Before we understand Bitcoin, I insist that you read this post which explains Money in great detail. Without having the understanding of it, the idea of Bitcoin cannot be understood completely.
There are a million articles, op-eds, videos and podcasts which talk about Bitcoin.
And here is another one but my version of understanding of Bitcoin. Not all cryptocurrencies, just Bitcoin.
But why only Bitcoin? Because Bitcoin is fundamentally different from all other cryptocurrencies. But before we know about the fundamental difference, we will have to understand the roles of money, existing technology and the challenges that were solved and the pieces which enables Bitcoin.
First is Money
💬 Who doesn’t know money? Pfft
If you haven’t read the post mentioned above about Money. I insist, read, here.
Moving on, money is used as a medium to buy or sell goods. Eg: Paying money to get your food or drinks.
This exchange of good or services quickly lead us to our second section called
There are two ways today to facilitate a transaction: cash or via bank over internet, by cards, by cheque etc. And this is where the first and obvious challenge lies how do we validate the transaction or did the transaction even happen?
💬 What? I paid for it with my hard earned money, it is valid. Isn’t it?
Nope ❌ , doesn’t work like that. Both parties should agree that transaction has happened or you need an entity which can be trusted by both parties to say that transaction has happened. Let me explain, in detail:
Cash – 💵
Let’s say you paid for your coffee with cash, the transaction will happen or you will get your coffee if the store accepts your cash. You both mutually agree. But when can the store disagree? If you pay in USD instead of INR in India, store can deny the transaction.
💬 Ooooh, smart! 🧠
Now, let’s see it from different side. From the eyes of the government👮. If the coffee store took your cash and never reported it, then there is no way for the government to know that a transaction has happened which means loss in taxes unless you are being watched.
That is how money is laundered or drug cartels work. But good people also use it to stay anonymous but pay their taxes honestly 👏 . Because there are more number of good people than bad ones, the government is fine with cash economy.
Bank – 🏦
If you had paid for your coffee via a bank through your mobile or credit/debit card etc. then the bank becomes the facilitator and the shop can rely on the bank that the transaction will be legit because of the trust 🤝 .
This transaction can also be seen by other parties like government which has entrusted the bank to facilitate the transaction. It is also called formal economy. With data from these transactions, government can build policies which affects interest on loan, taxes etc.
Bank ensures complete transparency to the government and can leave certain sections vulnerable. If done in disproportionate manner, you can call it surveillance. This is how government agencies often also catch launderers, they call it money trail 🏢 ➡️ 💁♀️ ➡️ ☕ . And yes, banks enable it if they are not part of it.
Is there no one which can say the transaction is invalid if done via bank then? It can be made invalid if:
- it is done fraudulently like through your credit cards. But the card companies or banks provide security against it in the form of refund or insurance.
- it is done beyond the boundaries of the country or the jurisdiction of the bank. Beyond which it always has to prove that the transaction is valid and not illegal on your behalf. That is also the reason why remittances, sending money abroad 💸 , are slow.
At this point, it is pretty clear that both systems, cash and bank, enable illegitimate transactions. It should also be clear that a transaction is valid only in a circle with certain radius, let’s call it Validity Circle(not a standard term, it is just to simplify the understanding).
💬 Got it! But how does Bitcoin fit in here? I have heard it is also being used by mafias for laundering.
Right! About that. It is possible for anyone to send/receive Bitcoin. You can’t stop that and that is part of the the Bitcoin ethos like cash. But what Bitcoin does offer that cash doesn’t is the money trail which we talked about earlier. If let’s say an account or wallet is seized, the transactions can be traced back to the point of origin, actually to the first Bitcoin transaction ever, and it is out there in open for everyone to check.
But you cannot block the transactions. And that what makes it different from Banks as well, which can seize or withhold accounts or deny transactions as per their will. For example, today almost all banks are not letting crypto exchanges to receive money even though the account owners want to.
💬 But how is Bitcoin able to do this?
In the age of internet 🌐 , a financial system should run on internet. Duh!
Because it has to be accessible to everyone – people living in conflict zones, in remote areas, in poor neighbourhood or in wealthy estate. With satellite internet, internet is going to be available to everyone and with that the Bitcoin’s financial system.
💬 Umm.. but my bank will also be available, right?
Yes, but you forgot about the devaluation of the currencies and censorship by banks and governments. With this comes the first genius idea of Bitcoin, there is no one party which runs Bitcoin like central banks.
Bitcoin is a decentralised system run by an open network of computers over internet. This makes Bitcoin a global currency which you can send anywhere in the world without having to carry it like sheep or Gold or USD. Built for internet, it also solves the remittence problem explained above. Basically, the Validity Circle of Bitcoin covers entire world and doesn’t stop with borders.
To perform the transaction, you have to pay fees like you do to your bank, only it is called Gas fees⛽ in Bitcoin and other crypto. It is completely decentralised and anyone can put in their (powerful) computers to help validate the transactions and put it in on a decentralised ledger called blockchain and the process called mining ⛏️ begins which generates new Bitcoin, more on it below. And it is not just one computer, the entire network tries to do this.
The good part is miners(validators) do not get to know the identity of the transactors, mostly and its not easy to know either. So, Bitcoin also wants to keep you anonymous which is a very powerful tool to empower people with their money.
💬 Mining sounds like Gold mining! 😆
Well, now that we are here. Let’s talk about Bitcoin’s Gold properties first,
Store of value
Do you remember from the post History of money and how Gold was entrusted with store of value?
