There are so many that are trying to wrap their head around Bitcoin and looking for simpler explanations. This is just the sort of challenge that helps me see if I have grasped it well. So let me try!
Bitcoin is difficult partly because it is two things at once, one complicated technical part and one simpler part. That complicated part is basically information infrastructure, called Blockchain, and the less complicated part is the content on that infrastructure. Basically money tokens, the virtual coin.
The Blockchain is the revolutionary part of the story while the currency Bitcoin is modelled to be a sort of digital gold. Something that there is only so much of, which is meant to make it valuable.
If I talk a little about the money token part first and then just touch on the technicalities later, perhaps it makes more sense. Although I suspect that prior knowledge to how our regular currencies really work also helps but I won’t go there now..
Bitcoin as money
Bitcoin came about as a reaction to a feeling of how flawed our banking system was. At least that is my reading from the message that is stored in the first block of this decentralized database that is the bitcoin blockchain (explanation for this later). The message that is embedded reads: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”.
So, what Bitcoin was meant to solve for is basically: how can a network of people agree to issue a fixed amount of tokens that can be used for trade in a way that no individual actor can choose to “print more money”?
No central authority can say how much should exist and (importantly) no central authority can prevent a transaction from taking place. This concept was proven very important when WikiLeaks was blocked from accepting VISA/MASTERCARD payments, but could sustain operations through Bitcoin.
So the features of Bitcoin are basically that there is no central authority “calling the shots” so to speak. And there is only a limited and predictable amount of bitcoin that are in circulation.
The tokens (Bitcoins) are all located at some adress where owner of that adress can choose to send it to someone else. As a gift or payment. The value of the Bitcoin is simply derived from how much people are willing to trade it for, denominated in $US or any other currency.
A note here can be made on some of the flaws of Bitcoin. There are some pretty negative effects from design decisions on: how many Bitcoins should exist, when they should be created and how they should be created.
These negative effects include:
1. Bitcoin distribution, that is to say, who has them and who doesn’t, is far far worse then wealth inequality in national currencies such as US Dollars.
2. Due to the technical implementation of bitcoin, each Bitcoin (each digital token or entry in the accounting system), requires enormous amount of energy to maintain. Server-parks and specialised hardware is using very large amounts of electricity because the protocol that is Bitcoin has been designed to be computation heavy.
3. People holding on to it. The modelling on gold, in that there is a finite amount that will be “mined to the surface” and that those tokens will never decay is pushing people to hoard these Bitcoins. It is not used so much for trade as it is for speculation, just like gold is.
Behind Bitcoin — the Blockchain
In order to create these money tokens that are not under the control of a single authority, a new type of ledger (accounting entry keeping tool) was needed.
Most money ledgers, such as those for national currencies are basically one big server at the heart of a bank or a central bank. Those ledgers, or databases, are one big computer that has an entry for each person, an account. Next to that account there is a value stored, the account balance.
On the central computer of the central banks there are accounts for each of the retail banks such as Chase, RBS, Santander, Nordea, Bank of America. I suspect you’ve seen these names on a building or two somewhere. All of these have an account with central bank ledgers, just like most of us have an account (or more) with one or more of these banks.
These bank ledgers are all individual computers that talk to each other individually and say things like:
Alice wants to send $100 to Peter, I will update the balance on Alice account to the current balance minus $100, if you (other bank) will update Peters account to current balance plus $100.
So, voila, the transaction has been made. (Here I invite the curious reader to look into how these accounts are handled when a bank lends money for say a mortgage)
What’s new with the Blockchain is that instead of having that one computer there is a bunch on different computers that all make the same entries on their books.
Kind of like people sitting in a ring and one person holds up a sign saying: “Alice sends $100 to Peter” then all the others write down that “Alice sends $100 to Peter”. Once most people are done writing that in, that transaction is said to have occurred.
That may seem a little cumbersome but it means that even if a few people leave the ring, the ring still knows that Alice and Peter have transacted. And when a person comes back to the ring the look at the notes of the person next to them and make sure they are up to date to whatever transactions have taken place. Therefore it is a very robust system and there is no cheating (that is to say, no one can just manipulate their own records because it wont match those of the rest of the group).
The innovation that is the blockchain is therefore a distributed database, where it is not just one computer that stores it all and that can manipulate what is in it!
This innovation has been used to launch hundreds of other currencies that work similarly to bitcoin but have other features built in. These currencies are called crypto-currencies because the blockchain (which I tried to describe by the people sitting in the ring) works by using mathematical ciphers to ensure that the information that gets passed around the network is correct, hence cryptography and crypto-currencies.
Blockchain is a very useful innovation that has implications far beyond money, it is a way to help computers talk more fluently to each other. If you are interested in what this technology might have in store, read some of the work of Viney Gupta, like this piece. Or watch him explain on Youtube.