A Casual Introduction to Digital Currency: Why Bitcoin and the Dollar Really Aren’t So Different
“It doesn’t have any real value, it just exists on computers!” — Your Financial Advisor in 2017
When most people hear the term “digital currency”, their mind immediately jumps to Bitcoin and Blockchain technology that powers it. While Bitcoin is an example of a digital currency, something you may not know is that the US Dollar is also one.
“Wait, how is that possible? Bitcoin is just magic money that exists on computers, it doesn’t have any actual value!”
Bitcoin and the Dollar are much more similar than you might think. With the exception of paper money (which becomes more obsolete every year), both the Dollar and Bitcoin use a system of digital ledgers to track balances and facilitate transactions. In fact…
At the most fundamental level, both the US Dollar AND Bitcoin just exist as numbers in computers; they are just stored and manipulated in different ways.
How can this be the case? Let’s dive in further…
Disclaimer: The topics and systems are discussed in this paper are, in reality, much more complex than they are presented here. This article is meant simply to give the reader a new perspective on Bitcoin and other cryptocurrencies by examining the functional similarities between cryptocurrencies and our existing fiat system.
I Don’t Understand Digital Currency.
Let’s think about some familiar ways we deal with money every day. It’s rare for most of us to stop and think about these things, since we are so used to just using them in our day to day lives. But when you think about it, the whole thing actually seems kinda ridiculous.
Most of us have an banking app on our phone that shows us the balance in our account. When we get paid from our job, that number in our banking app magically increases. If we don’t have direct deposit, we take a paper check into the bank, and then the number goes up a few days later. When we swipe our plastic debit card to pay for something, the number on the app goes down.
So effectively, we live in a society where a number on an app controls our entire life, and I can swipe a piece of plastic for a burrito.
Absurdity aside, what questions could we ask to give us a clearer understanding about what is actually happening? A few you might come up with are:
- When I open my banking app, where does that number actually come from?
- When I get paid at my job, how does that make the number go up?
- Similarly, if I use my debit card, how does that make the number go down?
- What about if I deposit a check?
I Don’t Understand Banking.
In practice, it’s simpler than you might imagine.
Each bank maintains a ledger. A ledger is basically just a file; a digital log of every transaction that takes place between accounts. It contains the sender, receiver, and amount, and possibly some other information like dates. You might think of it as a very, very secure spreadsheet.
The example above shows transactions between Bitcoin addresses, but these could just as easily be accounts at your local bank, using account numbers and US Dollars instead.
If Bob and Sally both have accounts at the bank, and Bob wants to pay Sally $5, the bank simply records the transaction from one account to the other in the ledger.
- (Bob => Sally, $5)
But what about the balances? How do we know that Bob’s account has $5 he can send to Sally? It turns out, we don’t actually need to store the balances of each account; just by looking at all the transactions going in and out of an account, we can easily calculate the available balance.
- (Dave => Bob, $10)
- (Bob => Sally, $5)
- (Bob => Jim, $3)
- (Henry => Bob, $7)
By looking at the full history of the Bob’s account, we can see he has:
$10 – $5 – $3 + $7 = $9.
So the balance you see on your banking app isn’t just stored in a file somewhere, it’s just calculated from all the transactions in the ledger going to and from your account.
“So, can I just call my friend who works at the bank, ask them to add a new transaction going to my account with a few zeros on the end, and I’m rich?”
Not exactly. Since every transaction is recorded, the balance in every account is the sum of all the transactions that were sent to that account minus all the transactions made out of it. Since we can trace this for every account, it means you can’t just add a random value to a transaction because the money had to come from somewhere; i.e. be subtracted from a different account.
So in order to retire early, you’d have to find an account that already had that balance you want, and then add a transaction from that account to yours. This would be fraud in the form of an unauthorized payment, and there are an extremely extensive set of procedures in place to ensure this doesn’t happen.
So in summary, when you get paid, the bank just adds a row to the ledger showing a transaction from the businesses account to yours. Similarly, when you pay for something, the bank adds a transaction from your account to the account of the business.
On the surface this might seem somewhat confusing, but when you take some time to think it over, it really is remarkably simple. Building on this further, checks and debit cards become somewhat self-explanatory; they are just authorized messages that tell the bank to add a transaction to the ledger from one account to another. When you swipe your debit card, an electronic message is sent to your bank that says,
“Add a transaction to your ledger from my account to the account of this business for X dollars.”
