Explaining how to play baseball can be a bit tedious for the explainer and the explainee. Bitcoin and blockchain are like this also. It is complex, but, once you get past a few hurdles it all makes sense.
So, a lot is here, and a lot more isn’t.
What is money?
- Medium of account is the unit in which all prices in the economy are quoted
- Medium of transaction is anything used to facilitate exchange.
For example, you might accept apples from me as payment. That would make apples a medium of transaction. But if you live in America, you would only accept these payments after converting your original US dollar price. Your true price is measured in dollars because everything else you want to buy in the economy are also priced in dollars. In America, that makes dollars the medium of account. Dollars are money.
Suppose I am selling you something. When you ask me for the price, I will give you a quote in dollars. If you request to pay me in bitcoins, I will simply you give an equivalent bitcoin price by converting my dollar price using the most current exchange rate. Once you send me your bitcoins, I will then immediately convert them into dollars so that I end up with the original dollar price I wanted in the first place. If the exchange rate between dollars and bitcoins changes, the amount of bitcoins I will require from you will change as well, so that the price I quote you in bitcoins could literally fluctuate by the minute depending on the volatility of the exchange rate. The dollar price, however, will remain unchanged — This is price stickiness, a key feature of money.
Money has a powerful influence over the economy. In particular:
- Changes in the supply/demand of money cause inflation/deflation
- Changes in the supply/demand of money cause changes in interest rates
- Changes in the supply/demand of money cause business cycles
So, to abbreviate all that and make the long story short: Money is a widely agreed-upon record-keeping device. Monetary policy is a protocol designed to manage the supply of money over time.
Changes in the supply or demand of bitcoins do none of these things and that means it is not “money”. Central banks control the supply of money, the decisions they make greatly impact the economy.
While bitcoin has many useful features, these are all overshadowed by the fact that its price is too volatile for it to be reliably used as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor.
Bitcoin is a protocol. It is a set of rules
As in other sources, I refer to the protocol as Bitcoin (with a capital B) and the units of currency as bitcoins (lowercase).
The Bitcoin protocol consists of two main components:
- Ledger is also called the blockchain, it records all transactions that use the protocol. Copies of this ledger are stored on computers that comprise the network and each transaction is referred to as a block
- Network. Any computer can be part of the Bitcoin network. If two people want to enter a transaction of bitcoins, they simply have to record their transaction on the ledger. To do this, they announce the transaction to the network, and each computer within the network records the transaction on their respective copy of the ledger. The ledger will identify the two people using their Bitcoin addresses.
Before recording a transaction, the computers in the network will verify that the payer actually owns the bitcoins. To verify ownership, the payer must provide a digital signature that is associated with their Bitcoin address and the bitcoins being transferred. The computers use this signature to solve a (hard) mathematical equation which, if solved, proves that the bitcoins being transferred really do belong to the payer. After verifying ownership, the transaction is grouped with other yet-to-be-processed transactions to form a block, which still needs to be processed. To process the block, the computer solves another (very hard) mathematical equation — this process is called proof of work. Once the block is processed, the block is part of the blockchain, and the transaction is complete.
The proof of work for each transaction is dependent on the proof of work of the preceding transaction, and therefore every other preceding transaction. This means that the ledger is backward dependent, and it’s impossible to go back and rewrite a transaction without affecting every transaction that follows.
Proof of work is a competition to approve transactions. Each entry in the competition costs a little bit of computing power. A miner’s chance of winning the competition is equal to the proportion of the total computing power that they control. So, for instance, if a miner controls one percent of the computing power being used to validate Bitcoin transactions, then they have roughly a one percent chance of winning the competition
The first computer to process a block is given a block reward of new bitcoins — this reward is built into the Bitcoin protocol and is called mining. The more computing power you donate to the network, the more bitcoins you are likely to be rewarded.
Every bitcoin in existence is created by mining. The number of bitcoins rewarded for processing a transaction reduces over time and converges to (but never reaches) zero. By this construction, there will never be more than 21 million bitcoins ever in existence, making bitcoins scarce. This rate of reduction is arbitrary, however, and the block reward can actually be adjusted to any value that the network collectively agrees upon.
If you don’t want to mine bitcoins, you can just buy them on the open market, they’re for sale
Bitcoin is just one implementation of a crypto-currency protocol. We can easily create other crypto-currencies similar to Bitcoin by simply changing some of the underlying rules of the protocol, such as Litecoin.
Bitcoin solves many problems about securing transactions. In the world of atoms we achieve security with devices such as locks, safes, signatures, and bank vaults. In the world of bits we achieve this kind of security with cryptography. And that’s why Bitcoin is at heart a cryptographic protocol.
New companies are doing new things with bitcoin and blockchain
Imagine Google creates a protocol similar to Bitcoin called gCoin, anyone is able to mine gCoins by contributing computational power to the network. gCoin would be used to buy and sell goods on the internet faster and cheaper than using a credit card. Google provide a ‘wallet’ which is essentially a checking account for gCoins. You would “deposit” your gCoins with Google, use their online service to keep track of them and transact them, and Google would charge you a monthly fee just like a regular bank.
Many startups are building services that allow customers to easily transact regular bitcoins instead of building their own protocols, Bitcoin banks.
If the Federal Reserve Bank created a bitcoin protocol, lets call it fedCoin it would give the entire system of bitcoin and blockchain credibility. fedCoin would have the same authority as United States Treasury Bonds and the other competing monies would establish their own monetary policies to attract users and customers.
The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and fedCoin at a rate of 1:1. The outcome of this rule would be that fedCoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.
So unlike bitcoin, the price of fedCoin would be anchored. Should fedCoin trade at a discount to dollar notes and reserves, people would convert fedCoin into these alternatives until the arbitrage opportunity disappears, and vice versa if fedCoin should trade at a premium.
The Fed would set and adjust the block mining reward at its discretion. In this way the central bank can conduct monetary policy by changing the block reward, which in turn changes the future supply of base money.
Why would people start using the FedCoin protocol and not the original Bitcoin protocol? Again, it’s simply a matter of network effects, and the fact that FedCoin would be legal tender under the law, including the requirement to pay taxes with them. The answer to this question is the same answer to: Why do people US dollar bills instead of notes printed by private banks? It’s tautological: People use US dollar bills because people use US dollar bills.
Start playing baseball buying and selling Bitcoin
Go to coinbase. It’s the gold standard
and, in closing – Physical cash is still a superior technology for those who demand anonymity. Cash does not leave a paper trail, but Bitcoin does…