In this post I will try to explain a bit more about Bitcoin by using real life analogies. It will be far from scientific, very incomplete and won’t contain any detailed technical descriptions of the underlying protocol. But I do hope it will shed some light on the subject for those of you who are are new to the world of digital currencies.
You must have heard and read about ‘Bitcoin’ a million times by now. It’s ‘in the news’ all the time. Some people hail Bitcoin as the future of money, which will liberate us from the power of financial intermediaries, others raise a warning finger, saying it will disrupt the system, cause chaos and make you lose all your money. Banks, governments, guru’s, your neighbor, they all seem to have rather strong opinions and entrench themselves along ideological lines, trying to win you over to their camp. You are either for it or against it. It is very rare people actually have a balanced opinion based on an actual understanding of what Bitcoin is, how it works and how it is used.
In fairness, I have to admit I am fairly new to world of digital currencies as well. So in case you see some flaws or can offer additional insights, please drop a comment.
Anyway, let’s get started. Imagine a student house where Lisa, Marc, Jessica and Peter invent a system to keep track of who performed cleaning duties in the house. If you perform some cleaning work and you can proof you actually did the effort, you earn a ‘cleaningcoin’. If you empty the garbage bin, you get 0.1 cleaningcoin. If you vacuumclean the whole house you get 1 cleaningcoin.
It works like this. If Lisa empties the garbage bin and at least two of her housemates can confirm she actually did the work and did the work properly, she is awarded 0.1 cleaningcoin. This is done by adding the following row to a list:
Reward for cleaning duty: 0.1 cleaningcoing to Lisa
Great, now Lisa owns 0.1 cleaningcoin. How do we know? Because it is on the list.
Let’s assume Lisa is in a frantic cleaning mood and cleans the whole bathroom as well. She earns another 0.2 cleaningcoin for this (provided at least two housemates confirm she did the work and that the bathroom is clean).
Reward for cleaning duty: 0.2 cleaningcoing to Lisa
Great stuff. How many cleaningcoins does Lisa own now? The answer is 0.3, as we simply sum the rows on the list where Lisa is the receiver.
You may ask ‘how is this helping me in my understanding of Bitcoin’? Well, there are a few interesting points to make. First of all, Lisa, Marc, Jessica and Peter invented a system (the Cleaningcoin system) for running the house (keeping the house a livable place). Second, they issue cleaningcoins as a reward for performed duties/work. Also, the reward is only received if the work has been confirmed by housemates.
Getting a reward (=incentive) for (confirmed) work, with the greater goal of running the house and keep it clean (=goal), is something you could directly translate to Bitcoin.
Getting a reward for performing work, with the greater goal of keeping the Bitcoin network (of computer nodes) running: That’s a fundamental part of Bitcoin. That’s how they are issued in the first place. Because someone does some sort of job, thereby contributing to running the network, he/she is rewarded bitcoins.
You could say that the house is the network and that Lisa, Marc, Jessica and Peter are the computers in that network. They all contribute to keep the network up and running and get rewards for that in return. It is incomplete and insufficient to fully explain Bitcoin, but in essence Bitcoin is just a digital incentive to drive specific resources and behaviors in a network of computer nodes. Just like cleaningcoins are virtual incentives to get our students to keep the house clean.
You may say ‘but what is the incentive?’ How will owning cleaningcoins benefit – let’s say Lisa – if all she can do is compare her ‘balance’ with those of her housemates? That’s a good question. In our student house analogy, this ‘keeping score’ may very well be the final purpose of the system. For Bitcoin, there is no ‘keeping score’ among network nodes. It is about owning as many bitcoins as possible, preferably more than anyone else.
Let’s assume Lisa, Marc, Jessica and Peter sit together one evening and decide the following: Because not only do you contribute to keeping the house a livable place when performing cleaning duties, you also use valuable energy and resources (which you could have used elsewhere). And as time (and resources) are worth money, cleaningcoins should be worth money. How much? That evening our students decide 1 cleaningcoin is worth 10 US dollars.
Look, now it becomes an interesting incentive. Lisa has earned 0.3 cleaningcoins because she emptied the trash bin and cleaned the bathroom. That earned her 3 US dollars. Given this, she is more than willing to keep the house clean now.
‘But wait’, you might say. ‘It’s useless to own cleaningcoins. Nobody will accept them as valid currency. You can’t buy anything for them’. Good point again. But among our 4 students is a growing trust in cleaningcoin and it’s value. One evening, Lisa is thirsty and craves a coca cola. She happens to see that Peter has an unopened bottle in his room and makes the following offer: ‘Hey Peter, how about I give you 0.1 cleaningcoin for your bottle?’ Peter has to think a bit, but decides it is a fair deal. He has trust in the value of cleaningcoin and confident he can use it later to pay for something he may want from his housemates.
Lisa tells all housemates she wants to transfer 0.1 cleaningcoin to Peter. The housemates check the list and verify that Lisa indeed has a minimum of 0.1 cleaningcoin to spend. They add the following row to the list:
0.1 cleaningcoin from Lisa to Peter
Again, how does this help in understanding Bitcoin?
Well, again the observation here is that our students invented a system of issuing rewards (in cleaningcoins) for the use of resources and energy (to perform a cleaning task). They also agree to an (initial) value in US dollars and in some cases they are even willing to accept it as payment (like for the coca cola). This system simply exists and works because they agreed to it.
