As you no doubt have noticed by now, I am very interested in Bitcoin and the underlying technology of blockchains. In this first of three posts on Bitcoin we’ll look more into what Bitcoin is.
This is part 1 in a series of 3 on Bitcoin. Part 1 will cover what Bitcoin is, part 2 will cover why you should care about Bitcoin and part 3 will cover the basics of buying, selling and spending Bitcoin.
The short version
Enough with the talk already just show a video:
In this first post we will dive deeper into what Bitcoin actually is. For some the video above will be enough and for others more information is needed. As this is a blog I am more than happy to indulge in more information on the topic. And the topic for today in reference to Bitcoin is What is Bitcoin?
But before we spend time understanding what Bitcoin is I believe we need to have a better understanding of our current system of money. Therefore I propose a simple game, or task if you will. before you read on try and answer the following question:
What is money?
The current system of money
I cannot say by certainty that Bitcoin is money, because it is actually heavily debated what constitutes money. In most western countries today, and probably outside the West as well, there are basically three types of money: Cash, credit and commodity. Before we truly get into what Bitcoin is I believe it to be of the utmost importance that we study the current system of money a little as this should make it clearer why Bitcoin is so interesting.
Commodity as money. In this day and age the only commodity really though of as money is gold. That being said very few places actually take gold in exchange for goods. In some countries, Denmark excluded, silver is also considered a commodity-money. Since this is not the case in Denmark VAT is actually applied when buying silver coins. This is not the case with gold. If you live in Denmark and is interested in buying gold or silver it can actually be done really easily at the main train station in Copenhagen at the shop Tavex. I have considered buying gold as a means of further diversification but have yet to make a purchase.
Cash is probably what comes to mind for most people when describing money. This day and age though cash make up very little of the actual money supply of a lot of countries. For Denmark the figure is about 5%. Cash in the form of notes and coins minted where formerly made by the National Bank of Denmark but this proces has been outsourced. The National Bank is still responsible for the proces and the actual distribution of cash to the other private banks in Denmark. The National Bank itself is a private institution and not controlled by the state.
Credit: The remaining 95%* of the money supply is made up of credit, which in this day and age functions the same as cash, just in a digital form. This means that every time a digital transaction is made, it is actually credit, which means something that started out as a loan, that is transferred. This type of money is created by the private banks when customers borrow money. It does not exist prior to the actual loan being granted, but is created by adding credit to the borrower. This means that 95% of the money supply of Denmark have been created out of thin air by the private banks, each time they lend money to a customer. This goes a long way in explaining why the cost of housing, among other things, have increased so much the last 15-20 years.
How the hell did that happen you might think. Back in the day there was such a thing as the gold standard. This meant that a national bank could only print as much money as there was gold to equal that value. This standard was lessened after the second world war and completely removed in the United States in the early 1970’s at which point everyone else followed and did the same. This basically means that now there is no limit to how much money can exist and basic supply and demand theory therefore explains that the value of money is diminishing since more is created each day. This current system of money is often referred to as FIAT, latin for ‘let it be done’, which basically means a system of trust. Money has value because everyone, or at least most, believe and accept that it does. That is it. There is no underlying value to the money you carry in your pocket. Scary, I know! On top of this it is required by law in Denmark that you have a bank account, take part in this trust based money to pay your taxes and rely on banks to pay and keep your money. So maybe money isn’t what you thought it was?
To dive deeper into money creation in our day and age see this link as an example.
You could also just check the rules of Monopoly, rule number 11 to be exact:
What is Bitcoin
This is a simple question but the answer(s) can vary greatly in complexity. Just as it can be difficult to explain what moneys is so it can be difficult to explain Bitcoin. Bitcoin was started in 2009 in the wake of the financial crisis by someone using the alias Satoshi Nagamoto. So the creator of Bitcoins isn’t known. It was introduced through something known as a whitepaper under the headline: Bitcoin: A Peer-to-Peer Electronic Cash System. But let’s at least try to understand it better both in reference to the money we know and what new Bitcoin brings to the table. This is a short overview of what Bitcoin is:
I will refer to Bitcoin as a money system, but this might not actually be true. I am not certain that something can be called money without the state sanctioning it as money and the state of Denmark does not believe Bitcoin to be money. I however will refer to Bitcoin as a money system for the sake of argument in this post.
Bitcoin is a form of money
Bitcoin is taxed as a form of commodity alongside things such as art her in Denmark. Bitcoin can be traded and held as a means of storing value. These characteristics makes Bitcoin appear as a form of commodity alongside gold. Bitcoin actually shares a lot of characteristics with gold in the sense that it is finite and mined.
Bitcoin is a form of commodity
Bitcoin however is not credit and cannot be created at the will of it’s user and as such it does not qualify as credit-money. It is however in some sense created out of thin air as bitcoins are awarded for helping complete transactions, a proces known as mining.
