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Understanding Bitcoin is sometimes difficult for newcomers because it’s really two things:
- digital gold
Bitcoin vs Other Payment Networks
In
terms of acting as payment network, Bitcoin works quite differently
from other online payment systems such as PayPal or Venmo. These
traditional forms of payment over the internet, which are tied to the
legacy financial system, involve the use of centralized, trusted third
parties to order transactions and keep track of user account balances.
Bitcoin is Permissionless
In
the case of Bitcoin, those who are in charge of ordering transactions
are dynamic and potentially anonymous. This is the key differentiator to
understand about Bitcoin.
The way in which transactions are
processed allows bitcoin to act in a permissionless,
censorship-resistant, and apolitical manner.
No single entity is in control of the financial activity that happens on the network.
No single entity is in control of the financial activity that happens on the network.
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.The above quote is what the pseudonymous Satoshi Nakamoto wrote in the original Bitcoin white paper.
Nakamoto
effectively created a decentralized solution to what is known as
the double-spending problem. This was an issue seen in many previous
digital payment systems.
Bitcoin as Digital Gold
Now that we’ve covered Bitcoin as a payment network, let’s take a look at bitcoin as a form of digital gold.
Bitcoin
is often referred to as digital cash due to its ability to be
transacted over the internet in a manner similar to physical cash, but
the digital gold analogy makes more sense due to the monetary properties
of bitcoin.
In the beginning, 50 bitcoin were created roughly every ten minutes, but that increase in supply is halved every four years.
The issuance schedule will continue until around the year 2140, when the supply will be capped at nearly 21 million bitcoins.
This monetary policy is a part of the Bitcoin network’s consensus rules, and there is no central banker in charge of controlling the supply.
This monetary policy is a part of the Bitcoin network’s consensus rules, and there is no central banker in charge of controlling the supply.
CHAPTER 2
Why is Bitcoin Important?
Bitcoin
is important because, before it existed, there was no true form of
digital gold. The existence of a digital, cash-like asset opens up a
whole new world of opportunities that would simply not be possible via
the centralized online currencies of the past.
Bitcoin
creates the possibility for privacy in online transactions, which would
not be possible when there is a regulated bank or other financial
institution responsible for payment processing.
And
criminals aren’t the only ones who should care about online
privacy. Online privacy is effectively part of one’s personal security
these days .
Additionally,
bitcoin is perhaps even more useful for those who live under
authoritarian regimes who wish to control every aspect of the local
people’s lives. For example, those who wish to flee Venezuela with their
personal savings can do so more easily with a bitcoin passphrase that
they’ve memorized than with any sort of physical vessel for wealth
storage.
Bitcoin has also proven useful as a way to
get around many of the onerous financial regulations seen around the
world. In the past, Abra CEO Bill Barhydt has discussed how the
programmable nature of bitcoin has enabled his company to build a
global, non-custodial bank that doesn’t need to deal with anywhere near
as much regulatory compliance as a traditional financial institution.
Many
economists and governments around the world would love to see a
movement away from cash for a variety of reasons. For example, a
cashless society would allow central bankers to more easily
implement negative interest rates . Additionally, lawmakers would be
able to more easily collect taxes, enact capital controls, and generally
control people’s money when they can simply tap a bank on the shoulder
to gain access to anyone’s financial history or the money itself.
Obviously,
the prevention of things like terrorist financing and money laundering
is another key point brought up by those who would like to see cash
almost completely removed from the economy. But the problem is that
digital currency is a black and white matter. Either people have full
control over their digital assets and can move them privately or they
can’t. Encryption backdoors do not work .
Governments
view the aforementioned reasons for moving to a cashless society as
nothing more than a boon for law and order, but the reality is this
situation would create a complete surveillance state, at least in terms
of people’s finances.
Bitcoin is effectively a
much-needed alternative for this potentially Orwellian future where
governments are able to surveil all financial activity, tell people who
they can and can’t transact with, and easily steal from individuals
through bail-ins or the inflation tax.
In summary,
bitcoin is important because it creates an alternate financial system
that will allow individuals to freely transact and store wealth in an
apolitical manner.
Before sending or receiving some bitcoin, Bob
must download software that can interact with the Bitcoin network such
as Bitcoin Core. When Bob runs this software for the first time, it will
download the complete history of every transaction that has ever been
made on the Bitcoin network. This is known as the initial block download
(IBD).
In Bitcoin, every user is responsible for
making sure new transactions are following the network’s consensus
rules. This is the only way to confirm that some received bitcoin is not
fake. It’s sort of like guarding against a counterfeit dollar bill or
tungsten dressed up like gold. To confirm the authenticity of some
received bitcoin, a user must have access to the entire history of
Bitcoin transactions, beginning with the network’s launch back in 2009
(although the vast majority of this data can later be pruned).
The
history of transactions downloaded by Bob are grouped together in
blocks, and new blocks are generated on the network roughly every ten
minutes. These blocks of transactions are ordered in a chain known as
the blockchain.
