Bitcoin: A Simple Explanation

Bitcoin is a new kind of digital currency that, unlike other forms of payment, is designed for a world in which we are all digitally connected. Other forms of payment, like cash and credit cards, have their place, and probably won’t be going anywhere soon, but they aren’t really suited to the way we are going to be living in five or fifty years. Bitcoin is. Bitcoin is. You can easily start trading today with an automated trading bot like Bitcoin Lifestyle.

In fact, if you have a bank account, and especially if you use credit cards or PayPal, then you’re already using digital currency. If you own or trade stocks, you are using digital money. No one is walking around with bags of cash to settle up at the end of the day; most of the movement of money between these banks and businesses is nothing more than numbers on balance sheets.

The difference is that unless you are using cold, hard cash, anything you do with your money has to go through the banks, the brokers, or the credit card companies. And, as you know, they all charge their fees and have all sorts of conditions and penalties, usually written in micro-printing on a form no one takes the time to read or understand.

With Bitcoin, no one is in control but you, unless you decide otherwise.

The story of how Bitcoin got started is that an unknown person or group using the name Satoshi Nakamoto created Bitcoin and released it in January of 2009. Satoshi set up a system that would create digital tokens and also put controls on them so that Bitcoin could be treated in some ways like gold and in some ways like cash.

Why did he or they create it? It seems that he had some of the same concerns about the banking and financial systems that are frequently used to justify Bitcoin now. We know this from the original white paper he published announcing Bitcoin in 2008 and a Cryptography forum and from subsequent forum posts and emails. He does not seem to have had any specific political objective, but simply expressed a dissatisfaction with the banking system and offered Bitcoin as a technological solution. (source) There have been a lot of claims about what Bitcoin’s political role is since then, but other than the fact that Bitcoin is certainly going to be disruptive to the way money moves, it isn’t at all clear how it will change political structures. Satoshi would probably say that that is up to us.

Let’s take a look at some of the properties of Bitcoin:

How Bitcoin is like gold:

They have to be mined.

What “mining” in this case means is that work has to be done in order to get them. With gold, that means picks, shovels, pans, and a lot of physical effort. With bitcoins, it means that computers have to solve math equations providing “proof of work” that the miner has earned a payoff of a certain amount of bitcoins.

The reason that Satoshi set it up this way is that if all the bitcoins possible were released all at once, then he would own them all and there would be no reason for anyone to want them. However, since he made it a challenge to get them, for the early adopters it became a competition to see who could get them, it spread them out more evenly, and made people willing to exchange them. One early adopter famously bought a pizza for 10,000 bitcoins. Those same coins now would be worth a fortune, but if nobody had spent them early on, then they wouldn’t be worth anything. When people saw them a way to buy or sell things, they began to have value.

Just like gold, there is also a limited supply. Unlike gold, we know exactly how many bitcoins there will eventually be. 21 million. This is to keep Bitcoin from becoming inflationary and to keep them valuable. Rather than there being an infinite number of bitcoins, bitcoins are nearly infinitely divisible, which gold is not. If one bitcoin becomes worth too much, the decimal can be moved to the right. Since Bitcoin’s recent run up in price, this is already being done by many merchants and exchange, notating prices in milliBits (1/1000 BTC or .001). The number of bitcoins is capped at 21 million, and that cannot be changed, but the number of places the decimal can be moved to the left can. Currently, each bitcoin can be divided into one-hundred-million smaller coins, called “satoshis,” after the inventor. That’s a very small amount, but if the need ever arose to make even smaller divisions, it could be done.

It’s important to note that this makes Bitcoin an inherently deflationary currency. Because the number of coins is limited, over time, the value of each coin will tend to rise. This is a very good thing for regular people. Salaries and savings will increase just by virtue of remaining the same. On the other hand, one tool governments use to overspend is to increase the money supply, decreasing the value of money (inflation) which makes the value of what the government owes less and, therefore, easier to repay.

Currently, almost no one mines bitcoins. The system is set up to make it more difficult to solve the math produces the bitcoins. This is to keep them from being produced too fast, and again, having too many of them end up in the hands of too few people. In the last year, the difficulty rate has increased so much that people went from mining with their desktop computers, to using the high-performance graphics cards, to using Application Specific Integrated Cards (ASIC) machines that are specially designed to do this kind of math. Now mining is really only done by professionals who buy and maintain special equipment.