There is another part to the stability of the Gold. There is abundant Gold on the Earth and out in space to practically make its value zero. The only reason the Gold still hasn’t lost its value is because we do not mine it enough. It is highly regulated to keep the economy stable because there is no alternative to make people believe that their money has value. This having stability against everything else has a term called hedging. As explained in History of money and economy post, Gold also didn’t do well.
This is what Bitcoin changes and fundamentally. Bitcoin has been programmed to have a limit to act like a precious metal, our beloved Gold, but in actuality and digitally. There will be 21 million Bitcoins forever and not 1 Satoshi(1/10^9 Bitcoin) extra. It has a hard limit. Not all Bitcoins are available for transaction, it is currently in mining phase which means they are getting generated as the transactions are happening.
This makes Bitcoin a digital alternative to have an actual store of value replacing the Gold. While Gold can be multiplied or added, Bitcoin can only be divided. Since it cannot be expanded, a bitcoin will have an increasing or stable value in terms of other currencies which might sound like inflating asset like others. But if we see it from different point of view, it does not, in which the Bitcoin is a primary currency – the store of value. The awesome phone will always cost, 0.000001 BTC(Bitcoin’s trading name).
If everyone own Bitcoin, then the only way you can get less Bitcoin for your work if the debt economy creates new value(in value economy) and in abundance. Hence, Bitcoin solves the problem created by Fiat money and in measurable ways.
Bitcoin does a fabulous job by separating the value economy from debt economy as I explained in Two Types of Economies and can keep everyone’s hard earned money safe which can be accessed from anywhere. This takes away the power from banks and governments to play with people’s money through irregular lending and corruption.
💬 It is a nice idea but I saw people on Twitter talking about its not a good hedge, it’s volatile which also makes it bad store of value. Heck! It dipped down 20% yesterday.
You are right. Bitcoin is not that today but it will be in years to come as more people participate in buying and selling and making the network stronger.
💬 It also sounds like a threat to countries sovereign rights.
It actually does not, I wrote an entire post on explaining this in Bitcoin for Banks and Governments. Anyway, back to the original question,
How do I trust these transactions?
With Bitcoin came another genius idea of establishing trust on an anonymised network. It is called Proof of Work 👨🏭 . This idea is genius because whoever thought of Bitcoin, Satoshi Nakamoto(unknown), connected the value with the real, physical, world.
Bitcoin demands a proof that the validation of transaction has happened. And how? By spending Energy⚡ to run those powerful computers. You cannot fake it. This is what makes Bitcoin different from all other cryptocurrencies. That’s also what gives Bitcoin the real value, the energy required.
Before we know more about it, let’s see it in relation to Gold because Fiat money doesn’t serve the same purpose in essence. Today all transactions are cheap, either cash or bank. But the cost of generating new money is not. New money requires a debt or in case of Gold it requires mining which consumes a lot of energy.
Mining in Bitcoin is not different. The term is called mining because when a transaction is available for validation, it is put together with a bunch of other transactions called block🀄 and that block has to be put on the ledger called blockchain⛓️ . Everyone in the network has a copy of the same blockchain and to add a block requires Energy to be spent by solving a cryptography problem by everyone. Whoever does it fastest is awarded new Bitcoins and that is why it is called mining.
Bitcoin network has a leverage to truthfully validate the transaction in return of getting new Bitcoin and transaction fees. But there are also guardrails to keep the system trustworthy:
- the Energy will have to be spent, which is difficult to produce.
- the wider the network, more difficult it will get someone to falsify the ledgers and everyone to accept.
But out of the two, the real guardrail is the wide network.
Bitcoin has been in the news for consuming a lot of energy. If we look it from different point of view, Bitcoin also provides leverage to get cheap energy, for miners to make more profit. If energy becomes very very cheap then the only guardrail which can keep Bitcoin network safe is the wide network.
💬 Gotcha! I think I understood everything about Bitcoin.
At the end
Since Bitcoin will require lot of energy, at least for a long time, to transact, it doesn’t make a solid case to be used as a currency for daily needs. Any money shouldn’t cost a lot for day-to-day transactions like buying coffee. For that there should be other cryptocurrencies which are cheap to transact. But there is this Lightening Network which might work out in long run.
In the post Bitcoin for Banks and Governments, I explained how Government can make their sovereign cryptocurrencies without having to worry about the Bitcoin. Bitcoin is the future and so is crypto economy. If not today, then tomorrow but eventually it will work because everyone gains out of this system.
Bitcoin will become the standard. It is also the true global currency which no one owns unlike USD.
And all being said, while Bitcoin can protect from inflation from Fiat money, what it cannot protect from is inflation because of the disparity between rich and poor. Rich person willing to shell out more Bitcoin for the awesome phone or coffee will keep their prices higher. This can only be changed by government through its policies which protect poor. Governments’ support to Bitcoin and separating debt economy will actually help everyone.
But real things
We should solve this financial problem and then we have far more real things to worry about like surviving pandemics 🦠 , drinking water🚰 , healthcare 🏥 , asteroid collision ☄️ , food 🥘 , volcanos 🌋 , tornados🌪 , climate change 🌊 etc. We have to protect the Earth 🌏 and we also have to reach to the other stars and galaxies.
Our survival is not complete, it perhaps never will be but we have to keep trying. Everything else is a distraction.
If you have read so far you might also want to checkout Two Types of Economy, already referenced above. And also about Future of Cryptocurrencies which explain why other cryptocurrencies exist and why some of them are here for long term.