The Nature of Bitcoin

| Originally published on on January 12, 2014 |

Note: if you are not  familiar with how Bitcoin works from a technical perspective, you may want to read some background first. It is not strictly necessary, but probably useful. I would recommend this post by Michael Nielsen or the original paper (PDF) by Satoshi Nakamoto.

The first item in my frameworks post was the difference between the Bitcoin protocol and the currency. This is an important distinction, but it is not completely straightforward as both aspects are very tightly interrelated. Thinking of them as distinct entities is actually misleading. This post will discuss this relationship and its implication for the value of Bitcoin and the value of other cryptocurrencies.

Let’s start with the protocol. The underlying Bitcoin protocol is an invention that enables de-centralized, trustworthy transactions between an arbitrary number of entities. Up until now, a 3rd party has been needed as an intermediary (at least for markets above a certain size), usually extracting a fee and often restricting what can be done. Examples of these 3rd parties include banks, stock exchanges, insurance brokers, payment processors, etc.

There are 3 key elements in how the Bitcoin protocol enables these decentralized transactions: 

  • a public ledger (the “blockchain”) of all past transactions
  • the cryptographic encoding of transactors’ identities and the info being transacted, and
  • the work of “miners” to verify a transaction’s validity and formalize it in the blockchain.

An added bonus of these transactions is that there is unprecedented inherent flexibility in the process since they are fully programmable. This post in Umlaut magazine does a great job of illustrating this programmability.

Now this is an important point: the whole system relies on a large number of miners expending resources (computer equipment, electricity) to take potential transactions, validate them and put them into the blockchain. Why would anyone do this? Clearly they need to be compensated and, crucially, this compensation has to be baked into the system or it would otherwise just allow a 3rd party intermediary into the system and defeat the attempt at true decentralization. 

So this “baked in compensation” is where the Bitcoin protocol and the Bitcoin currency meld together, in 2 ways:

  1. a miner who successfuly adds a block of transactions to the blockchain is issued a certain number of Bitcoins as compensation by the system (this will be the case for the next 100+ years in gradually diminishing amounts)
  2. the protocol requires some arbitrary amount of Bitcoins (the currency) to be transferred in each transaction, a portion of which is given to the miner as a transaction fee.

Without this compensation (the issuance of new Bitcoins and the payment of transaction fees in Bitcoins), there would be no incentive to mine (i.e., validate transactions) and the system would fall apart. As we can see, the functionality the protocol enables and the Bitcoin currency itself are very much a single entity: one cannot exist without the other. And this has some implications for broader questions in the ecosystem, including that of value.

Now, let me ask: is it valuable to be able to complete a transaction (e.g., sell property, pay for merchandise)…

  • with anyone in the world,
  • in a very short amount of time,
  • without having to disclose more information than absolutely necessary?

I think anyone would agree that the answer is “yes”. After all, there are many very valuable companies that make money in precisely this way (and are clearly less effective at it). 

So if miners are providing a valuable service and the way they are compensated is via these scarce Bitcoins, which can then be used for subsequent transactions within this system, are the Bitcoins themselves worth something? It seems reasonable to think that they are since they can actually “buy” real work.

In this way, the Bitcoin “economy” has bootstrapped itself into existence. The system does very real, very useful work and compensates the participants doing the work with Bitcoins. Bitcoins that can then be used in, and to power, subsequent transactions and are therefore valuable. This, I believe, is a large part of the intrinsic value of the Bitcoin currency, and it is intimately tied to the way the Bitcoin protocol works (of course, the magnitude of this value is highly uncertain and I’ll leave that discussion for a subsequent post).

A final point, for now, on this value: once we establish that there is value in a Bitcoin (because it can be used to enable future transactions in the Bitcoin economy, which are valuable), then it’s a short leap to use Bitcoins in a fungible way. In other words, they can be used to power a transaction where I pay someone for a cup of coffee (over the Bitcoin system), or where I establish a contract with someone (also over the Bitcoin system), or where I certify the existence of some document (again, over the Bitcoin system). All of these are transactions that require 2 (or more) parties, a valuable medium of exchange and some work to be validated in the blockchain.

Bitcoin is therefore money: a unit that is worth something (a store of value) and that can be used to transact (a medium of exchange).