In part 1 of this primer on bitcoins we first took a step back and took a look at money.
Now we’re going to dive into the world of bitcoins so we can understand what they are and how they work before we return with part 3 of the primer on some of the downsides and legal risks of bitcoins. If you are interested in reading more about bitcoins there are plenty of resources available online but I highly recommend this 25-page research paper by Goldman Sachs that approaches bitcoins from a variety of angles and where I obtained many of the data points for this section of the primer.
The Two Bitcoins
Before we delve into the fun world of bitcoins we need to clear something up. Bitcoin can actually refer to two different things. One uses the capital B and is called Bitcoin. The other one has a lower case b and is called a bitcoin. This gets super confusing when the word starts a sentence so the capital letter doesn’t tell you anything. But they are two very different things.
bitcoins, the lower case version, are a form of virtual currency in that they were created to be used as online money. How they are treated legally is a very different matter that we’ll discuss later, but for the most part when you read about people buying a villa in Bali with bitcoins, or an ATM for bitcoins here in Austin, or how a site was hacked so members lost all their bitcoins you are reading about the lower case bitcoin.
The capital letter Bitcoin is the technology that makes bitcoins a potential currency. And it’s actually the more important of the two. But we’ll talk about that later. For now, let’s discuss how bitcoins could be used as virtual currency.
Bitcoins as Currency
First, let’s clear up one thing about bitcoins as a potential currency: they were not created to buy illegal things. This is a common misconception about bitcoins–that the mob or criminals are using bitcoins to buy drugs, weapons, and DVDs of Ishtar.
So Why Make Bitcoins?
Bitcoins were created like so many other internet services: to make things cheaper. The paper that launched it all starts innocently enough:
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.
When you buy something on the Internet you almost always use a credit card. Sometimes you might use a direct bank transfers, other times you could use another trusted third party like Paypal. But all of those transactions involve a third party not directly involved in the transaction. Those third parties get paid for ensuring the transaction goes smoothly. On average, those third parties will take just under 3% of the total transaction (they take around 2.5% for physical retail transactions due to the increased risk of fraud in the e-commerce market). In 2013 an estimated $609 billion in goods and services was purchased online. Meaning $17.8 billion was given to banks and credit card companies and Paypal and others.
The hope is that using bitcoins could reduce those transaction costs to only 1%. That would be $6.1 billion in total fees and would save the industry $11.7 billion. Of course, whether the saved money would result in lower prices to consumers or just higher profits to the companies would remain to be seen, but the hope is that the money eventually flows to the consumer.
But how do you create a brand new form of currency without having the same kind of third party involvement? The purpose of using bitcoins to buy things was to be cheaper, after all–it wasn’t just to create a new form of currency with the same transaction costs (although some people really liked that idea too). So the system of bitcoins and Bitcoin was created to try and create a new form of currency: the bitcoin.
Okay, I’m ready. What’s a bitcoin?
Glad you asked and that you’ve stuck around this long. The short answer is that a bitcoin is like any other digital file, a series of 1s and 0s that can be used by certain programs. In this case, those programs are wallets that both hold your bitcoins and allow you to transfer them to other wallets so you can pay for things. In this way, bitcoins acts like currency.
Anyone who has worked with computers knows about two essential digital functions: copy and paste. So if the bitcoin is just a digital file, what’s to stop people from hitting a few buttons and becoming virtual billionaires or turning the bitcoin economy into hyperinflation 1946 Hungary like we discussed in part 1? And how do you ensure the reliable transfer of these bitcoins without using a trusted third party that will want it’s 2.9%?
The answer to those questions is what makes bitcoins look and act like a virtual currency (also called cryptocurrency) in meeting those five essential elements we discussed in part 1. How these bitcoins can be used also forms the basis of Bitcoin, the network.
1. Bitcoins have fixed units of measurement
The standard unit for a bitcoin is the BTC just like the standard unit in the United States is the dollar. However, unlike the dollar which can be divided into 100 cents, a bitcoin can be divided into 1 million pieces. The smallest trackable unit of a bitcoin is currently 0.00000001 BTC. What that is worth, in terms of buying power, will be discussed later. But just like fixed money had an advantage over a barter system because everyone agreed on how much of the currency was being traded, bitcoins have a common and precise measurement.
2. Bitcoins don’t disappear
By virtue of being digital and on a shared network, bitcoins don’t disappear. They may, however be stolen just like gold jewelry. Or you may forget your password to the wallet that holds your bitcoins, just like you could bury a jar of gold coins and forget where they are. But the bitcoins themselves don’t disappear.
3. Bitcoins are controlled and scarce
Rather than having a government or central bank issue new bitcoins, the Bitcoin system is responsible for creating new bitcoins. We’ll discuss how that happens later when we talk about Bitcoin mining, but know that there is an algorithm for adding new bitcoins to the BTC economy. And there is a fixed number of bitcoins in the BTC economy. If you want to see the current amount you can check this graph and see how there are a bit over 12.1 million BTC as of March 24. The rate at which BTC are added is based on the number of BTC transactions rather than a fixed time. That’s why the line on the BTC supply isn’t straight–it fluctuates based on activity.
