated approximately every ten minutes. One can then aggregate the separate transactions to determine how many coins [fractions of bitcoin] a given bitcoin address has, but this is not provided by default. See for example the balance of this address, which has been reconstructed from its transaction history.
Well, this sounds quite ordinary, doesn’t it? So far I have described a slow excel spreadsheet. On top of that, there is dilution from the newly issued coins being allocated to the bitcoin miners. Yes, of course, unlike your local bank, in theory, everyone in the world with access to the internet can participate in the bitcoin network. But for most of you reading, this will sound like your typical experience of having a bank account that is part of the global financial network. You may even view the transaction fees as exorbitant. In that light, Bitcoin doesn't seem like a revolutionary new invention. So, what is all the hype about?
A common misconception is that people use bitcoin for privacy reasons. This is debatable. While bitcoin users maintain a degree of anonymity [pseudonymity], their transactions are visible to anyone with access to the internet. Imagine people being able to view all your card statements online, in real time, but not knowing that these are your statements. That is, until you transact with them, at which point they can see all your past, current and future activity. If this fills you with horror and does not match your idea of being anonymous, then you are not alone [and surely have your venmo transaction settings set on private. Right?]. Of course, just like in the real world, you can have multiple accounts.
The innovation Satoshi Nakamoto introduced was that he found a way to build and maintain a payments network in a decentralised way. Or, more precisely, a trust-less way. There is no CEO of Bitcoin, as no one is officially in charge. On one hand, this may seem scary, if you are someone who mixes up numbers and accidentally sends money to wrong accounts. Your bank may be able to reverse such an error, but bitcoin will not, as it cannot. On the other hand, this may be exciting if you are someone that finds it hard to open a bank account, or is at risk of having your bank account closed and your assets frozen [can you see now why bitcoin is deeply political?].
Technical Details
This is a longer section, but I will keep my promise, and there will be no formulas. If you want to know how bitcoin “works” at a medium level, read this. If not, feel free to skip this section. The main takeaway is that Satoshi tied cryptography with economic incentives and in the process created the first successful global cryptocurrency. Some details have been abstracted away and simplified.
Bitcoin Users
Bitcoin provides users the ability to transact on the internet without having a third party in charge. This requires that users are able to prove that they authorise a given transaction to other network participants, without compromising their account details so that others could later impersonate them. Say you have 10 bitcoins in your account. You want to send 5 bitcoins from your account to another user’s account. You will need to prove to the other network participants that that account belongs to you. However, you want to do it in a way that does not reveal details about the account that would make it possible for others to drain the remaining 5 bitcoins.
Since users don’t have a bank to vouch for their identity, in the blockchain world, they use digital signatures. Each bitcoin account has a “private key” which is used to authorise transactions. This is also a point of failure in the system. If someone gets hold of a private key, they could use it to steal all coins belonging to the account the private key is linked to [this is important]. In the real world, when they create a new bitcoin account, users are usually given “seed phrases “ instead. These can be transformed into private keys, so should not be shared with anyone else either.
Once you authorise a transaction with your private key, all other network participants will only see the authorisation message (“signed” message) and your account public key, and can use those to confirm that you approved the message. This allows you to verify your identity without exposing your private key. In order for this to work, publicly visible account details are generated from the account private key, using a special function. That function is designed so that another algorithm can then check signed messages for their authenticity by only having access to the original message, the signed message, and the account public key.
In short, you can prove you approved a transaction using your secret number [private key], without sharing that secret number. Sounds like magic, but this is the power of cryptographic algorithms!
Bitcoin Miners
Users pay fees to bitcoin miners in order to have their transaction included in the blockchain. After a user has created a new transaction by signing a message to approve it, they then send it to the bitcoin network to propagate across nodes. All nodes keep track of the network state, and miner nodes actively work to update that state. The miners’ job is to collect a number of transactions in a “block” and attempt to extend the blockchain with those transactions. To do so they must solve a cryptographic puzzle by brute force [random guessing]. The more energy/electricity miners spend on attempting to solve the puzzle, the higher the likelihood that they are the one to solve it. This method is called Proof-of-Work.
