Bitcoin explained in plain English

Like Paypal and Visa, Bitcoin is a system that can send money digitally.  The innovation that sets Bitcoin apart is that it isn’t controlled or operated by a single company.  Instead of having a company like Visa run the system, anybody can join the Bitcoin network and participate in the record keeping that keeps Bitcoin running.  Nobody owns the Bitcoin software or the Bitcoin network.  If an oppressive government wants to shut down Bitcoin, it can’t simply go after a single company.  An oppressive government would (in theory) have to go after everybody running Bitcoin server software on their computer to shut it down.

In practice, the decentralization doesn’t actually work.  Most people buy Bitcoins through exchanges run by private companies, which are subject to government-imposed laws and regulations.  While Bitcoin’s innovation is interesting, it doesn’t actually do anything useful in the real world.  However, very few people actually understand Bitcoin.  So, journalists and cryptocurrency fanatics can make up fancy stories about how Bitcoin or other cryptocurrencies will change the world.

What Bitcoin is

Bitcoin was originally designed to be a “Peer-to-Peer Electronic Cash System“.  Think of other peer-to-peer systems like Napster or BitTorrent, except that users can exchange Bitcoins instead of files.  Instead of having a single set of records controlled by one company, the set of records is copied to all the volunteer record keepers in the Bitcoin network.  There can be hundreds or thousands of copies of the Bitcoin ledger distributed around the world.  Changes to the ledger (from people sending Bitcoin to one another) are distributed throughout the network and each participant duplicates the record-keeping process on their copy of the ledger.  This is the “distributed ledger” that everybody keeps talking about.

All of this means that the Bitcoin network can run by itself.  Anybody can join the network and help keep it running.

Bitcoin in the real world

Unfortunately the key benefit to Bitcoin (the “decentralization” everybody keeps talking about) doesn’t actually pan out in the real world.  Most people get Bitcoins by buying them via a centralized exchange, which are all private companies that can be shut down or bullied by the government.  As all developed countries have laws against money laundering, banks will enforce these laws and will refuse to do business with exchanges that may be enabling questionable activities like online gambling with Bitcoins.  Cryptocurrencies are effectively regulated by governments around the world.  The only practical alternative to exchanges is to trade Bitcoins in person.  However, this defeats the main benefit of digital money as face-to-face transactions are inconvenient.  It’s unlikely that a system that involves trading paper money for Bitcoins will revolutionize the world.

Currently, the trend is that banks and credit card companies have been cutting off access to Bitcoin and other cryptocurrencies.  Banks have to comply with anti-money laundering regulations so that they don’t intentionally or unintentionally help criminals profit from illegal activities.  A key part of fighting money laundering is knowing who your customers actually are.  Criminals are less likely to use a bank as part of their illegal activities (e.g. to trade stolen Bitcoins for cash) if the bank knows their true identity.  However, Bitcoin was designed to be anonymous as stated by its inventor’s white paper.  (Bitcoin doesn’t fully succeed in allowing for anonymous payments.  However, the anonymity that it does offer is enough to be problematic.)  Bitcoin’s design makes it difficult for banks to obey the law if they are to allow access to Bitcoin exchanges.  This is one of the many reasons why Bitcoin is unlikely to become a mainstream payment method for goods and services.

You can safely ignore the hype

If somebody tries to explain Bitcoin to you and you don’t understand it, the problem isn’t you.  The person explaining Bitcoin likely has some misguided understanding of Bitcoin because there are certain things that they want to believe.  Some people want to look smart by being early believers in new technology that they don’t understand.  Some journalists want to write clickbait stories.  Some people want to believe in get-rich-quick schemes.  Some people are getting rich quick through cryptocurrency-related scams.  Whatever the case is, I wouldn’t worry about it.  You aren’t missing out on a revolutionary new technology.  Bitcoin’s only innovation is interesting but useless in the real world.

If you’ve found this blog post helpful, please feel free to share it with others.  I don’t want to see people lose money to the current cryptocurrency mania because they don’t understand it.  I am releasing this blog post to the public domain, so feel free to make your own version of it (no attribution is required).

 


Appendix A: What Bitcoin mining is (and why everybody is saying it’s bad for the environment)

The problem with a set of records delivered over the Internet is that you don’t know if some stranger on the Internet has nefariously tampered with the version that they sent you.  It is possible for somebody to cheat the system by spending Bitcoins and then distributing a copy of the ledger that leaves out their spending, allowing them to spend their Bitcoins again.  Other users somehow have to figure out which version of history is correct.  To prevent shenanigans, each node on the Bitcoin network will determine trust based on “proof of work“.  Trust will go to the side that has spent/wasted the most computing power to back up their version of events.  The theory is that the honest users will always control more computing power than dishonest users.