That’s how it is with Bitcoin. By using your valuable computer resources (which will actually cost you money) to perform certain tasks and thereby keeping the Bitcoin network running, you are rewarded bitcoins. Bitcoins had an initial value. It was not much, but the point is that it DID have value. Also, in 2010 someone apparently accepted 10.000 bitcoins for some pizza’s. Just like Peter accepted a cleaningcoin for a bottle of coca cola.
Now, this system with cleaningcoins, which have value and can be used as a payment method, works among our 4 students. They all live in the house and keep the house clean by performing cleaning tasks. But how about John? He lives next door in another student house. They don’t have this system and he definitely doesn’t perform cleaning tasks in his neighbor’s house. Is he forever excluded from getting and spending cleaningcoins?
Well, think about this. One evening John visits the house of our 4 students and they brag about their Cleaningcoin system. John really likes it and asks whether he can participate without actually moving into the house and start performing cleaning duties. While they talk, Lisa is thirsty again (don’t ask me why she is always thirsty), and notices that John has an unopened bottle of Mountain Dew (don’t ask me either why everyone seems to walk around with unopened bottles). She has no cash, but remembers she still has 0.2 cleaningcoin. It is a bit of a bold move but she asks: ‘Hey John, how about I give you 0.1 cleaningcoin for that bottle of Mountain Dew?’
John’s initial reaction is ‘wtf?!’, but he then realizes that he can always use his 0.1 cleaningcoin to go to either Lisa, Marc, Jessica or Peter and get something for it in return. So he agrees. Again, Lisa’s housemates check the list to see whether Lisa has a minimum of 0.1 cleaningcoin to spend, after which they add the following row:
0.1 cleaningcoin from Lisa to John.
This is quite a big step. Cleaningcoin left the house! Or did it? Cleaningcoin isn’t a real coin, nothing tangible that John can put in his pocket and bring to his own house. The only record that John actually owns 0.1 cleaningcoin is the transaction on the list in his neighbor’s house. That list doesn’t leave the house.
Now we have come to the point to note that no one has an account with cleaningcoins. How many cleaningcoins someone has is fully documented by the list in the house. Lisa, Peter, John; we know how much they own because all transactions are on that list.
How many bitcoins someone has is documented by a list, with all the transactions. This list – or ledger – is what they call ‘blockchain’. No need for a bank with bank accounts and account balances. Just a blockchain.
Let’s assume John was able to convince his housemate Claire that the 0.1 cleaningcoin he has in his possession has value. He wants to buy some cigarettes from Claire with it. For this to work he has to go to his neighbors and announce he is transferring his 0.1 cleaningcoin to Claire. Lisa, Marc, Jessica and Peter check the lists to see whether John has a minimum of 0.1 cleaningcoin and add the following row to the list:
0.1 cleaningcoin from John to Claire.
As you can see, John can’t update the list himself. He is not part of his neighbors’ house (not part of the network). So instead he announces his transaction, which is then validated by Lisa, Marc, Jessica and Peter and added to the list. Once it is added, the list will show that Claire is now in the possession of 0.1 cleaningcoin.
Again, this is how Bitcoin works. All transactions are announced to the Bitcoin network and the various nodes in the network validate these transactions, before they are added to the list (the blockchain).
You may wonder where exactly this list or blockchain is stored. The answer is that every node in the Bitcoin network has a copy. In our student house analogy this would compare to Lisa, Marc, Jessica and Peter each having a copy of the list.
Whenever they hear about a transaction they check their copy, validate the transaction and add it as a row to their list. They constantly compare their lists so they stay completely in sync.
This is where I will stop with the analogy. There is a lot more to the actual Bitcoin protocol, how the list (blockchain) is updated, who gets rewards (in bitcoin) for exactly what type of work, how security is handled, etc. But the essentials of how Bitcoin came about and how it works should be clear.
In short, bitcoins are digital incentives for performed work (=use of computer resources and energy). Bitcoins have actually left the house (=bitcoin network of computer nodes) as people started to accept bitcoins as payment for real life services and products. As more and more people started to trust the value of bitcoin and accept it as payment method, demand grew and so did the value.
Let me offer a final note on what I started with. The divide between those who hail the arrival of Bitcoin and those who keep warning against it. Who is right?
In my view, it really depends on how you approach it. Could it be that bitcoin is currently overvalued and that a crash is imminent? Could be. Will bitcoin continue to rise and gain even more trust and acceptance? Yeah, why not? But to me this is a bit beside the point. Currencies may rise and fall, but the key is that Bitcoin represents a system, a technology, a shift in thinking about how financial transactions can be handled, validated, recorded, secured, etc., without the need for banks. You may like it or not, but this move from centralized systems to more decentralized setups is a wave that is already coming and washing over us. At its core, Bitcoin is blockchain technology, which enables decentralization, networks where many network nodes serve some greater purpose, just like Lisa, Marc, Jessica and Peter invented a system to serve the greater purpose of keeping the house clean. Blockchain technology will be the backbone for many other developments, not only those related to financial transactions. It will reshape existing businesses and create completely new ones. Most importantly, it is here to stay, whether Bitcoin (or any of the other digital currencies) will rise or fall.