No really. What is it? I was asking you. You don’t know either, do you? Let’s see if we can figure it out together.
I started buying tiny amounts of bitcoin a year ago. Those first few purchases were based more on curiosity and hype than understanding. Then when the global pandemic broke out I knew enough about bitcoin to know that a crisis like this could be a perfect storm for speeding the popularity and adoption of the technology, but I still didn’t understand it.
Global economies are in crisis. Stocks plummeted 35% in a month before experiencing a (temporary?) rally. This past week the price of an oil futures contract went negative in value. Some 30 million Americans are unemployed. In an effort mitigate the economic fallout the Federal Reserve, US Treasury, and federal and state governments are injecting upwards of six trillion dollars worth of stimulus into the US economy. Bitcoin was built to protect people during times like these. I think.
I wanted to understand the machinery behind bitcoin. How does it work? What even is it? Is it even real?
Over the past couple of months I decided to use some quarantine time to read up on the subject. What follows is my current understanding of the key concepts and terms of bitcoin, in order from the easiest to understand to the hardest and most esoteric aspects of it. I write posts like this mostly as learning exercises for myself, so take this with a grain of salt. I’m no expert, and there are almost certainly inaccuracies below (please feel free to correct me in the comments and I’ll update the post). Maybe this post sparks some curiosity for someone out there, which would be pretty cool.
What is bitcoin? (easy peasy)
Bitcoin is digital cash. That’s the easiest way to think about it.
Bitcoin is exchanged on a peer to peer network. Imagine the difference between paying someone using a credit card and paying someone with cash. Credit card payments go through a 3rd party processor and they can be reversed. Cash goes direct from you to the other party and they can’t be reversed. Bitcoin is digital cash.
There is no centralized bitcoin authority. Bitcoin is not a company and it is not controlled by a government. There’s no bitcoin customer service department. Again, think cash. If you had a question about a twenty dollar bill, you wouldn’t try to call the company that printed it.
How can you buy bitcoin? (easy)
You can acquire bitcoin on an exchange like Coinbase.com. It’s very easy. You can set up an account on your phone in minutes and buy as little as $1 USD worth of bitcoin.
1 whole bitcoin today is worth about $7,500 USD. Bitcoins are divided up into smaller units, and the smallest possible indivisible unit is called a Satoshi or Sat. 1 Satoshi = 0.00000001 bitcoins.
How do you store bitcoin? Is bitcoin secure? (getting harder)
You store your bitcoin in a wallet which functions using 2 types of keys. An easy way to understand wallets and keys is to think of wallets as digital lockers, like the locker you had in high school. Your wallet’s public key can be thought of as the number on the front of your locker. You can tell others your public key and they can use your public key to give you bitcoin. Your wallet’s private key can be thought of as the secret combination to open the locker. Only you have this secret number. It keeps your bitcoin safely locked in your wallet and you use it to send bitcoin to others.
Your private and public keys are mathematically related. Your private key creates your public key using complicated math functions. Your private key also digitally signs transactions anytime you send bitcoin. This private key signature is used by the bitcoin software along with your public key verify your funds during a transaction. It is impossible to use the public key or the signature to reverse engineer the private key, because keys are created using one way math functions. This is the genius of bitcoin technology and the process makes your wallet very very secure.
Public and private keys use 256 bit encryption, which is extremely secure. There are 10^77 possible 256 bit key combinations, which is a number so big that it is bigger than the number of atoms in the known universe. This makes hacking bitcoin keys impossible.
The other main security feature of bitcoin is the blockchain, which is where bitcoin transactions are recorded.
How do bitcoin transactions work? (very hard to understand)
Bitcoin transactions are recorded on a blockchain. The bitcoin blockchain is a public ledger of all bitcoin translations going back to the very first transaction.
When you send bitcoin to someone, you initiate a transaction. The transaction includes your private key signature and your public key. Nodes, or powerful computers using bitcoin software, use transaction data to verify your funds without being able to see your actual private key. This process is called proof of work, and it is usually completed within seconds of initiating your transaction.
Once verified, your transaction data goes into a pool of transactions. Miners, people who operate the nodes, then scoop up a group of transactions from the pool. This new group of transactions is called a block.
The block of transactions is coded using a process called hashing. Hashing uses another complicated math function to encode the entire block of transactions into a single 64-character string, know as a hash. Each block’s hash contains its transaction data and also contains a hash from the previous block, which then creates of chain of blocks which can be coded or decoded into a ledger of all bitcoin transactions going all the way back to the beginning of time.
Miners race to confirm transactions. The first miner to hash the block of transactions and link them to the blockchain gets to keep the transaction fees. The transaction fees are the miners’ reward for expending the electricity and processing power needed to do all that math.
Once this process is complete the transaction is irreversible (like cash and not like credit cards), because changing any one block would change all the other subsequent blocks on the chain. This feature not only creates valuable irreversibility, it also adds security, since it makes fraudulent double spending impossible.
Where do bitcoins come from? (what the?)
In addition to transaction fees miners get brand new bitcoins as a reward for confirming transactions to the ledger. These newly minted bitcoins are called a block reward.
There is a limit programmed into the bitcoin software for how many new bitcoins can be mined. Miners currently earn 12.5 bitcoins per block. That limit will steadily decrease over time. This creates hard scarcity within the currency of bitcoin, which adds to bitcoin’s soundness and value.
There will only ever be 21,000,000 bitcoins created. In May, the block reward for miners will be cut in half. This event happens roughly every four years, and is called a halving.
By about 2025, over 95% of the bitcoins that will ever be created will already have been mined. And by 2140, the very last Satoshi will be mined and the supply of bitcoin will never increase again.
What does it all mean?
We’ve learned that bitcoin has all of the characteristics of sound money because it is portable, durable, divisible, (becoming more) acceptable, and in very limited supply. But so is the almighty Greenback, so what gives? Why would anyone go through all this trouble when we have plenty of ways to buy our iced grande quad Americanos?
The difference with the currency of bitcoin is individual sovereignty. No central bank or government can decide to print more bitcoin. No consumer bank can decide to take it away from you. Bitcoin is owned and controlled only by the network and by you. It transfers power to the people.
Individual sovereignty along with all of the other characteristics and features detailed in this post mean that bitcoin could very likely turn out more of a store of value than a medium of exchange (think about the difference between gold and cash). That means that if bitcoin continues to grow in popularity, the other properties of bitcoin should cause its value to increase. You’re only a quick Google search or stroll through the Twitterverse away from discovering how high in people think the value of bitcoin can go.
Obligatory disclaimer time. NO ONE knows the future. Everyone learning about bitcoin should know that market today is still small, so the price (technically the exchange rate) is very volatile. Just this past March, the price of bitcoin fell 50% in a day! I’m not a financial advisor, so don’t buy bitcoin based on this blog post. In fact, its unlikely an actual financial advisor can even tell you whether or not to put some of your hard earned money into bitcoin. The general guidance from bitcoin experts is to only invest in bitcoin in proportion to your personal understanding of the technology and only invest funds that you’re comfortable losing entirely. That said, my money is betting on bitcoin being much more valuable in the future.
If you’re interested in learning more, The Bitcoin Standard is a book that is widely considered the best primer on bitcoin. Also, here’s great 90 minute intro to bitcoin from Andreas Antonopoulos, one of the world’s most popular speakers on the subject: