For Absolute Beginners: Bitcoin
This post explains the significance of Bitcoin to a layman who has no background in technology, crypto, or blockchain.
Bitcoin is a term that all of us have come across at some point of time in the recent past. But a few of us really understand it and look at it with significance.
So what is Bitcoin?
Is it just an investment to make quick money out of a market frenzy? Or does it represent a practical application?
Does it have any inherent value?
If these are questions on your mind, I hope that you find my post beneficial.
Any General Transaction Today
We’ll take for example a transaction between Alice and Bob. Let’s say Alice wants to purchase three chocolates from Bob. Alice can go about this transaction in two ways:
- Barter Transaction: Alice understands that Bob is fond of cotton candies and decides to trade cotton candies in exchange for chocolates from Bob.
- Monetary Transaction: If Bob prices each chocolate at $1, Alice can simply pay $3 to purchase the three chocolates.
Understanding the Authenticity of these Transactions
Now let us understand the underlying belief systems that validate the above transactions.
1. Barter Transactions: The Barter transaction was valid because
- Need: Bob was tempted by Alice’s cotton candies and hence agreed to give away the chocolates in exchange. But this need might not be perennial. It just worked in this case. But, Bob might not always be tempted by Cotton Candies.
- Common Interest: Both Bob and Alice had a common interest i.e. “Cotton Candies” 🍭! This could have very well been something else like “Pokemon Cards”, “Taazos”, “Gold” etc.
- Perennial Value: Some items like Gold have had perennial value across different societies. These are ideal for any barter system that has to sustain the test of time. Even today monetary systems are backed by a country’s Gold/Oil Reserves. This is what creates a bridge between Barter and Monetary Systems.
2. Monetary Transactions: The monetary transaction between Alice and Bob was valid because:
- Authority: There is a Central Authority(US Govt/Federal Reserve) backing the USD($) and recognizing it as an official currency.
- Faith: Both Alice and Bob believe in this “Central Authority” and hence believe that the USD($) has value! If Bob lived in Russia and believed in a different “Central Authority”(i.e Russian Govt) he might have not accepted the $3 from Alice.
- Scarcity: Units of Monetary Transactions like Currency($USD) have value because they represent some form of scarcity. If currency could be printed infinitely it would lose value. This scarcity is typically anchored over a nation’s reserves like gold, oil, etc.
Now let’s try to understand Bitcoin from this Barter-Monetary Framework. Let’s now assume that Alice tries to offer 1 Bitcoin to Bob in exchange for 3 chocolates.
Bitcoin and Barter Systems
- Need: Does Bob really need Bitcoin? If Bob follows the latest prices of Bitcoin, he might realize that “1 Bitcoin” is worth tens of thousands of dollars. This in turn might tempt him towards Bitcoin, but there is no natural need as in the case of Cotton Candy as Bitcoin is not a physical tangible asset. But Bitcoin can definitely have a perception-based need due to its demand-related price.
- Common Interest: Alice and Bob can both have Bitcoin as a common interest. This is what is most likely to make Bob accept Bitcoin.
- Perennial Value: Bitcoin definitely does not have Perrenial Value. It does not represent any resource that has been a central need.
So on the first examination, we feel that Bitcoin does not fit in as well as other barter items like “Gold”, “Oil” or “Cotton Candies” did. But before we start examining if Bitcoin fits into Monetary Framework, let’s look at a few side questions:
1. What makes popular barter items like “Gold”, and “Oil” a need? What attaches perennial value to it?
Gold: Most pre-modern civilizations looked ascribed value to gold because of its rarity and shiny nature. This made it a central part of the Jewelry and Treasuries of any society. This could very well have been any other substance with the same characteristics. It just happened to be Gold, Silver, Platinum, and Diamond. They satisfy an aesthetic need that is entirely a non-tangible construct.
Oil: Modern Civilizations depend on Oil/Petroleum/Coal as fuel for machinery and eventually as a source for Thermal Energy and Electricity. This coupled with its scarce nature gave it perennial value. It is important to however note that Oil did not have this kind of value 500 years back as the technologies that needed it as fuel did not exist back then. This means that need is transitionary and changes from era to era.
