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How Do Bitcoins Work Anyway?

And what's their future? A roundup for non-geeks

Everywhere these days one hears people foretelling the fortunes of cryptocurrencies such as Bitcoin—like so many fairies, good and bad, wishing around a cradle. Most people, including New Yorker staff writer Nick Paumgarten, have hoped to just avoid the scene, partly because few enthusiasts can even explain what the cryptocurrencies are or why they exist. But Paumgarten dove in and his recent long form article offers helpful explanations along with illuminating profiles of digital currency pioneers.

First, why? Bitcoin and Ethereum enthusiasts want, in Paumgarten’s words, “a better, decentralized version of the World Wide Web—a Web 3.0—more in keeping with the Internet’s early utopian promise than with the invidious, monopolistic hellscape it has become. They want to seize back the tubes, and the data—our lives—from Facebook, Google, and the new oligarchs of Silicon Valley.”

Well then, how? The term enthusiasts kick around is “blockchain”:

Broadly speaking, a blockchain is an evolving record of all transactions that is maintained, simultaneously and in common, by every computer in the network of that blockchain, be it Ethereum, Bitcoin, or Monero. Think, as some have suggested, of a dusty leather-bound ledger in a Dickensian counting house, a record of every transaction relevant to that practice. Except that every accountant in London, and in Calcutta, has the same ledger, and when one adds a line to his own the addition appears in all of them. Once a transaction is affirmed, it will—theoretically, anyway—be in the ledger forever, unalterable and unerasable.
Nick Paumgarten, “The Prophets of Cryptocurrency Survey the Boom and Bust” at The New Yorker October 22, 2018

Now here’s the important part: The records can’t be revised because “everyone is watching, and because the software will reject it if you try. There is no Undo button.” There is also no middleman because everyone has the same records, which are added to by starting new chains.

“Mining,” as in “mining Bitcoin” means getting paid for maintaining and building a blockchain, which requires a great deal of computing power to answer the difficult math problems that bypass the need for the trust which, in traditional systems, stems from government authority. Those with more computing power will make more money, paid of course, in the digital currency.

It’s risky, Paumgarten finds, “… as a store of value, it has proved more fickle than the price of gold or real estate in Peru.” Cryptocurrency enthusiasts tend not to worry too much about the booms and busts because they see them as bumps along the way to developing a new type of currency that does not require government or big global tech involvement.

But who needs that?

The trust machine’s most obvious beneficiaries are said to be the disenfranchised and the so-called unbanked—the billions of humans around the world with no passports or access to any reliable kind of financial system. We may find it harder to see the utility here in our daily lives, where we can rely on Citibank, Visa, Venmo, and Western Union to handle our transactions and keep track of all the money flying around. Amid such a sturdy (if extractive) system, the blockchain can seem like a back-office fix, a change in the accounting scheme, of interest to the systems geeks and bean counters but not to oblivious customers. But if you are, say, a Venezuelan citizen or a Turkish journalist, or a refugee from Syria or Myanmar, the prospect of being able to maintain and render portable both money and identity could be hugely liberating, perhaps even life-saving. Unless you forget your private key.
Nick Paumgarten, “The Prophets of Cryptocurrency Survey the Boom and Bust” at The New Yorker October 22, 2018

Paumgarten’s eventual assessment? “It sure is neat, but for now it lacks its killer app, a use that might lead to mass adoption, as e-mail did for the Internet. ‘We need the hundred-dollar laptop, the iPod,’ a blockchain apostle told me.”

Other assessments span the map of reactions. Warren Buffett has called bitcoin “rat poison squared,” and “not a value-producing asset.” A political economist argues that, because the supply of bitcoin is fixed (to prevent inflation), it would lead to permanent deflation:

The reason is that the world economy is growing and in need of an increasing supply of money to make growing transactions possible. The only way this can be dealt with in a Bitcoin economy is by declining Bitcoin prices of goods and services, i.e. negative inflation. The quantity theory of money tells us that it could also be dealt with by increasing the velocity with which Bitcoins are used, but there is a limit to that possibility. Thus a Bitcoin economy would face permanent deflation, not a very attractive situation. Paul De Grauwe, “Bitcoin Is Not The Currency Of The Future” at Social Europe

On the other hand, a Wall Streeter-turned-enthusiast compares bitcoin to the iPod, which took off when it became available to PC users:

Just like the iPod, the technology behind cryptocurrencies is improving every day…

Developers are testing an innovation called the Lightning Network right now. It will allow bitcoin to essentially go from dial-up modem speeds to broadband speeds. This innovation will unleash enormous capabilities on the bitcoin network.

For example, the Lightning Network will allow bitcoin users to make almost limitless and instantaneous transactions at virtually zero cost. Teeka Tiwari, “Tuesdays with Teeka: Bitcoin’s “Apple Moment”” at Townhall

And, as for adoption, Tiwari notes that the Intercontinental Exchange (ICE), which owns the New York Stock Exchange, as well as Fidelity Investments, Goldman Sachs, Citigroup, and Morgan Stanley are all getting involved. Crypto may or may not be the wave of the future but it’s definitely not just geeks with weird internet handles coding for forty-eight hours straight.

Cryptos only got started in 2009 but there is now typical market competition among them: Bitcoin transactions are becoming more expensive, for example, and Ethereum is faster than bitcoin. The eventual big winner might be a new entrant. Also:

There remains an important question over whether governments will accept currencies over which they have no control. There have been concerns over who uses cryptocurrencies and how they are being used. This could impact all cryptocurrencies, but may in the end benefit longer-standing, better established cryptos such as bitcoin. Cherry Reynard, “What does the future hold for bitcoin?” at The Telegraph

In the end, as with any technology, a great deal will depend on whether cryptocurrencies are seen as solving real-world problems for ordinary people. That, in turn, may depend on the relationships between big tech and big government over the next few decades.

See also: How Bitcoin works: The social value of trust (Jonathan Bartlett)


Is Bitcoin safe? Why the human side of security is critical (Jonathan Bartlett)

How Do Bitcoins Work Anyway?