Decoding the enigma of Bitcoin

Innovation of Bitcoin is said to be the biggest thing since Internet or even since Bread became sliced :)

In the first blog post (Part 1, Part 2) I explained the history of money, different financial systems, and flaws in each. A need for an alternate financial system/ currency has arisen out of this. I had just mentioned the word ‘Rai of Yap’ in Part1 and had said that we will look into it later. Next section explains it in more detail.

Historical events similar to concept of Bitcoin

Rai stone on display at the Bank of Canada Currency Museum in Ottawa, Canada. (Source- Wiki)

• Rai of Yap: Yap is an island in Pacific ocean. The tribes inhabiting that island used very large stones called as ‘Rai’ made up of limestone as money. These stones were extremely bulky and non-portable. They were used as dowry or as money to buy farmland. But the physical location of the stones never changed. Only the ownership would change hands and everyone in the village kept an oral history of transfer of record. Once, in fact, a very large stone fell into the sea and as everyone had seen it drown to the seabottom, it was still considered as valid money (Unlike our current currency notes which are not usable if damaged). Hence each ‘transaction’ was part of ledger shared by every person in the village. This money was not affected by inflation and value was higher not just by size but also by factors like if any death occurred when ‘mining’ the stone. Once European explorers came in contact then they gave modern tools to carve the limestones. Hence the process became faster and more stones could be created by which its value was diminished. Did it strike a bell? :)
• Gold ownership by countries which is physically not present with them: Historically as a result of many inter-country treaties and financial pacts ownership of gold has been transferred from one country to other. However, the gold itself might not be physically shipped to the other country. Just recently as part of Germany’s gold Repatriation program they have shipped 366 Tones Of Gold From New York And Paris. This gold was owned by Germany but was physically present in other countries. (Source: Link)

So a currency or an asset need not be physically present with the owner. All involved parties just need to agree that who owns it.

What is the Difference between Digital currency, Virtual currency, Cryptocurrency and Bitcoin?

• Digital Currency: Any currency which is non-physical in nature and created by a set of computer systems (software, network and database) and whose primary purpose is to be used over the internet. The transactions (transfer of ownership) is almost immediate and is borderless in nature. Both virtual and cryptocurrencies are digital but the opposite is not true.
• Virtual currency: Digital Currency which is unregulated and is used by a particular virtual (online) community is called as virtual currency. It is usually used on a particular online platform but is not a legal tender in any country. It is also not attached to fiat currency nor backed by any physical commodity. All cryptocurrencies are virtual currencies but the opposite is not true
• Cryptocurrency: A virtual currency which is decentralized and involves very strong cryptography (i.e which implements security through software code) techniques is called as a cryptocurrency. Bitcoin is just one example of cryptocurrency. There are almost 700 cryptocurrencies in the market however Bitcoin is the first and most popular with a market cap of more than 1 billion $
• Bitcoin: That’s what the remaining and a lot of subsequent articles will be about :). The definition of Bitcoin as per its official website is-

“Bitcoin is a consensus network that enables a new payment system and a completely digital money. It is the first decentralized peer-to-peer payment network that is powered by its users with no central authority or middlemen. From a user perspective, Bitcoin is pretty much like cash for the Internet. Bitcoin can also be seen as the most prominent triple entry bookkeeping system in existence” — bitcoin.org

At this point, I will highly recommend to read my article on the mysterious origins and philosophical ideology behind Bitcoin

Pillars of Bitcoin

Note: Bitcoin is the name of the currency as well as the entire network system which is responsible for mining or creating the Bitcoins. Paper currency and coins are ‘minted’ by the Government but bitcoins are ‘mined’

• Bitcoin is Digital: Bitcoin is a non-physical currency which is created by a protocol running over hundreds of thousands of computer systems. This protocol strictly follows a particular algorithm. There is no underlying asset like Gold or silver which is backing this currency.
• Bitcoin is private: There is absolutely no sovereign authority over Bitcoin. Further, it is not even owned by the developer, founder or group who invented this currency. No particular individual, any organization or Government has any control over Bitcoin. This currency is also borderless and not restricted to a particular geographic region.
• Bitcoin is Decentralized, peer to peer distributed system: There is no centralized issuing authority in Bitcoin. There is no central server or point of control. All participants (which are individual machines or a group of computer systems) in the bitcoin network (called as ‘Node’) are peers and no one peer has higher authority over other. Bitcoins are created by a process called as ‘Mining’ and we will dive deep into this topic later. It is a distributed system of literally thousands and thousands of computer systems connected to each other over the internet.
• Bitcoin is a cryptocurrency: Very strong anti counterfeiting measures are in place through cryptography. Hypothetically speaking, Bitcoin system can never be hacked neither new bitcoins be created individually by node or group of nodes. We will also look into techno functional aspects of this in detail later.

