Knowledge for the World

What is Bitcoin? - In Layman's Terms

People are asking about Bitcoin and rightfully so. Bitcoin has gained a lot of traction over the past few years, and to most people it is still a mystery. The price of bitcoin has jumped from as low as a few dollars to over $1000 each. Because of the increased popularity and growth, many investors have enjoyed buying bitcoin despite the risk. Bitcoin is still a young currency, and like the first few years of the Internet most people are still unaware of how to use it or benefit from it. I'm going to provide a high level overview of what bitcoin is from both a lightly technical and economic perspective.

Non-technical technical overview

First, we must understand the difference between Bitcoin (with a capital "B") and bitcoin (with a lower case "b"). The first, as a proper noun, is the name of the network and system as a whole. Bitcoin in this context is the name of a technology. Lower case "b", bitcoin, is the name of the actual units of currency. As an example, an investor can own bitcoin but not Bitcoin. Nobody owns Bitcoin, but we will get to that in a bit.

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Encryption

You can't talk about Bitcoin without mentioning cryptography. Don't worry, you don't have to know the details of cryptography to be confident about Bitcoin. A basic overview is perfectly sufficient. Cryptography sounds intense, and it is, but it basically boils down to the study of secure communication. It's derived from Greek - kryptos meaning 'hidden' and graphia meaning 'writing'. The entire purpose of cryptography is to keep some data a secret and only let the right people read it. In order to keep data a secret, cryptographers have created ways to hide messages so that they appear to be nonsensical. Then they give a key to the right person who they want to read the message. You may remember a simple example from A Christmas Story. Ralphie has an encoded message and he waits anxiously for his Orphan Annie Secret Society decoder pin to arrive in the mail. His decoded message is unintelligble without the pin, but once the pin arrives in the mail he is able to decode the message into something much more meaningful: "Be Sure To Drink Your Ovaltine". In this example, the pin is what cryptographers refer to as a "key". Of course, modern cryptography uses much more advanced and complex means of encryption to keep messages hidden.

The type of cryptography Bitcoin uses is just a little bit different from Orphan Annie's secret message. A person who wants to receive encrypted messages will generate both a public and a private key. The public key is given out to anyone who wants to send a message. The sender will use the public key to encrypt the message, and it can only be decrypted by the person who has the private key. Once someone encrypts a message with the public key, anyone who finds the message can't understand it without the private key.

If this sounds complicated, don't worry. Just understand that private keys are are what give a person the ability to unlock a message. Public keys give a person the ability to lock a message. Bitcoin uses this type of encryption - "public key" or "asymmetric". As you can imagine, the public key is used as a public address. Other people can send you bitcoin if you have a valid public address. Every single public address has a corresponding private key that allows the owner to "spend" the value stored in that public address.

Fortunately for the average user, all of this happens behind the scenes by whatever software they are using to manage their bitcoin. But it is nice to know a little bit about what is going on so you can gain confidence in the technology.

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Blockchain

The blockchain is nothing more than a public ledger of all bitcoin transactions. Every time bitcoin is exchanged this transaction is first validated by the blockchain and then recorded on the blockchain.

It's important to understand that no one owns or controls the blockchain. The blockchain is shared by all computers on the network. This means no one can reasonably hack or alter the network. In fact, mathmatically speaking it is a much more efficient use of processing power to mine bitcoin than it is to steal bitcoin so there is virtually no incentive to steal.

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Bitcoin Wallet

At a basic level, a bitcoin wallet is a file composed of private keys. Your private keys are the secret that only you have that allows you to "spend" your bitcoin. Your wallet can have one or many addresses associated with it. The address is what other people will use to send you bitcoin.

A wallet can exist on any device. Many people choose to use online wallets so they don't have to maintain the software on their computer. This keeps their computer from being used as a node on the Bitcoin network, and prevents them from having to worry about security or backups. This is a fine option as long as you choose a reputable company to maintain your wallet. Others choose to download wallet software and manage it locally. If you choose this option, it's important that you remember to backup your wallet in case of some disaster and keep it as secure as possible.