To perform proof of work, Bitcoin “miners” do a set of very difficult mathematical calculations to try to find results with a certain number of zeroes in it.  It’s basically computers competing over their ability to produce special numbers with a really long series of zeroes.  Record keepers in the Bitcoin network (“nodes”) will trust the side that has wasted the most computing power.  Because the math needed to find the special numbers is much harder than the math needed to verify the numbers (sort of like how Sudoku puzzles are harder to solve than to check), participants can easily verify which side wasted the most computing power.  This is the key idea behind “blockchain“, the technology that tries to solve the problem of not being able to trust what strangers send you over the Internet.  Honest record keepers will continue to add valid pages (blocks) to the Bitcoin journal.  If the honest side controls more computing power, they will produce a longer chain of valid pages (blocks) than dishonest record keepers.  Eventually, the honest record keepers’ version of events will be considered the authoritative one.

This system works as long as honest users throw more computing power at the problem than dishonest users.  A dishonest user cannot pass off a bogus version of events (such as one that omits their spending) unless that user has more computing power than all of the honest users combined.  To make attacks from dishonest users very difficult, the Bitcoin system provides incentives to its users to maintain a large standing army of computers that are ready to waste more computing power than people trying to cheat the system.  Bitcoins are given out to users who devote computing power towards the Bitcoin cause.  This is called Bitcoin “mining”, as the miners exert effort and are rewarded with digital “gold”.  The creation of new Bitcoins is part of Bitcoin’s design.

If Bitcoin’s price averages $10,000, Bitcoin miners will receive $6.57 billion dollars worth of newly-printed Bitcoins in 2018 (1800 Bitcoins will be created every day in 2018).  Bitcoin miners will also receive transaction fees from people who pay extra to have their transactions added to the ledger first (their transactions will be confirmed first).  This might sound crazy but Bitcoin mining is on track to being a multi-billion dollar industry.  Various companies will fight over their share of newly-printed Bitcoins.  Competition will cause them to use a lot of electricity since electricity is the main ingredient needed to mine Bitcoins.  Digiconomist has a webpage that estimates Bitcoin’s power consumption, which is currently about 1.3% of the United State’s energy consumption- that’s the same as millions of Americans.  Bitcoin mining will consume as much energy as entire countries like Bangladesh.

While Bitcoin mining is one way to get Bitcoins, it is very expensive for most people compared to buying Bitcoins on an exchange.  This is because Bitcoin mining benefits from scale.  Big companies such as Bitmain will spend millions of dollars on designing computers that do one thing and one thing only: mine Bitcoins.  Think of a calculator: it is a computer that does only one thing.  Because it is designed for only one task, it does it very well.  A calculator is incredibly energy efficient and cheap compared to your smartphone or laptop computer.  Similarly, a computer that is designed specifically for mining Bitcoins does it more cost-effectively than everyday computers.  Without millions of dollars spent designing special computers, access to very cheap electricity, and large data centers, normal citizens can’t compete against Bitcoin mining juggernauts.  These companies drive up the cost of mining Bitcoins (Bitcoin is designed so that fewer Bitcoins are produced if more computing power is spent on mining), pushing out the small fish.  You will likely lose money if you try to mine Bitcoin on your home computer.

Appendix B: Buzzwords and technobabble explained

ICO: Initial coin offering, or “it’s a con offering”.  Generally speaking, these are investment scams where investors exchange real money for fake money (or a stake in a fake business or Ponzi scheme).

Immutable: can’t be changed.  In theory, Bitcoin is designed so that the ledger can’t be changed.  In the past, the ledger has been changed by the Bitcoin community banding together to fix bugs.  One such bug allowed a hacker to give him or herself 184 billion Bitcoins.

Trustless:  This refers to a trust problem that only decentralized systems have; centralized systems don’t have this problem.  For Bitcoin specifically, the problem is this: some stranger on the Internet sent me a journal of all Bitcoin transactions and I don’t know if I should trust it.  Bitcoin’s key innovative technology, the blockchain, attempts to solve that problem so that decentralization can work.

