Bitcoin

A RENAISSANCE OF MONEY

Forty-six days after the fall of Lehman Brothers in 2008 and directly amidst the world's collective realization of the dollar system's precarious position, a presciently timed white paper was sent to a very small online community called the Cryptography Mailing List. The paper was written for members of the cryptography discipline, not the monetary one, and therefore it didn't even register as relevant to money back then. Looking back, however, we must with authority insert this day, October 31, 2008 and the creation of Bitcoin into the official record of monetary evolution. The date is momentous not only because the paper proposed an alternative to our current financial infrastructure, but also because of what ensued. Bitcoin, a novel monetary instrument, is now owned by at least 1% of the world's current population, or about 100 million people.18 Vehement criticism of Bitcoin's rise from politicians, bankers, and the financial media has  occurred alongside an exponential increase in its user base and market value. Bitcoin's arrival, growth, and staying power now warrants an honest, well-researched, and holistic view of this new monetary technology. Instead of dismissing Bitcoin as an unregulated and unbacked currency, we must instead try to understand why exactly Bitcoin has amassed such a ground- swell of attention and market value. In only twelve years, it has already captured about 6% of gold's total market value despite gold's several thousand-year head start.

In the realm of monetary science, Bitcoin is an alien invader. It doesn't resemble anything that came before it because it relies heavily on technological innovations of the past half-century. An area of computer science called applied cryptography crept up on the financial system and startled it. The invasion continues to reverberate with each passing year of Bitcoin's growth in mind share. When we look back at Bitcoin's origin through this book's layered lens, we can see that a new first-layer money had been invented and that the monetary and cryptography sciences had merged. The unification is only now, a dozen years after Bitcoin's creation, becoming accepted as a monetary discipline. Before we speculate on how it will play out, we must understand Bitcoin's origin, early history, and the evolution of its own money pyramid.

Satoshi Nakamoto and the Bitcoin White Paper

The paper published on October 31, 2008 that changed the world of money forever was written by Satoshi Nakamoto. Anonymity and mystery surround the Satoshi persona and his, her, or their writings. The creator remains unknown even now, something that strengthens Bitcoin's neutrality, as no leader exists who wields too much influence, can be coerced or blackmailed, or will try to change Bitcoin's rules. The importance of the architect's identity is now arguably irrelevant, but it still doesn't diminish the intrigue of the facelessness; Satoshi would send his last known correspondence in April 2011 and disappeared from the Internet forever. The myth and legend of Satoshi will make a grippingly dramatic film one day, but the software he designed forever changed the very notion of money. The first sentence of Satoshi Nakamoto's paper "Bitcoin: A Peer-to-Peer Electronic Cash System" read:

A transferable online cash without financial institutions implied coordination, but how, and by what rules? The only globally accepted and neutral money not relying on a financial institution is gold. The most fascinating component of Satoshi's design of Bitcoin was his intention for it to mimic gold as a first-layer, counterparty-free money. And that meant a supply that does not originate from a balance sheet. Satoshi's paper built upon foundational and widely accepted cryptography building blocks which legitimized his idea among some members of the Cryptography Mailing List.

Defining Bitcoin

The word "Bitcoin" officially refers to two things, (1) the Bitcoin software protocol and (2) the monetary unit within that soft-ware. In this book, we'll refer to the monetary unit as BTC in a distinction from the software itself. Bitcoin, the software protocol, is a set of rules. It uses a military-grade encryption algorithm called Secure Hash Algorithm 2 (SHA₂), first published by the U.S. intelligence community in 2001. Usage of SHA₂ is considered so secure that it's actually required by law within areas of government that handle highly sensitive information. Bitcoin's design combines SHA₂ with intelligent rules so elegant that it's able to embody gold's monetary properties in the digital world. Bottom line, the cryptography used by Satoshi was proven and secure. These ingenious rules built a coordination mechanism that he called a "chain of blocks," but the world would come to call it Bitcoin's blockchain.

Computer Science

Before diving into the specific technical innovations of Bitcoin's blockchain that made it a successful digital currency, we have to acknowledge that understanding Bitcoin on a technical level requires an abundance of computer science expertise. Textbooks have been written on the Bitcoin software, filled with programming-level detail on all of Bitcoin's major components including keys, addresses, wallets, trans- actions, and mining. In the next two chapters, we will discuss and explain these components, but for those that want a more immersive experience in the brilliant cryptography behind the Bitcoin software, start with "Mastering Bitcoin" by Andreas Antonopolous. It is written in a way that is approachable even to those who don't have a strong computer science background but are curious about the rules that make Bitcoin work. For everybody else, understand that Bitcoin's rules make it a trusted digital currency much in the same way that people trust email for digital communication. They might not know exactly how it works, but it does.

Useful Bitcoin Analogies

Let's first explore three elementary metaphors for Bitcoin: gold, land, and email.