The bank sends back an “OK”, and you get your burrito.
“Alright, this totally makes sense, but I see a problem: there are lots of different banks everyone can use, so what if both accounts aren’t at the same bank? Can an account at one bank send money to an account at another bank, even though they have different ledgers?”
And now the fun begins!
I Sort-of Understand Banking
The way we accomplish this is that banks can have accounts with other banks, just like customers can. Different banks can transfer money between customers by having an account with each other or by both having an account at a different, third bank (most likely a Central Bank like the Federal Reserve).
Let’s say Bank A has an account at Bank B, and vice versa. When Dave, a customer at Bank A, wants to pay Sarah, a customer at Bank B, Bank A records a transaction from Dave to the account it has for Bank B. Conversely, Bank B records a transaction from Bank A’s account to Sarah. These two entries together, each on different ledgers at different banks, represent just a single transaction from an account at Bank A to an account at Bank B.
Bank A Ledger:
- (Dave => Bank B, $10)
Bank B Ledger
- (Bank A => Sarah, $10)
Easy enough. Now let’s say that instead, Bank A and Bank B both have an account at the Federal Reserve Bank. Then the ledgers could look like:
Bank A Ledger:
- (Dave => Bank A, $10)
Federal Reserve Ledger:
- (Bank A => Bank B, $10)
Bank B Ledger:
- (Bank B => Sarah, $10)
At the top of the chain are Central Banks like the US Federal Reserve. As you can see from the example above, each of these banks also has a separate ledger (although by law, the Federal Reserve ledger does NOT have to balance inputs and outputs, which gives them the power to create new currency, or digitally “print” money). Central Banks can even have accounts with other Central Banks, allowing for transactions between countries with different currencies.
All of these ledgers, if combined, would show a full log of all transactions that have ever taken place, with every input matching an output, creating a system that is very difficult to tamper with.
So when we talk about transferring money electronically, it’s not really the money itself we are sending; it’s a message telling banks how to change their respective ledgers. To reiterate:
Money is transferred electronically by sending messages to banks that coordinate changes to their respective ledgers.
Kinda crazy, right?
When you swipe a debit card at a business, that signal is sent through a payment processor like Visa, who coordinates the necessary changes to ledgers for a transaction to occur from your account to the account of the business, regardless of what banks are involved. This makes debit cards a fast and convenient way for all business and customers to interact. Payment processors usually charge fees to businesses for this service, oftentimes about 2.9% of the transaction value. Ever wonder why some businesses give discounts to pay in cash?
Direct deposits, wire transfers, checks, and other mechanisms are really just methods for banks to coordinate changes to their respective ledgers. There is an enormous amount of work put into processing and securing these messages and ensuring everything is as it should be. Clearinghouses like ACH, networks like SWIFT, payment processors like Visa and MasterCard, and apps like Venmo all serve to move currency by adding transactions to ledgers and ensuring the legitimacy of those transactions.
I Understand Banking!
“OK, OK, so I get that digital currency really just refers a ledger of transactions, and we can move money electronically by sending messages to coordinate changes to ledgers. And the whole thing is held together by a conglomerate of banks, networks, clearinghouses, and payment processors. That’s all great, but how is Bitcoin anything like that?”
I Don’t Understand Bitcoin.
If the above statement applies to you, fear no longer, in just a few sentences that will change!
Knowing what you know now, Bitcoin will be shockingly easy to understand. In fact, there are only a few (but key) differences between Bitcoin and the US Dollar as it exists today. Unlike the Dollar, with Bitcoin:
- Instead of multiple ledgers for each bank, there is only one ledger.
- Copies of this ledger are stored on a network of computers around the world instead of servers at banks, and anyone can participate in it.
- Unlike with the Federal Reserve and the Dollar, no central authority can arbitrarily change the ledger and create more Bitcoin at will.
And that’s basically it. Congratulations, you now understand Bitcoin!
Yep! Most people struggle to understand Bitcoin because they don’t understand how the US Dollar is represented digitally. But once you do, it makes understanding how Bitcoin works much more straightforward. And you can see how they are much more similar than you might have originally imagined.
