A quick history of money and how Bitcoin challenges our understanding of financial systems.
Since its inception in 2009, Bitcoin has seen both tremendous growth and periods of disillusionment. From a valuation of $0.08 per coin in 2010, Bitcoin is now a successful institutional investment asset held by Tesla, Square, and Microstrategy, as well as a global currency accepted by fintech giants such as PayPal and Mastercard. 2020 was an important year for Bitcoin, as it reached more mass adoption and broke its all time highs set in 2017 prior to a historic crash that wiped out nearly 80% of its value.
Critics of Bitcoin (and other cryptocurrencies) point to its volatile prices to label it as a speculative asset at best, and a conduit for criminal activity (e.g. money laundering) at its worst. On the other hand, Bitcoin investors cite Bitcoin’s impressive performance and resilience during the pandemic along with growing adoption figures to frame Bitcoin as digital gold and an inevitable change in how we view money.
Regardless of your views on Bitcoin, there is no denying the heightened interest and the shift in narrative amid the unprecedented era of global fiscal policies and the acceleration of digital transformation forced by the pandemic worldwide. Bitcoin still has a long way to go until it is broadly accepted as a new monetary asset. However, now is the time to challenge our current understanding of money and the financial systems that run on top with the framework of decentralized currency enabled by Bitcoin.
So what is Bitcoin, and how does it work?
Before diving into Bitcoin, we need to first understand the concept of money. Despite its prevalence and importance in society, money is surprisingly hard to define. To quote the 2020 Stone Ridge Shareholder letter, “Money is, and has always been, technology.” Specifically, it’s a technology characterized by its core set of functions:
- medium of exchange
- unit of account (measure of value)
- store of value
- standard of deferred payment
Throughout history, money took on the form of commodities (e.g. cowry shells), precious metals (e.g. silver, gold), and fiat currency (e.g. US Dollars). The modern financial system based on fiat currency was popularized when the US ended the gold standard in the 1970s, unlinking our currency from precious metals. This enabled global financial institutions to lean on central authorities (e.g. central banks) to uphold the core functions of money and respond to the economy. While this system has proven to be efficient as evidenced by periods of economic prosperity, it has also shown significant risks as well. We have already witnessed how the global financial systems can collapse in 2008, not to mention country-specific issues like the hyperinflation in Venezuela since 2016.
Bitcoin, on the other hand, is a decentralized monetary asset. This means that unlike traditional banking systems that rely on a central trusted authority (i.e. banks or middlemen like Western Union), Bitcoin derives its trust through what’s called distributed consensus. At its core, Bitcoin is a digital asset (i.e. lines of code) that can be exchanged online via Bitcoin’s blockchain network. In order to accept, store, or spend Bitcoin, a user needs a Bitcoin wallet either through a service provider (e.g. Coinbase, Binance) or a specialized hardware (e.g. Ledger, Trezor). Now that’s a lot of technical jargon, so let’s break it down with a realistic scenario of a Bitcoin transaction:
Consider Steve, a Bitcoin user living in Dallas, Texas. One day, he learns that the Mavericks are now accepting Bitcoin as a form of payment for basketball tickets and fan gear. Steve selects his seats online and checks out via BitPay to find a QR code containing a Bitcoin payment request. This QR code encodes the destination Bitcoin address, the payment amount, as well as other metadata about the transaction (e.g. merchant name). Steve scans the QR code, and the Bitcoin transaction is authorized, completing a transfer of some Bitcoin from Steve to the Dallas Mavericks.
At a cursory overview, this transaction looks no different than a typical credit card transaction. Some form of money was transferred from one user to another online. So what differentiates a Bitcoin network?
A Bitcoin Transaction in Detail
As with any transaction, Bitcoin transactions involve inputs and outputs. Inputs are existing Bitcoins that users own, and the Bitcoin wallet is responsible for keeping track of those values. Outputs are simply the funds on the receiving end of a transaction. Bitcoin transactions behave similar to physical money exchanges. For example, if the transaction price exceeds the value of a single input, the wallet can aggregate several inputs (similar to exchanging four quarters for a dollar bill) into a single input.
