What Is Bitcoin and Why Was It Created?
Bitcoin is hailed as the world’s first decentralized digital currency – more people than ever before are aware of its existence today. More important than the “what?” however, is the “why?”; in this article I will touch briefly on what Bitcoin is, with a more pronounced focus on the rationale behind the inception of this financial tool that has the potential to be the most empowering in generations. For more information on the mysterious and still anonymous creator(s) of Bitcoin and the events that preceded its creation, please refer to my sister article – Who is Satoshi Nakamoto?
I once dated a woman with very little self control (clearly, right?). Whenever she had more than a hundred dollars or so, she’d give it to me and tell me not to let her spend it. Now, I’m generally cautious with my own money, but if a friend needed to borrow a few bucks for gas, an obnoxiously expensive college textbook, or if it was my turn to buy lunch, I’d have no problem throwing in – with my own money, that is.
Now, imagine if I were to take the money my girlfriend had given me and loan out 90% of it to an acquaintance (or even a stranger) who promised to pay me back what he borrowed, plus interest. How do you think that would’ve sit with my girlfriend, using the money she trusted me to safeguard for personal profit? Would telling her, “Well I kept 10% of it just in case!” assuage her anger? Probably not, and believe it or not, that’s exactly how the “trusted” banking system works in the U.S. – it’s called fractional reserve banking.
Even more absurdly, there are banks who aren’t even required to keep that 10 percent! “Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves. This rate is called the ‘interest rate on reserves’ or the ‘interest rate on excess reserves’, the IOR and IOER, respectively. This rate acts as an incentive for banks to keep excess reserves.” (5).
To summarize, not only is the bank free to use your money to generate profit, only required to hold on to a small portion of it in the event you want to withdraw it – they are paid interest by our government, with our tax money, for every fraction of your money they happen to keep! Obviously, in a situational example with two people this sounds ridiculous – but it’s par for the course in our financial system.
The Subprime Mortgage Crisis
If the possibility for this to go poorly wasn’t readily apparent, let me give you a prime example of this system failing miserably; After the mortgage market froze in the 1930s and banks were unwilling or unable to continue lending, the federal government intervened in an attempt to bring stability to the national housing market (7). This intervention took form in the establishment of the Federal Housing Administration, or the FHA, which protects banks against losses on qualifying FHA-insured loans, making them more willing to offer mortgages to the public – particularly during tough economic times when they might otherwise close their doors (7). As a result of this newfound confidence, in 1949, mortgage debt was equal to 20 percent of total household income; by 1979, it had risen to 46 percent of income; by 2001, 73 percent of income (7). A far more dangerous bubble than the one Bitcoin is alleged to be, this culminated in a situation where the majority of the mortgage lending greedily perpetrated by the banks on the promise of protection from the FHA (using our tax dollars) consisted of existing homeowners refinancing under the impression that they were taking advantage of lower interest rates to extract home equity. “Instead, they often were exposed to complex and risky products that quickly became unaffordable when economic conditions changed” (6), (8). Essentially, the banks hedged their bets on their FHA insured loans, took advantage of the trust the people had in them, and left the homeowner trapped in a situation they couldn’t afford and had no business being in. While the average person was left in financial ruins, often going bankrupt and having their homes foreclosed on, the banks were reimbursed by the FHA (read: taxpayers).
This extreme recklessness led to the bursting of an unsustainable housing bubble called the Subprime Mortgage Crisis. The ratio of household debt to annual income rose to nearly 130%, just under 9 million jobs were lost, and the U.S. entered a pretty severe 2-year economic recession, which many of you likely remember (9). The financial institutions we had put so much trust into had failed us once again, and the common man paid the price while the government bailed out the perpetrators. These bankers knew what they were doing and ignored the inevitable result in the name of profit. There were no arrests (of course, that only happens when the institution feels threatened – see Charlie Shrem), and while programs were altered slightly, in the big scheme of things, all remained the same and many Americans’ faith in the system somehow barely faltered.
For some however, this was the last straw. It wasn’t the first time the system had failed the people, not even close. In the wise words of former U.S. President, George W. Bush,
“There’s an old saying in Tennessee — I know it’s in Texas, probably in Tennessee — that says, fool me once, shame on — shame on you. Fool me — you can’t get fooled again”.
In the wake of this crisis, still in the tail end of the recession it caused, and with George W. Bush and his way with words in mind (at least I imagine) a man or group of persons working under the name Satoshi Nakamoto set out to remove trust in the institution from the equation. Given the political and financial climate of the time and Nakamoto’s reference to the “almost exclusive reliance on third parties”, (like the FHA, etc.) one can, as many others do, safely infer that it influenced its creation.
And so, on January 3, 2009, the infamous whitepaper was posted on a cryptography mailing list (2). But what exactly was proposed? The second portion of this article will focus on a summarization of the technology offered in this whitepaper; what Bitcoin is, how it works, and what problems it solves.
So, What About Bitcoin?
The key point made in Satoshi’s whitepaper was the idea that proof is more powerful than trust; rather than accepting a handshake agreement, transactions should be backed by cryptographic evidence. What this means is that in order to cut the potential cost of mediation between parties and remove this “trusted” third party, Nakamoto envisioned irreversible transactions, with an easily implemented escrow mechanism to protect buyers – all backed by an open ledger of digital signatures called the blockchain.
Allow me to simplify: Let’s say I owe that ex girlfriend of mine $90 because I loaned it out to someone I knew couldn’t pay me back, and surprise – they didn’t. (Sound familiar?). Now, this girlfriend doesn’t trust me anymore, so I would use my Bitcoin client (my automated, trustless, “Bitcoin-bank-clerk-equivalent”) to transfer $90 worth of BTC from my wallet address to hers; this constitutes the transaction message.
Then, the transaction request would be signed with my private key using cryptography to keep it private, at which point it would be broadcast to the ledger network, or blockchain. Now she can see the transaction, and no longer needs to simply take my word for it. Computers all around the world, performing “Proof-of-Work” by hashing complicated equations, would then verify this transaction as legitimate, thereby removing any trust in a third party.
The $90 of BTC appears in her wallet, having been available to verify on-network throughout the whole process. We still break up, unfortunately, since I spent her money after she trusted me with it. Trust is fickle, isn’t it?
The sheer simplicity of the Bitcoin network, coupled with how effective it can be is the real beauty here. The concept of proof of work incentivizes those using computing power to legitimize the blockchain by rewarding them with Bitcoin, and also serves as an initial method of distributing the coins without a centralized authority (2). Once all coins are distributed, those hashing transactions will be rewarded with transaction fees, ensuring a smooth transition after all 21 million bitcoins have been mined, and thus we have a self-sustaining, decentralized currency ecosystem that operates without trust, and without the threat of abuse. Nakamoto was truly onto something, expanding on the idea of those before him, whoever he was.
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