From the moment a bitcoin is minted, its every move is recorded, and it is this record that ensures bitcoins cannot be counterfeited. In order to create the blockchain, approximately every 10 minutes the Bitcoin software compiles all the transactions that have occurred into a file called a block. This block contains a reference to the previous file and is a record of every transaction that has ever occurred. When all the blocks are linked together, it forms a chain of blocks, thus the blockchain.
The security of Bitcoin depends on the process of linking all the transactions. Imagine if a one dollar bill were tracked each time it was used, from its printing to eventual retirement. Every pack of gum, soda, flower, or toy that was ever bought with that dollar would be recorded. If a counterfeiter made a copy of this dollar bill, it would contain a record of the rightful owner, and when he attempted to spend it, the built-in security would disallow the transaction. A counterfeiter would have to go back and convince each merchant that the transaction never took place. In essence, a counterfeiter would have to change every single transaction prior to making the copy.
Bitcoin's solution to the counterfeit problem is the combination of the blockchain and miners. As more transactions are added, the blockchain makes it virtually impossible to change prior transactions. The miners are charged with confirming that the bitcoin being transferred is not counterfeit. The act of mining for bitcoins involves using powerful computers to solve a complex mathematical equation. The answer to the equation contains a key that verifies all the previous transactions. If this key does not match the previous transactions, then the miners know the bitcoin is counterfeit.
In very simple terms, this is how a bitcoin transaction works: If Keith wants to send a bitcoin to Alan, he must broadcast that message to the Bitcoin network. The miners listen for this message and then use supercharged computers to ensure that Keith is the rightful owner. Once they verify Keith's ownership, they allow the transaction to occur and record it in the blockchain. For their work, the miners are rewarded with free coins called a coinbase – currently, for every group of transactions (block) that a miner verifies, the miner receives 25 bitcoins.
As we continue our journey to Bitcoin Enlightenment, we will wrestle with several more terms that may challenge some and enthrall others. For now, the most important terms to remember are peer-to-peer network, blocks, blockchain, and miners. The Bitcoin peer-to-peer network allows users to transfer value; these transactions are stored in files called blocks; these blocks are linked together to form a blockchain; and miners solve a mathematical equation that proves ownership of a bitcoin.
Is It a Currency?
As a currency trader and self-proclaimed economics nerd, I thought defining Bitcoin as a currency would be rather simple. In order for something to be called a currency, it has traditionally needed to be a medium of exchange, a store of value, and a unit of account. As a medium of exchange, Bitcoin passed with flying colors; when the first pizza was bought with bitcoin, it satisfied this condition. As a store of value, it fell a little short – wild price swings have made it difficult for Bitcoin to become a trusted store of value. Finally, as for a unit of account, the jury is still out. Currently, there are not any products or commodities that have their value expressed in units of Bitcoin, but this is changing rapidly.
Perhaps we are too tethered to the conventional definition of a currency as a medium of exchange, a store of value, and a unit of account. Ultimately, both paper money and bitcoin are only valuable as a currency if acceptance is widespread or required. It's the “required” condition that carries all the weight. If you don't pay your taxes, the government has the right to seize your property. We have given the government both the right to issue currency and the right to enforce its use; this is not a political statement – it's just the law of the land. The argument against bitcoin as a currency is that you cannot use it to pay taxes, and it is not backed by an enforcement authority like an army. Both of these are true, but the argument misses a bigger opportunity.
What if Bitcoin did not need to live up to the textbook definition of a currency – what if it were a hybrid? Maybe it's a commodity or maybe it's a payment system, or perhaps it is something in between. But bitcoin is being used as a medium of exchange, and regardless of its formal definition, the technology is revolutionary. Like many others, my aha moment came when I started thinking about Bitcoin as a payment system. Viewing Bitcoin as more than a currency allowed me to see that it has all the hallmarks of a revolutionary technology – it is strong, fast, and efficient.
Bitcoin's strength is the lack of a single point of failure. When hackers attacked Target, they had it easy. All they had to do was find an open door into the single database that contained all the customers' personal information. Bitcoin does not require personal information, and the database is distributed across an infinite number of computers. While hackers have been able to find a way into some computers, none of the attacks hobbled the entire organization. Even the failure of Mt. Gox, formerly the largest bitcoin exchange, hardly caused a hiccup. Imagine if a major stock exchange closed without warning – our financial system would be in shambles.
Bitcoin is fast because it reinvents the middleman. Think about what it takes to transfer money from one person to another. First, we both have to open a bank account, which is accompanied by a mountain of paperwork to verify identities. Then I need to instruct my bank to withdraw money from my account by writing a check, sending a wire, or using an electronic debit. Once it arrives, the payment needs to be verified, cleared, and delivered. All along the way, numerous points of friction exist, and all along the way, this friction costs us a fee.
Bitcoin is efficient because the middleman is compensated by the technology. The Bitcoin software pays the middleman, also known as miners, a predetermined amount of money. Paying the miners bitcoins is also the channel by which the money supply steadily develops. The miners compete to be the first to solve a mathematical equation, which processes the transaction and ensures that the bitcoins are not counterfeit. The first to solve the problem receives freshly minted bitcoins. It is this innovation that makes it impractical to strip the currency from the technology. The currency is an integral part, similar to how without the “@” sign, e-mail would not work.
Arguing about whether it is a currency misses the point of the technology. Bitcoin is a tool that securely verifies, clears, and conveys financial transactions. In short, it redefines the role of the middleman in the financial services industry. E-mail enabled us to send a better message, faster and more efficiently. Bitcoin does the same thing for money.
Let's take a deeper dive into how Bitcoin acts as a tool to verify, clear, and convey financial transactions. The revolution is the combination of the blockchain and the miners – together, these components become the reinvented financial intermediary. The blockchain records every transaction, while the miners verify and convey the transaction.
Starting with the very first bitcoin created, the Bitcoin software began recording its every move. I always find it easier to humanize new concepts, so let's call the first bitcoin a socialite named Genesis. Wherever Genesis goes, the blockchain records her movements. In essence, it is taking pictures of her every move and recording it for posterity. Every 10 minutes, these pictures are gathered into a file called a block. Inside this file is a picture of not just Genesis, but all her friends, too; wherever they went in the last 10 minutes is recorded in the file. Also included in this new file is a picture of the previous block. This picture of the past links all the blocks together, forming a chain called the blockchain. Have you ever taken a picture of yourself in a double mirror? The same effect occurs with Bitcoin: it appears you can see forever.
The blockchain is the paparazzi of the Bitcoin world. Wherever Genesis goes, she is followed by photographers: if she buys a pack of gum, the paparazzi are there; if she goes out to a club, the paparazzi are there; even if she just sits at home on her couch, the paparazzi are there recording everything. Now when Genesis gets spent at the club for a bottle of Crystal, the miners get involved.
The miners solve a mathematical puzzle that lets them see all the pictures the paparazzi took of Genesis. The miners go back and trace her every move to make sure the Genesis at the club is the real Genesis and not an imposter. The first miner to solve the puzzle and look at all the pictures is paid in bitcoins.
What makes Bitcoin strong is that anyone can be a paparazzo and anyone can be a miner. Anyone