How Bitcoin works – intro

Understanding how Bitcoin works on the technical level can be a little tricky. For most people it usually takes a lot of time and studying as Bitcoin combines a lot of innovative approaches to solve the problems of a free market monetary system. These approaches often don’t have any parallels in technologies we are already familiar with so we have to challenge ourselves with understanding completely new concepts.

Another difficulty emerges because of language that has developed around the Bitcoin eco-system. You will hear about “sending Bitcoin”, “receiving Bitcoin”, “Bitcoin accounts”, “confirmations”, “Bitcoin wallets” and other words that might work in current financial system that everyone is used to, but completely mis-characterize what is actually happening in the Bitcoin network. Once beginners get used to this language, it drives them to create a model of Bitcoin which turns out to be quite incorrect when they start digging deeper and learning more.

These terms probably started to get used because they expressed what people were already used to from their usual financial operations. There is nothing wrong with adopting them in Bitcoin, it is just that they make it more confusing for beginners to really understand what’s going on under the hood.

The purpose of the How Bitcoin works series is to take a different approach and introduce a totally simplified metaphor for Bitcoin – The Bitcoin island – and in each episode introduce a new concept or increase the accuracy of previous explanations. The series will hopefully make it possible even for your grandmother to understand what Bitcoin is and how it works – at least on a layman level. This understanding will give you more confidence in owning and using Bitcoin in your everyday life.

Since we will work with a simplified metaphor only, a lot of the descriptions will be imprecise and factually incorrect. The point of the series is not to give you a precise technical specification and documentation of Bitcoin – for those you can read the Bitcoin white paper instead. Its purpose is to help you create a mental model of the system that will enable you to think about it more clearly and understand why Bitcoin users are so enthusiastic about it.

Enjoy the ride!


 

A general overview of money and motivations of Bitcoin

Basically throughout the entire history of civilization commodities have always served as money. Market would select commodities with best properties to be money, the status very often going to gold and silver. As time progressed the market also introduced money substitutes, usually in form of paper deposit claims to gold or silver. That is also how all the major currencies we use today have started – as paper claims exchangeable for a certain weight of gold when presented at the bank. For the last ~ 40 years the world has been experimenting with something completely different – purely token money. For example a 100 US dollar bank note is a sophisticated piece of paper that doesn’t hold any guarantee of a counter party to be exchangeable for a specific commodity as it used to be the case historically.

What’s more, most of the current supply of money is not even physical in nature, it exists as data stored in the banking system’s computers. We can thus think about today’s government issued money as purely abstract token money that exists in the real world as data stored on some media.

Both commodity money and token money have their respective advantages and disadvantages. The main advantages of commodities are that there is no counter party risk (you can hold them on your person), their supplies are limited by physical factors and each increase of supply requires expenditure of energy and resources (this property has always been the best protection mechanism for savers against inflation and devaluation). The disadvantages of commodities are costly production, maintenance, storage, transportation, divisibility and the fact they are also used for non-monetary purposes in consumption and production (this damages the market by increasing entropy and sending wrong signals by mixing monetary and non monetary supply and demand).

The situation is exactly reversed with token money: they excel at low cost of production, maintenance, exchangeability and single purpose use as money, but are dreadfully deficient as “stores of value” and as a market signaling mechanism. This is because they are centrally managed by a small group of people that can benefit greatly by creating new supply and using it to finance their personal goals. In fact creation of additional supply is a way how to move resources from general population to the people in power over supply without the population ever noticing it. The advantages of token money have been greatly boosted by the evolution of internet which allowed the entire world to use purely abstract token money – no more paper or coins are necessary, the entire system is based on pure information.

Another disadvantage of abstract money is that a small group of people have complete control over the banking system which records who has what amount of money. In case the small group of people decide it’s in their interest, they can freeze anyone’s account, modify his balance or simply take as much as they want for their purposes. It also introduces a lot of counter party risk as it shifts all control over money to the banks instead of the owners and it allows total surveillance of everyone’s personal financial interactions.

Bitcoin is the free market’s solution to the question of money and it tries to take the best of each world – all the advantages of abstract token money without its negatives. It focuses on having a strictly predictable and limited supply while making sure no single person or group of people can create additional supply or change ownership records. Bitcoin puts emphasis on fixed, predictable and strictly enforced rules under which it operates (unlike in the current system where rules can drastically change every couple of years with new administrations).

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