The Bitcoin Basics

Hi everyone, welcome back to The Bitcoin Course. Now that we’ve discussed at a high level what bitcoin is and how it works, let’s take a moment to analyze it in the context of the financial landscape today.

Since bitcoin is a new form of money, let’s begin by first asking ourselves: what exactly is money?

What is money?

Money is generally defined as something that can be used as a medium of exchange between equal values of work and resources. In this way money can act as a store of value, a unit of account, and as a medium of exchange.

When discussing how bitcoin functions as both a currency and as a payment system, it’s useful to understand how society has transferred value historically. Over many generations, people have adapted different mediums to transfer value amongst them, and each of these methods has responded to inefficiencies in the methods that preceded them.

Historically, people used the barter system in which they traded something they owned for something they wanted.

The medium of exchange in this system ranged from livestock to grains to textiles depending on what groups had in supply or needed from others.

The value of these goods is not guaranteed in any way, rather the parties have the obligation to inspect the goods and determine their unique value themselves. There is also no traditional manner of recourse if one party changes their mind after the deal.

Bartering is quite limited for a few reasons. First, it relies on parties having complementary needs (or a coincidence of wants as it is often called).

Second, there may be an absence of a common measure of value between the parties.

Third, many items are not easily divisible, and finally, perishable goods depreciate in value quickly.

The limitations of the bartering system led to the rise of commodities as a method of transacting. Gold was the most popular commodity to use primarily because people valued its physical properties.

So what made gold so good to use?

Gold is scarce (so there’s not too much of it), durable (so it will last over time and use), divisible (so it’s more practical to exchange), and distinctive (so it’s hard to fake)

In practice, gold was used much like bartering. There must be a physical delivery of gold for the transaction to occur, and there is no recourse available after a transaction.

There is also no central authority guaranteeing the value of gold, rather people maintain a belief that gold will remain desirable in the future in determining its present value. While it was more convenient to trade with gold than to barter, people were still limited because storing and transporting gold can be fairly difficult.

Since gold was not extremely practical, countries began developing paper money to act as placeholders for easier use. In the US, cash was traditionally backed by a set amount of gold.

However, this “gold standard” eventually gave way to the fiat money we see today. Instead of a one to one relationship between paper notes and a physical commodity, governments simply declare that the paper notes have value and can thus be used in commerce.

In this system, the underlying value of cash is rooted in the trust people have for whatever government is backing the currency.

An important consequence of fiat money is that there is now an unbounded supply of money. Governments can print more money at will as a political tool, devaluing the money already in supply.

In many ways bitcoin is a return to a currency that is backed by its own inherent usefulness. As gold is valued for its unique physical properties, bitcoin is valued for unique properties that make it what it is.

When analyzing why bitcoin is valuable, it’s important to distinguish the protocol from the currency. The Bitcoin protocol creates this decentralized ledger for secure transactions that we’ve discussed before, and in order to use the ledger, you have to buy some bitcoin (the currency). It is the access and ability to use this ledger system for transactions that provide an underlying value to bitcoin.

Thus while the exact valuation of a bitcoin might fluctuate as the system grows and matures, the underlying value of the protocol will drive the value of the currency.

Alright, so we can see that using a virtual currency maybe isn’t all that unusual considering how people have transacted in the past. We still haven’t really addressed why it might be more advantageous to use bitcoin though.

To do that, let’s look at some of the inefficiencies and limitations of existing payment platforms.

What are the limitations of legacy payment platforms?

Many of the problems with the existing payment platforms stem from the fact that they rely on central intermediaries to handle transactions.

As we discussed before, non-cash transactions have historically relied upon some degree of trust. In order to trust that money is being transferred reliably, we have relied on central institutions like banks to manage the transactions.

However, that service comes at a price.

For one, the infrastructure of these legacy payment platforms is old and expensive to use. This leads to institutions having to charge transaction fees simply to cover their own costs to use systems like ACH or SEPA. The transaction fees serve to pass these costs down the line to merchants and consumers, increasing transactional friction.

