Why Bitcoin Exists And How It Works

Intro

Most people look at Bitcoin based on recent price moves. When prices rise, it’s “a revolutionary asset that is transforming traditional financial systems”; when prices fall, it’s “a ponzi scheme and the longest standing scam ever”.

The aim of this post is to explain the value proposition of Bitcoin, away from that, away from any price action, away from short-term greed or fear.

After reading this, you will understand in simplistic terms: 1) why Bitcoin exists, 2) how it works.

I’m writing this at the end of 2022, a moment that feels particularly bearish. Friends who were asking how to get involved are now asking if “I still believe in crypto?”, if “I’ve sold my bitcoins, yet?”, if “it’s all going to zero?”.

My love for cryptocurrencies has not waned in the slightest, though, and nor has my long-term bullish bias.

Give me 15min of your times to go through it all.

Traditional Digital Payments And Processes

Let’s say you go to a restaurant with a group of friends but, instead of splitting the bill 10-way, you use your credit card to pay for everyone and ask them to pay you back later.

How will they pay you back?

• Some will make a bank transfer
• Others will send you something on PayPal, Venmo, etc.
• Others will use some local banking service for fast payment (FPS)

All these payments system share something in common: They all required the person to pass by a central entity, which keeps their funds safe and verifies that they’re indeed the legal owners and then transfer the amount on their behalf to another account within that system.

Another way of saying this is: at some point your friend created a PayPal account, sent money to PayPal so that the funds were reflected in their account, then, when they issue a payment, they ask PayPal to send money to that other person’s account.

For most people this works great, especially in stable and developed countries.

Banks, credit cards, Paypal, Venmo, your neo/digital banks are credible entities and people love the security, user experience, speed and legitimacy of it all.

Proponents of Bitcoin don’t fully agree, though. They see issues with these centralised modes of transfer. They think it requires at least an alternative system, where assets would be held by the users themselves and sent to other users directly over the internet, without being held by or passing through a middleman, through a central entity.

Before we move on to explaining some of the issues with traditional -centralised- systems we should understand this: in order to offer their service, banks have to:

• Gather your person details,
• Review and approve the submitted info,
• Store that information on their server,
• Hold and secure custody of your funds,
• Approve transactions when initiated,
• Charge a fee for their business to be commercially viable,
• Process fund transfers with the relevant intermediaries
• Apply general compliance measures (not interact with drug dealers, money launderers, terrorists, etc.)
• Work within normal working hours and within the financial structure of the jurisdiction they operate in.

The above is in place because it works and it makes sense. But it doesn’t work well for everyone nor in all cases.

If money is a tool to purchase/sell goods and services, the tool itself -along with the system it operates in- can vary, be adapted to different needs, and broadly improved on.

Issues With Traditional Centralised Value Transfers

Lack of privacy and/or freedom —

In order to interact in this system you have to provide a proof of ID, a proof address, you contact details, basic info on source of funds, planned activity, etc. That all sounds ‘ok’ until you realise it’s not a given, it doesn’t necessarily have to be that way (and wasn’t for a very long time).

It’s especially relevant for centralised servers (think of PayPal or Venmo or even banks) that can get hacked and release your personal details, your social security number, etc. It might not have happened to you but it does happen.

Holdings are debt-based not owned privately —

When you deposit assets in a bank or a neo-bank, or a prepaid credit card, or an exchange/trading platform…. you don’t hold those assets… not really.

The money is in fact in possession of the platform; and I have a legal right to those assets. But there is an added layer, an added complexity or risk. I must interact with them in order to do things with my funds (trade, transfer, exchange, etc.).

If you hold gold, nobody holds it for you. If you want to give it to someone, you do; if you don’t, you don’t. There’s no other party involved.

In the case of HSBC, I have legal recourse if for some reason they didn’t allow me to access my funds but they’re still held by another entity and that entity can: make mistakes, experience downtimes, kick me out, restrict access based on government request or political misalignment in some countries, etc.

• Disproportionate fees and intermediaries

A philippino maid in Hong Kong needs to send some of her salary to her family back home. A nigerian farmer wants to make a transfer to buy grains from a neighbouring country. Someone needs an emergency influx of cash to deal with a medical emergency abroad… Those things will cost, not just a fraction of a percent but rather several percents, take time, be based on the company’s approval, etc.

Money transfer companies (think Western Union) will charge 3%, in some cases as much as 5% or 10% if you include fast transfer and/or a currency exchange. That’s a MASSIVE difference for people in countries where the US$ 1 can represent a lot of money in the local currency.

So while people in Europe might transfer euros from Belgium to Spain through their banks and not think about it for more than a minute, for other people in different situations, the simple cost of transfer -and the time it takes if intermediaries are needed- can be very impactful.

Even for people in developped countries, sending large amounts of money can take a lot of time and require you to work with the banks’ open hours/days, incur larger fees depending on the beneficiary bank and country, provide more personal information, and in some cases require you to justify the fund’s origin and reason for the transfer (which ultimately isn’t a bad thing, as it prevents money laundering or criminal financing, but you still need to justify it when your transaction is perfectly compliant of course).

• Barriers to entry

Another point that might be missed by most people in developped countries are barriers of entry into the banking or financial system.

In the description of centralised systems, I mentioned the need to go through a KYC (“know your customer”) process, to give a proof of address, justify the source of funds, etc.

In many countries, a staggering number of people can’t even provide that -but still need to interact and be part of the financial systems.

There is more than 1.5 Billion people currently ‘unbanked’ in the world.

Some people don’t have enough funds to put in for the banks to see it worth holding an account for them, others don’t have the ID documentation needed, or some won’t have a recognised address because they live in such remote or underdevelopped areas, or are in countries that aren’t allowed to interact with other countries (even if their specific activity is totally ‘legit’). This is a serious problem that might be easy to overlook but affects so many people and is the reason why alternative monetary solutions (i.e. crypto) has gained most traction in third world countries.

• Prone to reckless monetary policies

While the above issues takled centralised entities from the perspective of the transfer system, another point to consider is the value of fiat currencies themselves (the US dollar, the Euro, the Japanese Yen, etc.).

It would be easy to miss because, for the average consumer, unless there’s a serious inflation spike, most developped countries have a relatively stable currency. But the value of each currency unit very much fluctuates and -on a long enough timeline- decreases. A simple example is that a dollar, a pound, a euro, a yen, a rupiah, whatever it is, buys you less today than it did at the time of your parents or your grandparents.

This happens mainly because the supply of a given currency is controled by the government or central bank of that country, and, there’s very little keeping them in check or stopping them from increasing or decreasing the supply. Many people think that for each euro or each dollar there is an equivalent gold backing in the central bank’s reserve… and that’s just not true. Cash as we know it, is a virtual concept that is enforced by a government which taxes citizens, funds projects, trades with other countries, etc. but it varies greatly based on the countries productivity, resources, action, political takes, international relations, etc.

This, in turn, affects the spending or saving power of individuals -for better or for worse.

In Turkey or Lebanon or Venezuela, decisions made by the central banks caused massive inflation which devalued local currencies massively relative to other foreign currencies but also wrecked havoc in the countries own economy. Things cost more currency unit. Your lira or your bolivar you had saved a year ago doesn’t mean the same thing, can’t buy you the same amount of stuff, doesn’t have as much value in other countries, etc.

This is tough for people who might have saved for decades and find themselves unable to make ends meet. Or in a more corporate way, hurts business with international trade. Or for the country means that the economy is going ‘bankrupt’.

Even in more stable and powerful economies, the currency devaluation is a subtle but serious phemomenon that has a real impact on the livelihood of people -it just happens slower.

• Vulnerable to political incentives

Beyond the obvious moral hazard and the influence politics can have on economic policies -and the impetus to go for the easy/short-term policy rather than the unpopular but correct one, there are other issues with a centralised currency:

One, would be to block access of individuals if, say, their views didn’t align with the country’s views. I don’t mean about illegal behaviour but of protests, activism, and so on which -in many countries- can be enough to freeze their assets.

Two, on an even broader scale, countries can block other countries access to their financial system, assets that would be held in their accounts, commercial deals, etc.

So is there a perfect solution to the above? At the moment, not really, or it’s too early to say. But Bitcoin and cryptocurrencies can be an alternative to that system.

Looking at the above, we want a mode of holding and transfering value that would be:

• Private
• Censorship-proof
• Freely accessible to all
• Unhackable and unseizable
• With a fixed and unalterable supply
• Self-custodied (not held by third parties)
• Enabling digital peer-to-peer transactions (no intermediary)

The big question is how do you construct and maintain something that does that?

Think of the following: in a village of ten people looking to exchange value amongst each other, they can use either a centralised mode or a decenstralised one.

The centralised one resembles banks: they appoint one person they trust, everyone gives him all all their money, go through identification process and then let that person record and handle each transfer they request by updating his ledger (records of transactions). At any given time, the central entity knows who has what.

The decentraslised one is more cumbersome but doesn’t require any trust, any centralisation, any pooling of assets, any identification process. It works like this: each of the ten people have their own ledger (record of transaction) and record how much everyone has at the very start. Whenever a transaction happens between two or more participants, the transaction is broadcast to everyone so that everyone can confirm that:

1. the person initiating the transaction indeed has enough funds,
2. the transaction has taken place and been received by the recipient,
3. everyone has recorded the same transaction and so that everybody’s ledger/record is the same.
4. They then move on to the next transaction and the next one, etc.

The above might look trivial but if you use that system, you’ve essentially created a way to hold and transfer value in an immutable, private, peer-to-peer way. That’s never been done before.

Of course the illustration is about digital transactions and how bitcoin operates.

To take part in the bitcoin network, you don’t need to open an account with a financial institutional or on a website owned by a business, you don’t need to deposit your funds with anyone, you don’t need to reveal your personal details, you don’t need to pass through something to transfer value to someone else (you just send it to them directly), nobody can block you out, nobody can access your funds, nobody can refuse a valid transaction, and, nobody can change the total supply, the total number of bitcoins that will ever be issued. Everything is hard-coded, private, unhackable, intermidiary-less, censorship-proof.

Each transaction is batched into blocks that are reviewed, processed, recorded by the whole network, not just one entity. Then they move on to the next block, based on the consensus reached for the previous block, and so on and so on, thus making a -wait for it: blockchain!

This is what the village illustration shows. You as a user hold bitcoins, other people in the village hold bitcoins, everyone can see which user (wallet address) holds what, when you want to issue a transaction, you broadcast it to the network that then looks at your wallet address (along with any address issuing transaction at that time) to see if the address holds enough bitcoins, if it does, all participants now update their ledger to show you have x-amount of bitcoins less and the recipient address as x-amount of bitcoins more. Once everyone has reached consensus about all the transactions that have happened and the balances of all wallets on the network, the network moves on to new transactions and so on.

An additional note is that on the bitcoin blockchain, in order to prevent any kind of manipulation where one person would bribe the majority to input fake transactions, each transaction recording process requires expanding energy; this means that paying the energy cost of bribing the majority would be greater than simply participating in the network and earning/mining by just processing legitimate transactions.

This is pretty much it, without getting into technicalities of course.

It has massive implications: the creation of a digital asset that has a set supply, isn’t controled by a government, central bank or business, or even by a defined group of individuals but just by all the participants of the network itself, to transfer value directly with each other, without needing to create an account or handover their funds is a revolution akin to or greater than the internet (although of course it is built on the internet).