The Basics of Bitcoin

[originally published at TheoryOfSelf.com]

Venturing a bit off-topic for this blog again, but enough of my friends have asked me these questions over email and in person that I thought it would be worth writing up my thoughts so they would be easy to share. Here’s what we’ll be going over:

  1. What is Bitcoin?

  2. How does it work?

  3. Why does it matter?

  4. Should I buy some Bitcoin?

  5. What about the other cryptocurrencies?

None of the answers I’ll offer to these questions will be definitive or exhaustive, but they should hopefully be enough of a starting point to help you learn more if you would like to.

What is Bitcoin?

Bitcoin is a new kind of money. It is a trustlesspermissionless currency. Trustless because you don’t need to trust anyone else (like a bank) to use it to send or receive money, and permissionless because no one can stop anyone from using the network. This makes Bitcoin function a lot like physical cash does in the real world: if I pay you $20, you don’t need to trust anyone that you now have the $20 and nobody can stop you from accepting it as payment. This is very different from 20 digital USD, which requires trusting a bank to hold it for you and permission from them to spend it. These properties are why criminals prefer cash (and also why ransomware relies on Bitcoin). The reason that Bitcoin is both trustless and permissionless is because it is decentralized. There is no central authority figure (like a central bank, e.g.) that governs the behavior of the Bitcoin network. Bitcoin is also very scarce (only 21M will ever exist) and because there is no central authority no one has the authority to issue more. The scarcity and lack of central authority is why Bitcoin is often compared to digital gold.

How does it work?

Here is a good introductory presentation. I recommend reading it with the speaker notes - or if you prefer to watch/listen instead there is also a video of the talk.

Why does it matter?

There are two reasons that Bitcoin matters. The simpler reason is that many people believe Bitcoin is so scarce that it may become a very powerful instrument for storing value, the way people use gold to store value today. Bitcoin is scarcer than gold, cheaper to store safely and faster and easier to spend when you want to liquidate it. Potentially some of the people who currently buy gold (perhaps to avoid inflation in their local currency) may choose to store their wealth in Bitcoin instead. The more people who choose to do that, the more individual bitcoins will rise in value, which in turn will inspire more people to keep a portion of their savings in Bitcoin. This positive feedback loop is responsible for Bitcoin’s meteoric price rise to date, and many believe that there is still considerable room to grow.

The more subtle but more important reason that Bitcoin matters is that it represents the first and most successful and important example of a collective truth. Whether you believe in the value of Bitcoin as a payment method or not, it is objectively true that the Bitcoin blockchain is a faithful and accurate recording of every Bitcoin transaction that took place since 2009. The same blockchain can also store other data as well, and new business models and social institutions may well spring up taking advantage of the brand new reliability of shared history, revolutionizing financial markets, interbanking systems, land records, art provenance and others. It’s entirely possible our grandchildren will view 2009 as the dawn of recorded history. It is literally the first objectively verifiable record of historical data.

Should I buy some Bitcoin?

Maybe. Bitcoin is either worth a lot more money than it is today or it is worth nothing, and it is impossible to know which yet. Even if it does turn out to be the optimistic case the price will almost certainly drop violently several times on the way to higher values. It is important not to think of Bitcoin as a safe investment. If the idea of the price tanking or of you accidentally losing the coins somehow makes you nervous, you own too much Bitcoin. That said, there are very few investments available at the retail level that have this kind of high-risk/high-reward profile — those are usually reserved for more capitalized investors like VC firms. If there is money in your budget currently allocated to high-risk/low-reward investments like casino gambling and lottery tickets, I think it’s reasonable to reallocate some or all of that budget into Bitcoin.

What you should absolutely not do is try and time the market. Nobody knows what the price will be tomorrow or in a week and anyone who tells you they do is either lying to you or selling you something or both. If you decide it makes sense to hold some amount of Bitcoin, I recommend using dollar cost averaging and purchasing a fixed amount on a regular interval regardless of price until you’ve reached the right amount of Bitcoin for your risk preferences. Then put your coins into cold storage and forget about them for at least five years. If the idea of not being able to quickly sell your coins in the event of a price drop makes you nervous, you have too much money in Bitcoin. As a long term investment Bitcoin can make sense as part of a balanced portfolio. As a short term investment it is strictly gambling.

What about other cryptocurrencies?

The same technology that powers Bitcoin (the blockchain) can be used to start other currencies, sometimes called altcoins. Some of these are interesting, sophisticated new technologies that intelligent people take seriously (Ethereum) and sometimes they are obviously scams (OneCoin) or jokes (Dogecoin). Some aim to solve problems in Bitcoin like governance (Tezos) or privacy (Monero), others aim to cultivate niche communities (PotCoin) or serve as test labs for Bitcoin changes (Litecoin). There are literally hundreds of altcoins, though only a handful actually matter.

I personally am a Bitcoin maximalist, which means in the long run I believe there will be one dominant cryptocurrency and it will be Bitcoin. Every cryptocurrency consists of two components: the code/technology (i.e. the consensus rules) and the network (i.e. the ledger and the users vested in it). In order to be truly decentralized, the technology needs to be open-source. Since the code is freely available, enterprising developers can take the code from any successful cryptocurrency and apply it to the ledger of their choice. Since the existence of Ethereum necessarily implies the existence of Ethereum-but-with-Bitcoin’s-account-balances, cryptocurrencies can never compete strictly on the basis of their codebase or featureset. The only way they can differentiate from each other in the long run is on the basis of their network of users. Since Bitcoin has the most wealth, the broadest userbase and the longest history of successful operation, I suspect that it is the only ledger that ultimately matters.

Many intelligent people disagree, though, so your mileage may vary. I am not an investment advisor and this is not investment advice. :)