BTC is digital gold. It's a form of money. People trust BTC because they believe it to be rare and valuable in a very similar way to how people for millennia have put their faith in gold. It has a price in hundreds of different currencies, just like gold does. And most importantly, it doesn't originate from the balance sheet of a financial institution, just like gold doesn't. Gold and BTC are both counterparty-free assets. We'll have the opportunity to draw more sweeping comparisons to gold throughout the rest of the book.

BTC is digital land. There are only 57 million square miles of land on Earth. Similarly, there will only be 21 million BTC. Thankfully, this digital land is divisible into the tiniest of parcels. Mark Twain once said "buy land, they're not making it anymore" to endorse investment in real estate, and BTC can be thought of in the same way. BTC is scarce, akin to the amount of land on Earth. We'll explore how it achieves scarcity shortly, but as more people journey from British pounds, Japanese yen, and U.S. dollars to the Bitcoin world, this digital land will only become harder to acquire at current prices. We can liken BTC's price rise to a land grab and explain its exponential increase in market value and adoption as mirroring the Internet in the 1990s. The price for a slice of the Bitcoin pie has risen steadily over the long-term because people are treating it like prime real estate. There is no single gatekeeper in the Bitcoin realm, making every human being a potential property owner. Ownership will become more expensive as its world gets more crowded; once people finally understand the renaissance of money taking place, the fear of missing out will become overwhelming.

Lastly, Bitcoin works similarly to email. You might not understand the computer science behind how it works, but the basic action of sending and receiving email is a universal practice. Email addresses can be shared with anybody, but only the password holder can access received messages. Bitcoin works in a similar way. You can share your Bitcoin address with anybody sending you money, but only with your password, called a private key, can you spend it. Email is a protocol to send and receive data; its formal name is Simple Mail Transfer Protocol (SMTP). Bitcoin is also a protocol, but to send and receive value instead of data.

Blockchain and Bitcoin Mining

What makes Bitcoin tantamount to gold, human civilization's most proven monetary asset? The answer lies in the rules of the Bitcoin protocol.

The Bitcoin blockchain most fundamentally describes a record of transactions simultaneously kept by all peers in the network. In order to properly define blocks and chains, let's first dive a little deeper into the word peer. In Bitcoin terms, anybody can be a peer by operating a Bitcoin node, which is a computing device running the Bitcoin software. Only those that operate a Bitcoin node are using it in a wholly trustless way, meaning they are only relying on their own software to verify the settlement of BTC transactions (trust- less can be thought of as the opposite of "having counter- party risk"). They are not delegating to any bank, exchange, or software company. The magic of Bitcoin is that every single person in the world can become a peer and operate a software that allows participation in a global financial net- work. Most people rely on some form of provider to interact with Bitcoin however, such as smartphone applications for wallets and exchanges for trading and custody. Wallets and exchanges are like the banks of the Bitcoin industry; as people count on banks to interact with their USD or home currency, people rely on wallet companies and exchanges to interact with their BTC. But they don't have to, and that is what makes Bitcoin so powerful. Anybody with a computer and the Internet can transact globally without depending on any single company, government, or entity. Using the Bitcoin software should only be done by people with a high degree of proficiency, and therefore most will trust the private sec- tor for that expertise.

Now we can define blocks. A block is a set of data that includes the details of unsettled Bitcoin transactions that people are trying to complete. These transactions can be thought of as emails that have been sent but not yet received, or existing only in cyberspace. Blocks become chained together and unsettled transactions get confirmed when a block is mined. But what exactly is mining?

Just as gold miners expend energy to dig gold out of the Earth's crust, Bitcoin miners, peers that compete over new supply of BTC, expend energy that award them the currency within the Bitcoin software. Bitcoin miners are awarded BTC when they find a random number; think of it as a computational lottery. In order to find that number, they perform trillions of computations every second. That makes Bitcoin mining virtually one giant random-numbers game, and only the fastest and most powerful computers can compete in a game in which computational guessing is most valued. In the early days of the Bitcoin network, BTC could be successfully mined by anybody using the average laptop. Today, highly efficient supercomputers called ASICs (application-specific integrated circuits) are required to successfully mine BTC. Technical expertise isn't necessarily warranted; electricity, ASICs, and software give anybody access to participate in the process of BTC supply introduction. Miners are financially motivated; they are awarded BTC for their services which they can keep or exchange for local currency. They help make the Bitcoin network more secure by dedicating a tidal wave of energy and computing power toward adding blocks to the chain. This tidal wave is commonly referred to as hashpower, with the word "hash" coming from Secure Hash Algorithm 2 (SHA₂) used by the Bitcoin software for encryption. Bitcoin mining is also called performing proof-of- work, which was invented before Bitcoin in 2002 by cryptographer Adam Back, who holds a Ph.D. in computer science from the University of Exeter. Satoshi Nakamoto cites Back in his white paper and bases much of Bitcoin's original credibility upon using proof-of-work, a proven technology by 2008. Proof-of-work in Bitcoin is equivalent to digging for gold as stated in the Bitcoin white paper:

Make no mistake, this isn't just an analogy. Satoshi Nakamoto was tremendously deliberate in the design of Bitcoin; it was meant to mimic gold because gold is historically our planet's most enduring counterparty-free form of money. Finding gold isn't cheap or easy; it requires energy, as does finding BTC. Once a miner successfully mines a block and wins BTC as a result, the block becomes an update to Bitcoin's shared transaction ledger so that every peer in the network has the latest understanding of which Bitcoin addresses are associated with exactly how much BTC. Blocks become chained together during this process to leave an accounting record, the Bitcoin blockchain, for all peers to witness. The term blockchain has grown in popularity, but distributed ledger technology is a simpler way to describe a network structure whereby all peers keep a ledger, or a record of transactions. For this reason, the term Distributed Ledger Technology (DLT) has been adopted by central banking research departments to describe software that mimics Bitcoin's original distributed ledger design.

How much BTC does a miner earn when successfully mining a block, and who determined the supply of BTC? The next component of Satoshi's elaborate design lies in Bitcoin's monetary policy, or the rules around the supply of BTC and how it comes into existence. Not set by human beings in the boardroom of a central bank, Bitcoin's monetary policy is an algorithm programmed by Satoshi in 2008 to specify its exact issuance schedule into eternity. The issuance rules were coherent, elegant, and just. They felt fair to the earliest participants in the network. For the first 210,000 blocks (or approximately four years) of Bitcoin's existence, 50 BTC was awarded to the successful miner of each block. For the next 210,000 blocks, the reward fell to 25 BTC per block. Each passing 210,000 blocks, the mining reward halves again. Each of these epochs, or periods of time to complete each phase of Bitcoin's issuance schedule (210,000 blocks or ~4 years), show how Bitcoin's monetary policy is set in stone, not up for debate in the halls and teleconferences of central banks. Bitcoin is currently in its fourth epoch with the mining reward standing at 6.25 BTC per block, which is valued at over $200,000 today. Satoshi mapped out the supply schedule all the way until the final block reward estimated to occur over a century from now in 2140. Why he chose 21 million as BTC's ultimate supply or 210,000 block epochs will probably remain an enigma, but something about the mathematical precision of it all vehemently attracted people. The exact scarcity specified at the beginning of Bitcoin's existence isn't even necessarily an impressive feat. What's impressive is that every participant in the network coalesced around it and the associated supply schedule rules to form a true consensus about Bitcoin. Its scarcity and the rules that secured it not only persisted, but they also quickly became written in stone.

The Bitcoin protocol mandates that blocks occur on aver- age ten minutes apart, but the actual time between blocks can take seconds or hours depending on how long it takes a miner to win each proverbial BTC lottery. The algorithm that adjusts the computational lottery every two weeks to make sure blocks occur on average ten minutes apart, called the difficulty adjustment, was designed by Satoshi Nakamoto and has been working like clockwork for the entirety of Bitcoin's existence. No single peer has control over the entirely automated difficulty adjustment. The difficulty adjustment algorithm is considered untouchable by Bitcoin's users and software developers today because it is one of the properties of Bitcoin that makes it truly neutral and resistant to centralized control. With superior mining ASICs, a miner can win an outsized proportion of block rewards, but eventually Bitcoin immunizes itself to improvements in computer processing power by gradually diluting advantages away. Regular increases in mining difficulty function as one of Bitcoin's security mechanisms, preventing today's fastest computers from running away with block rewards and driving innovation in computer chip manufacturing. The rules surrounding the supply of Bitcoin have become tamper-proof, incorruptible, and the new gold standard for monetary scarcity. The result of Bitcoin's unique and brilliant rule set is a truly novel form of money. With razor precision and free software, one can measure exactly how rare his or her BTC collateral is at any moment.

Send and Receive

The final technical component to understand about Bitcoin is the relationship between keys and addresses and how peers send and receive BTC. Addresses, which are used to receive BTC, are generated from numbers called private keys. This effectively means that possession of BTC itself is the possession of a number. Private keys are 256-character binary strings, like this:

These numbers can be stored in smartphone applications called wallets, on dedicated memory devices called hard wallets, simply written down on a piece of paper, or frankly in any way you can store a number. The private keys generate an address that is used in order to receive BTC, but the address cannot be reverse engineered to reveal the private key behind it, thanks to SHA₂ encryption technology. Bitcoin addresses look something like this:

32bp4f8zjbA8Bzm3TiAq5jav3DsU4LPSQR

That's it: private keys (send) and addresses (receive). BTC can be sent around the network after it's mined without any central router to authorize or censor the transactions. Any peer in the network with Bitcoin software can send, receive, and surveil transactions, but no single peer can prevent them from happening. Note that people using a smartphone wallet do not need the full Bitcoin software in order to transact in BTC; wallets allow people to self-custody BTC private keys but rely on third-party nodes to relay transactions to the network if not used in tandem with a Bitcoin node.

Source: Nik Bhatia: Layered Money
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