Because of the rising difficulty, the cost of new equipment, the cost of electricity, etc., it is said that it’s very difficult to make mining pay. Another reason mining is becoming less profitable is that Bitcoin becomes scarcer as time goes on. When Bitcoin was first introduced, miners were rewarded with 50 bitcoins for each problem, or Block, that they solve. That payout is set to halve every four years currently each block is gets a reward of 25 bitcoins. So, if you are thinking of becoming a miner, you should have a lot of resources and expertise on your side if you want to make a go of it.

So, again, why is Bitcoin like gold? Because it takes work to get them and because they are scarce, they are seen as valuable. And since you can’t just make more of them when you want, their price is likely to rise over time–for sure, Bitcoin is highly volatile and we are going to see huge spikes and crashes, but keep an eye on the trend of the charts and you will notice that they always trend up.

How Bitcoin is not like gold:

Unlike gold, there is nothing to hold in your hand.

You may see people selling physical bitcoins, and these are interesting, and even useful, to have, but what you’re seeing is a fun storage system for bitcoins. The bitcoins are said to be in the coin because a long string of numbers and letters that represent the PIN number for that bitcoin is sealed inside the coin. Really, though, those numbers are just the access keys to the coins which are on the web. Once those keys are used, the physical coin becomes an empty shell and has no monetary value outside of the materials its made of.

Unlike gold, it is almost infinitely divisible. If you have an ounce of gold and want to buy a cup of coffee, just exactly how do you get your change?

Unlike gold, you can store all the bitcoins in the world on a single thumbdrive or in a notebook (if you wanted to take the trouble of handwriting all those numbers and letters). With gold, you have to have a vault, guards, …

Unlike gold, you can’t make anything with it if it loses its monetary value. Well, this isn’t exactly true. You can’t make a pair of earrings, say, but there are a number of uses for the blockchain, the public ledger that records everything that happens to every bitcoin that may revolutionize how we notarize documents, set up wills, conclude contracts, finalize large purchases of smart devices, etc. The businesses that will become the next Microsofts based on the non-monetary uses of Bitcoin’s blockchain are just being built now.

How Bitcoin is valuable:

One of the chief arguments against Bitcoin is that it has no inherent value.

But this is also true of just about any type of currency you can name. What makes a currency valuable is that two people believe that it is valuable and trust that it will be valuable tomorrow. Based on that trust, I can hand over a dollar and get a cup of coffee. The coffee shop can then pay their employees and buy more beans. That dollar shifts from hand to hand to enable a flow of goods and services in the other direction.

But paper money isn’t valuable in-and-of itself. Money used to be made of precious metals, and at that time an argument could have been made for inherent value. But in the 1971 the US was taken off the gold standard, meaning that money only has value on the government’s say so. Meanwhile, the government has the ability and the right to print money out of thin air to pay its debts. As I mentioned before, this is an inflationary tactic that benefits the government, but hurts just about everyone else.

One interesting thing is that Article 10 of the US Constitution requires the states to mint coins in gold and silver. It seems that the founders knew about the temptation of governments to print themselves out of financial crises. Bitcoin, if it became a backbone currency, would force governments to take real responsibility for the fiscal choices they make while protecting the earning power of the people. Sounds like a good thing to me.

How Bitcoin is like cash:

In a lot of ways, Bitcoin is more like a commodity, like gold, than it is cash, but in certain ways, it is just like cash.

The most important way Bitcoin is like cash: You can spend it.

Because Bitcoin is digital and divisible into really small units, when you want to buy something, you can use a computer or smartphone, take a picture of a QR code or paste in a bitcoin address, enter the amount you want to give the clerk, and hit send. Very easy.

This is especially good for situations when you are shopping on the Internet or would otherwise be using a credit card. For merchants, its good too since the fees to accept Bitcoin are a lot less than Visa fees. Right now it is a little challenging to find everything you want being sold by someone willing to accept Bitcoin, but that is fast changing.

How Bitcoin is not like cash:

It is impossible to forge: If I pay for something with cash, there may be, but usually isn’t, any concern that the bills are forged. If you pass over a large denomination, they may check it with a security pen or light, but little more is done. The math based nature of Bitcoin means that there is no possibility of it being forged.

