Understanding Bitcoin for Beginners

What is Bitcoin?

You’ve probably heard Bitcoin called money or a commodity or a store of value. The truth is it can function as all those things, but at its base it’s something quite different. Let’s start from the beginning. Bitcoin was first described in a paper that was announced in several places on Halloween 2008. Written under the pseudonym Satoshi Nakamoto, it describes a way to use a cryptographically strengthened public ledger to record and protect transactions.

Bitcoin was only an idea then, but after two months of planning and software development, the first block of 50 coins was released. This was known as the genesis block. A small development community turned that idea into a working system. One important part of that system is a way to release Bitcoins over time to reward those people who dedicate their computer power to making the system’s infrastructure work. These people are called miners. If things had stopped there it would’ve just been an interesting experiment, and in fact it remained just a curious toy of cryptographers for about a year and a half when the first real world transaction took place, 10000 Bitcoins for a couple of pizzas.

Understanding Bitcoin

Those Bitcoins were worth about 40 dollars at the time. If that transaction were to take place as I record this though, that pizza would’ve cost millions of dollars. A few things eventually brought Bitcoin wider attention and caused its value to rise. First people started accepting it in exchange for real world goods and services. It was mostly criminals in the early days, drawn by Bitcoin’s ease of transfer and semi-anonymous nature, but soon legitimate organizations, such as WordPress and the Internet Archive, accepted Bitcoin for donations and payments.

Second services appeared to give people ways to buy, sell, store, learn about, and protect Bitcoins. Many of those companies failed, but some were backed by experienced entrepreneurs and were successful. Third people started speculating, buying Bitcoin on the hopes it would increase in value, driving the price up further. Others used Bitcoin to store their wealth. As the value of Bitcoin rose, it attracted the attention of government regulators. Although there’s no way they can ban Bitcoin per se, that hasn’t stopped some of them from trying, and they can crack down on its support services, such as exchanges that convert Bitcoins to dollars.

Bitcoin’s increasing value also attracted the attention of thieves. Billions of dollars’ worth of Bitcoin has been misappropriated or misplaced, most of it because of common business fraud, incompetence, or bad technical implementations. None as far as I know has revealed a basic flaw of Bitcoin itself. Although it has suffered and recovered from some major technical issues. As Bitcoin grows it faces new challenges, some technical some social, but so far Bitcoin has always bounced back.

Its value has grown increasingly stable over time while more services appear to support Bitcoin’s users, but if history is any guide, the one thing we can expect from Bitcoin is more surprises.

How Bitcoin Works?

A lot of what makes Bitcoin new and interesting is that for the first time, it lets two people securely exchange value online without a bank, government, company, or any other central authority between them. Here’s a very high-level example of how it works. Let’s say that I want to send you $20 in Bitcoin. The Bitcoin wallet on my computer or phone includes my own Bitcoin address, which is a compressed version of something known in cryptography as a public key. It also contains data needed to sign transactions, known as my private key.

The private key data must be kept hidden because anyone who gets my private key can access and spend my Bitcoins. So, I tap Send, then I enter the amount to pay plus your address, usually by pasting it in or by scanning a QR code. Decide on the amount, in this case $20, and you see that it automatically gets converted into the appropriate amount of Bitcoin. The wallet uses my private key to sign the transaction and adds a little of my Bitcoin as a processing fee.

The wallet then publishes a signed copy of the transaction to the entire internet. The balance in my wallet immediately goes down by the equivalent of $20 in Bitcoin, and the balance in yours goes up by the same amount. Out on the Bitcoin network, our transaction gets bundled into a block with other transactions. This block is tied shut with a cryptographic puzzle, which specialized computers called Miners compete to solve. Whichever computer solves it first is entitled to claim any processing fees that were included in the block, along with a block reward of some Bitcoins, this is how new Bitcoins are introduced to the world.

The Miner publishes the soft block and it becomes part of the public ledger known as the blockchain. This block solving process takes about 10 minutes. But we’re still not done, your wallet shows that you’ve been paid $10 in Bitcoin but it’s not spendable yet. You see, several Miners might have solved a block at essentially the same time and they’re all competing to have their block be the next official one in the blockchain. The passage of time solves these conflicts. Without getting into the details, every additional block that gets solved confirms which ones should have come before, so it’s best to wait for confirmation of a few more blocks after the one containing your transaction, before treating the money as irreversible and spendable.

This all happens in about an hour. Now at first you might think that’s a lot slower than credit card transactions which seem to only take a few seconds. But credit card settlements can take days and can be disputed for weeks or months. They only seem to be fast because the credit card company is guaranteeing the transaction in exchange for some high fees. The same is true for checks, which take a few days to be cleared by the bank. By comparison, 60 minutes isn’t so long.

