Today you will finally understand Bitcoin
By: Madhavan Malolan
Tags: Future, Bitcoin, Money, History, Government

Bitcoin challenged our core economic assumptions — here is why it is the future. I will walk you through some core fundamentals that govern Bitcoin, without going into any technical details. These are notes I made after a fascinating conversation with an economics major.

What is a Bitcoin?

Bitcoin is money. If anyone tells you anything else, they most probably don’t understand what they are saying themselves. Bitcoin is money — plain and simple.

What is money?

Now that we claim Bitcoin is money, let us look at what money itself is. I had until recently believed I understood money. I was wrong. Money is a medium of exchange and a store of value.

What is a medium of exchange?

When you pay a shopkeeper with a currency note, she accepts it. She trusts that the wholesale shop she buys her stuff from will accept the same currency note. The owner of the wholesale shop accepts the note because she trusts that the bank will take the note and increase the balance she can spend on a website. She then trusts the e-commerce website to accept a transfer of balance from one bank account to another in return for goods. And the cycle goes on.

A valid medium of exchange is one which can pass hands without any depreciation in value. A good medium of exchange is also easy to carry out trade with.

Early tribes used shells, feathers and pebbles as a medium of exchange between tribes. These payments were made as an obligation or cover for damages caused.

What is not a medium of exchange?

A critical point in case for a medium of exchange is that value of the medium should not lose value upon change of hands.

During the tulip mania, tulip bulbs were exchanged as a tradable item. Bulbs were bought purely on the speculation that the next person would buy it at an equivalent or a higher value. Which is pretty much what we discussed money to be above.

But, a tulip doesn’t have consistent value. A bulb over time, if not taken care of loses value — i.e. if it rots, it sheds petals on poor handling. It is hence that a tulip is not a valid medium of exchange. It might be a great trading commodity, but not a good medium of exchange.

Boulders are bad mediums of exchange even though they don’t lose value on exchange, but are hard to exchange in the first place.

What is a store of value?

You lock up money in a bank. $100 kept in a bank is worth $100 at any time. What you can buy with $100 is a different matter, but no one will say that your $100 is now $90 because it is 20 years old.

Gold has been long seen as a great store of value because it doesn’t degrade with time. Silver is a slightly less favourable because, over time it reacts with Oxygen in the atmosphere to form a black ugly looking compound called silver oxide. Copper even less so. Copper turns green on oxidation and much faster than silver turning black. The statue of liberty was once brown, being made of copper — and in a couple of centuries turned green. Not so favourable for a store of value. Who would buy a green degraded statue when they can buy a shiny copper one?

What is not a store of value?

If you own 10kg of rice today, you can go to your neighbour and ask them to give you say 8 kg of wheat in exchange for the rice. Your kind neighbour might agree to do that. However if you went to her and asked her for 8kg of rice in exchange of rice that is 20 years old and fungus all over, odds are far less favourable.

If something loses its value over time, it is a bad store of value.

Where does Bitcoin stand?

As long as the next person takes Bitcoin and gives you a pizza, Bitcoin holds as a valid medium of exchange.

It is easy to pass from one holder to another, it is all digital and no bulk. If you can memorize your password (aka private key) you can cross borders with all the money. No international bank transfers, no suitcases filled with bills.

It is a store of value — face value of the holdings doesn’t go down with time.

Where does US dollar stand?

You can give a dollar bill or an online transaction to buy a pizza.

It is easy to store dollars in a bank.

A dollar bills face value doesn’t change with time.

It is all the same.

You pay at a shop using currency notes. You buy on Amazon using a credit card. You pay using a Paypal wallet on eBay. You purchase on the Lightning store using Bitcoin. All the same.

If there is nothing new, why the hype?

There are two fundamental differences between Bitcoin and Fiat currencies like USD.

Decentralized and trustless

Trustless is a Bitcoin jargon. It essentially means that there is no entity you need to trust. For fiat currency you need to trust the entity in the middle.

In the case of currency notes you need to trust the government issuing the currency. Every currency note usually holds a phrase like “I promise to pay the bearer the sum total of 1000 Rupees”, and signed by the head of the Central Bank. If you hold a 1000 Rupees note, you can safely assume that you can buy things worth Rupees 1000 using that.

This seems to be a fair assumption, it is fair to put that kind of trust on a government.

However, recently India as carried out a demonetization where it rendered all Rs 500 and Rs 1000 notes to be invalid overnight. It did allow people some breathing space to exchange these notes in a bank. If an Indian had been away trekking the Himalayas without connectivity over the past year, she would come back to learn that the Governor of the Reserve Bank of India had broken his promise to “pay the bearer the sum total of 1000 Rupees” — there is nothing the trekker can do about it. She trusted the government, and the government failed her.

Bitcoin on the other end doesn’t need you to trust an entity, rather needs you to trust the math. Yes, math. Bitcoin is rule based transactions governed by a branch of computer science and math called cryptography. Anyone can download a software and start validating the transactions that are happening using Bitcoin. The validation is simple. Alice can send Bob 10 Bitcoins only if she owns 10 Bitcoins — the math should add up. Multiple people can run these validations, by running these softwares. For every transaction that happens everyone who is running this software on their computer vote whether a transaction is valid or not. If the majority says it is valid, it is valid. The way the softwares do this voting is structured in a way that liars are severely punished, not by a central authority, but by the mathematical rules. It is hence that Bitcoin is decentralized.

