Bitcoin was developed after the 2008 financial crisis in response to central bank bailout of reckless banking practices which saw the credit crisis.
The first Bitcoin block ever ‘mined’ (the genesis block) included a message in the raw hexadecimal:
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”
There are three problems Bitcoin solves for described below:
- Consensus in decentralisation
- Double spending
Problem 1 Centralised money
Fiat is money that is made legal tender by a government decree. It generally isn’t backed by any commodity such as gold or silver and is managed by a central government authority such as the FED or Bank of England.
While the government authorities create money, manage the supply and work with wholesale banks; they do not operate in the retail and secondary markets for money. This is largely left to the wholesale banks and a huge cohort of intermediaries which support the financial system we know today.
The main issues with this system are:
- The centralised money system can fail as we’ve seen in 2008 because of untrustworthy bankers taking excessive risks trying to make a profit.
- Central banks have become addicted to increasing the money supply. i.e. creating money and buying assets artificially inflating the private sector so that it can stay afloat in times of crisis. For the working class without many assets, this generally reduces the value of money which makes it even more difficult to acquire assets and increases the cost of living because of rising inflation.
- Centralised money can be confiscated by authorities — although this is not common outside of criminal activities there have been cases where withdrawal limits have been put on cash machines or paper money has been discontinued at short notice.
The problem boils down to trust — Central bankers are generally unelected; how can we assess trust of a central banker or the banks and other intermediaries in a financial system effectively?
Problem 2 Decentralised consensus
Clearly centralised monetary authorities have their pitfalls, but what if there was a decentralised system — how could we trust that system?
In a centralised world, we trust our authorities for the truth of who owns what money and that they will custody and transport our assets with care and diligence.
The Byzantine Generals problem describes a problem of truth between two generals (which are akin to decentralised members of a system) invading a city but they are at either sides of the city so rely on messengers to agree the attack strategy and timing.
If general A sends a messenger with, “we will attack at dawn, can you join us?”.
But general B responds with, “no, we need to wait until dusk, can you confirm”.
The problem is how do the generals know:
- The message is the true and hasn’t been corrupted along the way (the messenger could’ve been captured and corrupted)
- Every second part of the message requires confirmation of receipt, resulting in an infinite loop
Essentially how do we agree the consensus between the two members of a decentralised network before we take action?
Problem 3 The double spend problem
Assuming we were able to trust a decentralised system in creating a digital currency — how would we prevent bad actors from spending the same digital value twice?
An alternative version of this problem is what if I were able to spend my digital value in exchange for a good or service and then reverse the transaction, so the value is restored to my wallet.
Not only do we need to trust the decentralised monetary system, we also need to prevent bad actors to ensure its integrity.
Bitcoin’s solution to these problems
Bitcoin is fully decentralised — anyone can create a node to validate the blockchain or mine blocks to maintain the digital payment network.
The ‘money supply’ is fixed to 21 million Bitcoins and cannot be altered because it is written into the software that all the miners and nodes use.
There are no centralised authorities to confiscate your Bitcoin, devalue your money or fail.
As the network is maintained by thousands of independent miners and nodes all over the world, if some were to fail the network would re-balance throughput and continue. The network is resilient.
Bitcoin uses a Proof-of-work consensus mechanism to solve for the Byzantine Generals problem — In order to add blocks to the blockchain, a member of the network must solve complex cryptographic equations. Given the cost of doing these computations is high, it incentivises members to publish honest information.
Every node on the Bitcoin network maintains a ledger which contains the full history of all transactions on the Blockchain. These are continually being verified across all nodes and updated once a new Block is agreed upon to ensure integrity.
If any member of the network attempts to broadcast false information, it is easily recognisable and can be ignored.
As all members of the network maintain the Bitcoin Blockchain in full, there is no need to trust other members for the information, making it a trustless system.
Bitcoin solves the double spend problem by making the whole Blockchain available publicly and through nodes which continually verify the integrity of the Blockchain, a double spend would simply be rejected. The transactions on the Blockchain are also immutable and cannot be reversed.
The more miners and nodes there are and the more blocks that are added to chain, the lower the probability that a false block can be added to the Blockchain. In fact you would need to control 51% of all the miners and nodes to successfully accept false information, and given the processing power to achieve that it can be considered highly unlikely.
It is fair to assume that Bitcoin and the Blockchain technologies will introduce a new trustless type of interaction with corporations and individuals which has been known as Web3.
While this is all very exciting, there are some challenges here which aren’t clear to me how to reconcile at all. For example, if Bitcoin was accepted as legal tender or a reserve currency for your country — what happens in the next pandemic or financial crisis if no one can adjust the money supply to prop up parts of the economy. We could end up in a very dark place without some welfare state view of the world.
Regardless, not all money is mutually exclusive so I would think even if Bitcoin doesn’t become the world’s reserve currency there is enough room to factor it into your investment portfolio and world view.