Wondering what the hype about Bitcoin is, but were afraid to ask?
The following is a gentle, non-technical introduction to Bitcoin. No programming or mathematics required. There is a small amount of economics, but I’ve done my best to reduce it to the minimum.
Here it is:
Bitcoin is peer-to-peer digital cash.
Let’s unpack that.
To understand how Bitcoin acts as “digital cash,” let’s review how cash works in the first place.
How Cash Works
First, let’s clarify what “money” is, since cash is a kind of money. Even though we use money every day, we don’t often need to think about what money is.
Functions of Money
Money has two fundamental functions:
As a medium of exchange
As a store of value
Medium of exchange: We use money as our medium of exchange so we don’t have to barter for everything. Let’s say I have tickets to the Michigan State football game, and you’re a local farmer with grass-fed beef. I regret buying season tickets, but you’re still a fan. And I want some of your beef. It may be hard to come to an equitable arrangement - my tickets probably aren’t worth even a quarter beef, even for the whole season. Money lets us exchange value in a neutral format, like “dollars.”
Store of value: Let’s say I’m a grain farmer. I get one big harvest per year. I could trade my grain for stuff, but then if I don’t trade my whole harvest for stuff I need over the next year, I have the problem of storing my grain to trade bit by bit. Money lets me exchange my grain for money, then exchange that money later for things I want.
Besides, cows and bushels of grain are bulky and hard to manage. Cows get hungry and they poop a lot. Grain needs to be kept dry and safe from insects and rodents. A suitcase full of $100 bills is much lighter and more compact than the equivalent in cows or wheat, and it will never poop on your carpet or step on your toes.
Cash is Peer-to-Peer
Consider physical currency. My farmer friend offers to buy my football tickets, and hands me a $100 bill. I look at the bill, evaluate it as genuine, and hand over my tickets to him. Exchange made! This is a peer-to-peer transaction. No third parties are required to authorize our exchange. He offers me a token of value (the Benjamin), I examine the token for validity (does it look counterfeit?), then we finalize the transaction.
Photo by Live Richer on Unsplash
If my friend offered me a $100 Monopoly bill instead, I would reject the transaction.
Photo by Kathy Marsh on Unsplash
How electronic transactions work
Using cash for every transaction would be burdensome and risky. Burdensome, because the amount of cash to make large purchases gets bulky. Risky, because what if someone steals my suitcase full of cash?
Imagine my farmer friend, instead of a $100 bill, writes me a $100 check for my Spartan tickets. Now we introduce trust issues.
I must trust that my friend has $100 in his checking account.
I must trust that my friend has not written too many checks and is overdrawing his account. (Bitcoiners call overdrawing the “double spend problem”).
I must trust that the bank will honor the check and credit me $100 when I present the check.
When we use checks to substitute for cash, our banks act as trusted intermediaries. The transaction is no longer directly peer-to-peer; we are working indirectly through middlemen.
Checks are an old technology, pre-dating electronics. The “clearing” process, where my bank checks with your bank to confirm that the funds are available to transfer, normally takes a few days.
Today we are more likely to use a credit or debit card than write a check.
Credit card transactions work similarly to checks, except they are electronic and happen much faster. Instead of days, a credit card will be approved or declined in less than a minute. The Visa and MasterCard networks function similarly to clearing a check, but - faster! They are more popular with merchants because the speed of the transaction verification means the problem with checks not being honored is eliminated.
Credit and debit cards are the current generation of digital cash.
Digital Cash
Let’s go through a simple debit card example. I go to a clothing store because I need a Thneed.
I pick out one in my favorite color and take it to the sales counter. “$3.98, please.” I insert my card into the chip reader, enter my debit card PIN, and a few seconds later the reader flashes “approved” and the merchant agrees that I may take the Thneed that I need in exchange for my $3.98 (minus processing fees).
Convenient, but not peer-to-peer. Instead, we are conducting business through a trusted third party intermediary, the credit card payment network. To trade my money electronically for her goods, I must first contact the credit card network, authenticate to them that I am authorized to engage in this transaction (via the PIN). The payment network then does it’s behind-the-scenes work to determine whether I in fact have the $3.98 available to spend. Its criteria satisfied, it authorizes the transaction, deducting $3.98 from my account, crediting ($3.98 - transfer fees) to the merchants account, and (transfer fees) to itself.
I’ve gone into painful detail about the behind-the-scenes activity happening with a card swipe, because we normally think of a card transaction as happening directly with the vendor. In fact, there are 5 parties involved: you, your bank, the credit card network, their bank, and them.
