How Bitcoin Works - The Fundamentals (Part 1/3)

2 January, 2021
Investing; Bitcoin

To understand Bitcoin is to understand how Bitcoin might be the future of money.* To do this we should start by understanding how money works and whether Bitcoin better fulfils money’s functions.

How money works

Currencies only have value in our common imagination. Money isn’t a material reality with intrinsic value; it is a psychological construct. How, then, does it succeed?

The key is trust.

“Money is the most universal and most efficient system of mutual trust ever devised” – Yuval Noah Harrari, Sapiens

Why do you believe in a gold coin or dollar bill? Because your neighbour believes in them. And your neighbour believes you believe in them. And you trust that banks believe in them. And banks trust that the government believes in them. As I said, money is a system of mutual trust.

When money was first created this system of mutual trust was non-existent. Money instead relied on physical resources with material value. History’s first known money was barley grain.

But over time we moved from trusting some thing to trusting someone. Fiat money — our modern day currencies — have value by trust. More formally we might say they have value ‘by decree’.

With a fiat system in place, digital money was born. Most money is now digital. The $1000 you store at the bank isn’t held in cash. It is held as a few digits on a central computer. But if money is digital, what stops it being copied and created at the click of a button?

How Bitcoin better fulfils the functions of money

Mutual trust is the greatest strength of fiat currencies. But it is also the greatest weakness. Why? Because trust can only go so far.

Let’s take the US Dollar as an example.

The USD is controlled by the Federal Reserve. The Fed is the single monetary authority. This singular power means that we call the USD ‘centralised’ — that is, controlled by a single, central authority. Problematically, this allows the USD to be devalued by this single, central authority — the Fed can increase the supply of money indefinitely.

The unlimited supply of fiat currency is why we trust gold as store of value. Unlike fiat currencies, the supply of gold is scarce. The problem with gold, however, is that it lacks the digital transferability of fiat currency.

How, then, can we combine the scarcity of gold with the digital transferability of modern currency?

The answer is Bitcoin.

First, Bitcoin, like gold, is scarce. Its supply asymptotically approaches 21 million coins.

Second, Bitcoin, like fiat currency, is digitally transferable. It can be transported across the globe in minutes.

Third, Bitcoin is decentralised. In other words, it is not controlled by a single monetary authority.

It is the last point which arguably creates the most compelling case for Bitcoin. But it is also the most confusing. As such, it deserves to be unpacked in more detail.

Decentralisation

Given that fiat currency is largely digital, what stops it being copied digitally?

In theory, the bank.

Under the current system, the bank stores a record of all transactions on its computers. This record of transactions is called a ‘centralised ledger’. A bank’s ledger keeps a record of whose money belongs to who. We trust the bank. And the bank trusts its computer.

We have faith that the bank and government won’t cancel the status of our money. And we hope that the government doesn’t excessively print money which devalues the money we currently own. But a system based on trust is inherently fallible. It only works until it doesn’t.

Bitcoin bypasses the need for trust in a central authority. The genius of Bitcoin is decentralisation. Bear with me, I’ll unpack what this means.

With fiat money, only the bank’s computer holds a record of transactions. With Bitcoin every computer using Bitcoin¹ has a copy of all the Bitcoin transactions (yes, it’s anonymous). Instead of the record of transactions being held by a singular bank who can manipulate the transactions (i.e. centralised authority), Bitcoin is decentralised because the record of transactions is held on every computer.

The ‘official’ Bitcoin ledger is the one that exists on the majority of computers. Say 500 people hack the ledger on their computers, but 10,000 other computers have the actual ledger, then the actual ledger prevails since it is on the majority of computers.

This means that to ‘hack’ bitcoin, you need to gain control of over half the computers holding Bitcoin. If the government wanted to control Bitcoin, it would require control of half the computers on the network… no easy feat.

Under a decentralised system, you and you alone have access to your money. No institution holds your money on your behalf.² Decentralisation removes the middleman role of a bank and reduces transaction costs. It makes Bitcoin universal and open to all, requiring neither a digital bank account nor physical exposure to an asset like gold.

* NB: Money and ‘fiat currency’ are NOT synonymous. Fiat currencies are just one of many kinds of money. In fact, fiat currencies only fulfil some of the fundamental functions of money. Gold fulfils some. Bitcoin fulfils all.

¹ In reality, this isn’t always the case. But for understanding purposes, it suffices to assume this is true.

² This actually depends on the method you use to buy Bitcoin. The Bitcoin cognoscenti and serious buyers hold their own Bitcoin. There is no institutional custodian. But the average Bitcoin buyer actually buys through a custodian who holds the Bitcoin on the buyer’s behalf.