Synopsis: Ever wondered about what makes crypto valuable? Is Bitcoin really an alternative money? Click here for a cryptocurrency 101 introduction!
This article explains how Bitcoin presents an alternative to the government-issued money system – a cryptocurrency 101 guide, if you will. But before delving into Bitcoin and blockchain technology, it pays to ask something even more basic.
What Is Money?
Money is a human invention for fulfilling specific needs: Keeping track of who owns the wealth, and facilitating transactions from one person to another.
Let’s draw a parallel with another human invention: writing. Writing’s purpose is to record ideas so they can be read later. This can be achieved through carving on a stone tablet, inking marks with a quill onto paper, using a typewriter, or through a word processor on a computer.
The typewriter was an amazing invention when it first came along – it made writing faster, and typewritten words were much easier to read than handwriting. But today, the typewriter has been surpassed. Computers never run out of ink, they have a backspace button, and users can use a computer to cut, copy, and paste text. Almost no modern writers cling to typewriters, except for decoration. Writers use the best available technology to do their work.
Similarly, at various stages of history, money’s purpose has been fulfilled using giant stones, salt, gold, and banknotes. Banknotes are not the only form that money has taken, and nor are they necessarily money’s ultimate, final form. Banknotes might be like the typewriter – a step on the evolutionary path.
Money is just a technology, and like any technology, if something better or cheaper comes along, then – as with the transition from typewriter to computer – the new technology could supplant the old one. This is the cryptocurrency 101 philosophy upon which Bitcoin and all the other tokens operate.
Government-issued money is also known as fiat money. Google ‘what does fiat mean?’, and the following definition is returned:
As this definition suggests, fiat currency is considered money due to “an arbitrary order”. That is, fiat money is money because the government says it is. Anyone who draws a banknote out from their wallet may see the words “legal tender” written somewhere. This means that the issuing government has committed to let the bearer pay taxes with it, use it to settle fines, and pay for licenses and permits which the government issues.
But just because the government has “decreed” that it will accept fiat money doesn’t mean everyone else must use it. For instance, transactions in the United Kingdom are usually settled with British pounds – but there is nothing to stop a buyer from handing over gold, or a giant stone, or Bitcoin, so long as the shopkeeper is happy to accept it. Any method can be used to settle a payment between two parties, so long as both leave the transaction feeling satisfied.
If People Trust It, It Is Real
The form that money takes is less important than the shared social agreement that it represents. Ask yourself – why is gold valuable? Yes, gold has practical uses. Yes, gold is rare and digging it out of the ground is difficult. But much more importantly, gold is valuable because there is a collective social agreement among people. Gold is valuable because other people think gold is valuable.
Cryptocurrency 101: If enough people believe any asset has value, then it does. The same is true of fiat money, and Bitcoin. If you trust the government and banks, you trust fiat money. But according to the 2017 Gallup News poll of Americans, just 12% of respondents said they trust Congress, and only 32% said they trust banks. There is room for an alternative.
Could Bitcoin Act As Money?
For something to act as money, it should be able to satisfy the below eight criteria.
- Unit of account
- Store of value
- Medium of exchange
Let’s run through that list and see how Bitcoin fares.
- Unit of account? Yes. Bitcoin is quantified numerically and can be easily counted.
- Durable? Yes. Bitcoin is software code, and therefore lasts forever. Bitcoin does not have wear and tear.
- Divisible? Yes. 1 Bitcoin can be divided into 100 million (or 0.00000001 Bitcoin). Even though 1 Bitcoin is now worth thousands of dollars, the smallest denomination of Bitcoin is smaller than the value of a penny. It is highly divisible.
- Portable? Yes. Digital currencies like Bitcoin are even easier to move than cash and gold. Bitcoin can be shifted around the world in mere minutes, at very low cost.
- Fungible? Yes. One person’s Bitcoin is no more or less valuable than another person’s.
- Scarce? Yes. There will only ever be a finite number of Bitcoins issued, and getting the newly-issued Bitcoin requires expending computer resources and electricity, through a process called “mining” which is explained here.
- Medium of exchange? Yes. As long as people are happy to accept it, then Bitcoin can be a medium of exchange. Thousands of people around the world are already trading real goods and services for Bitcoin every single day.
- Store of value? Bitcoin’s price is certainly quite volatile versus fiat currencies, leading to a reluctance to use Bitcoin as a store of value. But Bitcoin is no different than gold in this respect. Gold’s price also fluctuates when denominated in fiat currency, but the gold ingot doesn’t change.
Can Bitcoin be money? It is always difficult to trust new technology at first. Those who are old enough to remember life before the Internet may recall warily making their very first payment through online banking. Back then, there were all sorts of questions. Is it safe? Will it work? Will the money disappear in a puff of smoke? Before making that first payment, it was all very uncertain.
Once the “send” button was clicked, the user might have fallen into a panic, half-expecting that their worst fears would be realized and their payment would fall into some unrecoverable corner of cyberspace. However, once they became satisfied that they could trust it, online banking quickly became normal. Trust with Bitcoin similarly needs to grow with knowledge and experience.
The rest of this article lays out the basics of how Bitcoin works. To advanced readers, it will be pretty basic, cryptocurrency 101 level information… but for beginners, it should give the reader enough confidence to trust it. Crypto runs through a distributed ledger, called the blockchain. By the time this article is finished, the reader will confidently understand what these words mean.
Money is, in essence, a ledger. Each person’s bank balance shows how much wealth they own. The previous chapter’s story of the villagers on the island showed that it is essential for social groups to have a way of keeping track of money. Banks have traditionally filled this role by keeping a central ledger, but it results in the kinds of problems that come with trusted third-parties.
By contrast, the distributed ledger that Bitcoin runs isn’t stored in one single place, but on lots of different computers, all over the world, all at once. Bitcoin thus replaces the need for a bank by instead giving every member of the network a copy of the ledger. There are no central points of control. It instead relies on the consensus of the network as a whole. This is cryptocurrency 101.
The validity of a transaction is by majority vote of the miners on the network. Mining will be explained more fully in a later chapter, but for now, think of miners as the replacement for the banks.
Bitcoin’s core innovation, which distinguished it from all earlier attempts, is the blockchain. About every 10 minutes, Bitcoin miners create a new block of transactions data – consisting of people sending and receiving Bitcoin to each other over the preceding period. A transaction is “confirmed” once miners add it to a block, and the block makes it onto the blockchain.
The verification of the transactions that make up the blocks is done through the collective work of the miners. These blocks are arranged in a chronologically-ordered chain – hence “blockchain”.
As new blocks are added to the blockchain, it updates the amount of Bitcoin associated with each address (further described in the next chapter). Once this happens, the computers in the network accept it as a true and fair picture of the state of the ledger. This decentralized architecture removes the need for a trusted third party. Miners update the ledger instead of a bank.
One of the most important things about the blockchain is that it is immutable. Once an entry has been added, it cannot be changed. Think of the blocks in a blockchain as pages in one of the old written accounting ledger books. Once written in ink, it is indelibly there, forever.
Beyond tracking payments, there are other exciting uses for the blockchain technology – including voting, contract enforcement and data records. But that’s a bit beyond the scope of this cryptocurrency 101 article!