After gathering all the inputs, a transfer of Bitcoin is initiated. First, each input must have a proof of ownership and unlock the funds via a digital signature. Then, outputs are generated to transfer the funds, receive change if necessary, and pay for the transaction fee. The validated inputs are attached to the new owner’s address along with the requirement that the new owner must produce a signature matching that address to spend the transacted amount. This creates a chain of transactions that record the history of each Bitcoin’s exchange. In our example, Bitcoin locked against Steve’s keys in his wallet is transferred to the Dallas Mavericks. In turn, the Mavericks can use those funds for other transactions.
In this example, we assumed that Steve had enough Bitcoin to pay for his tickets, and that the transaction will be automatically validated. But without a trusted authority like a bank guaranteeing that Steve had the money or that Bitcoin can be transferred properly, how can we be sure that the transaction is valid?
Adding to the Blockchain
The distributed nature of Bitcoin comes into play when a transaction is added to the ledger and trusted by the network. After a transaction is propagated to the blockchain network nodes, it begins a consensus algorithm called proof-of-work (PoW) to verify the transactions and add it to the network. Instead of a central authority keeping track of valid transactions, we have Bitcoin miners (i.e. computers) who compete to validate them by solving hard mathematical problems. This process is called Bitcoin mining and underpins the cryptographic and economic theory behind Bitcoin.
Around every 10 minutes, Bitcoin miners pick up unverified transactions and begin cryptographic validation of transactions. Once a miner finds a solution, the transaction is added to a block, and the miner is compensated with a reward of newly minted Bitcoin. Once the block is filled with multiple transactions, other miners validate the work and the block is added to the ledger, thereby forming the blockchain. In order to offset the increase in computing power and thus preserve the value of newly created Bitcoin, the complexity of the cryptographic problem is increased accordingly.
The key cryptographic idea behind blockchain is that it is computationally intensive to prove a transaction, but trivial to validate the proven work. Thus, as more and more blocks are added to the blockchain, confirmations start to pile up and the network ensures trust in the system. This is because after six or more confirmations, it is nearly impossible to invalidate the existing blocks and reverse the transactions due to computation complexity. Thus, the Bitcoin mining process simultaneously serves the role of Bitcoin generation as well as transaction validation in a distributed manner without a single central authority to oversee the process.
What are the Risks?
Although more and more financial institutions are accepting Bitcoin as a form of payment, Bitcoin is not without risks. First and foremost, the value of Bitcoin is extremely volatile. Without a governing body like the SEC to regulate the price, Bitcoin’s price can fluctuate within seconds and crash without warning. Also, Bitcoin has a known scalability issue, where the maximum rate at which the network can process transactions is estimated to be between 3.3 and 7 per second. Contrast that with Visa’s reported 24k transactions per second, putting into question Bitcoin’s ability to replace existing financial systems as the de facto network.
On a more practical note, Bitcoin is also prone to hacks and human-error like traditional digital assets (e.g. online banking, credit cards) without the same protection. Traditional financial institutions provide some basic levels of protections for your financial instruments. For example, if you forget your password to the bank account or lose your credit card, the bank can reissue them for you. However, since Bitcoin is based on a decentralized trust model, if you lose the credentials to your Bitcoin wallet or lose the hardware wallet, those coins are lost forever (with some exceptions like Coinbase that holds a copy of your wallet on your behalf). As a nascent technology, Bitcoin also saw numerous hacks, where hackers stole millions of dollars worth of Bitcoin from various exchanges. In fact, in 2019 alone, there were 12 cryptocurrency hacks with $292 million stolen.
As the technology and the industry as a whole mature, some of these risks will be mitigated. But until then, understand that Bitcoin is a nascent digital asset governed by a distributed network. Thus, the same precautions we employ with our current financial system should apply to Bitcoin as well. At the same time, reconsider our relationship with money and imagine how Bitcoin can challenge our assumptions.
As quoted in Microstrategy’s latest shareholder letter, I’ll conclude with late David Foster Wallace’s commencement speech:
There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says ‘Morning, boys. How’s the water?’ And the two young fish swim on for a bit, and then eventually one of them looks over and the other and says, ‘What’s water?
The most obvious, most important realities are the ones that are hardest to see… Bracket for just a few minutes your skepticism of the totally obvious, [and reconsider] what is real and essential, hidden in plain sight all around us all the time.