Bitcoin Explained

A lot of people ask me what Bitcoin is? How do crypto currencies work?

Do not worry, I am not going to get too technical and use a lot of complicated words. In this article I will explain Bitcoin in layman’s terms, so that even if you have no technical background you will have the ability to understand the concept. By the end of this blog post you will know more about Bitcoin and how it works than 99% of the population. Before I discuss Bitcoin, I want to take a minute and discuss money.

What is money exactly? At its core, money represents a medium of exchange.

When I perform a service for you, you provide me money in exchange for the worth I provided to you. In turn, I can use that money in exchange for something of worth from somebody else in the future. Throughout history, worth has actually taken lots of forms and individuals utilised a great deal of various products to represent cash. Salt, wheat, shells and obviously gold have all been used as a circulating medium. Nevertheless, for something to represent worth, individuals need to trust that it is indeed valuable and will stay important enough in time for them to redeem that value in the future.

Up until a century ago approximately, we always trusted in some THING to represent cash. Something happened along the way and we have actually changed our trust framework from trusting some THING to trusting in some BODY. Let me describe. Over time, individuals found it too cumbersome to walk the world carrying bars of gold or other types of cash, so paper money was created.

Here’s how it worked: a bank would offer to exchange your ingot of gold, that’s worth ₤1000 for example. In return, that bank would offer you receipt certificates, which we call bills, totalling up to ₤1000. Not only were these papers a lot easier to store on oneself, but you could buy smaller value items without having to cut your gold bar into a thousand pieces.

And if you desired your gold back, you merely took ₤1000 worth of receipt bills back to the bank to exchange it for something of value, in this case that gold ingot, whenever you required. Therefore, paper began its use as cash as an instrument of functionality and benefit. Nevertheless as time progressed, and due to macroeconomic changes, this bond between the paper receipt and the gold it represented was disconnected. How that happened is a different story and you can find out more here.

However, governments told their people that the federal government itself would be accountable for the value of that paper money. They print onto the paper something like “I promise to pay the bearer on demand five pounds” such as is on the UK £5 note. It’s nonsense really as the Bank of England is not going to give you anything real if you made that demand. So banks are able to print money out of thin air. This is called fiat currency. Banks need to be careful not to print too much at once, otherwise inflation rises too fast and people lose trust in the currency. This happened in Germany after WW1 and was a factor in the rise of the Nazis and WW2. More recently, it has happened in Venezuela and Zimbabwe. Peoples savings were wiped out and the countries went through massive political strife.

Generally we all accepted the principle “let’s just forget gold and trade paper instead”. Individuals continued to trade with receipts that are backed by absolutely nothing, but the government’s promise. And why did that continue to work? Well, mainly due to trust. Even though there is no real product backing fiat money, individuals trusted the government and that’s how fiat money was developed. In Latin the word “fiat” means “by decree”, indicating that the dollars, euros or any other currency for that matter, have worth due to the fact that the government orders it to have worth. Amazingly in the USA, the Federal Reserve which issues US Dollars is not even a Government entity. It is simply a really small group of banks operating the reserve system by order of congress.

Anyway back to money. It is what is called “legal tender” – coins or banknotes that must be accepted if offered as payment. The value of money really originates from a legal status provided to it by a central authority, in this case, the government. Therefore the trust framework has actually changed, from relying on some THING to trusting some BODY, in this case, the government.

Fiat cash has 2 main downsides:

1) It is centralised: You have a main authority that controls and provides it. In this case the government or central bank.

2) It is not restricted by quantity: The government or central bank can print as much as they want, whenever required and pump up the cash supply on the marketplace. The problem with printing money is that because you’re flooding the marketplace with more money, the individual worth of each dollar, pound or euro drops and your own cash is worth less. When you see prices increasing throughout the years it’s not necessarily that costs are increasing. Part of the equation is that the purchasing power of your money is dropping. You require more pounds to purchase something that has an intrinsic value which hasn’t increased.