2. How does money fit into barter?
What if we were to examine the USD($) using the Barter Framework:
Need: USD($) much like Bitcoin is not a need in the sense that it does not represent a physical tangible asset that satisfies a real need such as hunger, fuel, etc. It’s a need because the economy(via Authorities) makes it a need.
Common Interest: USD($) is a common interest between Alice and Bob because of their faith in a common Authority. This is why Bob accepts USD($) from Alice.
Perennial Value: USD($) much like Bitcoin does not have perennial value. It does not represent any resource that has been a central need. Its value exists as long as the authority backing it exists. USD($) did not exist 500 years back because the authority(Govt of USA) did not exist.
So basically even the USD($) does not do too well when treated as a unit of natural barter. Maybe Bitcoin might do better when examined from the Monetary Framework!
Bitcoin and Monetary Systems
Authority
There is no government or corporate entity that acts as an authority to enforce or regulate Bitcoins. But does that mean there is no authority? Let’s sidestep once again to understand what authority is.
What is an Authority?
An authority is any entity that enforces a bunch of rules on a group/society and regulates in accord with a pre-existing social contract(Ex: Constitution/law for Govt Authorities.).
The entity that plays the role of authority need not be limited to governments or corporates. A computer program can also enforce a set of rules and regulate in accord with a social contract. This is exactly the kind of authority that backs Bitcoin. This computer program is called blockchain and it runs simultaneously on a network of hundreds of thousands of computers across the world. This is how it enforces reliability and immutability.
Faith
Let’s first try and understand what leads to faith in existing govt/corporate authorities.
Governments: Today we live in a world where most stable economies are led by either democracies or monarchies or a combination of both. Our faith in these institutions has been built over centuries of trust created due to the economic security offered by them in the past. But the past century has seen globalization being centered around a few key players like Britain(Colonial era), US-Russia(cold war), or US-China(post-cold war). Any internal crisis in these key players drastically impacted the rest of the world. As we move into a more multi-polar world we look for a form of globalization that is immune to a crisis within any such players. The USD economy no longer functions as a global anchor in such a multi-polar world.
Corporates: Corporates have led the past decades by creating reliable financial institutions that gained popular trust. We often see gift points/tokens being offered by companies like Amazon/Sodexo etc that play a role similar to that of money. But these have failed to scale in a geography agnostic way. They are also prone to scams and have also been known to trigger massive economic crises (ex: 2008 Lehman Brothers Crisis). Corporates eventually rely on govt systems to bail them out from any such problems. It’s therefore not reliable to anchor monetary systems on corporate institutions.
Can we create a monetary system that is not anchored to any govt/corporate institution? That’s exactly what Bitcoin aims to do!
Bitcoin is built on a Blockchain that runs on the global internet infrastructure that is not owned by any government or corporate entity. Every computer that participates in a blockchain must keep a record of all transactions that have occurred. This means that if anyone tampers with records on any one computer, other computers can correct the tampered records via a consensus mechanism. The only way to successfully tamper with existing transactions would be to simultaneously modify records on at least 51% of computers participating in the blockchain. This is known as a 51% attack. Given the global distribution of computers participating in Blockchain Network, it’s highly unlikely that anyone can coordinate a 51% attack. This is what makes a blockchain an immutable log of transactions. This property is what creates faith in Bitcoin as a monetary system.
Scarcity
Bitcoin is designed with a strict hard cap of 21 million Bitcoins. But all 21 million Bitcoins were not released simultaneously. Bitcoin is mined by making computers solve a very complex mathematical puzzle. The puzzle gets more complex as the number of participants and associated network size increase. This makes mining more difficult over time limiting the supply of Bitcoins. One can say Bitcoins are limited by a compute-based scarcity alongside a hard cap. This scarcity is what gives Bitcoin real value.
From our above analysis, it is clear that Bitcoin passes our Authority-Faith-Scarcity test and qualifies as a legitimate monetary system.
I hope that by now you are convinced that Bitcoin represents a practical application and isn’t just an investment asset to make quick money.
References
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