In addition to paying simply to use the payment rails, transaction fees are bloated by costs associated with insuring against credit card fraud, bad debt, paying for customer support, rewards programs, and the cost of covering purchases before people actually pay off their credit cards.

This often leads to credit card fees of 2-3% for normal transactions with cuts going to the banks and payment processors involved. It’s important to note that these rates have remained relatively the same for decades.

You’d think decades of massive innovation in the technology space would find a way to drive those prices down, but there has been no real competition in the financial services space that has been able to accomplish this because they all rely on the same antiquated systems, and the banks are perfectly happy with the status quo.

What are the advantage of Bitcoin?

This is where the decentralized network concept underlying bitcoin is so important, as banks are no longer a necessary party to transactions.

While the high cost of transaction fees has been a significant drawback to the legacy payment platforms, bitcoin is not free of fees. When sending a bitcoin transaction over the network, you depend on one of the miners to confirm your transaction and add it to the blockchain. In order to convince one of these miners to bother processing your transaction, it helps to include a small fee that goes to the miner.

Where this differs from the cumbersome transaction fees of the legacy systems is that the decentralized network essentially creates a fluid open market for these fees rather than having them set arbitrarily by the banks or credit card companies.

You will only end up paying the actual cost it takes for a computer to process the transaction and include it on the blockchain. In the near term these transaction fees are subsidized by the mining rewards, but as bitcoin production slows the transaction fees are expected to reach an equilibrium approaching the true cost of processing a transaction.

Companies that arise to make transaction simpler and more seamless for consumers and merchants may charge fees on top of this for their services, but the ability for people to transact over the blockchain themselves will act as a natural competition to keep these fees at a reasonable and competitive rate.

In the past, this fundamental level of competition has never existed in the space and thus the market price has not been forced down.

So now that we know a little about how bitcoin will drive transaction costs down, let’s take a look at the relative risks involved in the old platforms versus bitcoin.

Since it’s not necessary to entrust any third parties with your personal or financial information in order to use bitcoin, credit card and identity theft are not a risk when using bitcoin.

When using cash, there’s always the risk of running into counterfeit bills. With bitcoin on the other hand counterfeiting is not possible which reduces risk and potential costs.

While fraudulent and counterfeit purchases are eliminated with bitcoin, so too are chargebacks. A bitcoin transaction is irreversible unlike a credit card charge, and this significantly reduces costs for merchants.

And while bitcoin theft has occurred in the past, all of these breaches have exploited weaknesses unrelated to the protocol itself.

How does Bitcoin change international transactions?

It’s also important to note that the payment systems we’ve been talking about, while standard for most modern Western countries, are much less reliable in many parts of the world.

In fact, transacting between different countries can be an incredibly complex and expensive process. Many people in the bitcoin space have identified the area of international transactions as an area where bitcoin’s transformative potential is most promising.

Right now, if you want to send money from the US to, let’s say somewhere in Asia, you’ll have to not only pay large fees to exchange currencies, but also pay large amounts because the two countries are going to have different banking systems that don’t actually connect to each other.

Bitcoin on the other hand is goegraphically unbound and thus can be easily accessed by anyone in the world with an Internet connection. This means that the large unbanked populations around the world can now transact in the global marketplace.

One of the most readily identified use cases of bitcoin as an international payment platform is the remittance market. A remittance is when someone who works in one country sends money back to friends or family in another country. Current estimates put the global remittance market at over 500 billion dollars, and these transfers are rife with fees and other transactional hurdles that cut out massive amounts of the money being sent.

Christopher Smith discusses what money is, what makes good money, and how bitcoin compares to our notions of good money

Watch this interview on Youtube: https://www.youtube.com/watch?v=BSxe15lgkWc

Christopher Smith discusses what money is, what makes good money, and how bitcoin compares to our notions of good money

Watch this interview on Youtube: https://www.youtube.com/watch?v=BSxe15lgkWc

Greg Brockman, the CTO of Stripe, discusses the underpinnings of Bitcoin and how it allows people to transact over the internet like never before.