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Transactions

A transaction in bitcoin is nothing more than a transfer of value between one bitcoin wallet and another. When you send bitcoin to someone, the transaction contains your private key for authorization, the value you want to send, an address to send it to, and other pertitent information about the transaction.

Economic Overview

Decentralization

Although the technology behind Bitcoin is exciting, the entire reason it was created was to decentralize control of currency and allow for a stable economy. For thousands of years, gold, silver and other precious metals were used as currency. This was ideal for many reasons, but one important reason is that no single entity could take control over it.

Right now, no government is using the gold standard which means that each countries currency is backed only by the peoples' trust in their governments and banks. This has failed over and over again. This fiat money system allows governments to stimulate the economy artificially and temporarily, but ultimately fails in the long run because it is dependent upon the goodwill and competetence of politicians.

Zimbabwe is a great example of how the fiat money system is destroyed by incompetency in leadership. In the 1980's Zimbabwe gained its independence from Britain, and it's dollar was even more valuable that the American dollar. Their economy was thriving and growing. After a failed economic plan designed by the IMF and World Bank, Zimbabwe began to struggle. There were many factors that led to economic decline, but their government ensured failure by printing money as a solution to problems they couldn't otherwise figure out. At one point, they printed a $21 trillion bill to pay off debts owed to the IMF. The currency that was once competitive with the US Dollar had seen inflation rates of up to 80 billion percent.

Most countries do not experience this extreme inflation and rapid destruction of their economy. Less corrupt governments generally take longer to see the effects of their monetary policy. Even the United States has resorted many times to printing money in an effort to stimulate the economy. During Obama's presidency the Federal Reserve has effectively tripled the monetary base in the United States. During that same time period most people have not experienced a proportional increase in income or economic growth. Yet we have seen prices increase significantly for most goods and services.

The value of decentralizing a currency is that it takes power over the economy away from an elite group of bankers and politicians. The belief is that even a government on its best behavior cannot properly manage an economy.

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Scarcity

Scarcity is a necessary part of any currency. The word scarcity oftentimes carries a bad connotation, but in the context of a currency, scarcity is desirable. Imagine if money really did grow on trees. As a business owner, would you accept money from customers when you can just walk outside and pick it off a tree much easier? And would other business owners accept your money when they can do the same? This is a silly example, but the idea is that scarcity creates value. And value is a good thing.

Just like gold, there is a limited number of bitcoins in existence. Hardwired into the Bitcoin protocol is a limit of 21 million bitcoins. As I write this guide, there are just over 13 million in circulation and the rest have yet to be mined. Also akin to gold is the benefit that bitcoin can be split up into any denomination. So even though it is perfectly scarce, it can be infinately divided.

This ensures that when you trade something for bitcoin there won't be a massive influx of new bitcoins entering the market the next day thus devaluing your previous purchase. Also you can send or receive any denomination of bitcoin.

Other Considerations

Anonymity

One of the most controversial aspects of Bitcoin is that it allows for perfect anonymity. All transactions are recorded publically on the blockchain, but there is nothing that connects you with any public address. It's very easy to conceal your identity and make perfectly anonymous transactions. This is a valuable tool for maintaining privacy and security.

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Blockchain is a public ledger

Even though transactions are anonymous, all address balances and transaction details are publically available on the blockchain. That means if you know someone's address you can look up the assocaited balance. One thing to consider is that if you continually reuse the same public address, and you give it to someone who knows you, they could look up the address balance on the blockchain. For this reason, its wise to generate a new public address for each transaction and many wallets manage this for you.

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Hopefully this guide has been beneficial. Almost all of my friends have now asked me "What exactly is Bitcoin?" so I decided to take a stab at writing a layman's guide. If I've misstated something or if you'd like to see more guides about Bitcoin feel free to leave a comment below!

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