Adding currency is done by issuing authorities all the time, lest you think BTCs are going the way of the pengo. The US mint produces new money every day–about 95% is used to replace older, damaged notes while the rest can be held in reserve or issued as new currency. One potential concern that comes up with bitcoins is that the current method for creating and verifying bitcoins has a cap of 21 million BTC (this will be reached by around 2140). However, bear in mind that there is currently only $1.2 trillion dollars in the world economy (this is the M0 money supply, or actual money in the forms of notes and coins) and there is a grand total of around $10.5 trillion dollars in total when you count other money supplies (this fact and a nice breakdown of the difference between money supplies can be found over at HowStuffWorks).
$10.5 trillion dollars counted down to the last cent looks like this: $10,500,000,000,000.00 (16 digits)
21 million BTC counted down to the last decimal place looks like this: 21,000,000.00000000 (16 digits)
Meaning that even with a finite supply of BTC, it seems like there would be enough for a BTC economy to function.
4. Bitcoins are transferable
Bitcoins can be transferred between indviduals using their wallet programs and the Bitcoin network. Several online vendors have also started taking BTC directly, such as Overstock and WordPress. And those are just the directly transferable BTC transactions–there are bitcoin ATMs that are starting to pop up and there are multiple BTC exchanges that let you convert BTC into other forms of currency for indirect BTC transactions. Directly or indirectly, BTCs are transferable.
5. Bitcoins have value
Now this is where things start to get tricky. First, there is no denying that bitcoins have value. While I write this the price for 1 BTC is somewhere between $515 and $520. People using BTC agree that there is value to them, but the value fluctuates wildly. Bitcoins could be purchased back in April, 2013 for around $100. At the end of November, 2013, bitcoins were being sold for $1,000 or $1,100. There have been huge spikes up and down throughout the year.
Compare that to how many Euros could be bought for one dollar over the last year (if you follow the link you’ll need to click the 1Y button to show the year). At the lowest point of the year it cost $1.27 to purchase 1 Euro. At the highest point it cost $1.39. That is what happens with generally stable currencies.
The unstable value of bitcoins is also a large criticism for its use as a currency. If a currency can’t be relied upon for its value then people will stop using it. Hungary had to give up the pengo and replace it with something completely new. The majority of BTC value spikes are due to speculators trying to make money–they aren’t using BTC to buy things but rather hoping the value will go up so they can make money off it. Whether they do or not, there is no denying the volatility they’ve created. And that can be a bad thing for bitcoins.
Consider this: in 2010, a programmer convinced someone to buy him two pizzas in exchange for 10,000 BTC. At the time, bitcoins had no value since very few people had them or used them. Those same bitcoins would be worth millions. There is no way that programmer could have known this, but everyone today who participates in the BTC economy knows the value fluctuates wildly. This makes both sides less likely to use them for transactions.
The Big B Bitcoin
But now we have to talk about Bitcoin, the network that made a new virtual currency possible. Remember that in order for bitcoins to be a viable currency not only did they need to meet the five essential elements (which they more or less do, with some warnings) but they also needed to have a method of transferring those bitcoins without involving a third party taking it’s 2.5%.
The solution to the problem of avoiding the dreaded 2.5% transaction fee while still being a trusted method of transfer is the capital B Bitcoin system. Here’s how it works.
To understand Bitcoin, we start with wallets. In order to conduct business transactions involving bitcoins you need to have a wallet.
In this case, a wallet is a collection of two essential things paired with optional items:
Essential thing #1: A public address
Think of this like the address that people send money to, much like your physical address is where the Amazon drone can drop off your copy of Ishtar. For bitcoin transactions, an address is typically a random string of 34 characters such as
Essential thing #2: A private key
This is like your mailbox key that keeps other people from getting their slimy hands on your copy of Ishtar. You go to your mailbox and unlock the door to pull out the sweet, sweet desert comedy stylings of Beatty and Hoffman. (I know, it doesn’t exactly work with the drone–let’s just imagine that the drone can wirelessly open the door to toss in the DVD, mmkay?)
For bitcoin transactions, a private key is a 256 bit number that can be reduced down to a 51 key string such as
So unless you’re really good at memorizing pairs of 34 and 51 character strings you will probably use wallet software to store your public address and private key for you.
Optional thing #3: Money
Just like with a regular wallet, it’s nice but not necessary to put money in it. But if you want to send money, you need to have money.
Now, here’s where the wallet starts to get a bit tricky because unlike physical currency this is all virtual. So instead of having money you have an address that Bitcoin, the network, agrees has a positive balance of bitcoins. Think of that address as a pocket within your wallet. And each of those pockets has the two essential elements–the public key and private key. If the Bitcoin network says that pocket has bitcoins in it, then you have money to spend.