Nick Tomaino, Business Development at Coinbase, discusses what it's like working with merchants who want to accept Bitcoin and the potential for future payment innovations

Watch this interview on Youtube: https://www.youtube.com/watch?v=DOgZy6-nO5s

Nick Tomaino, Business Development at Coinbase, discusses what it's like working with merchants who want to accept Bitcoin and the potential for future payment innovations

Watch this interview on Youtube: https://www.youtube.com/watch?v=DOgZy6-nO5s

Brian talks about the problems people have transacting in the developing world and how Bitcoin can revolutionize international transactions

Hello everyone, I'm here to tell you some more about bitcoin, specifically about how the bitcoin protocol works. I will assume the audience has at least a basic understanding of how money works, and I will be smearing out some details to make things easier to understand. If you ever want to know more of the details, you can do research online.

Bitcoin is a digital currency. Most people think of money transfer as taking place physically, like Alice gives Bob a $1 bill for some vegetables. However, if you've ever sent money overseas, you might have done a wire transfer, which doesn't involve you handing anyone dollar bills. Instead you call your bank, convince them you are who you say you are, tell them how much to send, where to send it and which account to take it out of. So we shouldn't be shocked at the idea of digital or non-physical money, since that's been around for a while in the form of wire transfer.

To understand bitcoin a bit better, let's first look at how the bank does the wire transfer. The bank has a big ledger or spreadsheet with all of their customers' personal and account information. When Alice calls them and claims to be Alice, she gives them enough information about herself, maybe where she grew up, a secret number and the name of her first love, to convince them that she really is Alice. That's called authentication; the bank wants to be reasonably sure the request is authentic. Then Alice tells them she wants to wire $1 to Bob's account and the bank makes sure that Alice actually has enough dollars in her account to pay Bob along with all the bank fees and if she does, then they send the money. So that's how banks do wire transfers.

There's something important in all this, and that's how much trust Alice has to place in the bank for this to work. The bank has control over her money. The bank has a lot of her personal information. The bank could lie to her about how much of her money is there and she probably wouldn't find out. It's a very privileged position.

Sending bitcoin is actually very similar to sending a wire transfer, except there is no bank. Instead of a bank, bitcoin uses peer-to-peer networks, digital signatures and proof of work to accomplish the same task of transferring value. We're going to talk soon in more detail about each of these technologies, but first let's walk thru an example.

Let's say Alice wants to send 1 bitcoin to Bob. She doesn't have to physically hand anything to Bob. Remember the requirements to wire money? Alice had to authenticate herself or prove she was who she said; she had to say how much to send, where to send it, and where to take it from. So Alice creates a transaction, which is just a message with the to, from and amount listed and digitally signs it. Then she announces it to the bitcoin network thru the internet and the network starts gossipping about it 'Did you hear Alice sent Bob 1 bitcoin? Did you hear Alice sent Bob 1 bitcoin? Did you hear...'. After a few seconds, the whole network has heard about it.

Bitcoin miners are part of the network, so they hear about the transaction and put it in a block with other transactions. Then the miners start the proof of work and when they do enough work, they announce the block to the network and Alice's transaction to Bob becomes official.

(Check out the external link for another good visual representation to supplement the lecture!)

Let's talk about peer-to-peer networks.

There are thousands of computers around the world called bitcoin nodes that are connected to each other in what's called the bitcoin network. Anybody who has a computer and an internet connection can become a bitcoin node. Each bitcoin node is connected to or knows about several other bitcoin nodes called their "peers". They are called "peers" because no bitcoin node is more authoritative than any other, which is why the bitcoin network is called a peer-to-peer network, instead of a master-slave network.

Bitcoin nodes hear about transactions and pass them around to their peers. After a little while, every computer has heard about them. The peer-to-peer architecture enables all the bitcoin nodes to update their shared ledger, the blockchain, in the same way without trusting any node more than the others.

(For a map of all the Bitcoin nodes check out the website in the lecture supplement.)

Ok, now let's talk about public key encryption briefly, since digital signatures are a type of public key encryption.

Public key encryption might sound complicated, but the basic idea is simple. The core thing to understand is the idea of a trapdoor function. It's all about things being difficult to reverse. It's easy to light a piece of paper on fire, but it's difficult to reconstruct the paper from the ashes. So a trapdoor function is something that's easy to apply, but difficult to reverse.