On the other hand, like credit cards, there is an acceptance process before the person being paid can be certain the transaction has taken place.

It works like this: The math problems I talked about as being a way to mine bitcoins also are collecting records of the transactions that have been taking place and weave them into the math of that problem. When that problem, or block, is solved, then the transaction is written into the math history of Bitcoin and cannot be reversed.

But it is not just one computer trying to solve this problem, there are thousands or millions of computers chugging away at this and communicating back and forth. They start sending out confirmations that this transaction is valid and has been recorded. One confirmation is usually enough, but six is considered to be truly secure and protects the payee from something called a double spend, which we’ll talk about in the section on how to use Bitcoin securely.

It should take about ten minutes to mine one block according to the schedule set up by Satoshi. That means that to get six confirmations, it might take an hour. In fact, the number of ten minutes is only an average, so it might take less, and it might take more.

That means I may have to wait a long time for my cup of coffee at Starbucks while the next block gets mined. In practice, though, scamming the system is difficult and expensive, and for a cup of coffee, most retailers can feel safe passing over that cup of coffee even on zero confirmations. For a car, I might have a cup of coffee in the dealer’s office while we wait for at least a few confirmations. And in fact, most of these purchases will be made online where the time between a purchase and the shipping of the product will make waiting for confirmations a non-issue.

How Bitcoin is secure:

This part gets a bit technical.

As a whole:

Bitcoin is based on the idea that when you give your bitcoins to someone else, you are ‘signing’ them over digitally. This signature is time stamped and sent out to all the computers that are running the right kinds of Bitcoin software.

These computers can be miners, but many are regular computers running programs like the Bitcoin Qt program. All of these computers communicate together to make sure that there are no contradictions or inconsistencies. It is generally thought that once six of these computers have accepted a transaction, that it can be considered to be fully secure. In practice, fewer confirmations are enough for most transactions.

Each transaction is written into the math problem that the miners work on to mine bitcoin. Once a block with that transaction is solved, then it is part of a public record. And each block that is mined is based on the block before it, making the blocks into an interwoven chain (the block chain). This means that no one can counterfeit a block to trick the system.

There are times when there are discrepancies or conflicts. In this case, the majority opinion wins. You will hear people talking about the possibility of a 51% Attack, or the possibility that some gets enough computing power to be the majority of the Bitcoin network and thus take over the system.

Some people feel that groups of miners are uncomfortably close to this, but miners want to see Bitcoin succeed so that all of their hard work will pay off; a 51% attack would undermine trust and crash Bitcoin, so it is unlikely to happen from within and most miners are careful to keep their computing power below that threshold to avoid the appearance of this kind of attack.

Some others feel that a government or rich bank could orchestrate this kind of attack, but most mining these days is done by specially designed computers. Because of this, it would take more computing power than all the super computers in the world to pull off a 51% attack from the outside.

Personal security:

Even if the system as a whole is secure, each Bitcoin user needs to be careful with how the get, spend and store their bitcoins. The need to be careful is no different in being sensible in how you need to be careful with cash or with your banking information. There are specific things every Bitcoin user needs to know and we will cover that as we talk more about getting, saving, and spending Bitcoin.

So what happened to Satoshi Nakamoto?

No one knows. In the beginning, Satoshi posted on forums and emailed back and forth with the earliest Bitcoin users and developers. Within a short amount of time, he just simply stopped answering emails after saying that he was moving on to other things.

We know a few things about him, or them. His name is Japanese, but he wrote in a mixture of American and British English — suggesting that he might be more than one person. People in the know say that he is a brilliant computer programmer, but that he is not a professional. Because we can see all the way back to the first block mined, we know that Satoshi mined a significant number of Bitcoin (about a million and a half), and that two-thirds of them have never been touched. This means that Satoshi is a rich person or group at the current exchange rate.

We also know that Satoshi no longer has any ability to control Bitcoin. The code is open source, and any change to it has to be agreed to by a majority of miners before it can really take effect. Many programmers have studied the entire code, front to back, and so it seems that Satoshi has really gifted Bitcoin to the world, retaining those first million or so Bitcoin.

It is my guess that we will someday see those million Bitcoin get used and learn who Satoshi really is. In the meantime, though, it will have to remain a mystery.

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