The Bitcoin Block Chain
When it’s time for you to conduct a bitcoin transaction, your wallet and the wallet of the other side in the transaction uses the Bitcoin network to add the transaction to the Block Chain. This is a giant database that is a complete ledger of every transaction involving a bitcoin.
Say you are buying my copy of Ishtar because I have grown weary of all that sand. We have agreed to complete the sale using bitcoins. I have my wallet create a new address for you to send me money. (This isn’t required but highly encouraged to keep all transactions secure.) I send you the public key for this new address and await payment.
You instruct your wallet to deposit the agreed upon amount of bitcoins into my new address. The instruction you give your wallet will include the address where the money is going as well as where the money is coming from (because your wallet probably has multiple addresses/pockets of money from different transactions).
The instruction sent from your wallet will be signed using your private key. Your wallet then transmits this instruction to the Bitcoin network where miners race to verify the transaction. Mining can technically be done by anyone with a computer and special software but doing so quickly requires specialized hardware and software. Speed matters because transactions are lumped together in batches (typically the last ten minutes’ worth) and the first miner to verify the batch is rewarded with 25 bitcoins.
Verifying the transaction is a very technical mathematical operation that looks at the old bitcoin address (where the money came from), the new bitcoin address (where it’s going), and the signed transaction (which factors in your private key but doesn’t disclose it to anyone). The process allows all the pieces of information to be checked without also revealing your private key. It also ensures that the same bitcoins aren’t used in multiple transactions–the double spending problem associated with digital cash. Regular currency avoids double spending because you hand over a physical item like a ten dollar bill–you don’t have that same bill to be used again. Electronic transactions utilize a third party to ensure that the purchasing party doesn’t spend the same money twice (typically by establishing limits and then ensuring the purchasing party pays their bills). For bitcoin transactions each transfer is based on the old address and the new address–the same money cannot be used twice.
Once the transaction is verified it is added to the Block Chain, the giant ledger of every bitcoin transaction ever made. It is possible to follow a bitcoin transaction backwards from address to address all the way back to when the bitcoin was first created (as a reward for mining). If you’re into that kind of thing.
Mining and Transaction Costs
Mining is the replacement for the current system which uses a trusted third party as the go-between with today’s transactions. Today, if you wanted to buy my copy of Ishtar I would wait for a message from a trusted third party (American Express, Paypal, etc.) before handing it over. With a bitcoin transaction I am waiting for confirmation from the Bitcoin miners before I hand over the DVD. The good news (for me) is that it’s far less expensive to complete our bitcoin transaction since I am not paying the 2.5% of the total to the third party verifier. The bad news (for you) is that the verification doesn’t come instantly. And if you were ever using your credit card at a store and had to wait 10-15 minutes for verification of the payment you’d be pretty frustrated. As it is, those extra 15 minutes of waiting for Ishtar could seem like forever.
For most online transactions this 10-15 minute delay doesn’t matter much–whether the Ishtar DVD is put into an envelope and sent immediately or 15 minutes later shouldn’t matter much. But this does prevent a limitation for bitcoin transactions in the real world where speed matters. There are already some bitcoin payment providers that are attempting to bridge this timing gap by providing instantly accessible transactions, but those come with a higher transaction cost and might not be as desirable.
Speaking of transaction costs, we discussed earlier how bitcoin transactions were aiming for 1% transaction fees instead of today’s trusted third parties taking 2.5%. But we also just learned that miners are being paid with newly minted bitcoins–money not attributed to either the buyer or the seller. So where is the 1% coming from? Mostly from the wallet providers as a cost for converting bitcoins into currency. In the future, however, all the bitcoins will be issued so miners can’t be paid with new money–instead the Bitcoin network allows for transaction fees to be built into the transactions. Miners then will function similar to third parties today, taking a portion of the transaction to ensure the transaction is completed and the hope is that they take 1% or less. Because otherwise that would be a lot of work for nothing.
Now I’m Going To Blow Your Mind A Little Bit
Because you’ve come a long way in understanding this new form of virtual currency and the system that makes it work, here’s a fun little bit of information to blow your mind. Feel free to just skip this section if it confuses you too much but otherwise it’s a fun thing to think about at this point.
There’s no such thing as a bitcoin.
We’ve been talking about virtual currency this whole time trying to make the equivalent connections between these small b bitcoins and actual money because that’s how our minds work. We’re used to money and we’re accustomed to electronic transactions with money because we’ve used credit cards and those are backed by real money. But there aren’t any bitcoins.
All there is in this bitcoin economy is Bitcoin–the network that verifies the Block Chain. A positive number, divisible into a million pieces, is created and passed from address to address. But that’s all it is–an address of a number where we first imagined something of value existed and then we moved it to the next place. Nothing was ever there in the first place.
In this case, bitcoins are really like fiat money. It only has value so long as everyone agrees it has value. And that is the start of some of the risks facing Bitcoin. Risks that we will cover in part 3 of our primer next week.
Ready to read part 3? Then here you go.