Ok. How do the trapdoor functions work?

Each person has two numbers called the public and private key. We call them keys because both of them can lock and unlock things. The public key is used to apply the trapdoor function. It's public, so anyone can do it. The private key is used to reverse the trapdoor function, and since it's private, only you can do it.

So how does the digital signature work?

You take a message and encrypt or lock it with your private key. Then you send it out to whoever and anybody can decrypt or unlock the message with your public key. The reason it's called a digital signature is because if somebody tries to change the message, they won't be able to encrypt it to make the digital signature because they need your private key to do that. It's difficult to forge, but easy to check.

Digital signatures can be read by anybody, but only you can write them, sort of like a handwritten signature, but better. Bitcoin uses digital signatures to verify that someone is spending money from their own account, not someone else's.

Imagine you go to a foreign land, and you hear about a great wonder of the world there.

Imagine you ask a man named Jerry where it is and he takes you to a small office building and says "This is the wonder you seek". You probably wouldn't believe Jerry right? Why would an office building be considered a wonder of the world? So you keep looking.

You come across a woman named Sherry and ask her "Where is this great wonder that I have heard about?" and she takes you to a gigantic pyramid. "This is the wonder you seek." she says. Sherry is much more believable than Jerry, right? The pyramid clearly took a lot of work to make it. That's what makes it a wonder.

Proof-of-work is a similar idea, except it works with numbers instead of buildings.

An important fact about numbers is that most numbers are big, however you define "big". Proof of work uses another trapdoor function, like with digital signatures, but instead of making something that is difficult to forge, it uses something that is difficult to predict.

So I put a number into this trapdoor function and hash it, as it's called, and it outputs a completely different number in an unpredictable way. If I hash another nearby number, the output is completely different from the previous output. So now if I come to you with a big number that when you hash it comes out as a really small number, that's evidence that I searched thru a lot of numbers to find it. Most of the big inputs hash to big outputs, because most numbers are big. So that special input that comes out small, it's like a block in the pyramid, evidence of a lot of work. You can't just take a small number and run the hash backwards because it's a trapdoor function, it doesn't go backwards. So that's proof of work.

Bitcoin uses proof of work to determine which version of the blockchain is the real one, which makes falsifying the history of the bitcoin economy very difficult.

Say Jerry and Sherry from earlier both come to you with different versions of the blockchain and Jerry's blockchain has a bunch of big numbers that hash to big numbers, where as Sherry's blockchain has a bunch of big numbers that hash to small numbers. Sherry's blockchain, like the pyramid, represents a lot more time and effort, a lot more work, because small numbers are rare, so her blockchain is probably the one that everyone has been working on.

To summarize, let's go thru the example with Alice and Bob one more time.

Alice wants to send 1 bitcoin to Bob. She creates a message saying 'I, Alice, want to send 1 bitcoin to Bob's account'. That's the transaction.

Then she encrypts or locks it with the private key to her account, making a digital signature. Then anyone can unlock the digital signature with her public key to see that she is indeed who she says she is, but nobody can change it and relock it without her private key.

After digitally signing it, she announces it to the nearest bitcoin node, which then begins spreading the news of the transaction to all its peers, who in turn spread it to their peers and so on until the whole peer-to-peer network has heard about it.

Meanwhile, at some point a miner will hear about it and put it in a block, which is basically a bag of transactions. Text is the same as numbers to a computer, so the miner then treats that block as a big number and starts searching for another number to stick on the end of it so that the two numbers together hash to a sufficiently small number. This is the proof of work. When a miner finds that special number, the next block is said to be mined, and Alice's transfer to Bob is complete.

Ross discusses the Bitcoin protocol, explains the blockchain, and talks about developments in Bitcoin mining

(See the supplement for a breakdown of existing mining pools.)