Earlier I said that Bitcoin works without a central authority between the sender and the recipient. What’s replaced it is this worldwide network of Miners where no one person is powerful enough to disrupt the entire network. Now it’s not a foolproof system, but so far, it’s proven remarkably resilient. I skimmed over a lot of details on how Bitcoin works. Really explaining it fully requires sophisticated references to computer networking, automated conflict settlement, cryptography and a host of other specialties.

Fortunately, the source material is all easy to find. First and foremost is the original Bitcoin paper, available at bitcoin.org/bitcoin.pdf. For further less technical information, there’s lots to explore on the rest of the Bitcoin Foundation’s site at bitcoin.org.

Bitcoin as a Currency

The paper that created Bitcoin in 2009, described it as a peer-to-peer electronic cash system and for the first few years of its life, much of the talk was about how it was eventually going to be how you’d pay for a pack of gum at the corner store. Instead, it more often serves as an investment vehicle, or of a store of value. But it can be used for transactions, just like several other forms of money. Let’s look at those other forms in a historical perspective to understand how Bitcoin is different from them.

We’ll look at five aspects of each kind of money. The forms they take, whether they work well online, the authority that guarantees their value, what your recourse is if you spend it and then want to take it back without getting lawyers involved, and the overall cost of use, taking the risks into account. As a point of reference, we’ll start with Bitcoin. In form, it’s a purely digital currency. It doesn’t exist in another place and so it’s completely online ready.

Its authority comes from an online network of individual players, there is no central authority. When you spend Bitcoin, it is absolutely spent. There’s no way to get it back. Finally, the cost of use for Bitcoin used to be very low, typically only a few pennies per transaction. But as the Bitcoin network has become overcrowded, transaction fees went way up in late 2017. Technical measures to lower them are being attempted as I record this, but it’s unclear how successful they’ll be in the long run.

So that’s Bitcoin. Now let’s jump in our time machine and go back to the very first form of money, barter, or trading one thing for another. Gold falls in this category because you must physically exchange it for whatever you’re getting. In barter, you must bring a physical object from one place to another, as such, it is not in any way online ready. The only authority when you barter is physical proof, that is, seeing and probing the object. There’s no central authority guaranteeing its value.

Once you’ve made the exchange, there’s no recourse, and the cost of use is actually very high because of the cost to carry and secure the physical objects. Eventually, cash came to stand in as tokens for those unwieldy physical objects. Now cash is also purely physical, so it doesn’t really work online. The authority is whatever government backs the cash, whether it’s the United States, or Zimbabwe, or anywhere else. When you spend cash, you have no recourse, it’s just gone.

Finally, its cost of use is low. Moving forward in time, we come to checks. These are mostly physical, although that is changing somewhat, in that you can now take pictures of checks and deposit them digitally in that way. As such, they’re a little bit online ready, but mostly they’re a physical form. The authority comes from whatever bank issued them and you do have recourse by going to that bank. The cost of use for checks is moderate. That is, you must spend a certain amount in fees and overdraft protection and so forth in order to make the checking system work.

Plus of course, you must have the money on reserve at the bank. Finally, we come to that most modern invention, credit cards. At this point, credit cards are mostly digital, and you can use them online quite well. As with checks, the authority is the bank that issues them, which can give us recourse if you want your money back. The cost of use, however, is very high, because the bank is guaranteeing the value until the transaction closes, which can be weeks or even months later.

Now the point of this comparison isn’t to say, Bitcoin is great, or Bitcoin is awful, but rather to help you discover those situations where Bitcoin is the right form of payment to use.

Bitcoin as an Asset

Bitcoin is commonly called a cryptocurrency. That word links it with other kinds of currency such as dollars and yen. Currencies are so called mediums of exchange. That is, their purpose is to pass from hand to hand in exchange for items of value. There are plenty of places to spend Bitcoin this way including such big vendors as Overstock and Expedia, but it’s far more often used as an investment vehicle, or to store value. Let’s examine its use as an asset rather than a currency, by looking at three things.

Its value, how easy it is to exchange, also known as its liquidity, and how easy it is to hold, which I’m calling protectability. Bitcoin’s value has been a history of sudden price spikes followed by slow sags, followed by more spikes. The first big spike came in 2011 when its value shot up from pennies to almost $30, but few people knew about Bitcoin then, and there weren’t many trustworthy ways to buy it and sell it. After this first rally, it sagged to near two dollars.

Bitcoin’s first taste of mainstream fame came with the second spike in 2013, when the government of Cyprus announced a plan to seize certain bank deposits. Cypriots got their money out of banks and into Bitcoin, sending the price from about $15 to over $250, before it dropped again to settle around $120. Another big spike in 2013 brought the price above $1,000 before again it dropped hard to just above $200.

