Nothing in life worth doing is ever easy. The creator(s) of bitcoin sure took that piece of conventional wisdom to heart when they built the bitcoin blockchain 12 years ago. They combined complex concepts and processes from multiple fields — economics, finance, software development, cryptography — to create a disruptive technology that has the potential to change how the world uses money.
Because of the scope and complex nature of this project it is very difficult to explain it in simple ways. To crudely restate Einstein, “If you can’t paraphrase someone else’s ideas, you don’t get it.” In terms of bitcoin, I understand it conceptually and as an investor but its in-depth technical functionality is beyond my expertise. So my task, as a self-admitted regular guy who is not a subject matter expert in any of the above fields, is to explain how bitcoin works and help you learn a thing or two about how it works. If bitcoin is 7 layers deep, we are discussing the two outermost layers.
Since bitcoin is a system we’re going to use the three components of a system to organize the article: Input, Throughput, Output.
Borrowing from one of the previous articles in this series, “Bitcoin is a set of instructions coded into software that uses math to turn electricity into unchangeable facts that are written in a ledger shared on thousands of different computers. Anyone can view and verify the ledger for free. The more people that join and use the network, the greater the value of bitcoin.” I hope this makes a little more sense after this article.
There are four main inputs for bitcoin: electricity, equipment, people, and the protocol. We will focus on three of them, with the two most important inputs being electricity and the protocol.
The great part about the protocol is that it is a piece of software free for anyone to download onto their computers. This is called open source software. So even if the world experiences a nuclear war and all humans go underground for a generation and shut off all electricity, as soon as electricity comes back to the grid and computers with the bitcoin protocol are hooked back up, bitcoin will automatically start being minded.
But another great thing about the bitcoin network is that it is decentralized and distributed around the world, so for bitcoin to stop being mined that would mean that the entire world’s electrical grid is shut down. So even if large chunks of the world were ravaged by natural or manmade disasters, the bitcoin network would go on mining bitcoin. And if the entire electrical grid did indeed go down, we would be worrying about survival, not bitcoin.
Electricity is the largest expense to mine bitcoin. This is why we see companies moving to areas where electricity is cheap and/or alternative energy sources are abundant. Large mining organizations operate in Rockdale, Texas (cheap electricity), China’s Yunnan, Xinjiang, Inner Mongolia, and Sichuan provinces (cheap electricity and access to hydro power), and Kazakhstan (cheap energy, low taxes). Smaller mining companies exist throughout the world. But mining companies are not the only players involved in bitcoin.
Even though bitcoin is a piece of code, an eloquently written software that can bring a lot of positive change to the world, it still needs humans to carry it out. There are 5 major groups of people playing in the bitcoin sandbox at this time: miners, node operators, traders, HODLrs, and consumers. While these categories certainly overlap, I will discuss them one at a time for clarity.
Miners are the individuals (people and companies) who own the computers that perform the hashing that solves complex math problems and get rewarded with bitcoin when they do. Mining companies are also node operators and individual people can also run a bitcoin node. This is where someone downloads the free, open source bitcoin protocol onto their computer, giving them the ability to verify every transaction on the bitcoin blockchain since the genesis block in 2009. There is no financial incentive to do this. Being a node operator (and not mining bitcoin) is part of the distributed, decentralized, open-to-anyone ethos that guides bitcoin…which is why people do it.
Traders are people who buy and sell bitcoin on a daily basis on public markets and exchanges. They typically make their living from trading activities and many traders conduct both cyrpto trading and traditional financial trading (stocks, bonds, commodities) to earn money. Traders can buy, sell, and trade bitcoin just like a company stock or commodity, directly from apps on their phone. HODLrs are investors with long terms horizons (at least 1 year but typically 5+ years) who buy and hold bitcoin in order for it to appreciate. HODL stands for “holding on for dear life” and is one of those fun internet words that was originally created from an error, where someone meant to say they were “holding bitcoin” and instead made up the understanding we now have for the HODL acronym. Now everyone uses it.
Consumers are people who buy bitcoin to spend it. This is accelerating every day as more businesses and government accept bitcoin as a form of payment. Within a decade, bitcoin has gone from an obscure technical hobby for tech nerds to a form of payment accepted at companies like Amazon, Starbucks, AT&T, Burger King, Microsoft, KFC, Subway, as well as a variety of governments as a way to pay taxes. Many other retailers now accept it globally and are rolling it out in phases across their entire companies.
And for businesses that don’t directly accept bitcoin already (they will), consumers can get bitcoin debit cards that link the card to a bitcoin account. All retailers accept these cards because it is a Visa partnership and works just like a normal debit card.
‘Trust’ as an Input? Sort of.
Bitcoin was built to remove human trust from the money exchange and money creation processes…sort of. The goal is to have a form of money where you do not need to involve other people (3rd parties) to do things with that money. The entire current financial system is built around middlemen (3rd party intermediary companies) guaranteeing the proper settlement of your financial transactions. Bitcoin removes the need for human trust from a financial transaction. I said that bitcoin has “sort of done this because people still need to trust that the new tools will work the way they are intended.
But we trust and take tool reliability for granted everyday. The average person doesn’t wake up worrying about financial fires, things that could burn down the financial foundations they’ve built for their families, especially if they’ve “played by the rules of the game.” We don’t question how cash is created, what digital ledgers the Federal Reserve manipulates, how quantitative easing works, or the significance of capital markets.
We similarly trust that the electrical systems in our homes will not cause a fire. But it wasn’t always that way. When the U.S. infrastructure for residential and commercial real estate was transitioning from gas to electric there was a war between the entrepreneurs in these two camps, and the gas folks ran campaigns highlighting the fires that electrical systems can cause. They were not going down without a fight, letting the industry they built over 100 years be taken away from them easily.
The more useful and efficient system eventually won and almost everyone in the United States now powers their homes with electricity. We don’t question how electric companies accomplish this, we don’t need to know the intricate details of how electricity works, we just accept it won’t kill us when we flick a light switch. Bitcoin will eventually get to that point once a greater number of individuals, businesses, and institutions understand its benefits. When you flick the bitcoin switch and have the ability to transfer, store, and spend wealth in a smooth manner with extremely low fees, it will just be the new normal.
Bitcoin is a system built entirely around an expensive verification process that uses computer processing (problem solving) to solve complex math problems, verify bitcoin transactions and get rewarded with bitcoin. Bitcoin was built to eliminate the need for any trust or accountability between humans involved in bitcoin transactions. The network is 100% verify, 0% trust. The verification process is “expensive” in the sense that every person or company mining bitcoin has access to the entire bitcoin ledger, from the 1st block ever added to the blockchain to the ones being produced today. It costs money to mine bitcoin and expenses include the hardware (computer mining rigs like ASICs), electricity, and opportunity costs such as the time it takes to learn how to set these things up (this especially applies to non-technical experts looking to get involved with bitcoin mining.).
Borrowing from one of my articles earlier in this series…a bitcoin “block” is added to the immutable (unchangeable) distributed ledger roughly every 10 minutes since bitcoin’s birth in 2009. The money supply mechanism (how many bitcoin are created and when they are created) is rooted in math instead of in human desire. So while the U.S. dollar has an elastic money supply policy that can be flexed whenever deemed necessary by groups of humans, bitcoin has a hard money supply policy administered through an Elastic Complexity Policy, which is called the hashing difficulty adjustment process.
Hashing is the process of a miner’s computers solving complex math problems and then being rewarded with bitcoin.
As bitcoin’s price rises and more miners join the network — and they do this because they are incentivized to earn a larger financial reward through higher priced bitcoin — then more effort goes into trying to solve the more difficult math problems. Interestingly this process does NOT lead to the creation of more bitcoin. The difficulty adjustment process is built into the bitcoin protocol and prevents more than 21,000,000 bitcoin from ever being created and from being created too quickly. The final bitcoin will be mined in the year 2140. In short, growth in bitcoin’s value per coin cannot increase its supply, it is the hardest money ever created, even more hard than gold because bitcoin’s supply has math-based absolute scarcity. When drilling technology improves the annual supply of gold will increase.
Picture a professional athlete, like the NBA superstar Lebron James. He has the ability to adjust his level of focus, intensity, and skill that he deploys when shooting around with others. So Lebron doesn’t play with the same level of intensity when he’s playing horse with his 10-year old niece in his driveway as he does in the 7th game of the NBA finals. Bitcoin’s difficulty adjustment process is similar to this logic, its level automatically adjusts based on environmental factors in the network.
When more miners join the network and the overall hashing power increases, the bitcoin protocol automatically makes the math problems harder to solve. As hashing power decreases — when miners shut down their rigs — the difficulty process again automatically adjusts to make math problems easier to solve. This natural adjustment process is baked into the bitcoin protocol and is protected by the distributed, decentralized network.
The bitcoin protocol and its consensus-based rules are what maintain the network and its expanding value. Bitcoin has a strong bias in favor of its status quo. If people want to change the code, that is where “hard forks” emerge. Bitcoin Cash (BCH) and Bitcoin Satoshi Vision (BSV) are two examples of a hard fork, but that’s a deeper layer than what we’re covering here.