Blockchain: a journal of all (Bitcoin) transactions since the very beginning.  Transactions are grouped together into chunks called blocks, which form the ‘pages’ of the journal.  Miners solve difficult math puzzles so that they can attach special numbers to each block, proving that they spent a lot of computing power.  A series (or chain) of blocks with the most computing power spent on ‘proving’ that chain will become the authoritative blockchain.  This system works as long as the honest users waste more computer power and electricity than dishonest users.

Decentralization: a system that works without a trusted central authority.

Double spending: Cheating the system to spend the same Bitcoin two or more times, ultimately resulting in spending Bitcoins that you don’t have.

Secure: An adjective that describes systems other than Bitcoin.  For starters, Bitcoin was hacked to create 184 billion Bitcoins.  When the Mt. Gox exchange was hacked, at least 5% of all Bitcoins at the time (at least 650,000) were stolen.  Many people also lose Bitcoins due to their computer being hacked, being tricked into giving away their passwords or identity, or from malicious browser add-ons.  Bitcoin also has outstanding security issues that haven’t been fixed.  If a single party controls 51% of the world’s Bitcoin mining power, that mining power can be used to disrupt the Bitcoin network.  Currently, more than 51% of the world’s mining power is controlled by Chinese companies.

8 thoughts on “Bitcoin explained in plain English

  1. This explanation is rather shallow and doesn’t actually give an accurate in depth historical context to Bitcoin’s development.

    A better way to explain Bitcoin mining would be: “50BTC is given every 10 minutes to the first person who can guess a random number. As more people try to guess the number, the software increases the size to be more difficult, trying to average out to be guessable every 10 minutes”

    It’s not a very difficult mathematical calculation, it’s a lottery.

    Historically it was very very cheap to mint (guess the number) Bitcoins.

    The algorithm Satoshi used for Bitcoin uses very low work/energy/capital input to produce many Bitcoins during the start, but as time passes the amount of work/energy/capital increases in addition to the reward of Bitcoins rewarded decreases. Nothing improves as more work/energy goes into the network, the algorithm is simply designed to waste more capital and produce less Bitcoins for later users.

    • Well it’s more about guessing random numbers with certain properties. It’s difficult in the sense that it’s computationally expensive to do, but not computationally expensive to verify.

  2. It takes a while for a new technology to become mainstream. If the tech is not truly promising, there wouldn’t be so many talents from the tech world to make the switch to the blockchain space.

    I suggest you read the following blog post by Fred Wilson (http://avc.com/2018/03/pay-attention-to-the-package/):

    “Tech investing is a lot about big trends and timing them.

    We knew mobile was going to be a game changer as far back as the mid 90s, but it didn’t really take off until the iPhone came along in 2007

    We knew personal computing was going to be a big deal in the late 70s, but computers didn’t become truly personal until operating systems got graphical user interfaces in the mid 80s.

    The internet was super interesting in the late 80s and early 90s but it didn’t go mainstream until we had web browsers in the mid 90s.”

    • You’re basically saying that Bitcoin will be a revolutionary technology by comparing it to revolutionary technologies. That’s kind of a circular argument.

      e.g. “The Internet wasn’t a game changer when it started. Bitcoin also wasn’t a game changer when it started. Therefore, Bitcoin will be like the Internet???!”

      • No, my point is that just because blockchain technology hasn’t reached mass adoption in 10 years, it doesn’t mean its a failure. A lot of other breakthrough technology also didn’t achieve mass success in the first 10 years.

  3. Also, your statements contradict each other. If cryptocurrency is too anonymous to be problematic, then your point about centralized exchange (which are subject to government-imposed laws and regulations, including KYC/AML) being too big of a risk doesn’t hold.

    Pick your position – is cryptocurrency a tool for criminals because of its anonymous nature or is it too dependent on centralized exchanges to be traded (which makes account holders information public to the exchange)?

    • Centralized exchanges have to do weird things to comply with anti-money laundering regulations. For example, Coinbase in Canada will allow customers to buy -but not sell- Bitcoin. The exchanges will have to do all sorts of contortions that will make Bitcoin and other cryptocurrencies inferior to other forms of digital money (like Paypal, Visa, wire transfer / SWIFT, etc.). Imagine you were only allowed to buy Euros but not sell them… it would be a little ridiculous right?

      • That’s because the entire cryptocurrency space is still so early. The government doesn’t even know how to regulate it yet. However, this is besides the point.

        My original point is about centralized exchange having the customers’ information and it would be hard for criminals not to leave a trail. Your reply talks about something irrelevant.

        I have 3 employees who live across the world. I pay them every few days for a relatively small sum. What other payment methods work as well as cryptocurrency in terms of speed and transaction cost?

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