Let’s use real estate in a city like London. It is difficult to build new houses as the available space is highly restricted. So when the Bank of England prints money to keep the economy moving, and lends it at a very low interest rate, there is more available cash chasing a finite asset. So the amount of cash that the asset is able to exchange for goes up, even though the underlying asset has not increased in its intrinsic value. It’s just that the money is worth less today than it was last year, and significantly less than 10 years ago. You hear about it in the news. It’s called inflation.

I often think that back in the day the average person had the same problem getting their head around paper money as people do today around crypto currencies.

In principle, if you can understand and accept the principles behind fiat currency, then it is not a massive leap to understand how crypto currencies work.

We already have a central authority that releases money, so why not make money mainly digital and let that authority keep an eye on who owns what. Today we generally utilise charge card, wire transfers, Paypal and others forms of digital cash. The amount of physical money on the planet is nearly negligible and is getting smaller with each year that passes.

So if cash today is digital, how does that even work?

For example, if I have a file that represents a pound, what’s to stop me from replicating it a million times and having a million pounds? This is called the “double spend issue”. The solution that banks utilise today is a “centralised” solution; they keep a ledger on their computer system which tracks who owns what. Everybody has an account and this journal keeps a tally for each account. We all trust the banks and the banks trust their computers, and so the option is centralised on this transaction ledger in their computer systems. You might not understand this, but there were many efforts to create alternative kinds of digital currencies, however none achieved success in resolving the double spend problem without a central authority.

Whenever you offer anyone control over the money supply you’re providing massive power and this creates three major concerns.

The first concern is corruption; power corrupts and absolute power corrupts most definitely. When banks have a mandate to develop cash, or value, they basically control the circulation of value worldwide, which gives them almost endless power. A small example of how this power can be damaging was seen in the Wells Fargo’s scandal. Employees secretly created countless unapproved bank and credit card accounts in order to pump up the bank’s profits stream, without their customers learning about it for years.

The second issue of a centralised system is mis-management. If the central authority’s interest isn’t aligned with the people it controls there may (will) be a case of mismanagement of the cash. Printing a lot of cash in order to save a specific bank or institution from collapsing is what happened in 2008. Arguments will be made that it was for the public good, but you have to take a Politicians word for that. The issue with printing too much money is that it triggers inflation and generally deteriorates the worth of the public’s cash.

The last issue is control. You are generally giving away all control of your cash to the government or bank. At any time the government can decide to freeze your account and deny you access to your funds. Even if you stick to cash, the government can cancel the legal status of your currency. This happened in India, and on a smaller scale, everywhere. When a new coin or note is introduced to replace existing cash, after a while, the old notes and coins become out of date and are worthless.

Then in 2008, something remarkable happened that went pretty much unnoticed. In October 2008 a file was published online by a guy calling himself Satoshi Nakamoto. The document, likewise called a white paper, recommended a way of creating a system for a decentralised currency called Bitcoin. This system declared to create digital cash that resolves the double spend problem, without the need for a central authority.

At its core Bitcoin is a transparent journal without a main authority. In effect it is a ledger, just like the bank has, stored on a kind of database called a blockchain. Now imagine that there are thousands of computers around the world that earn payments for maintaining this financial ledger. These computers are running algorithms that verify transactions and write the transactions to the ledger. These computers earn small payments for verifying these transactions. And it is all encrypted. The ledger is also replicated across a ton of independently owned machines around the globe.

It is theoretically impossible for a bad actor to decrypt and alter the ledger over thousands of machines simultaneously. So we have a ledger system that can be trusted, removing the need of a bank.

There is also more transparency with Bitcoin specifically. Unlike a bank, anyone with a blockchain explorer which is freely available (think File Explore on you PC, but for Bitcoin), can actually have a peek at the ledger to see what transactions and balances have been recorded. You cannot see who owns each account, but you can see the movement of value.

