⌛🪶Bitcoins: Explain Like I’m Five
Unless you have been living inside a cave, I am pretty sure you have come across the word Cryptocurrency. Either in the news, on social media, or with your enthusiastic crypto trader friend. Many people find it hard to understand how this currency works or what gives it legitimacy. I will cover all these in today’s article.
Today’s article is divided into two parts:
- A layman's explanation of what cryptocurrency is?
- How did this new currency originate?
Let’s begin!
Understanding Cryptocurrency
Game Time
Consider yourself sitting in a classroom with 30 other students. I, get the role of the teacher and ask all of you a question.
Find a unique prime number that ends in “99”.
Anyone who finds a number will be given a “Superman” card.
You start checking primes on paper. 17, 19, 23…71, 73, 79….173, 179, 181
Suddenly your friend Alex shouts.
199!!
I check the solution. Yes, it is a prime number ending in 99. Alex gets the Superman card as the reward.
I write the name Alex and the number 199 on the blackboard.
Alex: 99The game continues.
Finding the next number becomes tougher as more number has to be checked.
Soon two more solutions are discovered.
499, 599!
Two more names and numbers go on the board.
Alex: 99
Mohan: 499
Jenny: 5993 cards have been distributed in 30 minutes of time. The fourth solution is taking incredibly long! Finally, after 1 hour, you find out 1499.
You win the card and your name goes on the board.
Alex: 99
Mohan: 499
Jenny: 599
You: 1499Now I add in another rule.
The number has to be less than 10 million.
This rule limits the number of solutions. Now everyone knows that there are only a limited number of solutions that exist. Hence, a limited number of rewards will be given.
The number of solutions is still high, but with the discovery of one solution, finding the next one becomes difficult.
After 3 hours of working, we decide to continue the game for the next day.
While going to your home, you hear a conversation going on between Alex and another friend of yours Rohan.
Rohan: Hey, Alex! Congrats on getting the Superman card! Would you be willing to give me that card if I offered you a box of chocolates?
Alex: Umm… yeah I am not a big fan of Superman, plus I got that number very easily. So yeah deal!
Now, you are thinking. Wow! Just for one Superman card, he got a box of chocolates! I must work hard to win more cards tomorrow.
The next day the game continues and after 3 hours, 15 more people have won the cards. Among the winners (and non-winners), some are like Alex — not a big fan of Superman, and some are like Rohan.
The news of the Superman card being exchanged for a chocolate box spreads.
One of the winners is willing to exchange his card. But not for the chocolate box. For doing his geography homework!
Another winner decides he will exchange his card if someone pays him $20.
And the trades start happening.
Two important things have happened here—
- A box of chocolate = Geography homework = $20 = A superman card.
- There exist only two ways to get a Superman card:
- Find a winning number to the problem
- Use money/service/product to exchange with someone else.
Next, consider what will happen when a person outside your classroom comes to know about all of this and how important this Superman card is for you people.
She may plan to purchase a card from one of you in order to either sell the same card in the future at a higher price to another friend of yours (when finding a new number becomes super tough) OR exchange the card for doing some of her house errands.
Suddenly the “Superman card” becomes a legitimate and valuable tool of use.
In the analogous world of cryptocurrency, the math work is called mining, the Superman cards are the crypto coins, and the blackboard is the public ledger, which everyone can see (and that prevents cheating).
The above may seem similar to the “Tulip Mania” where Tulip buds were being exchanged for money. But, there are four important conceptual differences that make cryptocurrency different and much better than Tulips.
Blockchain
Let’s consider the same classroom. Seeing the number of transactions of Superman cards going on among all the students I have decided to note down all the transactions on the blackboard. So, that no student can make an allegation of false transaction.
Let’s consider 3 transactions.
Transaction 1: Alex gave 5 cards to Jenny on 25th August 2023
I use TR for “transaction” and record this as—
TR0_ALEX_5_JENNY_25082023_TR1Transaction 2: Mohan gives 3 cards to Daniel on 27th August 2023
TR1_MOHAN_3_DANIEL_27082023_TR2Transaction 3: You give 1 card to Sam on 29th August 2023
TR2_YOU_1_SAM_29082023_TR3Can you observe one interesting pattern in each of the recordings?
In each of the recordings, a snippet of the previous transaction has been added in the beginning. Each transaction is linked to the previous transaction. A series of such transactions (called blocks) makes a connected chain. And this is the fundamental concept of Blockchain.
Once a block is added to the blockchain, it is extremely difficult to alter any information within it without changing all subsequent blocks. This is because altering the information would change the block's data, which would require changing the data of all following blocks as well. This makes the blockchain resistant to tampering and ensures the integrity of the recorded data.
