Over the last few days, I’ve been exchanging emails with Ricochet’s own Michael Stopa, asking Michael — one of the few people I know who truly understands both technology and the English language — to tell me about Bitcoin. (The background: During the Bitcoin craze with which last year concluded, I finally succumbed to temptation, buying a few hundred dollars’ worth. By the very next morning, I had lost a third of my money.)
Herewith, and with thanks, again, to Michael, the best succinct explanation of the blockchain phenomenon I have yet encountered. My own occasional comments appear [in brackets].
Let me say at the top that the one thing I can’t tell you (and probably the thing you want to know the most) is whether bitcoin value will go up or down and when. Sorry. [Michael knows—I’m sure he knows. He just won’t say.]
That said, the basic innovation of bitcoin is the public ledger of all transactions that allow everyone to see who (or what “wallets” anyway, not the actual human beings) has how many bitcoins and where, over history, have they been moved to; i.e., all the transactions that have ever existed. This is, of course, the blockchain. The blockchain is what is called a linked list. You could think of this like a book where instead of reading the pages sequentially, you find, at the bottom of each page, a line telling you what page to go to next. And when you get to the next page the first thing you find is an encoding (a so-called “hash”) of the page from which you have just come. Thus in some sense each page contains the information of the preceding page, which contains the preceding page, which…
The encoding machine (the hash function, in bitcoin this is called SHA-256) produces codes of the same length irrespective of how long the input is — specifically 256 bits. The technical details of this hash function are not really so difficult, but you do need a little mathematical savvy to work through it. One thing that might occur to you immediately is if we are encoding (or encrypting) a whole page of data into 256 bits (64 characters) then the encoding cannot be unique. It must be possible to find two pages of information that “hash” into the exact same string of 256 bits. This apparent paradox is solved by statistics (it is very unlikely to find two such pages). So far the best source I have found for details of this is on a site called blockgeeks.com.
So, this linked list blockchain can’t be quite that simple, of course. If all we need to do to add a new page to the book is take the previous page, hash it, and put that on the new page with the latest transactions, then anyone could willy-nilly be adding pages all day. So the encryption process also includes a number, called a “nonce,” which has to be “mined.” That number is such that (this is a little subtle) once it is concatenated with the hash of the most recent page and hashed again, then it results in a number with a lot of leading zeros (meaning it is less than some fairly arbitrary target). Just using a 10-digit decimal example, the hash of the hash+nonce would need to give a number less than, say, 0000025000. That result depends on both the nonce and the previous hash (plus other data) obviously. So each time the blockchain gets updated a new nonce has to be found. Once a nonce is found (and the technical details here are to me still somewhat opaque) the blockchain gets updated (and the finder gets some bitcoin for his trouble).
The reason for that is that I am planning to write this all up with copious references on our Harvard Lunch Club page. We will also change the name of the podcast to the Harvard Lunch Club Bitcoin podcast, a la the Ice Tea Company that did the same and saw their share prices skyrocket. (I am kidding a bit here). Maybe we could make it a page on Ricochet, too? [From your lips, Michael, to the Blue Yeti’s ears.]
Anyway, regarding the stability and prospects of bitcoin, what is needed is a genuine calculation of how it will fare in the market. The market, in this case, is the universe of other currencies. Only geeks will use it just because it is cool or democratic. Other folks will use it because it costs less to use it (or else its value is more stable). One thing that mystifies me is how a currency can be useful when its value changes by 30 percent in a day. Surely there must be an expectation that its value will flatten out eventually. [True enough, but in countries where Bitcoin is reportedly unusually popular, such as Venezuela, the native currency is even more unreliable, right?]
Regarding the marginal value of using bitcoins versus other currencies what you are competing against are, of course, the central banks. Transaction costs (e.g., for international transfers) are small but, of course, they add up. These costs are to some extent fixed because the bank has to keep a record of all of the transactions in whatever currency and keep all that information secure. So ultimately the competitive advantage of bitcoin is that they have worked out a system of securing transactions that is cheaper than the old methods. (As I am sure you know, bitcoin transactions are not free. They take computer power and mining costs, etc., that cost money … but they are arguably far cheaper than what the banks need to charge).
Then the question is how will banks compete? They’re not going to take this lying down. Possibly this will force them to innovate their transaction-recording technology (no doubt they are working on it all the time). But I am not sure how, other than becoming cryptocurrencies themselves, governments and banks can surpass bitcoin here.
Lots of other things here, like taxes, for instance. But let me stop there. I hope I haven’t just filled up your inbox with unusable dreck! [No, Mike, you’ve provided a lovely brief education. Thanks.]