More precisely, miners need to find a hash of the block header which is smaller than a given number. The block header contains compressed data about the previous block and the transactions included in the current block. Therefore, it is uniquely described by its position in the blockchain and the transaction included in it. Therefore, you cannot do a “jump” and pre-emptively solve the puzzle for a block in the future without having information on the preceding block and the transactions to be included in the given block. The puzzle difficulty adjusts over time to match the average computing power of the network, so that a solution is found around every ten minutes. [can you deduce the implications for the energy use of the network?].
Once a miner finds a solution to the puzzle, they aggregate all transactions they want to include in the new block with the solution to the puzzle and also award themselves the block bitcoin reward. The only way to generate new bitcoin is via the block reward. All other bitcoin must be acquired from existing users. The block reward decreases approximately every four years. It started at 50 bitcoin per block, an is now 6.25. Eventually, at around the year 2140, there will be no block reward and miners will only receive transaction fees [yes, that could be a challenging time for bitcoin].
The puzzle is generated so that it is hard to solve, but very easy for other miners to verify if a solution is valid. Once a solution is found, it is easy to propagate through the network, where other nodes quickly check that the solution to the puzzle and all included transactions are valid [no over or double-spending]. Note that all miners are nodes but not all nodes are miners. Being an ordinary node requires much less energy than being a mining node but still allows one to verify that transactions are valid [this is important, and can lead to large miners having less power over the protocol than you may have originally expected].
Once a new block has been verified, the nodes start collecting the transactions to be included in the next block and extend the new, now longer chain. In cases of two miners finding a puzzle solution and extending the chain at around the same time, other miners decide which chain to extend and eventually everyone converges on the longest extended chain.
Nowadays a large portion of bitcoin mining is done via mining pools. Pool operators order transactions and the miners are responsible for solving the block header puzzle and do not need to run nodes themselves. While this is efficient, it threatens decentralisation by giving too much power over transaction content to the mining pool operators. Stratum, the protocol used by miners and pools to communicate with one another, is releasing a second version of its protocol to remedy this issue. The new version includes a “Job Negotiation Protocol” which allows miners to negotiate their transaction sets with their pool.
In conclusion, by combining cryptography and economic incentives, Satoshi created a trust-less payment system where no one party is in charge of the network, as long as they do not control more than half of the energy used to secure bitcoin.
Why is bitcoin important?
After reading [or skipping] the technical description of the protocol, you may be thinking that all of this sounds like a very interesting coding exercise, but wondering why on earth would it have any value in the real world? And yet, bitcoin has experienced multiple market cycles, has survived them all, and is currently sitting at slightly under a trillion USD market cap. So there must be something valuable hidden behind all the technical jargon, right?!
Let’s steel-[wo]man the case for bitcoin. Here, I stretch the points in favour of bitcoin to their logical maximum.
It’s like gold, but better
Argument: Did you know that government money used to be backed by gold? But after World War 2 this became difficult to maintain as governments increased spending beyond what their gold reserves could support. Some governments [cough, USA] even went as far as to confiscate their citizen’s gold reserves. So the gold standard ended, and fiat money [government-issued money] has reined supreme ever since. The main beneficiary of this change has been the US dollar, So when bitcoiners compare bitcoin to gold, they don’t always refer to gold as we know now. Sometimes they dream of bitcoin being as powerful as gold used to be.
But, was it good that gold was so powerful? It constrained governments balance sheet expansion by printing unbacked money. Which was good because it reduced the ability of governments to cause inflation and thus devalue the money their citizens were already in possession of. Yes, of course, governments could come across a continent full of gold and crash its market price and this caused other problems [cough, Spain]. However, as less of the world remained unexplored, the chances of substantial shocks to gold’s supply decreased over time.