While in the above examples, you can easily figure out the names of the people who did the transaction and other details, in real blockchain this information is hashed — a term used in the crypto field that simply means taking a piece of information as an input and giving a string of numbers and alphabets as an output which follows specific properties.
Check the image below which shows how simple texts (left) as input will generate a completely different output (right), also called as a digest
The hashing and linking bring security to the entire chain. It makes it extremely difficult for anyone to tamper with. Further, as more and more blocks are added, the chain only becomes stronger.
Counterfeiting and Scarcity
In the classroom game, one of the students John decides to print exact-looking Superman cards for himself.
He comes to the class the next day with 100s of Superman cards in his bag. Everyone gets skeptical and asks me — the teacher, the central authority, how did John get so many cards in one day.
I tell everyone to calm down. Just check the blackboard!
There are only two ways to get the Superman cards. Find a number solving the problem or exchange. Both of them are being recorded. And to no surprise, there is not a single transaction or record of John on the blackboard.
John is busted!
The system is intrinsically resistant to counterfeiting.
For any monetary system to work in place, or in fact, for anything to hold value, it should be extremely resistant to counterfeiting. Why?
Consider a recent example. A handwritten advertisement written by Apple Founder Steve Jobs for the Apple-1 Computer was recently sold at an auction for $175,759.
What if there existed 10,000 “exact” replicas of this handwritten note? Not photostat copies but exact counterfeit. Indistinguishable from the original. Will each of the 10,000 copies sell for that high price? Of course not. Further, what if it became very easy and publicly known how to make exact replicas of this note? It will lead to further commoditization of the handwritten note and it will be no different than purchasing a mass-produced printed photograph.
The same applies to the currency system. The scarcity and inability (or rather difficulty) to counterfeit are some of the strong contributors to what gives value to the currency. (We will talk about a third important contributor in a moment.)
Not a joke!
You can gauge the importance of this by noting that throughout history, strict laws have been created to prevent counterfeiting of the currency. Death penalty or exile has been very common across empires, as common punishment for counterfeiting.
In the 13th century, Mastro Adamo a counterfeiter of the Florentine fiorino, was punished with death by hanging. The English couple Thomas and Anne Rogers were convicted on 15 October 1690 for "Clipping 40 pieces of Silver". Thomas Rogers was hanged, drawn, and quartered while Anne Rogers was burnt alive. Evidence supplied by an informant led to the arrest of the last of the English Coiners "King" David Hartley, who was executed by hanging in 1770.
21 Million Bitcoins
In our classroom example, the number of solutions is limited by design. By design, we mean that the rule of the 10 million upper limit makes the total number of solutions possible “limited”. There cannot be infinite solutions. In the same fashion, the total number of bitcoins is limited to 21,000,000 in number by design. As of 2023, 19 million bitcoins have been mined.
This limit creates scarcity and when you add the feature of counterfeit-resistant, the entire system becomes valuable making both the Superman card as well as the cryptocurrency valuable.
Note: Bitcoin is one of the many different types of cryptocurrency. The most popular one.
Decentralization (I am fired!)
In the classroom game, I was the one who recorded all the transactions and rewarded the cards. But think of it. Do I really need to be there in the classroom?
Thinking along the same lines, all the students decide together to fire me. BUT they decide mutually that the same rules will be followed by everyone. The big blackboard, the recording system and the reward system will be maintained.
But I had all the Superman Cards, right?
The students decide that once anyone finds out the solution they will add a card number to that person's name. We don’t need physical cards anymore!
(This is exactly what the bank does when you get your salary. They “add numbers” to your account name (and remove from somewhere else)).
But I was the one who was recording on the blackboard!
Again the students together decide they ALL will maintain a copy of the blackboard with themselves. Plus, all the blackboard copies must look the same all the time. So, everyone will note the transactions and rewards at the same time. If someone tampers with her copy of the blackboard, it will be quickly cross-checked with the copies of others.
With all this system in place… BOOM! I have been fired! Now there is no central authority to control the game. The power rests on each and every one. The network.
Again when more people join the network the network becomes stronger and stronger.
Digitization: Let’s remove the physical blackboard
Unfortunately for me, the system designed by all my students is working smoothly after I have been fired. Now the students think of removing the physical blackboard and maintaining all the data of transactions on their personal iPads.
This speeds up the system, removes the inefficiencies, and makes it easy to search past transactions.
If you find the concept of digitization a bit difficult to grasp, consider the fact that in current times, coins and banknotes are much rarer than you think. More than 90% of all the money (~60 trillion) exists only on computer servers. When you do a bank transfer to your friend, the banking system (central authority) simply subtracts that amount from your account and adds the same to your friend’s account. There is no movement of physical notes or coins.