Deterministic

A central bank mints money. How much money is to be minted is controlled in essence by the head of the Central Bank.

The Central Bank pumps more money into the system to combat inflation. It doesn’t usually pump too much money, because doing so will reduce the economic value of the currency and hamper the buying capacity of that currency on the international market. It is thus in the best interest of the government to not mint excessive money.

Zimbabwe during 1990s printed a lot of money to fund the Congo War without accounting. That resulted in a loaf of bread costing a truck load of Zimbabwe Dollars. A Zimbabwe citizen cannot question this central authority that minted Dollars rampantly, almost at will — causing the hyper inflation. Zimbabwe had to finally move to USD as the medium of exchange even within Zimbabwe. Zimbabwe Dollars are now worthless.

Bitcoin is scarce and will be introduced into the market at a deterministic pre decided rate. There will be a total of 21 Million Bitcoins. All of them will be introduced into the system by the end of year 2134. No inflation adjustments will take place. No entity can destroy the face value of a Bitcoin by over-minting.

What is the intrinsic value of Bitcoin?

None. There is no doubt about that. If you fly to Mars today, the Bitcoins that you hold on your computer are worthless.

In the section “What is money”, we talked about medium of exchange and store of value. It is not a requirement for a medium of exchange or store of value to have intrinsic value.

Feathers, shells and pebbles used by early tribals had intrinsic value. They were ornamental. Gold has intrinsic value because it is ornamental. Gold is also used in many sophesticated machinery — but that is not why it is a store of value. If it were the case, it would mean Sillicon would be a super important store of value.

Feathers, shells, pebbles and gold are all scarce. Atleast the ones used in trades. The rarity is the cause of their value. And in that respect, Bitcoin is just as scarce.

That leaves us with the ornamental value. For which I argue, that the ornamental value is an effect rather than the cause of the value in exchange. Gold is considered particularly beautiful because it is scarce and a convinient way to show off wealth. Wealth is nothing but buying power in trade.

Is it okay for a currency to have no intrinsic value? Yes. We have been using a currency that has no intrinsic value for decades. Without most people realizing, the US governement followed by other governments of the world have done away with the the gold standard. You could once take a $100 bill to the govenrment and ask for the equivalent amount of gold. You can’t do that any more. Meaning a currency bill is nothing more than the promise made by the state.

Why am I still using dollars to buy my grocery?

Bitcoin is not new. It was invented and deployed in 2009. Even after 10 years, we don’t see it as the primary form of currency.

Underground activity

One of the main critiques of Bitcoins is that it facilitates underground activity. Drugs purchases and terrorist funding have become particularly easy with this new medium — so is the claim. It is true that there have been such cases that have been exposed.

If a funder takes a suitcase of dollars to a terrorist firm, there is absolutely no way to trace it back. Bitcoin can be traced back. It is not an anonymous currency.

Internet in the early 1990s saw maximum adoption from the Porn industry. There were speculators who said the internet is a bad thing because all it does is encourage pornography. It is a valid claim in the myopic view. But Bitcoin will open up a whole variety of possibilities.

Government Regulations

Governments have shown varied responses to Bitcoin. South Korea, India and China have been the latest to show opposition to Bitcoin.

Bitcoin being a medium of exchange diminishes the buying power of the fiat currencies. A Rupee becomes more valuable if more Rupees are traded on the international market. If Bitcoin becomes a prevelant form of exchange internationally, it will be at the cost of other fiat currencies — atleast in a few areas. We will however see that this is not a zero sum game.

Real technical challenges

There are some real technical challenges that Bitcoin is facing at the moment. Bitcoin can support only 7 transactions per second whereas Visa processes 45,000 transactions per second! This seems to be a huge difference, but starting Jauary 2018 solutions like Lightning network have been deployed, which will be able to match Visa like processing very soon. The breakthrough is just around the corner.

Bitcoin is also facing some challenges maintaining its decentralized nature. Again, work is in progress.

Why should I be excited about Bitcoin?

Decentralized, trustless, deterministic

As we saw earlier, Bitcoin cannot be screwed by a single entity. It is a major improvement over the current form of currency we are using.

A modern currency for a modern world

A lot of our transactions have now moved online — but the currency still remains the same.

There is no way to pay for only 10 minutes of a movie that you watched, or get paid a couple of cents for filling up a form. It is not possible to make a very small payment using USD, because Visa and Paypal charge a transaction fees which make such transactions of a few cents infeasible — you will pay more in transaction fees than the actual value. These are called micropayments.

With scaling solutions like Lightning Network on Bitcoin, these micro transactions become very much feasible. It is thus not a zero sum game with fiat currencies, because these are avenues where fiat currencies don’t get traded in the first place.

Bitcoin is the first such system that has worked. If the few unanswered questions have found their technical solutions, it will be the biggest thing that would have happened to software since the Internet.

How to trade Bitcoin and become rich?

I don’t know.