Understanding Bitcoin

Understanding Bitcoin – Getting Started

I have been fascinated by the rise of Bitcoin, Ethereum and other Crypto-Currencies for a long time. There is no doubt that these new technologies will re-shape the world of online commerce, traditional finance and other industries in ways we are just beginning to understand. The industries that embrace these new technologies will be primed to exploit countless new opportunities and avoid future obsolescence.

There is a lot of information out there but it’s not always easy to sort the good information from the bad. This blog post is designed to point you in the right direction, not so you can invest in Bitcoin and other cryptocurrencies, but so you can learn about how they work and the implications they hold. Allow me to be your helpful guide through the hype and the FUD to a more informed understanding of the “Internet of Money”.

What is Bitcoin?

This is the fundamental question that is likely the reason you are reading this post. It’s the question we are aiming to answer.
I don’t however think that it’s the best place to start when you begin to try to understand Bitcoin, Blockchains and various other cryptocurrencies. I believe a better understanding of the phenomenon that is Bitcoin can be derived from the question:

“Why Was Bitcoin Created?”

It’s very hard to write software without having a core problem you’re seeking to solve. This problem you seek to solve or opportunity you seek to exploit will be fundamental to the final software you design. If you really want to understand Bitcoin, you need to first look at the ‘Why’. Understanding it’s purpose allows you to understand its design.

In the early days of Bitcoin, before being widely known and living more as a curiosity on cryptography mailing lists, the answer to this question was very clear. It was designed as a permission-less system for transferring value from one entity to another without the need for intermediaries. The intermediary in this scenario of course being Central Banks.

This direct competition toward the established banking system was not implicit, it was directly explicit. In the ‘Genesis Block’ that launched Bitcoin’s blockchain, Satoshi Nakamoto included the message:

“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”

This message serves to explicitly demonstrate the software’s purpose, Bitcoin’s “Why”. Satoshi’s software was designed to disrupt what he perceived to be a failing and corrupted banking sector.

In fact, we can look at several other excerpts from his posts online that leaves us in no doubt as to the intentions behind the creation of Bitcoin. Another forum user in communication with Satoshi at the time put to him that “You will not find a solution to political problems in cryptography”.

To which Satoshi responded:

“Yes, but we can win a major battle in the arms race and gain a new territory of freedom for several years.

Governments are good at cutting off the heads of a centrally controlled network like Napster, put pure P2P networks like Gnutella and Tor seem to be holding their own.

Satoshi

Regardless of what you think of Bitcoin or the current financial system and whether you’re a fan of this new technology or not, understanding Satoshi’s motivations for designing the software in the first place will better help you understand it.

Diving in and trying to understand ‘Blockchains’ ‘ICOs’ and various other iterations of Satoshi’s design before learning the story behind Bitcoin, will leave you with more questions than answers and make true understanding more elusive, for longer.

Now we have a better understanding of the Bitcoin’s core motivations it would be a sensible time to take a look at these supposed problems with the current Banking and Finance industry to allow us to make direct comparisons with Bitcoin.

How FIAT money works.

So, the creator of Bitcoin, Satoshi Nakamoto saw in the current financial system a design that he could improve upon, one he could democratise. To understand his software, we should try to understand the problems in the current financial system as he saw them.

This post is designed to give you answers I know, but let’s ask another quick question…

“Where Does Money Come From?”

Most people that don’t work in the finance world answer this question in one of two ways. Either: “The Government print it” or “A Central Bank like the Federal Reserve or the Bank of England create it”.

This is accurate. To a point. Let’s take a closer look…

In the UK our Government is responsible for the creation of physical money, the kind you keep in your wallet, but this currently only accounts for around 3% of the money in circulation today. How many times have you paid your mortgage in cash? So, let’s ignore physical cash for now.

Central banks can and do influence the money supply, but people are often surprised to learn that organisations like the Federal Reserve and the Bank of England are private organisations, not an extension of Government. That is an important point that is not widely known.

So how exactly do these private entities control and manipulate our money supply?

In simple terms a central bank has three ‘levers’ it can pull to affect the money supply and indirectly influence the economy:

  • They can reduce the ‘reserve requirements’ of retail banks. This means banks can lend out a larger amount of money in relation to the deposits they hold.
  • Changing short – term interest rates. Lowering them effectively makes money cheaper to borrow and increases liquidity (the cost of this being inflation).
  • By buying and selling Government bonds. Buying them allows them to inject money into the supply and selling them allows them to shrink the money supply.

In this post I want to focus primarily on lever one. The reserve requirements of private banks.

The reality is that the majority of money in circulation today was created by private retail banks in the form of loans and mortgages. As reserve requirements fall, banks can loan increasing amounts to consumers compared to the deposits they hold. This means ultimately that the majority of new money created, is created as debt.

So what exactly do we mean by ‘created as debt’?