Making change to the code is very difficult because it requires gaining consensus from every developer on the global network to alter its status quo. Changing bitcoin’s code by gaining consensus from dispersed developers is hard enough, but it’s even more difficult because of how the financial incentives are built into the system for miners. Abiding by the protocol and consensus-based rules are what maintain the network, expand value, compensate miners, and keep the money supply capped.
Bitcoin is not just a unique piece of code, it is a new form of money grounded in (a) the economics of currency and (b) a distributed network. The network’s security, value, and integrity expands as the network expands, making it more difficult for rogue actors (hackers) to make changes to the bitcoin protocol without having full consensus.
Bitcoin is a peer-to-peer tool like email. You can send an email to any peer in the world pretty much for free and without needing anyone’s permission, they just need an email address. Another peer-to-peer tool is something called TCP/IP, which stands for transmission control protocol/internet protocol. It is the set of rules that forms the infrastructure of the internet. Everything we use and interact with online is built on top of it. TCP/IP is a simple, “dumb” network that allows different uses and applications to be built on top of it.
The TCP/IP rules are what allow computers to talk to each other and form the internet. This whole process is the sending and receiving of information packets that let us listen to music, watch movies, tweet, sell cars, and do everything else imaginable on the internet. Bitcoin is also a bare bones protocol that accomplishes one thing extremely well (the hashing of a bitcoin) but also has the opportunity for other applications to be built on top of it. Whereas smart networks offer very sophisticated but limited services as part of the core function of the network, dumb networks are very basic and rely on end users to do things with the network…and what they can do is nearly unlimited, being constrained only by their creativity and persistence. That is bitcoin.
The most obvious output of the bitcoin system is bitcoin itself. Bitcoin are distributed to miners who successfully solve the complex math problems, and currently miners are rewarded with 6.25 bitcoin for each block they hash (successfully add to the blockchain). Part of the bitcoin protocol includes a process called the halvening/halving, where every four years the bitcoin rewarded to miners gets chopped in half. This is the mechanism that caps the supply of bitcoin. Miners were originally rewarded with 50 bitcoin for successfully hashing a block, then it went to 25 bitcoin in 2012, then 12.5 in 2016, and now 6.25 in May 2020. This monetary supply schedule cannot be altered and is built into the bitcoin protocol, so that they last bitcoin — the 21,000,000 — will be mined in year 2140. This process creates absolute scarcity, as no other bitcoin can ever be created under the original protocol.
The most important output of bitcoin is the immutable, indisputable, and secure nature of a bitcoin transaction once a bitcoin block is added to the blockchain. Bitcoin’s security is in the “Proof of Work” ledger verification that occurs during the hashing. Bitcoin node operators and miners share the ledger of all bitcoin transactions much like the members of a BitTorrent network share bits and pieces of files that users download. A BitTorrent network allows users to download tiny bits of a single product — like a movie or song — from thousands of computers around the world. The BitTorrent program then pieces the different bits together to form a whole product. While the bitcoin protocol doesn’t piece together a bitcoin from different computers, it does share the entire ledger with every network node in real time, as each new transaction is added to the blockchain. This protects the integrity of the blockchain, making bitcoin transactions one of the hardest facts to dispute on the planet. Once it is added, it is “settled.”
Bitcoin is a transparent transactional settlement tool. Once a block is added to the blockchain, it is there and cannot be changed. It is settled, it is final. An international monetary settlement tool should be agnostic and neutral to the monetary policy of different countries, and anyone around the globe, at any time of day, can join and use the network. That is bitcoin.
The open source nature of bitcoin is unique because bitcoin innovations benefit everyone on the network, not just the entity creating the innovation. There are hundreds of software developers dedicating their time (without compensation) to maintain the integrity of the bitcoin network by searching for and eliminating bugs, by attacking the protocol to strengthen it, and by building applications on top of the core protocol to improve its speed and scalability.
Jack Dorsey, the CEO of global companies Twitter ($26 billion market cap) and Square ($46 billion market cap), has taken this a setup further and is now funding bitcoin core developers to work on the software that benefits everyone in the network, not just his companies. In fact his companies have no direct benefit from the work these developers are doing other than being associated with being a bitcoin early adopter. Dorsey is an influential bitcoin advocate and calls bitcoin “the internet’s money.” He believes it has the ability to change the way humans think about and use money on the planet. The internet’s money is an important concept, because if the internet were a country, it would already have one of the largest economies in the world. Within the next decade it will easily have the largest economy.