Shortly before I made this video, Bitcoin had recently experienced its fourth big spike to nearly $20,000. Will it sag again? Will there be future spikes? A lot of people pretend to know, but really nobody does. It’s tempting to focus on the spikes, but anyone thinking of investing in Bitcoin should also keep in mind the sags. If you bought in late 2013 for example, you’d have watched your asset lose value for more than two long disheartening years.

So that’s Bitcoin’s value. Next, we come to its liquidity. How easily you can turn your Bitcoin into dollars or euros, or other forms of value. This was a big problem in Bitcoin’s early days. You basically had to know someone who wanted to buy your Bitcoin. Then exchanges appeared, but many were unreliable or flat out criminal. The biggest of these was Mt. Gox which was handling over 70% of all transactions. That is, until the company suddenly shut down, taking with it over half a million Bitcoins, which today would be worth billions of dollars depending on the market.

Nowadays, reliable Bitcoin exchanges have mostly shaken out the unreliable ones, but money changing also falls under government control, and debates still rage about how to regulate Bitcoin exchanges. I expect these debates to continue for some time, and they will affect Bitcoin’s value as an asset. Finally, we come to protectability. In short, if attackers can capture your passwords, they can steal your Bitcoin because your password is all that’s protecting it. But, the risk of an attacker stealing your Bitcoin isn’t as big as it simply disappearing.

People have lost Bitcoin by upgrading a computer, by losing control of a phone number, by tossing old electronic junk, and dozens of other ways. This is the secret that Bitcoin enthusiasts don’t like to talk about. Digital assets like Bitcoin are incredibly fragile. I wrote about this further on LinkedIn. In short, I expect Bitcoin to continue to have value as an asset. Even with its history of peaking and sagging, it’s held its value over the long run.

But any potential Bitcoin investor must be aware of its challenges.

Strength and Weakness of Bitcoin

Bitcoin is fundamentally different from all forms of money that came before it and it’s very young, having only appeared in 2009, with very few people knowing about it before around 2012. As time passes and more people use it, we all come to understand better just how it works well and how it sometimes falls on its face. Let’s take a moment to summarize bitcoin’s strengths and weaknesses, and to see how they developed over time. To do so, I’m going to look at what makes bitcoin special.

The first unusual thing about bitcoin is that it has no physical existence. That makes it good for online applications. It’s really designed for online use. That also means there’s no physical thing to lose or steal, but that’s a disadvantage as well because problems with information, like a hard drive failure or forgetting your password, could mean that you lose all your money. Further, being online means bitcoin is especially at risk to automated attacks from the entire internet.

The second unusual thing about bitcoin is that there’s no central authority. That means that there’s no bitcoin bank to fail, no bitcoin government to get overthrown, and nobody can stop you from sending and receiving bitcoin because there is no gate keeper. But on the downside, there’s no official mediator or police either. If your bitcoins get lost or stolen, nobody can step in to get them back. There’s also no informational authority, no help desk, no source of official advice.

It’s hard to know whom to trust. Another thing that distinguishes bitcoin is its use of the blockchain. That is a universal ledger that’s protected by miners. On the plus side, this fundamental technology is amazing and at this point, it’s well proven. It’s also completely open. Everybody can see what everybody is doing, and everybody can examine the programming code that makes it all work. On the other hand, the main bitcoin network was never designed to handle more than a few transactions per second, far too few for world-wide use and the complicated economics of mining bitcoin are weird and unstable.

They’ve also led to occasionally high transaction fees and long waits to get transactions confirmed. Bitcoin is the newest kid on the block, so its value is not yet well-proven, either in terms of price or social good. On one hand, it’s unusual status as a digital native might enable all kinds of new uses that aren’t possible with other kinds of money. If that happens, it’s price could go way, way up. Even if there aren’t such new uses, bitcoin’s volatility has made quite a few people rich already and nobody knows whether it could go up sharply again.

But this is all speculation. We really don’t know whether bitcoin will ever find its killer app and prices could just as easily go sharply down. Finally, bitcoin is unusual in that it’s truly international. Bitcoin works the same all over the world and distance doesn’t matter. By the same token, bitcoin doesn’t care who has it. You can be denied a credit card, but you can’t be denied a bitcoin account. Having said that, bitcoin has really failed in its original promise to enable micro-payments or international payments.Sporadically high transaction fees and slow network times mean that it’s often not economic to send just a few dollars, and because of government regulations, you might not ever be able to convert your bitcoin into your country’s money. Of course, all these strengths and weaknesses are subject to change. Bitcoin’s place in the market has already changed a lot since its creation and I expect it’ll continue to change for years to come.

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