Why don’t we just go back to gold then? Well, for one, if we are preparing for a doomsday scenario, gold is much easier to seize and harder to transport. Even, in an ordinary, non-doomsday world, bitcoin has the advantage of having a predictable “minting” schedule, that a mineral cannot provide. If the price of gold rose significantly, gold miners would accelerate mining activities in order to be able to sell gold at that higher price. Given that the supply of bitcoin as pre-determined, one only needs to worry about its demand fluctuations when estimating future price.
Sure, but gold has utility, and bitcoin doesn’t? The use of gold for utility is minuscule compared to its use as a monetary assets [some estimate upwards of 95% is used as a wealth store]. Therefore, any utility does not compensate for its other shortcomings. In contrast, with bitcoin, there are no distractions in the valuation model due to exogenous, non-monetary use cases.
Rebuttal: Only old people remember how important gold used to be and they are not that good at using the internet. How will bitcoin acquire network participants that both understand its potential and can use it?
Verdict: Yes, the gold bugs have not all gotten on board, but their children may [e.g. the curious case of Peter and Spencer Schiff]. So far bitcoin has onboarded a cohort of libertarians, speculators, and corporates led by persons in the former two groups. Oh, yes, and a few sovereign nations. Efforts to cultivate a broader appeal are ongoing but in the meantime Bitcoin could also sustain itself among existing users as long as they wish to transact for goods and services with one anther.
It’s the currency of the internet
Argument: The internet is a global economy, becoming less dependent on individual nation states, and could use a credibly neutral [sorry USD] global currency. So far online banking has made shopping online easier. However, government-backed digital money can also easily turn into a dystopian nightmare for humanity, as people face the risk of having their assets frozen or seized at the stroke of a government pen and computer button [if it can happen in Canada…]. Bitcoin solves this [this is the only time I will use this phrase in this article]. It may even become a reserve for stable coins on other crypto chains. Terra is running an exciting experiment in this space [that may end in tears].
Rebuttal: Other cryptocurrencies have a similar structure but also more utility than just sending money around.
Verdict: Time will tell if Bitcoin will suffer due to its limited functionality. My [fiat] money is on Bitcoin remaining the largest crypto asset as it is the first one and Satoshi’s figure is shrouded in mystery, giving him a messianic clout. One non-top cryptocurrency is already starting to use bitcoin as a reserve currency for their algorithmic stable-coin [hello, Terra]. So, there is a game theory aspect where using a competing crypto’s native token as a reserve is non optimal [cough, Ethereum], but aligning with Bitcoin [as the OG] or other friendly cryptocurrencies is permissible. Bitcoin would be the main winner of such a trend.
It’s a cult, and that’s a good thing
At this point you are probably thinking, this all sounds like a cult. If you are on twitter, you may have also seen the “laser eyes” profile pictures of the bitcoin devotees and ended up on the wrong side of one of their outbursts [ouch]. Cults are bad, right? Well, not always. If you want to buy into an asset, that asset having a devoted group of holders who will not sell based on an almost religious affinity seems like a positive thing. If that group of people is also on a missionary-like quest to recruit new members, that can also improve the prospects of the asset. Imagine if you could get shares in the protestant religion when it was getting started. Viewed like this, betting on bitcoin is betting on the idea that groups of people can “meme” things into existence [I promise not to mention any specific meme-coins in this post].
I did not choose the example of protestantism by accident. No, really! Martin Luther is widely considered to have posted his 95 theses on the door of the All Saints Church on 31st October 1517, in a move that kicked off the Reformation. Only a few hundred years later, Satoshi Nakamoto published The Bitcoin White Paper on 31st October 2008. Beyond the symbolic, the split of the Catholic Church was enabled by the invention of a new technology, the printing press, which allowed dissent about the church to spread, and facilitated the formation of new churches. Just as Luther “forked” the religion of the Catholic Church, Satoshi Nakamoto used a new technology, the internet, to “fork” government money and create and distribute a global currency, independent from any government. Add to that that Satoshi is an anonymous founder, who rose from obscurity to create bitcoin, and then faded back into anonymity. It all sounds quite prophetic.