Olaf Carlson-Wee, Head of Risk at Coinbase, discusses his vision for Bitcoin's future and how Coinbase works to secure Bitcoin for users

Watch this interview on Youtube: https://www.youtube.com/watch?v=y-qLJ_uxqho

Olaf Carlson-Wee, Head of Risk at Coinbase, discusses his vision for Bitcoin's future and how Coinbase works to secure Bitcoin for users

Watch this interview on Youtube: https://www.youtube.com/watch?v=y-qLJ_uxqho

Chris walks us through the Bitcoin mining process and how it contributes to the blockchain

Watch this interview on Youtube: https://www.youtube.com/watch?v=pgZ1GeT9rAg

Chris walks us through the Bitcoin mining process and how it contributes to the blockchain

Watch this interview on Youtube: https://www.youtube.com/watch?v=pgZ1GeT9rAg

Adrian talks about the ability for anyone to use the Bitcoin protocol to build exciting new companies

Watch this video on Youtube: https://www.youtube.com/watch?v=qJv5Tvb0738

Adrian talks about the ability for anyone to use the Bitcoin protocol to build exciting new companies

Watch this video on Youtube: https://www.youtube.com/watch?v=qJv5Tvb0738

A big part of what makes bitcoin so exciting is the vast array of potential innovations that can happen with the technology. Now that we’ve learned how to understand bitcoin at a high level and some of the potential uses it can have, let’s meet some of the individuals who are working in the space right now.

We’ll learn how these innovators first got involved with bitcoin, how they’re utilizing their unique skills and experiences to tackle interesting challenges in the bitcoin space, and how they see bitcoin changing the world in years to come.

Tim Draper, founder of Draper University, discusses what inspired him to invest in the Bitcoin ecosystem and how the technology can transform the world

Watch this interview on Youtube: https://www.youtube.com/watch?v=YGxOHR1vnSo

Tim Draper, founder of Draper University, discusses what inspired him to invest in the Bitcoin ecosystem and how the technology can transform the world

Watch this interview on Youtube: https://www.youtube.com/watch?v=YGxOHR1vnSo

Adam discusses his decision to launch a Bitcoin focused VC and the potential Bitcoin has to revolutionize financial markets across the world

Watch this interview on Youtube: https://www.youtube.com/watch?v=kRwVWPDdYH8

Adam discusses his decision to launch a Bitcoin focused VC and the potential Bitcoin has to revolutionize financial markets across the world

Watch this interview on Youtube: https://www.youtube.com/watch?v=kRwVWPDdYH8

Adam discusses his decision to launch a Bitcoin focused VC and the potential Bitcoin has to revolutionize financial markets across the world

Watch this interview on Youtube: https://www.youtube.com/watch?v=kRwVWPDdYH8

Matt discusses common misconceptions about Bitcoin, what needs to happen for widespread BItcoin adoption, and some exciting future use cases for Bitcoin technology.

Watch this interview on Youtube: https://www.youtube.com/watch?v=IbJbuPJTc8c

Matt discusses common misconceptions about Bitcoin, what needs to happen for widespread BItcoin adoption, and some exciting future use cases for Bitcoin technology.

Watch this interview on Youtube: https://www.youtube.com/watch?v=IbJbuPJTc8c

Derek discusses the hiring market in the Bitcoin space

Watch this interview on Youtube: https://www.youtube.com/watch?v=vQdB_onpR9Q

Derek discusses the hiring market in the Bitcoin space

Watch this interview on Youtube: https://www.youtube.com/watch?v=vQdB_onpR9Q

Here we'll point you in the direction of some good places to start researching which wallet service might be right for you

Chris shows us how easy it is to make an online purchase using bitcoin!

For those who want to get even more involved, Chris walks through how to turn your computer into a Bitcoin node

Chris discussed the open source nature of the Bitcoin protocol and why it's important

Daniel discusses how the Bitcoin ecosystem and public perception has evolved over the last two years

James discusses the patent filing proess and how different types of IP protection can be useful to innovators in the Bitcoin space

Teemu discusses how storing and transacting with bitcoin compares to traditional forms of money regarding your security

Watch this interview on Youtube: https://www.youtube.com/watch?v=8aKRZmMwwcM

Teemu discusses how storing and transacting with bitcoin compares to traditional forms of money regarding your security

Watch this interview on Youtube: https://www.youtube.com/watch?v=8aKRZmMwwcM