I’m Jason Firth.
One of the biggest questions out there, and one that I’ve been asked may times is “What is bitcoin?”. I think it’s an interesting thing to talk about for a bit. Before I start, I’m going to talk a bit about the money most people use. After that, We can talk about the technology, a bit about economics, and a bit about its impact on different societies. Finally, we’ll talk about the ways blockchain technology can work in sectors besides currency.
Currency is a medium of exchange for goods and services. Currency generally has 3 important attributes: First, it is used as a medium of exchange. Meaning you can trade it for goods and services without first having to convert it into something else. Second, it can be used to measure the value of a general good or service. Finally, it can be used to store value.
Over the millennia, many different things have been used as currency. Kings once used to split branches in half, and use the one half branch to prove the other half was authentic. Gold and Silver have been used because they don’t easily corrode, and there’s a limited amount in the world.
The problem with physical objects is they take up weight and volume, and if someone takes your gold or your sticks, you no longer have them.
As a result, businesses popped up to store your gold and silver, and they’d either issue slips of paper or let you write slips of paper to give the gold and silver to different people. Those slips of paper were much lighter and much smaller than physical gold. Writing slips of paper added a layer of security since you have to authenticate what you’ve been doing.
Those businesses eventually realized something: They can issue more pieces of paper than they actually have gold. As long as they have enough gold to give back to people who come in to cash in their pieces of paper, they won’t have a problem, and as long as they can eventually get the gold back, then they can lend out the extra gold and make interest on it. That’s how the banks became what they are today. That’s called Fractional Reserve Banking because banks need to reserve a fraction of the gold in case people come in to convert their slips of paper to physical gold. When someone says money is “backed by gold” that’s what this means.
Today, banks don’t need to store gold. They hold money to lend out more money. Basically, if they have a dollar, they can lend out up to 30 dollars. The new dollars represent debt. This money is accepted as money because the government has deemed it so. This is why this why Bitcoin enthusiasts or proponents of a gold backed currency call regular money “fiat money”. The government made it money by fiat, or by formal decree of the government.
Given these facts, money is created by banks issuing debt, and money is destroyed when debt is repaid.
One of the subtle but incredibly powerful organizations in an economy is the central bank. The main purpose of a central bank is a “lender of last resort”. In the US prior to its development, a bank could be in a situation where it was in good financial shape but a lot of people got scared and pulled their money out quickly. This situation is called a “bank run” and can result in the death of a healthy bank. By creating a lender of last resort that banks can always borrow from, they can be assured to get capital they need for short term requirements. In most countries, the central bank is separate from the government to try to protect governments from themselves: if governments can print money whenever they want, they are likely to print money instead of taxing. Many countries did this, and many of those countries ended up with a worthless currency. Notable examples are the Weimar Republic before world war 2 where people used wheelbarrows of money to buy a loaf of bread, Zimbabwe where their dollar became so weak they minted a 100 trillion dollar bill that would not buy a loaf of bread, and Argentina, where prices are currently moving up daily. Most central banks want to limit inflation to about 2%, meaning that prices generally increase by 2% each year.
So why would they want inflation? To answer that, you need to go back to the great depression. Europe has vivid memories of hyperinflation in the Weimar Republic so they are shy about inflation. The United States during the great depression in the 1930s had a different condition called deflation. Prices were generally falling so people had reason to hold onto their money because it would buy more tomorrow than it did today. As a result of that holding onto money, the “aggregate demand” — or the total demand for goods and services in the economy, fell. This drop in aggregate demand is one of the causes of the great depression. Modern economies are constantly trying to keep aggregate demand at an ideal spot, and chipping away at the value of money is one way to do that. For this reason, central banks consider both deflation and high inflation to be problems to be solved.
The way the amount of money created is controlled is by a number of levers that make it easier or harder for banks to lend, which in turn affects how easy it is to get or maintain debt. Remember fractional reserve banking? One lever the central bank has is changing the required reserve ratio. This can immediately increase or decrease the amount of money available to lend out by banks, changing the supply of money. Another lever the bank has is interest rates. The central bank doesn’t directly dictate the interest rates consumers pay for loans, but they set how much the banks must pay to borrow money, which sets the tone for interest rates in the broader economy. Finally, the last lever most central banks have to pull is called quantitative easing. This is where central banks buy government debt. This has 2 immediate effects: first, it converts an asset the banks hold into liquid cash, which provides more money to lend. Second, it increases demand for government debt, which allows the government to issue more debt at a lower cost. The downside to all these levers is that they are all effective short term levers, but in the long term the economy comes to rely on these for continued growth, and if you’re really unlucky you could overheat an economy by providing too much debt. Money will flow into any harebrained scheme, and for a while that will mean great profits for investors… Right up until markets turn out to be not as profitable as expected, people leave markets en masse, and the bubbles that has been inflated pop.
Anyway, that little macroeconomics lesson out of the way, let’s talk about bitcoin directly.
At its base, Bitcoin is a list of all the list of bitcoin transactions that have ever been. Simple as that. It’s called a “ledger”, and that’s the basic part of bitcoin. Ledgers are a basic accounting term that refer to a list of transactions.
