Understanding Bitcoin
The next step in the evolution of our monetary system
I first heard of Bitcoin as some digital asset whose price skyrocketed in 2017 and then again in 2020. Since then, there have been a variety of ‘expert opinions’ regarding investing in Bitcoin. Taking a break from the ocean of price prediction information, let’s try to ask the more fundamental question. What is bitcoin? To truly understand the concept of bitcoin, it is important to know the history of our monetary system.
A brief history of money
As human society progressed, people started to trade stuff with each other. For example, a farmer would exchange a bushel of rice with another farmer for a dozen of tomatoes. This allowed a person to specialize in producing particular goods or services of his choice, and then exchange them for all other goods and services that he wants. This process is called bartering.
The barter system was then replaced by the currency system which used the concept of money, which is a token that basically said that its holder provided some value to the society. He could then spend this token to obtain value from other people in the society. This improved the efficiency of trade, by removing the need for both the parties in a trade to have some goods or service that the other party values.
Here, money itself does not have any intrinsic value. It is just a token that society has collectively agreed to use as a store of value. The value held by each token is roughly equal to the total value of goods and services traded using the tokens, divided by the number of tokens available. Hence, for a token to be valuable, it should be difficult to create more of it. Metals like gold and silver were a perfect candidate because of their limited quantity, ease of use, and longevity.
The next step was paper currency. Here, the government printed a piece of paper that said that it owes the holder, a particular amount of gold. Hence, holding it was equivalent to holding gold, with an upside that paper currency was easier to use than a metal currency. Soon, society adapted to this paper currency, which was just a front for the true currency i.e. gold. This all changed when governments decided to remove the gold backing on paper currency. Now the value of the currency was not pegged to gold but was rather decided by demand and supply.
As I said earlier, the value held by each token is roughly equal to the total value of goods and services traded using the tokens, divided by the number of tokens available. Unlike gold, paper currency is not naturally scarce. Its quantity is decided by the central banks who print it, allowing the government to simply print more money and devalue the money that people already hold.
The current monetary system requires us to trust the government to not unnecessarily devalue our currency. But, our broken political systems have shown us again and again, that governments cannot be trusted. Hence, we need a currency that cannot be manipulated by any organization including governments.
Bitcoin
In the aftermath of the 2008 global financial crisis, this white paper was published by an anonymous person/organization named Satoshi Nakamoto. He proposed a new digital currency called Bitcoin that existed on an online ledger called the Bitcoin blockchain. Copies of this ledger would exist on multiple computers owned by different people, located all across the world, making the system distributed and decentralized. Here, distributed refers to the system existing on multiple networked computers and decentralized refers to the fact that no single organization has complete control over the system.
The creation of new bitcoin happens gradually in a predetermined way and the total supply of bitcoin is limited to 21 million. Even the code for Bitcoin is open-sourced which makes the system completely transparent, eliminating the need for trust in an organization. All these characteristics make bitcoin an ideal currency.
Blockchain
Blockchain is the technology that allows the existence of the bitcoin ledger in a way that makes it almost impossible to change, cheat or hack the system. As the name suggests, ‘Blockchain’ is a chain of blocks. Each block contains a set of transactions.
To add a new block, a miner collects and verifies a set of transactions from the mempool which is a pool of all unconfirmed transactions. He then creates a block that contains the transaction data, a hash of the previous block, and a nonce, which is an arbitrary number. A hash is a function that converts input data into an encrypted output of a fixed length. We can easily calculate the hash of a file, but it is practically impossible to get the input data from a hash.
The miner then has to compete with all other miners to be the first to find a nonce such that the hash of the block begins with a predecided string. For example, if the predecided string is ‘000’, then ‘000ABCD12’ would be an accepted hash. The only way of finding such a nonce is by trial and error which involves a lot of computational work. This process is called proof of work, for which the miner is rewarded a fixed number of bitcoins. This is how new bitcoins are added to the system. The miner also collects all the transaction fees that were included in the block.
Proof of work ensures that adding a block is a difficult process. If a hacker attacks a particular copy of the ledger and changes the content of a block then the hash of that block and all subsequent blocks change. The proof of work of all those blocks gets ruined and he has to do it all over again to hide the tampering. This would be a very expensive process as the hacker has to reproduce the computational effort of the entire bitcoin network. This is theoretically possible only if the hacker has access to more computational power than everyone else combined. This is called a 51% attack, which is impracticable.
Acceptance of Bitcoin
The most important characteristic of a currency is its acceptability. For a long time bitcoin has only been a niche currency. But lately, it is gaining acceptance among mainstream investors and companies. Using bitcoin is preferred mainly for payments involving different currencies that usually take days to resolve and include a large fee. Paypal, which has one of the largest merchant networks in the world with over 26 million merchants, announced that it would accept bitcoin as a payment option. Even companies like Tesla, Microsoft, and Virgin Galactic have joined the club. We expect this trend to accelerate in the coming years and make bitcoin a fully functional currency.