Well most people would believe that when you take a loan or a mortgage from a bank that they are lending you money that is entrusted to them by depositors. Makes perfect sense, right? The bank loans out money deposited with them, charges interest and depositors also get some of that interest back.

Unfortunately, that isn’t what is happening.

Due to these reserve requirements banks can create the money they loan out not from their deposits and not from the bank’s own earnings but directly from the borrower’s promise to repay the debt.

So essentially, the £20k you just borrowed to buy that new car wasn’t in circulation and didn’t even exist until you signed the loan papers. This new money in circulation was ‘created as debt’ and backed by your promise to repay.

The money that is borrowed will of course incur interest. The amount of money required to repay the debt will be higher than the sum of new money that was added to the circulation when the loan was issued. This in turn creates a need for the money supply to increase further to service the debt, requiring an increased need to issue new, and crucially, more credit. This is what fuels the ever-expanding debt of every nation state.

So, what are the implications of this?

An easy way to illustrate this is to look at a handy website that tracks current World Debt stats. Here are a few screenshots from the time of writing:

You can see that each major economic nation is in astonishing amounts of debt. But who are the creditors in this system?
The banks that created the money as debt for the consumer!
Ultimately, this debt is owed to these private banking corporations. They aren’t an extension of Government, but they do have the ability to create brand new money, enter it into circulation and charge interest for the benefit of using it. Makes banking licenses very attractive right? Especially if you bear in mind that over-exuberance and risky lending will likely be bailed out by taxpayers. What could possibly go wrong?

Satoshi would argue that this frivolous expansion of the money supply does not serve society well. It creates unsound money where savers are punished with inflation, consumers are punished with rising prices and capital is not employed efficiently creating huge bubbles and implosions in various capital markets. He would also argue that it consolidates power, enriches the banks and those closest to the source of cheap money and allows Governments to over extend their reach while punishing the rest of society.

Now we could explore in a lot more detail the wider implications this holds for the Economy and those that participate in it and deride the shortcomings of Keynesian economics, but we can revisit these topics in later posts. For now, we have a good enough understanding of the fundamentals of modern finance for us to have good context for understanding Bitcoin.

How Bitcoin Works

Cryptography and Computer Networking are complicated and specialist subjects. Fortunately, you don’t need to be a specialist to understand the underlying premise and design of Bitcoin.

We know from the above that Satoshi was primarily focussed on disrupting banking and what he saw as an unfair system that benefits the few at the expense of the many. His method for achieving this goal was to remove the banks and trusted third parties entirely from his design. His goal was to create an entirely Peer to Peer system where third parties were no longer relied upon for the creation and issuance of money and for actors in the network to transact with each-other.

To achieve this aim Satoshi’s design would need to replace three primary functions banks serve:

  • To store financial data.
  • To process transactions.
  • To issue new money.

To achieve these goals without providing any party with central control is a monumental achievement and required Satoshi to solve computer science problems that had not been solved before whilst demonstrating a deep understanding of economic incentives. So, let’s look at how Bitcoin achieves these functions without any central authority.

Storing Financial Data Without A Middleman

The first problem of removing a central authority is of course is that banks in our current system process transactions and store financial records for us. Without them, how will we keep track of who has what?

Bitcoin solves this problem by allowing every participant to effectively be their own bank. By this we mean that anyone and everyone in the network can keep their own copy of Bitcoin’s financial ledger, the Bitcoin Blockchain. This Blockchain stores a record of every single Bitcoin transaction that has ever taken place and is completely immutable, public and secure.

Sounds great, but we hit another problem. If two network users send Bitcoin to each other it makes sense that they can update their own copy of the blockchain, but how does everyone else know what they did to update theirs?

Well user’s Bitcoin wallets are connected to other participants in the network. When you make a transaction, your wallet passes the transaction to all of them, and they in turn pass it on to others in the network. The transaction will propagate around the network at increasing speed until everyone has received notification of it.

Processing Transactions and Issuing New Money – Bitcoin Mining

Bitcoin then, makes it possible for us all to store a copy of our financial data without a middleman, ergo, a bank who is keeping score. But banks perform other functions, how are Bitcoin transactions processed and how is new money created?

Bitcoin’s solution to these problems is ‘mining’. Mining displaces the need for a bank to process transactions and create new money. So what on earth is it? Nobody is digging Bitcoins out of the ground and how do miners process transactions?

Mining is best understood as a carefully considered game of incentives. Miners around the world are in an open competition to solve a cryptographic equation posed by Bitcoin’s protocol. To solve the equation they apply computer processing power to work through multiple potential solutions until one of the miners finally ‘guesses’ the correct one.

Anybody can become a miner on the network, it is completely permission less, meaning no central authority controls this process.

But what is the point of solving these equations? The ‘work’ miners do, on the surface of it, might seem pointless. The reality however is that this ‘work’ is not pointless and performs essential functions that allow the Bitcoin network to operate successfully without intermediaries.

