What is bitcoin? After reading the below*, you can answer that for yourself. It is different things to different people. This a two page take and introduces some very important concepts in layman terms.
All scenarios below are very simple models of real world activities to keep this brief and understandable.
You are paid $100 and you spend $10. Now you have $90. The ledger entry looks like this.
YOUR ACCOUNT — YOUR BANK
IN — $100 | BALANCE $100
OUT — $10 | BALANCE $90
All transactions are passed through the bank. The ledger entries ensure that you cannot overspend your balance. You cannot double spend the monies. In other words you cannot make a copy of balance that enables you to spend more than you have while retaining the original.
If you were to maintain an electronic ledger, say spreadsheet, and produce it as proof of balance other parties will not trust you. Your entry could be incorrect or altered. For these reasons the bank, a third party, is trusted by other parties and in turn they trust you when you produce proof of balance.
What’s the problem? Well, not a lot on the surface. But you have to follow the rules of the bank, rules of the government (KYC/AML/OTF), they can close your account, freeze funds, take funds, share data, get bail-in, apply negative interest. It’s also not friction-less. Imagine using your funds overseas (forex) or accessing them through PayPal or Visa. And finally but not the least, capital controls. Not all countries allow fund transfer easily. We have to deal with more third parties.
In terms of economics and what currency you hold, it may be worthless. And they are not equal. E.g., 1USD vs 1Peso. The monies can deteriorate in value (inflation), and fluctuate wildly (USD vs Lira).
Enter Gold and Bitcoin. 1 Bitcoin = 1 Bitcoin. It is like 1 ounce of gold is 1 ounce of gold. Like forever. Other metals react to nature (iron rusts). This is a reason gold has historically been store of value. And the monetary system was tethered to gold till 1971. It acts as a unit of reference. But gold is not easy to carry, store and transact. But with bitcoin you can. And without a ledger maintained by a third party.
Introducing Byzantine Generals Problem. A brief detour. A city is surrounded by generals’ armies to capture the city. For success, they should all attack at the same time. Or everyone stands down. The message to attack must be passed from one general to other. Each general must have confidence that he/she received the same message as others. Now this is not easy to achieve. The messengers between each general can be captured by the city. He can switch sides. Any combination of other generals can be bad actors. The goal is to achieve the same state (attack or stand-down). Anything different will be disastrous.
Bitcoin has the same problem to solve. Your ledger is distributed widely; stored in bitcoin nodes, currently 226GB. It doesn’t rely on a central third party. Each node must maintain the same state of your balance or transactions. Why? To avoid double spending. Any discrepancies will result in loss of trust and funds. The nodes basically do the job of the bank but they are distributed ledgers that doesn’t require maintenance by a single party. If one node goes down there are others. Your balance can be verified with the nearest node (I believe) however far it maybe. There are no incentive to run nodes, other than security and there are tens of thousands of active nodes and nearly hundred thousand passive nodes.
A system that achieves the same state in the above problem is said to be Byzantine Fault Tolerance. This is achieved by consensus. Bitcoin achieves this by Probabilistic Consensus. There is also Deterministic Consensus that some other systems use. The nodes receive blocks of transactions from miners. If blocks are malicious they are not allowed into the ledger.
Is there intrinsic value to bitcoins? When you buy, sell or spend bitcoins you generate transactions. These transactions are verified by miners and put in a block and chained (hashed) to previous block. The miners have incentives.
In order to successfully mine a block of transaction, they are required to solve a cryptographic puzzle. In the early days GPU was enough; but today we require application specific chips (ASIC miners). Why? Bitcoin has difficulty adjustment. Higher the difficulty higher the computing power required. The days of GPU mining are long gone; these days we have mining farms!
The first to solve the puzzle receive 12 bitcoins per block. A block is mined roughly every 10 minutes. Every 210,000 blocks, the reward goes down (roughly every 4 years). It’s deflationary. In 2140 all 21 million Bitcoins will be mined. Currently we are at 18 million.
In order to recoup the cost of production (cost of ASICs, datacentres, electricity, engineers, etc.) the miners sell the bitcoins. So in theory and practice its value is at least the cost of mining. Like gold mining, if the market price of bitcoin is less than cost of production, the miners can shut down the operation. In bitcoin, miners secure the network. More miners means more hashing power goes into bitcoin and this avoid all sorts of attack vectors. It fluctuates and it recently achieved the all-time high hashing power. Yes, the miners can allocate their power to mine other coins!
What other properties provide value to bitcoin? Like gold, it is harder to mine (requires effort and luck), is not infinite (unlike fiat currency that can be printed by central banks and governments and derives its value from fiat — law that states this note is IOU and can be used to pay tax), is not controlled by a third party (you are your own bank), borderless, verifiable and open source (hard to keep up with developments in this open sourced money).
What makes bitcoin different to other coins? Well, the network effect and market forces. Over 10 years it has evolved organically to have secured the best hashing power and some best cypher punks. Basically, any other coin should provide the miners with equal or better incentive to make them to move their resources from mining bitcoin to another coin. It has to be that good! Boy, have we tried and it won’t be the last. None has succeeded, may never will.
So we have three facets — the miners, the nodes and the developers. And finally the users. We are now on to layer 2 of bitcoin called Lightening Network and it is not a coin or token. It’s the scaling solution for bitcoin on top of Layer 1. Like internet’s TCP/IP there will be more. There will be growing pains.
Other must read:
Bitcoin is an inception point and a beginning. Imagine things you do now with the help of third parties and in future you do peer to peer. Say, property ownership records. Its mind bending to imagine the implications. “Bitcoin may fail. But we know how to do it” — N Taleeb
*accuracy not guaranteed.