So you’ve finally decided to swallow the red pill and see for yourself what surprises the rabbit hole holds… yet you can’t quite put a finger on this ‘thing’ called bitcoin. You read bitcoin started this whole new ‘revolution’ but you don’t quite understand how this disruptive technology works. You heard ‘currency,’ ‘digital currency,’ ‘cryptocurrency,’ ‘Internet money’ being used fairly often by the bitcoin users but you still wonder ‘How can this be?’ How can bitcoin be a currency like the US dollar or the Euro?
As you search the Internet, you find new buzz words like blockchain and decentralized network being closely linked with bitcoin yet, still, you are even more confused. That’s why you’ve decided to take a step back and ask yourself and Google for that matter: what is bitcoin?
The first definitions you come up with sound similar to these:
Bitcoin is an innovative payment network and a new kind of money. / bitcoin.org
Bitcoin is a worldwide cryptocurrency and digital payment system called the first decentralized digital currency, as the system works without a central repository or single administrator. / wikipedia.org
Obviously, you weren’t satisfied with these definitions so you dug deeper and discovered my blog. And luckily for you, you are in THE right place because I will explain what bitcoin really is without fancy words and geek slang. I will explain the concept in plain English, no IT knowledge involved whatsoever.
Fiat money vs. Bitcoin
First though, we’ve got to take a step back and clarify how today’s financial system really works. And NO, it’s not how you would imagine.
So, what is money? Money is anything generally accepted as payment for goods and services, and also repayment of debts. In other words, money is a consensus between a group of people; this consensus establishes a measurable, divisible item as being a medium of exchange (for example, you can buy with this item a wide variety of goods, therefore avoid barter trading or trading goods with other goods), a store of value (this item is valuable in some way and can get you a fixed quantity of goods at any point in time), and a method of deferred payment (in plain English, this item can settle any given debt).
You may think money is backed by something like gold or maybe your national economy. Truth be told, money is only backed by the word of what we generally refer to as politicians and governments. YES, that is right: ONLY their word, no gold, no industry, no goods and services, no economy! Indeed, the health of any given currency is reflected by the economy it represents but that doesn’t mean that currency is backed by its economy.
In the past, the value of money came from the commodity it was made but not anymore. The gold standard seemed like a healthy system until, well, it collapsed for good in 1971. Till then the US dollar had a fixed value in gold, according to the Bretton Woods agreement: one troy ounce of gold was worth 35 USD (the other currencies had a fixed rate relative to the USD). In 1971 however, US president Richard Nixon cancelled unilateral the direct convertibility of US dollar to gold.
From that point on, the fiat money ruled the worldwide financial system – and still does as you read this article. Fiat means ‘Let It Be Done’ in Latin and is used in a sense of decree or order. In other words, fiat money is money without any intrinsic value established by law. YES, that includes US dollar and Euro.
Why mentioning this though, you wonder? Well, it’s simple, because you will often hear bitcoin isn’t actually a currency because it isn’t backed by anything. Guess what, neither is the US dollar or Euro. The value of both Fiat money and bitcoin derives from a general consensus among us. Fiat’s value however is established by law first and foremost before we accept it and the laws of the free market come into place whereas bitcoin’s value is established exclusively by the free market – where supply meets demand.
Gold vs. Bitcoin
Ok, but that can’t be the sole reason why Bitcoin is regarded as currency, you may say. And this does NOT answer my question, you may also add.
Obviously, both remarks are absolutely correct. But to truly understand what bitcoin is, I am obliged to clarify some very important aspects about the real world and bitcoin misunderstood by many. And that’s why I also need to explain where bitcoin gets its value in the first place and why it is compared to gold (you may hear the term ‘Digital Gold’ quite often when referring to bitcoin).
The true value of money doesn’t come from the consensus or from a decree or law. Money is valuable because of its scarcity. In plain English, money is hard to find, there is a limited supply of money. That’s why gold is valuable, that’s why diamonds are valuable, because both commodities are rare, insufficient even.
One might say one bitcoin is only some programming computer code, so how can code be scarce? There are trillions and trillions of lines of code in today’s world, your operating system is comprised of countless lines of code, even this blog has thousands of lines of code.
But it isn’t the code itself that makes Bitcoin valuable. What it does actually replicates in the digital world the process of gold mining. What do we mean?
First of all, the anonymous person or group who created Bitcoin in 2008 nicknamed Satoshi Nakamoto came up with an ingenious plan to replicate scarcity in the digital world: firstly, he allowed the creation of a limited supply of Bitcoins namely 21 million. No more, no less, so, basically, there is no inflation involved whatsoever.
Who creates these Bitcoins? Well, the code, the program itself and no one can intervene. The Fed, the National Bank in this case is basically the hard code that mints new currency every 10 minutes or so (a compromise Satoshi Nakamoto made for the general consensus in the network to be reached, read Blockchain Explained for more info).
Where does this new currency goes? To the Bitcoin users of course! OK, but how? Is it given away like dividends? Actually no! In that 10-minute period, some specialized users who work very hard and invest lots of money to maintain the network called miners compete to solve a puzzle. To do that, they need a lot of computing power and electricity. Who solves the puzzle, gets a reward in Bitcoin, the new currency minted by the hard code.
How much? In the early days, the miners used to get 50 bitcoins, but in order to create a digital version of scarcity, Nakamoto had another great idea: after a set period of time, the reward is halved until the cap of 21 million is reached. It started at 50 BTC and now in 2017, it is currently at 12.5 BTC meaning it has been halved twice so far – from 50 to 25 and from 25 to 12.5 BTC.
So, according to Nakamoto:
The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation.
As of now, over 16.6 million Bitcoins have been minted or mined and are currently in circulation.
Banks vs. Bitcoin
Yet, one dire question remains before solving the whole ‘what is Bitcoin’ puzzle: how are these Bitcoins spent? And how or what keeps track of the Bitcoin transactions if there is such a person/thing?
To answer those questions, let’s first see how this problem is solved in the real world. In the real world, we have ledgers and all kind of accounting tools to keep track of how do we spend our money. We as consumers sometimes use these tools to see where all our money goes.
To replicate the real world financial system, Bitcoin has a whole network behind it that maintains a single history of all Bitcoin transactions, a giant database of spending. The term commonly used for this giant database is blockchain (you can also read more about this topic in the Blockchain Explained article).
The blockchain is nothing more than a big database shared/distributed among the network users – that is why you may hear very often terms like ‘distributed database’ or ‘decentralized’ as there is no central server with that database – a ledger that contains all the Bitcoin transaction ever happened from the creation of the network to the present state.
Why the term ‘blockchain’? Transactions are bundled together in a block by the miners and all these blocks are linked together from the earliest to the last, forming a giant ‘chain.’ When the miner solves the puzzle, he links the latest block of transactions to the blockchain and earns a reward.
Ok, yet how does the miner know of these Bitcoin transactions? According to Nakamoto, in the mint based model, the mint was aware of all transactions and decided which arrived first. To accomplish this without a trusted party, transactions must be publicly announced, and we need a system for participants to agree on a single history of the order in which they were received. The payee needs proof that at the time of each transaction, the majority of nodes agreed it was the first received.
The system for participants to agree on a single history of order is the puzzle-solving method based on rewards explained earlier and commonly referred to as Proof-of-Work (more about the topic in Blockchain Explained).
What Is Bitcoin?
The leaves us with the ultimate question that can’t be answered in just a few words, like you most likely noticed.
Hopefully, all these rambling makes sense for you and in case it doesn’t, let’s just make a quick sum up and call it an article: