To begin, let’s start by addressing question: what exactly is bitcoin? Bitcoin is most commonly known and referred to as a digital currency. While this definition of Bitcoin isn’t incorrect, it’s certainly incomplete. At its most fundamental level, Bitcoin is a breakthrough in computer science capitalizing on decades of research into cryptography. The breakthrough was in creating a protocol that allows computers to create a decentralized network over which to securely send digital information. While this may not seem revolutionary at first glance, it is groundbreaking in that it alleviates the reliance on central authorities like banks to handle online transactions.
Perhaps the most practical way to think about Bitcoin is to envision it as an Internet-wide distributed ledger. So what exactly is a ledger? A ledger is a book or database for recording and totaling economic transactions measured in terms of a monetary unit of account and tracking debits and credits to maintain a recorded monetary balance. Traditionally the maintenance of this ledger is entrusted to a central institution like a bank through which the transactions flow. Bitcoin on the other hand is a distributed ledger in that every computer on the network keeps a complete record of every transaction that happens using the network. This means that everyone can see every transaction and must agree that it is legitimate in order for it to go through. Since the system is open and public, anyone with an Internet connection can transact with anyone else in the world without having to go through a central intermediary like a bank.
In this way, the bitcoin “coins” themselves are the representative units for the slots on the ledger. Purchasing bitcoin or selling a product or service in exchange for bitcoin provides access to the ledger. Once you have Bitcoin you can transact with anyone else over the network with your transactions becoming part of this distributed ledger.
This distributed ledger is an entirely new form of payment system. It allows anyone in the world who is connected to transact with anyone else who is connected for any value, simply by transferring ownership of the corresponding bitcoin and having it be recognized and recorded in the ledger. One party puts value in, authorizes the transfer, then the recipient receives it with no effort on their end. Since there is no central intermediary playing a role, transaction fees are drastically reduced. The two users do not need to know or trust each other because only the owner of a bitcoin can send it, only the intended recipient can receive it, the bitcoin can only exist in one place at a time, and everyone can validate transactions and ownership of every bitcoin anytime they want.
While the practical value of bitcoin may best be understood by the distributed ledger analogy, it is also important to understand bitcoin as a digital currency. It is a way to exchange money or assets between parties with no pre-existing trust. In this way it behaves like digital cash because there are no chargebacks and if you have the money, you can pay with it, if you don’t, you can’t. This has never existed in the digital form before.
As a digital currency, its value is based directly on two things: use of the payment system today – basically the amount and frequency of payments running through the ledger – and speculation on future use of the payment system. It is not the case that the Bitcoin currency has some arbitrary value and then people are trading with it; it is more that people can transact with Bitcoin in an advantageous manner and as a result it has value.
However, the Bitcoins themselves are just a conceptual bridge to get people trading within the Bitcoin ledger system, which appreciates in value in direct proportion to the number of transactions that are happening within it, which itself is a direct consequence of the number of people on the ledger. In other words, like other networks it becomes both more valuable and more useful the larger it gets and the more widely adopted it becomes. Ultimately, if you can buy Bitcoins and conduct transactions in a more seamless or lower cost way, then their specific valuation becomes meaningless to you.
So now we know that Bitcoin is basically a distributed ledger system utilizing a digital currency to conduct transactions. We also know that this system allows us to make transactions without a trusted central intermediary, but we haven’t really addressed why that is. To explain this aspect of Bitcoin and its ingenuity we have to take a closer look at the software protocol that underpins the whole system.
For context, it is worth noting that since its inception the Internet has revolutionized the manner in which we are able to share and access information around the world. Consequentially every industry in the information services and communications sectors has transformed in some way. However, there has been comparatively little change in the way we are able to transfer monetary value and thus financial services look more or less the same as they have since before the Internet. While we can pay for things online, we are still using the same payment systems that have been in place for decades.
The central issue concerning digital payments has always been trust. In other types of interactions trust is of significantly less importance. For example, when reading an article on Wikipedia you know that the information may not be 100% trustworthy, but the ease and convenience of finding the information makes it valuable in spite of that degree of uncertainty. Likewise when sending an email we are aware that there’s a slight chance the recipient will not get a message, but the speed and low cost make it preferable valuable for most correspondence anyway. Plus whatever you’re sending can generally just be resent if necessary. Now compare that to sending someone 1 million dollars. It’s not going to be acceptable for that payment to not reach the recipient. This leads us to work with third party intermediaries (like banks) to send payments, and they charge fees to insure against payments not going through or a transacting party being unreliable. Since we can’t trust people on the Internet we’ve gotten used to paying a trusted institution to handle our transactions for us.
Bitcoin finally allows us to make reliable and secure transactions over the Internet, despite the fact that the Internet and those who use it can be untrustworthy.