Table of Contents
- Bitcoin is a monetary innovation, providing superior portability and divisibility than gold, cheaper and faster settlement than bank wires, and security against central bank inflation.
- Bitcoin is a peer-to-peer digital cash system, requiring no trusted third parties. Since no party can control Bitcoin, censorship is impractical.
- Bitcoin's a scarce digital asset. There will never be more than 21 million bitcoin. This makes Bitcoin impervious to the inflation inherent in fiat currencies.
What is Bitcoin?
Bitcoin is a digital asset over which no single party has central authority. It has four core properties:
- Scarce. There is a cap on the number of Bitcoin that will ever exist.
- Decentralized. No single party controls it.
- Permissionless. There is no gatekeeper.
- Censorship-resistant. Bitcoin transactions cannot be “blocked”, and users cannot be banned.
Anyone with an internet connection can buy, sell, and transact with Bitcoin.
How Bitcoin Works
Bitcoin is owned and run by its global user base, which includes many different stakeholders. For simplicity, we will focus on three: network users, node operators and miners.
Bitcoin users include anyone sending or receiving Bitcoin transactions. These users transact using either a Bitcoin wallet running on their computer or a third party service (e.g. River) that serves as an online wallet for people who do not want to hold Bitcoin themselves.
Given its permissionless nature, anyone can download and run Bitcoin node and wallet software. A Bitcoin wallet is used to securely receive, store, and send Bitcoin, while a Bitcoin node allows somebody to connect to the Bitcoin network. The Bitcoin network is a collection of nodes verifying and relaying transactions and blocks with one another. Bitcoin Core is a software package that includes both a wallet and a node.
When a bitcoin transaction is sent, it first propagates to all of the nodes in the network. Then, miners (people who process transactions and mint new bitcoin) order this transaction and others into “blocks” on Bitcoin’s “blockchain”. Blocks can be thought of as individual pages in a ledger, while the blockchain represents the entire book. This ledger keeps a record of all the blockchain’s transactions so that everyone running the software can be “on the same page,” so to speak. Every node in the network maintains an identical copy of this ledger.
In order to produce a new block, a miner must win what is essentially a guessing game or lottery. Miners must solve complex mathematical problems to generate “hashes” (long strings of numbers and letters that look random) in a bid to connect the newest block to the previous one in the chain. Once this block is produced, the winning miner receives a “block reward” of freshly minted bitcoin for their work in maintaining the ledger. This is also how new coins enter the system.
After a new block is anchored to the blockchain, this new state is relayed to network nodes to keep the entire network in sync.
Bitcoin vs. Traditional Fiat Currency
In the Bitcoin white paper, Satoshi Nakamoto referred to the world’s first cryptocurrency as “digital cash.” This has given people the impression that Bitcoin is a type of payment network. It is, but this is not all that Bitcoin is.
Bitcoin (the network/protocol, capital “B”) is an all-in-one monetary system, unit of account, medium of exchange, and store of value. The token, bitcoin (lowercase “b”), can be used as a currency. But its utility can often be better appreciated in areas of economic-political unrest where traditional payment methods are impossible (see Iran and Venezuela).
Bitcoin’s biggest selling point, when compared to traditional nation-state currency, is how it is managed. Any user can store and verify bitcoin on their own, thus becoming their “own bank,” in a sense. In contrast with central banks, Bitcoin’s monetary policy is immutably fixed and transparent to all.
Bitcoin and Decentralization
Bitcoin’s decentralization is multifold; it comes in the form of technical infrastructure, physical infrastructure and market participants.
As discussed earlier, Bitcoin’s node architecture makes it possible for anyone to download Bitcoin’s code to keep a copy of the blockchain and verify transactions. The more the better, but the entire Bitcoin network will remain active so long as one of these nodes continues to store and broadcast the latest state of Bitcoin’s blockchain. The nodes also keep miners honest because node operators choose which blocks to validate; if miners try to cheat the network, node operators can reject these blocks in favor of blocks from honest miners.
The miners themselves have a hand in keeping Bitcoin decentralized. Miners are scattered all across the globe, running billions of dollars’ worth of mining machines with the hope of extracting fresh bitcoin from the network. Like with nodes, the more miners the better, because the more competition there is to mine bitcoin, the less likely it is for a malicious miner to be able to strongarm the network.
Once a block is mined, it is essentially permanently added to the ledger unless a miner attacks the network or there is a competing block mined simultaneously.
In the case of two competing blocks, the network would wait for a new block to see which path of history to follow. The network always follows the blockchain path with the most accumulated work, which is typically the longest chain.
If someone wanted to alter the Bitcoin blockchain, they’d need tens of thousands of machines and millions of dollars to override the proof-of-work process and “reorder” old transactions. Even with much of the mining concentration in China, this would be very difficult to achieve. Furthermore, this would work against any miner’s self-interest since the bitcoin they earn is valuable only if the network itself is secure.
Finally, the last tier of Bitcoin’s decentralization is market participants from all around the world — be they buyers of bitcoin or entrepreneurs building on Bitcoin.
Bitcoin’s Limited Supply
More than mere storage management, Bitcoin’s minting processes are also anathema to traditional currency. As we’ve seen over the course of history and around the world (and lately, in the wake of the coronavirus), fiat currencies — currencies issued by governments with only that government’s guarantee as a backing — can be printed at will and have no cap on supply.
Bitcoin, by comparison, has a supply cap of 21 million BTC, and all bitcoin are released at a predictable and steady rate over time. An internal mechanism known as a “halving” cuts Bitcoin’s block reward (the prize miners receive for finding a new block) in half. Each halving event takes place roughly every four years and will continue to do so until sometime around 2140. Thus, Bitcoin’s inflation rate will halve every four years until it reaches zero.
Because of the consensus rules (the community’s agreement on a shared ruleset) enforced by nodes and miners, it is highly unlikely that anyone will ever change this cap.
Bitcoin Is Pseudonymous, Not Anonymous
One of the principal misconceptions surrounding Bitcoin is its anonymity. In fact, Bitcoin is far from anonymous; it is actually pseudonymous since each wallet can be traced on the blockchain using its public address. This is key to Bitcoin’s design, as it ensures that the supply can be easily audited.
The Bitcoin Blockchain Is Immutable
Bitcoin’s code is largely immutable for some of the reasons discussed above. Node operators must agree to activate a ruleset before it becomes adopted. So, without community consensus, it’s nigh impossible to change Bitcoin’s ruleset.
Bitcoin transactions are also practically immutable once included in the blockchain. The only way a miner could alter a block in the chain after it has been mined is by controlling a majority of computing power. This has never been done in Bitcoin’s history.
This is important because the older the Bitcoin blockchain becomes, the more costly and difficult it would be for miners to alter older transactions. (The older the confirmed transaction, the more costly it would be to “re-spend”.) The fact that Bitcoin is virtually impossible to hack is perhaps one of its most important features and one that has inspired confidence in its long-term sustainability.
Even though the number of bitcoin is capped at 21 million, each bitcoin itself is highly divisible. One bitcoin can be divided into 100,000,000 subunits known as “satoshis.” (If needed, these units could be made more divisible still.)
Spending 1, 10, 100 or even 1,000 satoshis on Bitcoin’s main network would not be cost-effective considering the transaction fee would exceed the actual balance being sent. Fortunately, Bitcoin features a secondary network called the Lightning Network that facilitates instant, near-feeless transactions. Adopters have heralded the network as a solution to Bitcoin’s scalability issue, and some have said that it also opens up the potential for “micropayments” for digital media and content.