We recommend that you have already read: Why Bitcoin? & Where is Bitcoin?
“What is Bitcoin?”
“What are we transferring?”
On the contrary to other “peer to peer” systems like BitTorrent, “What are we transferring?” becomes a very relevant question in Bitcoin, when we are transferring economic value instead of digital content.
If we are sending video files, it’s not essential which and how many movies, songs or tv-series are stored in the system. Every user can basically upload an indefinite number of files and the whole network benefits from this by having more content to consume.
But knowing what we are transferring becomes crucial in an economic system. If in an open and “permissionless” financial system would allow entering an indefinite number of basic units into the ledger, everyone would clearly do so. Who wouldn’t love to be able to print more money for themselves every time when necessary? Of course, it goes without saying that this option would also make the value of this basic unit decay very quickly.
Let’s imagine that I give my Netflix password to a friend of mine as a compensation for a good or service. The value of this password immediately decreases since now there are two of us using the password. If this friend and his friends pass it on to a hundred more people, the value will decrease even more. And in the end, the password will be so widespread that its value will be practically zero.
We can, therefore, see that in the digital world, producing scarcity is difficult. Digital information by nature is not scarce. It tends to be infinitely reproducible. I have a piece of information, I pass it on to you, and now we automatically have two copies of this information without really creating anything new or anyone giving anything up.
Clearly, however, digital money cannot work like this. In order for something to be scarce, that something has to be very hard to replicate. In Bitcoin, we have an accounting ledger (the blockchain) and a method (the digital signature), that allows us to determine who has the right to move units of value. But we are lacking something. A method to determine who can deposit units of value in this ledger. In other words: “What are we transferring?”
The technology that is used to solve this problem precedes the invention of Bitcoin. It goes back to the years 1990-1996 when Dr. Adam Back was solving a totally different problem. The problem of spam on emails.
His question was:“How can I avoid spam if I can’t create a whitelist of all of the authorized addresses who can write to me, or a blacklist, which would be a list of addresses that can’t write to me?”
His solution was to create the so-called “Proof of Work”. In this system, basically, anyone can verify that a certain amount of work/computer processing, and therefore computing power, has been used to create a certain value.
The way the Proof of Work mechanism works is quite simple. Basically, there is a deterministic and irreversible cryptographic fingerprint from a certain document that leads us to a certain function called a “Hash”. This hash is easy to verify once we have the document, but it is not easy, actually, it is nearly impossible, to recreate the document from the hash.
In the case of Proof of Work, what we are asked to do in order to create Bitcoin can be described as follows:
Every time we want to deposit Bitcoin (create new units to the blockchain), we have to make several attempts of guessing a random number to our deposit string and we have to change this random number (called the nonce) until the cryptographic fingerprint of our deposit, the hash, is demonstrably no smaller than a certain number called “difficulty”.Basically, this means that we have to find a number that starts with a required amount of zeros and finding that number proves that a certain amount of computer resources have been used to find this number. This is Proof of Work. We (our computer) have worked to find this number.
But we will see that this alone it is not enough to guarantee a form of money that is actually difficult to create. Proof of Work in itself does not guarantee that the supply of this currency, this digital gold, is not elastic in relation to demand.
We have seen that gold has a very important characteristic. If the demand for gold from the market grows, resulting in the price to increase, the production of gold in mines also increases. For example, it’s worth it for miners to expand mines with higher costs since the new gold they can potentially find would cover the extra expenditure. But this extra inflation of the gold supply doesn’t take place “over night”. Expanding mines takes time, so there is an inelasticity of supply in relation to demand.
However, when we consider using the computing power of some machines to prove that a certain amount of computing power has been used, Proof of Work does not have this inelasticity characteristic.
In fact, the Proof of Work designed for Hashcash by Adam Back in the 90s had the characteristics of being substantially very inflatable as a form of currency. Because with the increase in the performance of computers and with the improvement of processing power, it was possible, with the passing of each month, to produce more and more proofs of work. In other words, the computing mechanism solving a certain cryptographic puzzle became less and less expensive to perform.
For this reason, when the creator of Bitcoin, Satoshi Nakamoto had to face the problem of the scarcity of Bitcoin and the cost of producing it, he used the Proof of Work idea of Hashcash but added features to it.
In order to deposit Bitcoin on the ledger, you have to prove that you have spent electricity and machine power, however, an algorithm of automatic adjustment of the difficulty was added to make sure that the more computing power is used to make the deposit (i.e the more Bitcoins are created), the greater the difficulty of the puzzle that has to be solved. This means that the previously mentioned “difficulty” number under which I have to stay when looking for the solution to my puzzle becomes prohibitive, becomes difficult. Difficulty increases with the increase in production.
This makes Bitcoin the first case of an asset with an almost totally inelastic production in relation to the demand. It means that when more Bitcoins are demanded by the market and resulting in the value of Bitcoin to rise, the difficulty to create more Bitcoin increases immediately along with the incentive to create more of it.
So the Bitcoin system always tends to make it more difficult to create new Bitcoins when there are many people who compete to create new ones,and instead, it is easier when there are fewer people who compete or when the technological means are less developed.
This means that if many miners (as Satoshi Nakamoto has called those who extract new Bitcoins and engage in this Proof of Work mechanism that can be verified by anyone) extract bitcoins with increasingly powerful machines, the difficulty increases and it becomes more difficult to produce Bitcoins. On the other hand, if fewer miners continue to extract Bitcoins, or if the machines are turned off or become for some reason less powerful, the difficulty automatically drops, but the production is always kept in balance around a predetermined figure.
This predetermined figure is basically 50 bitcoins every 10 minutes. There is a sort of chronology inside the bitcoin blocks which guarantees that if more bitcoins are produced than 50 every 10 minutes, the difficulty goes up, if less are produced, the difficulty goes down.
But this number 50 is not fixed to be constant forever. It is actually halved every 4 years to create a total number of Bitcoins that, due to the characteristics of this mathematical series, tends to decrease over time.
For the first 4 years after creation 50 bitcoins are produced every 10 minutes, for the next 4 years only 25, for the next 12.5, then 7.25 and so on, approaching more and more a number closer to zero. And thus approaching a total number that comes closer and closer, without ever being able to reach it, to the famous 21 million units.
When we say 21 million we also don’t mean 21 million minimum units. Bitcoin is divisible to the eighth decimal place, so it is not necessary to spend whole Bitcoins since we can spend a hundred millionth of a Bitcoin. This is also the reason why even if a huge economy would be built on Bitcoin, a Bitcoin would be simply worth a lot more and we could just exchange very small fractions of it.
So what is Bitcoin? It is basically energy turned into value.