What is Bitcoin?

What is Bitcoin, and why is everyone getting so excited by it? 

Written on: May 9

Bitcoin the Technology

Bitcoin is a radical new system for value exchange that eliminates the need for central intermediaries which, for the past six hundred years or so, have been needed to inject trust into commercial transactions. If widely adopted, Bitcoin can make these middlemen, and all associated costs and inefficiencies, disappear. The implications are enormous. For instance, a recent Santander report estimated that bitcoin technology could save banks $20 billion in annual infrastructure costs. And banking is just one of the more obvious applications of the technology - bitcoin has the potential to fundamentally disrupt all markets that rely on central institutions to verify and settle transactions, and all communications that rely on central institutions to pass information. If bitcoin fulfills this potential it has internet-esque world changing implications.

Bitcoin is basically a ledger - or a "blockchain" - that is relayed across the internet by a vast network. The network is decentralized, meaning it lives on no central server but is rather hosted by a vast and far flung network of relay points, or "nodes". These nodes constantly receive bitcoin-related information from the network and broadcast this information, from peer to peer, out to the rest of the world. Thus bitcoin is not governed by any central institution that could undermine its initial mandate, and it is theoretically impervious to malevolent attacks against its infrastructure - the blockchain lives nowhere and everywhere.

Approximately every 10 minutes the blockchain is updated with a new block consisting of unrecorded transactions. These transactions are verified and settled utilizing a method of distributed consensus made possible by years of advancement in cryptography. Bitcoin's distributed consensus represents the solving of a famous computer science riddle known as the Byzantine General's Problem: how can a dispersed group of generals come to an agreement as to when they are meant to launch an attack when they are unable to speak directly with one another, and some of them might be ill-intentioned?

As it pertains to bitcoin, the generals are special nodes known as miners, the synchronized attack launch equates to agreement as to how the blockchain ledger should be appended, and these ill-intentioned generals would like to insert false transactions. The answer, which is discussed in greater depth elsewhere, is that each new block must have attached to it a cryptographic seal of all the transactions that came before it. A dishonest miner would need to retroactively change the historic transactions that came before it and quickly pass the revised blockchain around the network within a 10 minute period, a process that borders on mathematically impossible.

Bitcoin the Currency

Much focus within the media has been paid to the value and volatility of bitcoin the currency. The amazing climbs to nosebleeding heights, the staggering reversals triggered by some scandal or another, erasing billions in wealth with stunning quickness. And yet, little has been said as to why this virtual coin has any value at all. It is not backed by a commodity such as gold or silver, nor is it the legal tender issued by a central government. Why are bitcoins worth anything?

Some might argue that bitcoin's limited supply and deflationary nature offers value. Circulation is capped at 21 million units which are released in gradually reducing increments, until an estimated end date sometime in 2140. The coins are minted by miners in a costly process requiring massive amounts of computational power. We argue elsewhere that the cost of supply associated with production perhaps serves to provide a value benchmark.

Some say that there is demand for bitcoin because it is an exceptional medium of exchange, allowing cheap, fast and semi-anonymous transaction. Additional applications for the technology, if realized, should help increase demand as well. But this does not actually account for the value of bitcoin itself as an asset, but rather demand for the underlying technology.

Perhaps bitcoin is valuable because people want it to work. There is a limited amount of bitcoin and there is demand for it, whether the demand is due to belief in the underlying technology, its usefulness as a medium of transfer, or its ability to accommodate new and disruptive technologies. This also helps explain the extreme price volatility, as positive or negative news at times disproportionately influences market faith in the overall project.

All of these different supply and demand side explanations contribute in some capacity to the ultimate value of bitcoin. However, perhaps the reasons do not actually matter - bitcoin has made the transition from worthless to worth something, and it does not seem that the process will be reversed.

Why is Bitcoin Needed?

Bitcoin is the culmination of years of advancement in the field of cryptography, specifically in the cryptocurrency subfield. Cryptography is essentially the art of hiding secrets in plain view. It is the method of securing communications in the presence of "adversaries". Most obviously, cryptography has been used in times of war, but also powers many of the things people use everyday, such as email or banking passwords. Cryptocurrencies like bitcoin use cryptography to secure transactions and control the introduction of new units of value. Over the last few decades, advances in public-key cryptography, hashing functionalities and mining strategies paved the way for the rise of cryptocurrencies.

But bitcoin itself emerged due to a very specific alignment of events. The impetus for its development was the massive global meltdown of 2007-2008 in which irresponsible management of credit by financial institutions directly resulted in a staggering economic collapse. The monetary policies of governments in response, while perhaps the best of a number of horrible options, triggered inflationary pressure, an erosion of purchasing power, and national debts that today's youth might be paying down years from now.

This was the state of events when an unknown man named Satoshi Nakamoto suddenly appeared and introduced his new technology.

The Mysterious Satoshi Nakamoto

Mr. Nakamoto introduced himself to the world in November 2008 with his email to the Cryptography mailing list that began: "I've been working on a new electronic cash system that's fully peer-to-peer, with no trusted third party". Over the course of the next two months, through the email list and a dedicated forum, Nakamoto would engage in discussions with a gathering number of talented developers and cryptographic experts about his concept of bitcoin, until its eventual version 1 release in January of 2009. He stuck around for the next year and a half, acting as a benevolent guiding hand in Bitcoin's formative early stage, and then abruptly disappeared mid-2010 to pursue "other interests".