So you understand the basics, but you might have a bunch of other questions like:
- How do accounts work?
- How do we make sure the transactions are authorized?
- If each of the computers stores a copy of the ledger, and anyone can participate, what stops someone from changing their copy? How does everyone “agree” on what the right ledger looks like?
- If no one has the power to create more Bitcoin, where does it come from?
- What’s a Blockchain?
All of these are very valid questions. We’ll start by tackling that last one first.
I Sort-of Understand Bitcoin.
What is the Blockchain in Bitcoin? You’ve probably already guessed the answer.
It’s just the ledger! 🥳
Unfortunately, building this ledger isn’t quite as easy as recording a “from, to, and amount” entry in a file. This is because the Blockchain is distributed, or stored on computers all over the world, instead of on a single server at a bank. In fact, anyone with an Internet connection can participate in storing and maintaining the Bitcoin Blockchain. This is often referred to as running a Node.
Accounts on the Bitcoin network are extremely simple; each account has an address (account number) and a private key (password), which is really just a file containing a code that lets the user authorize transactions for that account.
Just like you use your password for your bank or your PIN on your debit card, private keys are the way to prove your identity to the Bitcoin network and make transactions out of your account. To make a transaction, the computers on the Bitcoin network use cryptography to check that you have the private key for that account, meaning the transaction is valid. Without it, any attempt to add a transaction moving Bitcoin out of your account will not be considered legitimate.
“So, unlike with banks, there is only one ledger called the Blockchain, and every computer on the Bitcoin network stores a copy of it, and transactions between accounts are authorized using special files called private keys. But since anyone can run a Node and store a copy of the ledger, doesn’t that mean anyone can change their copy of the ledger however they want? Don’t we need some way to make sure all the computers have the same copy and that no one is tampering with it?”
Correct. In addition to keeping track of all transactions and checking for authorization, the Bitcoin network must also make sure all of the Nodes have an up-to-date copy of the Blockchain that they all agree is correct. This is a process called consensus.
Consensus is the key element that makes the Bitcoin network possible. Put simply, it is the process by which all the computers come to an agreement on what the correct version of the Blockchain looks like.
This same process also results in the generation of new currency, and completing it is the only way new Bitcoins are created. You may have heard this process referred to as mining. Through a clever combination of cryptography, physics, and economics, all the computers on the Bitcoin network can ensure they are storing the same copy of the ledger.
How this happens exactly is a much more detailed conversation, but a key difference to know when comparing the Dollar to Bitcoin is that, in the latter, the amount of new currency, and how fast it can be generated, is physically limited by computational power and unbreakable cryptography (at least for now).
The network is designed in such as way that the rate of new Bitcoin generation slows over time, eventually reaching a maximum fixed supply of about 21 million (the supply as of March 4th, 2020 is about 18.6 million).
In this way, Bitcoin is really closer to a digital representation of Gold than the US Dollar.
In summary, the US Dollar and Bitcoin are actually very similar in practice, with the exception that Bitcoin:
- Uses only one ledger.
- Stores that ledger on computers all over the world that anyone can control, but cannot freely modify due to cryptography using private keys and the necessary process of consensus / mining.
- Cannot be created at will and has a limited supply that can ever exist.
Whereas the fiat currency system relies on legal contracts and regulation to stay secure, Bitcoin does so through mechanisms like cryptography and consensus. As a result of this, it doesn’t require payment processors, clearing houses, or even banks to function. This has advantages and disadvantages, but the point here is that these two systems effectively accomplish the same thing, but in different ways.
The real innovation that makes cryptocurrencies like Bitcoin possible is ability to store the same ledger across multiple computers in such a way that all computers agree what the correct version of that ledger is and no one can tamper with it. That’s quite an amazing achievement; after all, us humans can hardly agree on anything, so getting a group of random computers all owned by different people to agree on an entire financial history is nothing short of miraculous!
I Understand Bitcoin!
Well, maybe not entirely. But hopefully this article has given you a different perspective on Bitcoin (and other cryptocurrencies) by showing how, functionally speaking, they really aren’t much different from the money we use every day; they simply use different methods to accomplish the same thing. And if I’ve done my job right, hopefully now you can say with confidence…