Bitcoin: A Basic Understanding For Dummies

Bitcoin: A  Basic Understanding For Dummies

There has been ample media coverage of Bitcoin, and many public figures have been compelled to state their opinion. As Bitcoin is a complex topic, covering cryptography, software engineering and economics, it is difficult to grasp its essence and implications with only a superficial look at it. Thus some commentators might not have a clear picture of how it works and the implications. It is the goal of this book to equip the reader with the knowledge to evaluate the merits of this technology. Figure 1.1 summarizes some misconceptions around Bitcoin. Bitcoin is a decentralized digital currency. This means there is no person or institution behind it, either backing it or controlling it. Neither is it backed by physical goods, such as precious metals. This might seem counter-intuitive at first glance: how could it exist if no one controls it? Who created it then? How did the creator lose control over it? The answer to this seeming paradox is that Bitcoin is just a computer program. How exactly this computer program works is the subject of the second part of this book.

Bitcoin: A Basic Understanding For Dummies

The program has a creator (or creators) but his identity is unknown as he released the Bitcoin software using what is believed to be a pseudonym: Satoshi Nakamoto. Bitcoin is not controlled in a tight sense by anyone. The creator did not lose control of it because he FIGURE 1.1 What Bitcoin is (and isn’t) 3 (she?, they?) never owned the code. The code is open source and thus it belongs to the public domain, as will be further explained in section 1.2. One of the most innovative features of Bitcoin is that it is decentralized. There is no central server where Bitcoin is running. Bitcoin operates through a peer-to-peer network of connected computers. Bitcoin is the first digital currency built in a decentralized way, a technological breakthrough. The decentralized nature of Bitcoin will be further explored in section 1.1. Bitcoin creates its own currency called bitcoin, with a small b. The creation of a currency is integral to how the system operates, as it serves two simultaneous purposes. First, it serves to represent value. Second, issuance of new bitcoins is used to reward operators in the network for securing the distributed ledger. These two functions cannot be unbundled without significantly changing the design. The heart of the Bitcoin network is a database holding the transactions that have occurred in the past as well as the current holders of the funds. This database is sometimes called a ledger, because it holds the entries representing the owners of the funds. Bitcoin is not the first distributed database to be created. However, the requirements of a financial database are different from those of other applications, such as file sharing or messaging systems. In particular, financial databases must be resilient against users trying to double-spend their funds, which Bitcoin solves elegantly. This is explored in the following sections and in Chapter 2.

 Some critics have argued that Bitcoin is a Ponzi scheme. It is not. In a Ponzi scheme there is a central operator who pays returns to current investors from new capital inflows. First of all, in Bitcoin there is no central operator who can profit from the relocation of funds. Second, there is no mechanism to deflect funds from new investments to pay returns. The only funds recognized in the Bitcoin protocol are bitcoins, the currency. Transfers of bitcoins are initiated by the users at their will: the protocol cannot deflect funds from one user to another. Third, a new investment in Bitcoin is always matched with a disinvestment. Investors who put money into bitcoins usually operate through an exchange where they buy the bitcoins from another investor who is selling her investment. There is simply no new investment flowing into bitcoins: the amount of sovereign currency that has flown into bitcoins exactly matches the amount that has flown out of bitcoins.

 However, bitcoin, the currency, can be a bubble. Whether the value of bitcoin crashes, holds, or increases depends on whether bitcoins will be used in the future for different applications. There are several interesting applications for Bitcoin, of which the most straightforward (but not the only) are to serve as a medium of exchange and a store of value. It is too early to tell whether any of these applications will become important in the future.