Who would briefly surface to introduce a technology with a disruptive potential rivaling, say, the internet, and not claim a bit of credit? Was it an individual or a group? Cryptographers uncovering a new application for their field? Libertarians recognizing a method to decentralize atomized power structures? Savvy business men taking advantage of a new opportunity? The question of who is Satoshi Nakomoto is an extremely intriguing side story, fascinatingly told in a highly recommended NewYorker article written in 2011 by Joshua Davis. Whoever he is, he successfully mined one million bitcoins in the first few years when bitcoin were worthless, and his trove is now worth a quarter of a billion dollars. His bitcoin bullish nature is apparent by the fact that he has not sold a single coin.

There are two different bitcoin camps, each of which describes a different primary motivation to Nakamoto. The first camp, which might be termed crypto-capitalists, sees bitcoin as solving a host of practical issues implicit in modern finance, but applicable also in any trust-based transaction models. These practical issues lead to a number shortcomings in terms of high fees, overhead, transaction times and market inclusiveness, while also placing limitations on the types of transactions that can be facilitated online. These problems had, until bitcoin, been unavoidable.

The second camp, which might be termed crypto-anarchists, see bitcoin as potentially solving a host of problems implicit in the relationship between the individual and central power structures. Crypto-anarchists appreciate the commercial advantages offered by bitcoin, but are more excited as to how bitcoin changes the power dynamic between people and central financial institutions. And they see bitcoin as having the same potential to diffuse other centralized power structures, whether financial institutions, governments, or the internet itself.

Nakamoto the Crypto-Capitalist

"Commerce on the Internet", starts Nakamoto's Bitcoin: A Peer to Peer Electronic System, "has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model."

One weakness is that the bank, as intermediary, finds itself mediating disputes that often lead to reversed transactions. This has a massive knock on effect. Dispute arbitration requires additional resource, adding overhead. Transaction costs increase. Merchants, wary of chargebacks, require additional verification information from customers, leading to loss of business. Revenues fall. The additional information provided by customers leads to greater potential for identity theft, which serves to increase the number of transactions reversed, hitting merchant's bottom line and requiring additional arbitration and resource. And around and around it goes. This has led to domestic processing fees of 2-3%, a corresponding drop in profit for merchants and, as they try to offset this loss, higher prices for customers.

Another weakness is that credit card processing (and international transfers) are entirely inefficient. A swipe of the credit card sends personal information to the merchant, over to a payment processor, back to the user's bank for authorization and credit check, back to a different payment processor, and lastly to the merchant's bank. Not only does it take a long time for actual settlement, which greatly confuses banking ledgers and balance sheets while requiring a tremendous amount of resource reflected in further increase in transaction costs - the broadcasting of personal information back and forth across the internet has made fraud endemic.

According to the Bureau of Justice Statistics, approximately 7% of US residents 16 years or older were victims of identity theft in 2012. 85% involved fraudulent use of credit card or banking information. Not only is this traumatic for victims, it leads to reversals for sometimes irreversible services, leading to a corresponding drop in profit for merchants and, again, higher prices for customers.

Additionally, though we take our financial system for granted, close to half the world's population have no access to the modern banking system, and thus are largely excluded from the global economy. Indeed, in developing countries, in which foreign workers are arguably the largest source of financial inflow through their remittances, 8-10% of the ~$500 billion in earnings sent back home is wiped out through transfer fees. Transfer fees taken directly from the families and economies that need it most and rerouted into the pockets of intermediaries like Western Union.

Bitcoin cuts this Gordian Knot entirely, potentially saving untold billions (trillions?) in fees and overhead while offering entry into the global marketplace to the unbanked billions. The bitcoin establishment sees this as the paramount object of bitcoin, best achieved through cooperation with regulatory agencies, banks and governments to encourage wider, mainstream adoption.

Nakamoto the Crypto-Anarchist

In 2007-8 the world was engulfed in the worst economic disaster since the great depression, with literally billions of people affected. Estimates as to the ultimate economic damage vary, but some analysts maintain up to $15 trillion in total losses. While irresponsible mortgage lending has largely been blamed as inciting the meltdown, many view an underlying risk-taking culture proliferate amongst financial institutions as being the ultimate cause. Governments responded by bailing out failing banks with money that could almost not be printed fast enough.

This, according to Nakamoto, was entirely predictable. "The root problem with conventional currency is all the trust that's required to make it work," he wrote. "The central bank must be trusted not to debase the currency, but the history of fiat [paper] currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve."

The principal-agent problem occurs when a person or entity is designated to make decisions on behalf of another person or entity. Many times, these entities will be motivated to act in their own interests rather than the principals they are meant to be representing. In Nakamoto's examples above, the agents are represented by banks and government, but the same dynamic theoretically can goven any relationship in which an agent holds centralized power. This is true also of the internet itself, which paradoxically is becoming more and more centralized.

Massive central servers store our information and process our domain name service (DNS) requests. Both can be used to facilitate methods of surveillance by companies, governments, or a host of unsavory actors. For example, in March 2014 Turkish Prime Minister Recep Erdogan pressured domain name service providers to block twitter requests originating in Turkey, temporarily shutting down access just as a scandal involving his illicit use of funds was picking up steam.

According to Crypto-anarchists, bitcoin acts as a decentralizing counterweight against these trends of centralization, and that is the purpose to which the technology should be focused. The financial benefits of bitcoin are exceptional, but primary focus must be placed on rolling back a rapidly encroaching nanny state and reclaiming privacy. From this perspective, working together with regulatory agencies and governments is somewhat of a betrayal to the cause.

In the next part of the guide, we take a look at the bitcoin network and how bitcoin transactions work.

Bitcoin Price (USD): 853.48