Rebuttal: Cults can end in mass suicides, and the extreme volatility of bitcoin can lead to people losing all their savings. This sounds bad?
Verdict: Yes, things could backfire! [I may not be a history buff, but I have read Dune Messiah] Religion is a powerful force that needs to be deployed with caution. But if yielded correctly, it can be incredibly potent and resilient to external forces. This is why, despite the cringe reputation of the bitcoin “laser eyes”, I would not bet against the bitcoin community.
It’s the new price of energy
Bitcoin miners consume energy in a way that they can easily control. Once they have paid for their equipment, their profits shrink and expand with the energy they consume. Therein lies opportunity. For example, they can form symbiotic relationships with existing energy grids. Those grids often produce too much energy at certain times and too few at others. If we could store all energy we produce this would not be a problem. But, currently, we cannot.
As a result, having a major energy consumer who can absorb surplus energy when needed and also reduce their energy consumption to zero when energy is scarce can be a valuable moderating force. This is now being tested out in Texas and may soon roll out across the world. Furthermore, energy production can include a lot of waste. During oil extraction, gas is often flared, because it cannot be readily absorbed by the grid. Such energy can instead be redirected to bitcoin mining, reducing carbon emissions.
Traditionally, energy sources have been developed in locations where it is economically feasible to connect them to a grid or pipeline that can transport them to a location which can use the energy. With bitcoin, an energy consumption client is a computer away. This can help keep active and onboard renewable energy sources which would not be economically connected to the grid in the absence of additional profit sources such as bitcoin mining. We may soon live in a world where broad energy prices decouple from the location of the energy source.
Rebuttal: I can’t believe I am reading this! Think about the energy waste, how can this technology possibly be net positive for the environment?!
Verdict: The bitcoin protocol doesn't inherently need to use a lot of energy. It can run just as well on one or two computers as it does on thousands. The reason more computing power is used to mine bitcoin it is that society has decided that it has monetary value and that value is correspondingly safeguarded by more energy expenditure. Ultimately, this is a question of which activities we consider to be worth spending energy on and which we do not. I could point to equivalent energy expenditures, such as US clothes dryers, but does that really sway anyone’s opinion?
The bottom line is: Is a neutral store of value which provides people living under authoritarian regimes with a way to safeguard their assets worth the energy spending? I certainly think so. This can be an argument that is hard for people living in developed countries to comprehend. So let’s try another angle. Bitcoin increases the ability of citizens to opt out of their current government financial systems. Thus it provides a check on the power of even [currently] non-authoritarian governments. There is only so much that they can misbehave before their citizens vote with their feet and exit to bitcoin.
Conclusion
For all the reason listed above, I do not think Bitcoin will go away.
Is it guaranteed to become a big as gold once was? No.
Is it destined to be the world’s most valuable cryptocurrency forever? No.
Will governments stop it? There was a time when bitcoin could have been banned by governments, but I do think that time has passed. Cryptocurrencies are in too many ordinary people’s hands [wallets] now, and these people can vote.
Life is full of uncertainty and Bitcoin’s future is far from secure. Yet, personally, I think it still has more upside than downside. Why? Because it is still a non-consensus bet. A lot of people deeply despise it [you may be one of them, and that’s fine], and most of those people are not aware of all the narratives in favour of bitcoin. They also tend to reside in richer countries, where the geopolitical arguments for it seem weaker. And that, to me, is a clear blind spot.
Extras for the Hobbyists:
For the computer geeks: play with generating public keys and account keys from a private key.
For the history buffs: Listen to the Bankless episode on the crypto renaissance.