This means Bitcoin is pseudo-anonymous; everything is open, transparent and trackable however you still can’t infer who is sending what to whom. Let’s describe this with an example. You can see on your screen specific rows from Bitcoin’s journal. You will see that one Bitcoin address sent 10,000 Bitcoins to another Bitcoin address in May of 2010. This specific deal is the very first purchase, as far as we know, that was made with Bitcoin. A chap called Laszlo bought two pizzas. Laszlo released a post back in 2010 asking for somebody to sell him 2 pizzas. He was offering 10,000 Bitcoins. Well, someone smart did, and now the price of those two Pizzas today would be worth well over 60 million pounds.

To reaffirm the point, Bitcoin is decentralised; there’s no one computer that holds the ledger, they all do. With Bitcoin, every computer system that takes part in the system is also keeping a copy of the ledger called the Blockchain. If you want to compromise the system or hack the ledger you’ll have to simultaneously take over thousands of computers which are keeping a copy.

Like all cash today, Bitcoin is also digital. The main difference here is that you cannot get a Bitcoin note from a cash machine. However, there are cash machines already that allow you to send money to and from your Bitcoin address.

So in practice, how do you receive and own Bitcoin? All you require is to create a Bitcoin address and store it in a wallet. A wallet can be a software app or hardware that looks similar to a thumb drive.

To be frank, it is not everyday user friendly for the average joe. Think of the internet before the web browser. The internet was used by governments and techies prior to the invention of the internet browser which launched the world wide web. At the moment, one of the main barriers to mass adoption is that using Bitcoin for everyday transactions is inconvenient. When this problem is solved, cryptos will be set to go mainstream.

Interestingly, there are no actual coins, there are only rows of deals and balances. When you “own” Bitcoin, you own the right to access a particular Bitcoin address record in the ledger and send out or receive funds from it to/from a different address.

Why has Bitcoin gained such notoriety?

Well for the first time in recent human history, there exists a mechanism for the exchange of value that is outside the control of any central government.

Bitcoin is a kind of money that no government or bank can control. Let’s be clear as I have a lot of friends who say it is not money and put it out of their minds. I notice with a wry smile that it tends to be well off people that react this way. They see Cryptos as a threat, as do many governments. They are wrong in one sense as Bitcoin is money. They are right in the sense that Bitcoin is not Fiat money. They are both kinds of money.

Again, think about the time before the Web. All information was pretty much centralised. Generally if you desired information, it would have passed through several hands before you received it. Depending on who owned the newspaper, this would affect how accurate the facts were. And many governments can create information that is favourable to them. Now, the internet has democratised information. At a high level cryptocurrencies aim to democratise money.

The other reason that your financial adviser will tell you it is a scam or all worthless is that they lack imagination and they do not see a use case for it. But there are several drivers as to why Bitcoin currently has value and may continue to do so.

Bitcoin cuts a great deal of the intermediaries from the process of transferring money. You could send thousands of pounds worth of value to someone abroad and it would only cost a few pennies.

Unlike fiat currencies, cryptos are digital and can enable developers to add layers of programs on top of it and create new functionality like smart contracts. Lawyers watch out!

Bitcoin allows people to transact and send money circumventing restrictions that their government may have put in place.

Bitcoin also allows regimes like Iran, who may be sanctioned by the US, to trade with its friends, under the radar of US intelligence.

Bitcoin opens up commerce to 2.5 billion people around the globe who don’t have access to an existing banking system. These people are unbanked because of where they live and the life circumstance that they have actually been born into. Today, with an iPhone or android and one click of a button, they can begin trading using Bitcoin with no authorisation required.

Today there are a number of merchants online and offline that accept Bitcoin. You can purchase a flight or book a hotel with Bitcoin if you like. There are debit cards that allow you to pay at nearly any store that takes Visa with your Bitcoin balance.

In summary, as long as we live in a world of inequality, suppression and an ultra wealthy elite protecting their interests, there will be a demand for crypto currencies that are fully decentralised.

Related posts