In order to download the entire
blockchain, Bob connects with other peers on the network. He is able to
decipher which chain of transactions leads to the correct state of the
Bitcoin network because it will be the chain with the
most proof-of-work behind it, while also following the consensus rules
outlined in Bob’s local Bitcoin software client.
Proof-of-work
is used in Bitcoin to decide who gets to add a new block of
transactions to the blockchain. A traditional online payment system
would have a trusted third party order transactions on the network, but
the point of Bitcoin is to act in an apolitical, permissionless manner.
When proof-of-work is used instead of a trusted third party,
transactions can be ordered by a dynamic, potentially-anonymous group of
individuals or entities, which are known as bitcoin miners. This
structure makes the system extremely difficult to shut down.
During
the process of creating a new block, miners are expending computing
power to solve an extremely complex math problem. The miner who is able
to solve the math problem first is awarded with the privilege of adding a
new block of transactions to the blockchain. Miners are willing to
spend expensive computing resources on this work because they are also
rewarded with newly-created bitcoin and any transaction fees associated
with the transactions in the newly added block.
Once
Bob has downloaded the entire blockchain, he now knows the current
state of the network and is able to safely receive transactions. To
receive a transaction, Bob will generate a new Bitcoin address in his
software client. This address has both a public and private key attached
to it, which can be sort of viewed as a username and password that
would be used on a normal website.
Alice sends Bob the
bitcoin by signing a message with the private key associated with one of
her Bitcoin addresses that already has some bitcoin associated with it.
The message simply says that the bitcoin associated with Alice’s
address should be reassigned to Bob’s address. This message is then
broadcast to the Bitcoin network by Alice’s software client. Bob’s
software client sees the transaction, but he must wait for the
transaction to be included in a new block for it to be real and
confirmed. In fact, Bob will want to wait for up to six confirmations if
he’s receiving a large amount of bitcoin from Alice in exchange for
some goods or services ( see a deeper explanation of this point here ).
Bob
knows that the transaction is legitimate because his Bitcoin software
client checks to make sure that all of the rules of the network are
being followed. Alice cannot create new bitcoin out of thin air or send
some bitcoin that doesn’t belong to her because this sort of activity
would be detected by Bob’s software.
Alice would
potentially be able to trick Bob if he were trusting a third party with
transaction validation. It could be argued that Bob is not a true user
of the Bitcoin network if he’s outsourcing the validation of an incoming
transaction to someone else. After all, the whole point of the Bitcoin
network is to remove the need for trusted third parties.
For
smaller amounts, many people entrust a third party with transaction
validation due to the added convenience; however, it should be noted
that there are trade offs made with this setup in the areas of privacy,
security, and trust. Having said that, it is likely that a majority of
the daily transactions made on the network today are probably not
self-validated.
CHAPTER 4
Who Controls Bitcoin?
The question of who controls bitcoin has been one of the more controversial topics discussed by users over the years.
In
the earlier days, there existed a somewhat widespread belief that
miners were in control of Bitcoin’s protocol rules. However, history has
shown that users are ultimately in control.
The
reason that users are in control of Bitcoin is that miners need to
create blocks that people will find valuable. If miners try to change
the rules of the system and create new types of blocks with different
rules, then users will need to agree to the new ruleset and signal to
miners that there will be plenty of economic activity on this new
network with different rules.
If users don’t wish to
follow the rule changes being put forth by miners, then the users can
simply ignore those blocks with the new rules and stick with the old
rules. This is because users running their own Bitcoin node
software verify that the rules of the network are being properly
followed. When miners are mining blocks that don’t have any users, they
won’t be rewarded with the valuable block rewards that allow them to
operate at a profit. Invalid blocks created by miners are effectively
worthless.
This structure of incentives was put to
the test in late 2017 when a plan from some of the largest bitcoin
companies and miners to move to a new network with a larger block weight
limit was abandoned after it was revealed miners would not be willing
to mine on a network at a loss for an extended period of time.
More
recently, the view that developers, specifically those who work on
Bitcoin Core, are the ones in control of Bitcoin has become more
prevalent, but this theory also misses the mark. The key issue with this
train of thought is that users are able to ignore upgrades proposed by
Bitcoin Core developers or even adopt software created by a completely
different group of developers.
The user-activated
soft fork for Segregated Witness (SegWit) was a real-world example of
users ignoring the recommendations of Bitcoin Core developers and opting
to run code that was not included in an official release of the Bitcoin
Core software.
At the end of the day, developers
and miners are going to work on the network that is valued by users.
Developers generally need to work within the confines of Bitcoin’s
current consensus rules, and miners need to create blocks that follow
those rules if they want to get a return on their investment.
It
should be noted that Bitcoin users are able to opt out of the network
and transact on a different network with different rules at any point in
time. That said, there is a general stickiness to the rules of the
Bitcoin network as they exist today because a money is more useful when
there are more people who use it.
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