What is bitcoin? Part 1
Bitcoin is the world’s first global digital currency. It allows you to conduct peer-to-peer value transfer online without the need for a centralized authority.
Let’s break this down.
Scenario 1: You and I are at brunch and we go to split the check. I hand you a $20 bill. We’ve transferred value offline. No one supervised this transaction. We handled it between ourselves; it was a peer-to-peer value transfer. The $20 bill was issued by the U.S. Federal Government. Through the use of monetary policy, the government can put more or less of these bills into circulation. This may affect the purchasing power of that $20 bill but you’re likely not thinking about that in the moment.
Scenario 2: We’re splitting the bill but I don’t carry cash (who does really?). You pay and I choose to transfer money to you through Venmo, a popular mobile app that functions as a digital wallet. The transfer is done digitally, but it is not truly a peer-to-peer transaction. In reality, my Venmo wallet is linked to my bank account. After pressing send, a transaction begins that takes money out of my bank account, and into another one operated by Venmo at the same financial institution, ie. Bank of America. Meanwhile, you see your Venmo balance go up by $20 immediately. When you decide to deposit your balance into your actual bank account, you select “Transfer to bank” and the opposite process begins. In two days’ time, you receive the balance from Venmo in your bank account. Venmo is a cool and easy way of conducting bank transfers, but you’re still ultimately relying on centralized parties and banks to digitally transfer currency on your behalf. At every point, the account balances you see are representative of units of currency issued by the U.S. Federal Government.
So why is it that we can’t digitally send money directly to one another? Seems like we’re jumping through a lot of hoops here. As it turns out, it is really difficult to ensure that people are not using counterfeit currency online in the absence of a centralized authority to keep track of the balances. (In computer science, this is referred to as the “double spend problem.”) Whether it’s Venmo, your bank, or another financial service provider (likely a combination), someone is recording data regarding the amount of money leaving your account and going into another, reconciling this information. This happens every time you order something on Amazon, pay your utility bill online, or even buy a coffee at Starbucks with your debit or credit card. These processes can be extremely complex and expensive.
Scenario 3: We’re splitting the bill and I decide to pay you in bitcoin (BTC). I open a bitcoin payments app (much like a Venmo app) on my phone and enter your Bitcoin wallet address (think of it as your Bitcoin username). I select $20 worth of bitcoin and send it to your address.
After I hit send, information regarding the transaction (my address, your address, the amount of bitcoin transferred) is broadcast to a decentralized network of computers across the globe.
These computers solve complex algorithms to confirm that that the transaction is not fraudulent (that I did in fact have the currency to spend). Once the majority of the network agrees that the transaction is valid, $20 worth of BTC is reduced from the balance associated with my Bitcoin address and added to the balance associated with yours. No banks involved. No other centralized entities. Also, my BTC is not representative of a government issued currency nor is its value anchored to one in any way.
The software that enables this network to run is open source (https://github.com/bitcoin/bitcoin), meaning it is not owned by one central group. Over 400 people have contributed to the code that created the rules for the network to follow. (Rules, such as, the predetermined amount of bitcoin to ever be in circulation and what is required to consider a transaction valid.) The decentralized network of validators, show their agreement with the rules by choosing to participate and running a certain version of the software. Furthermore, there are processes in place for software upgrades to be made based on reaching consensus across participants. As users of the digital currency, we implicitly agree with the rules by choosing to buy and transact with bitcoin.
While the user experience of transferring bitcoin versus using a Venmo-like wallet may seem similar at first, the invention of Bitcoin presents an enormous paradigm shift. It is a completely different means of conducting the monetary exchanges we make every day. Without bitcoin, a $20 digital transfer requires innovative work arounds, days of processing and further ingrains the role of longstanding financial institutions as middlemen. What if this could change? And that’s just the tip of the iceberg.
So, who designed the software? And who are these network participants validating the network? Why would you use bitcoin? Why should you even care?
More coming soon.