Bitcoin has remained consistent and steady through several global crises and keeps adding blocks to the chain every 10 minutes like clockwork: March 2020 recession, Coronavirus, localized violence and protests across the globe. They bitcoin system keeps humming despite this environmental chaos, but it is important to understand some of its threats.
Threats to Bitcoin
The rise in costs to operate a mining farm and the consolidation of them are legitimate threats, especially if the block size gets bigger and eliminates computers with less processing power from being able to mine a block. The bitcoin mining community has already evolved from Do-It-Yourself miners working in isolation from their homes to a commercialized industry with football fields of warehouses full of computer rigs mining bitcoin.
Bitcoin production relies on economic incentives that make fraud illogical, difficult to coordinate across nation-states, and far costlier than its rewards. It is more profitable to mine it than to destroy it.
Honest nodes and miners have zero financial incentive to confirm fraudulent transactions on the network, because doing so puts the entire system at risk, cancelling out all the economic value the miners have accumulated for themselves. So for an attacker to destroy bitcoin they would have to deploy very large sums of money with no financial return at all and the hacker would need an ongoing attack because the other honest nodes would go back on the blockchain to the block prior to the attack and resume operations (forking). The cost to hack bitcoin gets harder and the network strengthened with each block that is mined.
Quantum computing is another legitimate threat to the bitcoin network, specifically a future super computer that could break the cryptographically protected SHA-256 algorithm at the core of bitcoin. To overcome this threat the bitcoin community would switch to a stronger form of encryption. Another threat would be a rogue nation infusing hardware backdoors into the manufacturing process of bitcoin mining rigs to torpedo the network. This could only occur with the mining rig manufacturer being complicit in this process, which again, defeats the economic incentives for that company.
A final threat would be the U.S. government (or other major countries) creating a “FedCoin” and people’s willingness to use it instead of bitcoin. Not only is this possible but I argue it is inevitable. The difference is that bitcoin will have a hard money supply (inelastic money supply) and any type of digital coin created by a central bank will have an unlimited supply, just like the U.S. dollar. In addition, bitcoin is a decentralized network that distributes the power of money to the people on the network, whereas a FedCoin would be a centralized project, giving the creating government immense power and knowledge over its citizen’s financial transactions. A FedCoin system would be a big brother, surveillance state on steroids where people willingly give over their private economic freedoms to their government. Both private and public centralized digital currency projects will always have an issue with limited user privacy and unlimited organizational power. Bitcoin is the pseudonymous currency, the people’s money, the money that puts the entire value creation process back in the hands of people.
Courage, freedom, and optimism are also important outputs.
Having the courage to try a different financial platform, a platform that could provide a more fair and transparent financial system for all humans on the planet, not just people who are lucky enough to be born in developed nations. Freedom to fully control your money in ways that you see fit without worry that the money can be frozen or confiscated by a government. And optimism that humans will continue to invent new tools and systems to solve the unexpected problems that our old tools and systems create.
If you believe that self-sufficiency, economic freedom, and feeling empowered are important, then you should learn more about bitcoin. If you believe your government and large companies will do a better job of looking out for you then you can, then bitcoin isn’t for you. Choose bitcoin, choose you.
1. I own a small amount of bitcoin.
2. I own small amounts of other digital assets.
3. This series of articles is for education, it is not financial advice.
4. We can always enhance our knowledge— this ties into the bitcoin ethos of self-sufficiency and DYOR (do your own research).
5. My goal is to give readers information to help you make choices that align with your life goals. You spend your time and money as you see fit and I’ll do the same. That’s the American way.
6. Make decisions from positions of knowledge, not fear.
7. Enjoy the journey.
Ammous, Saifedean. (2018). The Bitcoin Standard: The Decentralized Alternative to Central Banking.
Antonopolous, Andreas. (2016). The Internet of Money: Talks by Andreas Antonopolous.
Ferguson, N. (2008). The Ascent of Money: A Financial History of the World.
Bitcoin Mining Warehouse: https://news.bitcoin.com/bitcoin-com-cloud-mining-contracts-record-daily-sellouts/
Gas Fireplace: https://www.thespruce.com/the-gaslight-era-2175011
Lebron James: https://sports.yahoo.com/le-bron-james-gets-away-with-absurd-obvious-carry-vs-jazz-030357190.html
Bitcoin Lock: https://hackernoon.com/bitcoin-safety-a-guide-on-how-to-keep-your-wallet-and-private-keys-secure-94cf7b7f4a00
Bitcoin, “The How” was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.