Bitcoin is not credit
Bitcoin only exists digitally and as such cannot be held in your hand. A Bitcoin does not exist somewhere but rather is tied to a specific piece of code in an overall system. In some ways this means that there is no good answer to the question of ‘Where is a specific Bitcoin’ because it is nowhere. It does not physically exist.
Bitcoin is digital only
There is no need for a bank in order to transfer bitcoins. Users can simply transfer directly to each other. Of course there might be instances, and users, that require some sort of mediator, actually it is possible that most users would want this, but in essence it is not needed. Bitcoins can be transferred directly between two user.
Bitcoin is peer-to-peer
With cash it can be very difficult to follow a paper trail meaning following the money. This is not the case with Bitcoin. All transactions have an id, a place in the blockchain, but with the id being a hash, it might not be transparent who is behind the transfer.
Bitcoin is semi-private
Since all Bitcoin transactions are stored in a common ledger viewable and searchable for all, Bitcoin is a fully transparent system of money.
Bitcoin is transparent
The basic rules of Bitcoin
Bitcoin is a very clearly defined monetary system in which the rules are transparent. Bitcoin is trustless in the sense that you as a user make direct transfers to other users and therefore don’t rely on a bank. The total supply of Bitcoin has a maximum of 21.000.000 defined by the code. This means that the limit of bitcoins is capped. It is therefore, by definition, inflation resistant in some way. Again, applying basic supply and demand, the value of bitcoin will rise if the demand rises because the supply is limited. A bitcoin is divisible by 8 decimals meaning that the lowest possible amount of bitcoins is 0.00000001 BTC. It is therefore perfectly possible to send 0.0001756 bitcoin for instance. For a transaction to take place, user A must have a wallet containing bitcoins and then send an amount to a public address of user B’s wallet.
How does Bitcoin work
I will try and give a brief explanation, but know that there are a ton of guides, papers, articles, blogposts and youtube videos on the subject. The simplest explanation in a picture that I have found is this:
- User A wants to transfer bitcoins to user B. User A makes this request through an app as an example.
- The request is broadcasted to the Bitcoin network until it is picked up for processing. Processing is known as mining.
- The requests are packed in blocks and assigned a header.
- Miners then compete to match the blocks random header with a nonce, an arbitrary number, to get a hash.
- The miner that completes the block, meaning gets the correct hash, is awarded bitcoins.
- The hash value is then added as the header of the next block and thus creating a chain, hence the name blockchain.
In order for user A to send bitcoins a wallet is needed. A wallet consists of a private and a number of possible public keys. The private key controls the bitcoins associated with a given wallet and the public key is what is used as the recipient of a transaction. In order for user A to send bitcoins to user B, user A must use a wallet that has bitcoins ‘in it’ and send some to user Bs public key. That is basically it. In order to use Bitcoin you don’t actually need to know more.
Of course this can, and if you wish to understand it better, it should, be explained much more thoroughly. I however see no reason as to why I should try and complicate things further or risk making mistakes when trying to tackle the understanding of a monetary system. In order to understand Bitcoin well enough to understand why you should care about it and how to use it, a simple explanation is enough.
If you want to understand blockchains better, that is to say the underlying technology of something like Bitcoin, give this site a try: https://anders.com/blockchain/ It is simply unparalleled in explaining blockchains and it gives you the possibility of playing around in a clickable environment in order to better understand what all the fuss is about. Learning this should be mandatory in school if you ask me.
- If you want the image used above, it is available here.
- Another really good infographic is available here.
- Investopedia also has a really good infographic available here as well as a much more comprehensive explanation of how Bitcoin works.
- I find the video at the start of the post to be a really good short video explaining what Bitcoin is.
- Trace Mayer has a podcast called Bitcoin Knowledge which I find useful. There are many podcasts out there, be this guy has been around for a while. He has also made this Bitcoin beginners guide.
- Another noticeable podcast on Bitcoin, and other crypto-related-things, is The Bitcoin Podcast Network.
- I can also recommend subscribing to the Youtube channel of Andreas M. Antonopoulos.
I consider Bitcoin it’s own thing in my quest for financial independence and this means the topic has it’s own page on https://www.frinans.dk/bitcoin/.
And if you have more time, watch Andreas with an introduction to Bitcoin:
Next week we’ll take a look at why you should care about Bitcoin, in case I haven’t made that part clear as of yet.
As always comments are most welcome and I will do my best to answer all questions. You can follow or like the facebook page or follow frinans on twitter to get notified of new posts as well as interesting links and stories I stumble across. If you are interested in getting into Bitcoin you can sign up for Coinbase through my affiliate link, if you buy Bitcoin for a minimum of 100$, we both get a 10$ bonus. If you are interested in diversifying your investments further, then how about signing up for crowdlending through my Mintos affiliate link and gain an exclusive % on your investment.
May your savings rates be high and your returns be at the market average