Debit card purchases act as electronic cash but require trust and cooperation of many parties. They are not peer-to-peer.
"Show me the money!"
How do we know who owns what?
For physical cash, physical possession is enough. If I offer you $100 in cash, the fact that I have the $100 bill is sufficient.
When we use other ways to transfer money, it gets more complicated.
With a check, the value is tied to our identities. A check is not money. It is a promise to pay me money that your bank is holding in trust.
Notice that the promise is tied to my identity. Unlike a $100 bill which is equally valuable for everyone, that check is only worth something to me.
So, when I present the check to my bank, my bank wants me to show identification to prove that I am, indeed, the person who has the right to receive the funds. I endorse the check, indicating that I believe it is a valid claim on money held in trust.
Credit cards are similar - they are tied to the identity of the user.
The relationship is many-to-one. (OK, many-to-many if you include joint and corporate accounts, but let's not overcomplicate things.) A credit card ties back to me, but I can have many credit cards.
How Bitcoin Works
Bitcoin works like physical cash but electronically.
As Electronic Cash
To work with Bitcoin, you have to have a Bitcoin address. Bitcoin addresses are strings of 26 to 35 alphanumeric characters.
The code behind Bitcoin works using public-key cryptography. The key (pun intended!) to understanding public-key crypto is that instead of a single password, there are two keys. One is shared with everyone, making it the public key, and the other you keep secret, making it the private key.
Your Bitcoin address is based on your public key.
The public/private key pair is generated for you by your Bitcoin wallet software.
The Bitcoin network maintains a consensus of what Bitcoin is allocated to every Bitcoin address.
Let’s take the Michigan State Football ticket example. Say that Alice has the tickets and Bob, instead of offering $100, offers an equivalent amount in Bitcoin. That’s about 0.002 Bitcoin at the current USD/BTC exchange rate.
Alice has a Bitcoin address A and Bob has a Bitcoin address, B. Bob initiates a transaction of 0.002 Bitcoin from address B to address A. The Bitcoin network verifies the following:
Does address B have 0.002 BTC to give away?
Does Bob have control of address B? (Proven by Bob’s software using B’s private key to sign the transaction)
That’s it! The Bitcoin network takes some time to validate the transaction, and then it is done. 0.002 BTC is now transferred from Address B to address A.
Peer to Peer
I glossed over a lot of details by saying “The Bitcoin network validates the transaction”. Isn’t “the Bitcoin network” a third party?
Yes and no.
In order for Bitcoin to operate, someone must run the software that operates the network. A computer running the Bitcoin software is called a “node”. When Bob creates a transaction to transfer his Bitcoin to Alice, his software broadcasts that transaction over the internet to all of the nodes to process.
That software broadcast is a shoutout to the entire Bitcoin network: “Hey everyone! Can we all please agree that I’ve transferred X Bitcoins from B to A?”
Note that anyone can operate a Bitcoin node. Unlike your bank, or the Visa network, the Bitcoin network is made up of many independent operators. When a majority of Bitcoin nodes agree that a transaction is valid, then it becomes complete. This is why we say there is no middleman in Bitcoin - there is no single gatekeeper that can approve or reject a transaction. Either it’s a valid transaction, or it fails.
There are only two possible answers to that shoutout:
“Sure! We all agreed and it’s recorded now.”
“Nope, rejected.”
At no point are the Bitcoins we want to transfer under the control of some intermediate institution. Contrast with the check example:
My friend takes a $100 bill (cash) and deposits it to Bank A. “Here, hang onto this for me.”
He writes me a $100 check.
I take the check to Bank B, endorse it, and deposit it to my account.
Bank B talks to Bank A.
They agree to transfer the $100.
Now Bank B is holding $100 for me.
Using a debit or credit card has a similar sequence of intermediaries.
So, from the time my friend and I agree on a $100 transaction, there is a sequence of custodians that hold onto the money for us. Bitcoin fixes this by accomplishing a direct transfer in one transaction.
Conclusion
Now you have a better idea what it means to say Bitcoin is peer-to-peer digital cash.
Questions and comments welcome!
If you found this article helpful, please share and subscribe for more.
A Simple Introduction to Bitcoin
I enjoyed the read. Who controls the bitcoin software?
What would happen if a lot of the node operators all decided they hate person x or country y and refused to agree to their transactions? Would this be like a government freezing someone’s assets?