With cryptocurrency, the entire concept of physical notes and coins is removed. Everything is digitized.
But still, what exactly gives Bitcoins the “value”?
This is the final piece of the puzzle.
To understand what gives bitcoins or any cryptocurrency “value”, you need to understand what gives “any” currency its value.
The single-word answer is: Trust.
“Money is the most universal & most efficient system of mutual trust ever devised.”
-Yuval Noah Harari
Author of “Sapiens- A Brief History of Mankind”
While the above classroom example and Superman cards may appear as a trivial thing, you may find it surprising to know that almost exact same thing was used by prisoners in the concentration camps. Instead of Superman cards, the item of exchange was a “Cigarette”.
A loaf of bread was 12 Cigarettes
A 300-gram package of margarine: 30 cigarettes
A watch: 80-200 cigarettes
A litre of alcohol: 400 cigarettes.
Even non-smoking prisoners for whom the intrinsic value of a cigarette was null, were willing to accept cigarettes in payment for goods/services.
Why? Why does someone value a cigarette, a gold coin, or a dollar bill?
Because my friends trust in its value. Because the shopkeeper from whom I buy rice and milk trusts in its value. Because my neighbors trust in its value. And my neighbors trust them because I trust them. We all trust in them because our government trusts in them and collects taxes in the form of them.
The Bitcoin or cryptocurrency gets its value from the trust of the people in the system. The features of decentralized, digitized, counterfeit-resistant, and limited by design are “trusted” to be “good” features. And this trust is what gives the cryptocurrency its value.
The Origin of Bitcoins
Early Times
In 1983, David Lee Chaum, came up with the idea of eCash — an anonymous cryptographic electronic money. In this system, the money was cryptographically signed by the bank and stored in a digital form.
However, similar to what happens to most radical ideas, the acceptance (trust?) in the initial days was low. Only one US bank the Mark Twain bank in Saint Louis, Missouri — implemented ecash, testing it as a micropayment system. After a three-year trial that signed up merely 5,000 customers, the system was dissolved in 1998 and DigiCash, the company Chaum started went bankrupt in the same year.
Bitcoin
The origins of Bitcoin can be traced back to a mysterious individual or group using the pseudonym Satoshi Nakamoto. In 2008, Nakamoto released a whitepaper titled "Bitcoin: A Peer-to-Peer Electronic Cash System," outlining the principles and mechanics of a novel digital currency. The whitepaper proposed a decentralized network powered by blockchain technology, aiming to eliminate the need for intermediaries like banks in financial transactions. This concept laid the foundation for the revolutionary cryptocurrency we know as Bitcoin.
On January 3, 2009, Nakamoto mined the first-ever block of the Bitcoin blockchain, known as the "genesis block." This block had a reward of 50 bitcoins.Embedded in the genesis block was the text:
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.
The text refers to a headline in The Times published on 3 January 2009. It is said that Nakamoto used this headline to provide a date stamp to the genesis block as well as make fun on the banking system.
The First Retail Transaction
Remember how in our classroom example one Superman card was exchanged for a box of chocolates? A similar thing happened in the history of Bitcoins.
On May 22, 2010, Laszlo Hanyecz agreed to pay 10,000 Bitcoins for two delivered Papa John's pizzas. Organized on bitcointalk forum (similar to our classroom), Laszlo reached out for help saying "I'll pay 10,000 bitcoins for a couple of pizzas.. like maybe 2 large ones so I have some leftover for the next day."
A British man took up Hanyecz's offer and bought the two pizzas for him in exchange for the 10,000 Bitcoins.
As of today, the value of those 10,000 Bitcoins (or of those 2 yummy pizza) is $260 Million! Remembering this event, May 22, is now celebrated as Bitcoin Pizza Day.
Many organizations and clients slowly and steadily started accepting bitcoins. In October 2012, BitPay (a bitcoin payment service provider) reported having over 1,000 merchants accepting bitcoin under its payment processing service.
In November 2012, WordPress started accepting bitcoins.
In December 2014, Microsoft began to accept bitcoin to buy Xbox games and Windows software.
Altcoins
The success of Bitcoin spurred the creation of alternative cryptocurrencies, known as altcoins. These digital currencies sought to address the perceived limitations of Bitcoin and introduced various technical innovations.
Legality
With the increase in transactions and growth of the network, the number of countries recognizing Bitcoins or cryptocurrencies as a legitimate instrument of trade has increased over time.
Note: The above article is in no way an endorsement of bitcoins or any cryptocurrency. Do your own qualitative and quantitative research before you start your investment journey in Cryptocurrencies.
I hope this article gave you a good understanding of Bitcoins and cryptocurrency in general. Feel free to ask any questions related to this topic.
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