Bitcoin is called Peer to Peer, because there isn’t one bitcoin server out there. There are a large number of servers called Miners that work together as peers to provide the ledger to anyone who needs it and to maintain and constantly check the ledger to make sure everyone is following the rules. Everyone has the ledger and everyone adds to it. Because everyone has this ledger, it is called a Distributed Ledger.
If you’re wondering why those miners do this willingly, and where bitcoins come from, the answer to both is the same: Miners are entered into a lottery to receive a bitcoin once they process enough of the ledger. By supporting the bitcoin network, they are paid in bitcoin. This is the process by which new bitcoin are created, and the process by which bitcoin is maintained. Since the amount of time until a Bitcoin is created may be massive, many small-time miners team up. With enough miners, there is an expected flow of Bitcoins, and they are distributed between all members of the team depending on how much of the ledger each miner processed.
This ledger is made up of a list of every transaction ever made. Each transaction is in a logical grouping called a “block”. Each new transaction gets added to the end of the ledger, making a chain of blocks, where we get the term “blockchain”.
Everyone who has bitcoin has a “bitcoin wallet”, which is essentially a piece of software that maintains a copy of the blockchain password called a “private key” for creating new transactions regarding the bitcoins associated with the wallet. The wallet reaches out to miners, first to get all the transactions that have ever existed and maintain a list, then to add new transactions that you make.
From there, when you send bitcoin to another person, you send a block to the miners, encrypted using your private key. They verify it is legitimate then send it to all the other miners. This process can take quite some time. At least 10 minutes and as much as a few days! Each transaction has a cost associated with it and miners will tend to try to complete transactions with higher fees first, so the higher transaction fees you pay, the quicker your transaction will close. If enough transactions paying higher fees are taking place, your transaction could take an indefinite amount of time.
Since most of us don’t have massive server farms to get Bitcoin, there is another way to get them. Companies have set up websites called “exchanges” where people or companies that have Bitcoin put them up for sale. Individuals bid local currency on the bitcoins and pay with the local currency. This is the process by which Bitcoin is converted to regular money, how people become millionaires. They buy the Bitcoin low, or they mine it, and then sell the Bitcoin if it becomes much more valuable in the future. When websites or news organizations talk about the price of bitcoin, they’re pulling the price people are willing to pay off these websites.
These exchanges are something a bitcoin user must be wary of. In 2014, the mtgox exchange, the largest bitcoin exchange in the world, shut down unexpectedly. They couldn’t account for 850,000 bitcoins, so many users lost everything. More recently, the owner of the QuadrigaCX died without a backup of the passwords and many users lost their bitcoins to the tune of $190 Million. If the bitcoins had been in users wallets they would have been safe, but people trusted the exchanges.
We have gone over a lot of facts about bitcoin. To be honest, I personally think it is a terrible currency for people in most developed nations. Transactions take forever to process and cost a lot of money for small transactions, its extremely inconvenient — you need to download the history of bitcoin before using bitcoin, the price of bitcoin is extremely unstable so you may be poor one day, rich the next, and poor a third, most vendors don’t accept bitcoin, and you need to rely on unreliable exchanges to turn your bitcoin into local currency most people will accept.
Let’s compare to using banks here in Canada. Most transactions with the banks are free — I can deposit money, I can spend money using debit or visa, and depending on my bank, I may be able to withdraw for free as well. Debit transactions appear within seconds, and visa transactions affect the balance immediately. I only need a number or a piece of plastic or a few numbers to purchase something, and the money is already in a form almost every vendor accepts, so you don’t need to convert your cash into something else to spend it.
Now, that all being said, there’s a place where Bitcoin is a fantastic choice. Remember earlier when I was talking about countries with hyperinflation? Bitcoin expands at the rate the algorithm expands it at, not at a rate the government desires, so even though it has all these negatives, it’s used in countries like Argentina and Venezuela where money can’t hold value, because people can mine it, get a bit of bitcoin, and use it to order products over the Internet. For such people, Bitcoin represents the one way they can hang onto currency.
Finally, let’s talk a bit about the potential for blockchain technology. Thing is, money probably isn’t the best use of this technology. Maintaining a ledger of every cash transaction ever completed is a pretty expensive task if you want to spend a dollar on a Coke. However, there are a number of situations where the attributes of block chain are beneficial.
Presently, precious metals come out of the ground, and can be bought and sold, but there isn’t a ledger tracking the history of that precious metal. Because of that, unscrupulous companies might be selling the same gold multiple times — unless you can account for it. One application of blockchain is to have a miner create an entry in the ledger for each bit of gold, and then trades in gold can be tracked using the blockchain, and you can’t sell the same gold twice.
Another situation where blockchain might be beneficial is real estate. There is an entire industry for dealing with deeds. You pay for a copy of the deed, or you can buy title insurance, and it’s a non-trivial part of the job. Using a blockchain, we can trace ownership of property going back to the inception of the property.
Yet another situation where blockchain might be beneficial is stocks. Many trades are done electronically, so companies spend a lot of money on intermediates who handle the transfer of stock. With a shared ledger between banks, the system can be handled without those intermediates.
In short, anywhere that we need a shared source of truth and an enforced transaction history, blockchain can be a huge benefit. As I said before, probably not great for buying a Coke, but if you wanted to buy a million shares of Coke or Koch, you might find blockchain technology has benefits over our current systems. We’ll just have to see how history plays out!
Thanks for reading!