Over the last few weeks, I’ve been talking with a family member who was struggling to understand what Bitcoin is, and how it works. After he sent me an article that hardly scratched the surface to what Bitcoin is, but was useful for him, I realized that there’s really not a lot of good information out there about what cryptocurrencies are and how they work. Therefore, I thought I’d help out and try my own hand at explaining Bitcoin. Here it goes:
The main thing that makes Bitcoin (and other cryptocurrencies) so different from our current financial system is that instead of trusting banks, you trust the network. The network is made of computers around the world who are recording transactions alongside every other computer in the network. As information spreads at a limited rate, different computers will get transactions at different times so they compare with each other and take the average of what every computer thinks happened. This ensures that (unless almost half of the computers are working together) no one can rewrite history and change who has what amount of Bitcoin. Anyone who dedicates a computer to helping run the network is rewarded by a small amount of newly created Bitcoin – which is why being part of the network is called Bitcoin Mining.
When you receive a Bitcoin, you sign it with what’s known as a public key and the network records that the bitcoin is owned by whoever owns the public key you used. You then keep your private key separate, so when you go to sell the bitcoin, you can prove to the network that you are the legitimate owner. While it’s not necessary, you can use a different key pair for each transaction if you want to stay anonymous, as otherwise people could track which transactions were made by the same key pair.
If public / private keys don’t make sense, you can imagine them as the public key being your bank account number, and your private key being your PIN or other identifying information. You can give someone your account number, and they can deposit money into it, but can’t take it out unless they can convince your bank that they are you (by using your PIN, a fake ID, etc.). A longer, more in depth, and more accurate description of Public / Private key encryption can be found here.
There are four main strengths to Bitcoin and other cryptocurrencies over our current financial system. The first is, in my mind, going to be the biggest draw in the future but right now it’s the one that most people haven’t heard about: smart contracts. Smart contracts allow you tell the network “reserve X-amount of bitcoin of mine, to be given to person Y when these conditions are met” – basically an anonymous, trustworthy way of creating contracts without the need for legal professionals (although you may need software professionals). It should be noted that while Bitcoin can handle smart contracts, that’s not what it was designed for. While I hesitate to say that any currency is “the best”, I’ve understand that another cryptocurrency, called Ethereum, is one of if not the best of the popular cryptocurrencies at handling smart contracts.
The other three main strengths of the cryptocurrencies, at least as I see them, are:
- The lack of trust required. You don’t need a “trusted third party” like a bank, but rather you put your money in the hands of the network which is distributed around the world and is very difficult (to the extent that it’s almost impossible) for anyone to take control of and abuse.
- The ease of access. Anyone can buy and sell cryptocurrencies as all you need is an internet connection which is much more common than having access to a bank to a large portion of the population in third world and developing countries.
- The anonymity. You don’t need to have your name connected to your assets. While this will likely force us to rethink many issues (e.g. how we tax our citizens), it is something that many people are flocking to as online privacy becomes more and more of a problem in today’s society.
Finally, I’ll touch on the frequently mentioned “strength” of Bitcoin which is that it eliminates the middleman and the associated fees. I have to say that I disagree. The middlemen don’t exist because we use national currencies, they exist because we want convenience. The middlemen are not the federal treasury who print and theoretically own the money, they are the investment managers, the stock exchanges, and the banks who provide us convenient services and expertise. We can already see that this won’t change as recently Bitcoin exchanges (e.g. Coinbase) have started popping up all over the place which allows you to quickly and relatively simply buy and sell Bitcoin and other cryptocurrencies in exchange for a small fee. These function similar to stock markets, but they are simply for convenience as you can easily trade outside of the exchanges.
All in though, I do think cryptocurrencies are the way of the future and will completely change how your average middle-class investor will use and save their money.