The miner who wins this race will process pending unconfirmed Bitcoin transactions on the network and put them into Bitcoin’s next ‘block’ on the blockchain, replacing the need for banks to process transactions and for everyone to agree on what transactions have taken place and are legitimate. One a block is solved the race begins again to solve the next equation and process and confirm the next block of transactions for the network. This ultimately creates Bitcoin’s blockchain that records every single transaction. Forever!

So why would a miner go to all this effort spending energy and resource on mining? Well the incentive to do so is that the Bitcoin protocol will reward miners for their ‘work’ by generating new Bitcoins for the miner who won the race and processed each block.
In this way, Bitcoin’s protocol is starkly different from the way our current financial systems work. Mining democratically allows any participant on the network to process transactions and its Bitcoin’s open protocol, not a central authority that determines the rate at which Bitcoin’s circulating supply increases. Central authority has been removed.

In contrast to the FIAT currencies we discussed earlier Bitcoin’s rate of inflation is precisely predictable. We know that a new block will be mined every ten minutes and we also know the reward attributed for mining each new block. We can therefore predict the total supply of Bitcoins with significant accuracy for many decades into the future. If miners apply more computing power and start solving blocks faster than every ten minutes then Bitcoin’s protocol makes the equation harder, slowing them down. Conversely, if computing power on the network reduces it makes the equation easier, always arriving back again at an average of ten minutes per block.

It is also crucial to understand that Bitcoin has a hard cap to it’s money supply. Every 4 years the amount of Bitcoin rewarded to miners for solving a block is halved. The protocol therefore dictates that there will only ever be ~21 million Bitcoin in circulation and the last will be mined (via ten-minute intervals) in around 2140. Again this is a distinct contrast to traditional currencies that have been debased and inflated to reduce their relative value and purchasing power ad infinitum.

So how could 21 million Bitcoin possibly be enough to facilitate global commerce? Well… it’s digital and one Bitcoin can be divided down to 8 decimal places meaning that 0.00000001 Bitcoin is the smallest amount that can be sent in a transaction making it hugely more divisible than one unit of a fiat currency.

The Double Spend Problem

So, we have looked at a few of the most important concepts of Bitcoin at this point. We can understand the ways in which it directly contrasts the current monetary system today.

  • It doesn’t rely on central authorities to maintain balances and record transactions. Instead it uses a shared ledger – the blockchain. Anyone can run a Bitcoin node on the network and maintain their own copy.
  • It doesn’t need a central authority to process and verify transactions. This is done by anyone who decides to participate in mining.
  • Miners are rewarded for their computational power with newly minted Bitcoins. Rather than a relying on a fallible central authority to manage the money supply, the network relies on Bitcoin’s protocol to enforce the rules with no one person able to change them.

This is all well and good. But there is one more concept that is novel and should be introduced with any explanation of Bitcoin. The double spend problem.

The double spend problem poses a challenge to digital currencies. Unlike physical money it can be trivial to copy digital data. So, what stops a user from trying to spend the same Bitcoin twice, sending it to two merchants at once in attempt to double spend the same money?

Well bitcoin’s miners again play a role in this process. Should one transaction gain confirmations and get added to a block before the other then the second transaction would be deemed invalid by the miners and be pulled from the network. As more transactions are added to subsequent blocks the original valid transaction gains more and more block confirmations, eventually reaching the point where a ‘double spender’ would need to go back and reverse all transactions since the original to double spend. At a certain point this becomes computationally impossible.

This final concept is one which typically takes a few explanations to really sink in. But the way it functions is remarkable achievement. To date no such double-spend attack has succeeded and this is testament to the incredible ingenuity with which Bitcoin has been designed. To make sure we don’t put too finer point on this. Bitcoin has the first time in history created the concept of ‘digital scarcity’ an achievement that continues to be under appreciated.

The Bitcoin network continues to work with zero downtime and no successful attacks since its creation, a reputation that must be enviable to the likes of Mastercard and Visa.

Continue Your Learning:

So hopefully by now you have a fundamental understanding of how Bitcoin works. Surprisingly that puts you in a very small percentage of people. If this is your first read of anything about Bitcoin or Blockchain then don’t worry if you don’t feel you got it right away. I certainly didn’t make perfect sense of it first time round and there are thousands of inevitable questions that you’ll have that I couldn’t cover in just one post. Bitcoin to me represents the intersection of technology and economics and with that comes a wide variety of concepts and things to learn. Hopefully though you found this a good introduction and you feel more informed than when you started.

If you have questions, I want to hear them – I plan on following up this post with a list of questions I received and my best attempts to answer them! Fire them over to: richard@cryptocoach.uk
Check back for more posts that will look at these concepts in more detail and other interesting insights from what is happening in the world of cryptocurrencies.

Rick

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