“Bitcoin is a technological tour de force.” — Bill Gates

Attributes of money from Bitcoin perspective

• Bitcoin is scarce /limited: Bitcoin protocol is designed in such a way that there is a fixed amount of bitcoins that will be created by the system and distributed by its algorithm. As of now after every 10 minutes a block of 12.5 bitcoins is created and won by a miner. Till Sept’15 this limit was 25 bitcoins and before Nov’12 it was 50. The time of each bitcoin block creation (10 minutes) is constant. The Bitcoins/block will be decreasing and will go on till 2140 and total bitcoins which will be mined will be 21 million. After that no more new bitcoins will be created. Bitcoins will always be created by the system using the pre-defined set of rules and even in any unforeseen extreme circumstances this will never change. Hence Bitcoins is a scarce/limited commodity and it keeps inflation in check.
• Bitcoin is durable: There is one reason as to why Gold has remained to be the most valuable asset since ancient civilizations. It is highly durable. It is not affected by decay etc. Paper money is really bad at this attribute. Bitcoin money is non physical in nature. Hence durability is not even applicable to it.
• Bitcoin is divisible: A Dollar is divisible upto 2 decimal places (100 cents = 1 USD). However weaker currencies like for example 1000 Vietnamese Dong equals 0.044830 US Dollar (as of Sept’16). But dollar is not divisble more than 2 places. Hence there is always loss/profit when exchanging foreign exchange. Bitcoin solves this problem since one Bitcoin is divisible down to eight decimal places. The smallest unit is 0.00000001 BTC and is called as 1 satoshi
• Bitcoin is verifiable: A very small percentage of money in circulation is fake. It is very difficult for the naked eye to verify it. However, the bitcoin system is designed such that the currency can be stolen from a Bitcoin ‘Wallet’ but it cannot be duplicated or counterfeit Bitcoins are not possible.
• Bitcoin is portable:The biggest problem with the Rai of Yap was that it was not portable. If we want to carry millions of dollars then portability is possible but its security becomes a big challenge. Bitcoins can be carried in your wallet which can be installed even on your smartphone or laptop. You do not even need to carry it and can access your bitcoins from someone else’s system with your credentials. Hence Bitcoin is highly portable in nature.
• Bitcoin is fungible: 2 currencies like Gold bars (of exact weight and karat) or 10$ bill always have the exact same value. However price of gold in one region is many times slightly different than the price of gold in another region. Bitcoin takes fungibility to a whole new level. Since it is non-physical in nature the fungibility is exact same across geographies.

Currently almost every Financial Transaction involves third party which is costly in terms of fee and time

• Bitcoin is frictionless: When you transfer money between 2 bank accounts there is always a third party involved. Same is applicable when you make a payment using a credit card or rather almost any financial transaction in the current modern banking system. It takes a lot of time (and in some cases even weeks when it is remitting money across continents) and is a very costly process for banks as well as users. A third party is needed because there is a ‘friction’ between 2 parties involved in money transfer. However, transfer between 2 Bitcoin addresses is almost frictionless and instant. The transaction charge is really minor and balance is reflected with new bitcoins in a matter of seconds and then you can use them in just about 10 minutes.
• Bitcoin is Global: Till now only gold was considered to be a truly global asset. USD is accepted in less than dozen countries (also not by every merchant in a country). But availability of bitcoin is everywhere. It is decentralzed digital money and is not regulated (at least as of Oct’16). All you need is an internet connection from where you can access your Bitcoins in your wallet and use them for your purchases or transfers.
• Bitcoin is Recognizable: Every form of currency has a distinct set of properties because of which you can recognize it. Gold is really bad at this since just by looking at gold, it is very difficult to tell its quality and purity. Bitcoin can never be duplicated and the system is designed such that the applicatons accepting bitcoin always accept valid bitcoins.

Solution to 2 Problems of Digital Currency

• Byzantine Generals’ Problem: Bitcoin is a distributed decentralized computer network. The Bitcoin network a gives probabilistic solution to this problem. We have already discussed what this problem is all about.
• Double spending Problem: Every peer-to-peer digital currency is associated with this problem. With paper currency if one person gives it to another then the giver is never physically in possession of the spent money and hence can never double spend. In traditional online systems there is one central clearing house which takes care of double spend but Bitcoin is peer to peer with no authority amongst nodes. Eg: Arpita has 100 units of digital currency. Arpita is making an online payment with a merchant for 80 units. Now either Arpita hacks the system or there is a software bug in the system in such a way that the payment goes through but the balance in her account is still 100 units (instead of 20) and she further uses those 100 to make a payment at another merchant. Sometimes this is because of flaw in the online payment clearance and settlement process. For whatever reason, Arpita should not be able to spend more than 100 units even if 2 transactions split by nanoseconds are carried out by her.

We will find out in future posts how Bitcoin attempts to solve Byzantine General’s problem and double-spending problem.

Bitcoin satisfying the 3 functions of Money

• Bitcoin as a medium of exchange: Because of all the above attributes as mentioned bitcoin is far superior to the current form of money and has the power to be an alternate currency. Hence Bitcoin is the perfect medium of exchange.
• Bitcoin as a Unit of account: At least in the immediate future there is no way that Bitcoin will entirely replace our existing money system. But even as an alternate currency, the price of Bitcoin has to be stable. The algorithm within the protocol is designed in a way that there will be a constant supply of bitcoins so this is taken care by partially. However the price of Bitcoin against the most popular currency today which is USD is fluctuating. In the last 12 months, it has been a lot stable and on a steady increase when compared with USD. Stability depends more on factors like higher global acceptance of bitcoin, some form of regulation and development of futures market.
• Bitcoin as a Store of value: People ‘believe’ in a currency because it is an excellent store of money. This means that with time the ‘value’ of that money does not change or even better, it increases (as in the case of gold) with some predictability. Bitcoin supporters will always say that the value has steadily increased and there is no way it will diminish or go away. Bitcoin has been around now for 5+ years and with each passing day, the belief in this alternate digital currency is increasing exponentially.

We live in exciting times. A lot of innovation is happening in this space and no one can predict the future. But one thing is for certain — Bitcoin is the biggest innovation since the internet and mobile phones. It is here to stay and the only path from here is that of improvement

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