The Bitcoin Network

Bitcoin's payment network (also called the bitcoin blockchain) is what makes it possible for us to transact with one another. The network uses distributed consensus to verify and confirm transactions, and consensus is reached via a large global network of high-performance computers (called miners) running the bitcoin software.

Whenever someone sends a transaction it is broadcast instantly to the network and verified by the miners. Miners are constantly working to confirm individual transactions and include them in the next block of transactions in the chain. Once a new block is verified, all the transactions within it are permanently recorded on the blockchain. Rewards are paid out in bitcoin to miners who confirm transactions and verify the next block as a way to incentivize productivity on the network.

Each party who participates in the mining process has an identical up-to-date copy of the blockchain or public ledger, which is a record of all the transactions in bitcoin history. Each party's copy of the ledger is updated every time a new block is found.

The Currency

The unit of value that we send and receive on the Bitcoin network is also referred to as bitcoin, or bitcoins. Bitcoin is completely digital, meaning we can't physically hold it in our hand. It's also portable, divisible, fungible, and irreversible.

Bitcoin (the protocol and payment network)

Bitcoin with a capital “B” is typically associated with Bitcoin the protocol and payment network. The uppercase form, “Bitcoin,” is also often used to refer to as the ecosystem as a whole. Using Bitcoin with a capital “B” is the common way of referencing Bitcoin when writing about it in general terms.

An example would be, “I just learned about Bitcoin, and it’s a fast and cheap way for merchants to accept payments.”

bitcoin (the currency)

Bitcoin with a lowercase “b” written as “bitcoin” is usually associated specifically with bitcoin as the currency. When you intend to reference how much of the currency was transacted, or you’re focusing solely on the currency and not the broader payment network or protocol as a whole, you can use the lowercase form, “bitcoin.”

An example would be, “I just sent two bitcoins from my Blockchain Wallet to the merchant.”

What is blockchain technology?

How do Economists Define Money?

All the economics books start out with the 3 functions of money: medium of exchange, store of value and unit of account.

The most important function of money is the medium of exchange. Sellers accept it in exchange for goods and services.  As stated previously, without money, societies must resort to barter.

Money must also be a store of value. If you sell something or provide your labor, you want to be able to save that purchasing power for later.  Inflation or devaluation erodes money as a viable store of value.

The third function of money is the unit of account.  Money must be able to provide a measurement to assess the value of goods and services.  Essentially, it’s a yardstick to compare prices of goods and services and it provides a measurable signal in the constant shuffling of the allocation of resources.

Anything that provides those function will be a good money.  Whether that is rectangular pieces of cotton paper, digits on a computer, large stone wheels or shells, if it functions as money, it is MONEY!

Now, pretend you are in Davos sitting among the world’s financial elite. You face a panel made of renowned central bankers. You slowly raise your hand and ask the million dollar question: “Can anyone tell me what Bitcoin is?”. After a moment of stunned silence, the whole audience roars with laughter. As the laughter subsides, the “masters of the universe of debt”, will start the usual tirade: it´s a fraud (J.Dimon), don’t know …but it will end badly (W. Buffett), it´s only a speculative bubble (R. Dalio), it´s a Ponzi scheme, it´s backed up by nothing, it´s nothing at all… and so on.

So what is Bitcoin?

The Position of the Regulators

On January 8th, the Bank of Israel was the last Central Bank to issue a press release trying to define what Bitcoin is or – better – what it is not.

Here they go, “Bitcoin and similar virtual currencies are not a currency, and are not considered foreign currency and should be viewed as a financial asset”.

For the State of New York, Bitcoin is a “digital unit that is used as a medium of exchange or a form of digitally stored value“.

For the German BaFin it is a “unit of account” and therefore a “financial instrument”.

More comprehensive definitions have been attempted by the EBA in 2014 (European Banking Association) and the Banca d´Italia, which both define Bitcoin as “a digital representation of value that is neither issued by a central bank or public authority nor necessarily attached to a fiat currency, but is used by natural or legal persons as a means of exchange and can be transferred, stored or traded electronically”.

Quite to the contrary, the Bank of England and the English FCA have not taken a position yet.  In fact, the FCA has gone as far as to state that it does not regulate digital currencies and has no intention of doing so.

Money and Currency in History

Let’s see then how monetary history defines both currency and money. Money first.

In history, there have been many forms of money, but just looking at modern times, one can identify essentially two forms of money: representative commodity money and fiat money. Throughout history gold and silver, as commodity money, have been the purest form of money. Because they have an intrinsic-use value and they cannot be debased. At the beginning of the 1900s, with the gold standard – commodity money became “representative commodity money” – which was fiat money backed up and redeemable for gold. Our current system instead is based solely on fiat money (from the Latin, fiat – let it be) – which has no intrinsic value and is irredeemable – and whose value is sanctioned by the government which makes it legal tender within a country. Money must have some essential properties, such as being (i) a medium of exchange, (ii) a unit of account and (iii) a store of value. Money must also be fungible, portable, durable and cognizable.

When a money circulates within an economic system and is accepted as a means of payment – through banknotes and coins – then it is also a currency (from Latin currens-entis – in circulation). Which is essentially “a generally accepted system of money which circulates within an economic system”. Therefore you can have a money which is also a currency and moneys that are not currencies. For example, the moneys par excellence – gold and silver – have been also currencies throughout history until Bretton Woods. Today, one can argue that they are not a currency anymore, but still they remain the purest form of money. Although, to be precise, some gold coins are still today legal tender at face value in the US and therefore still a currency. In 1912 J.P.Morgan, when called to testify before the US Congress, said his famous words: “Gold is money, everything else is credit” .

On the other side, you have all the fiat moneys of the last 4 centuries – the Dutch gulden, the Spanish real and the British pound – which were both money as well as reserve currencies at that time and whose value collapsed to zero and do not exist anymore today as forms of money.

Bitcoin´s Money Features

So let’s see how Bitcoin fits in this framework:

– as recognized by the EBA, Bitcoin has the features of money, such as being a unit of account and a medium of exchange. The only doubts are for the store of value and the stability features, more difficult to attribute to Bitcoin given its high volatility. However, one can argue that the same feature can be hardly attributed to any of our fiat moneys, considering our central bank policies´ of debasement and monetary inflation. As evidence suffice to look at a graph of the US dollar vs. gold from 1970 to date, to comprehend that the US dollar is not a store of value (1). Bitcoin´s volatility is also a function of its lack of liquidity, small market, lack of regulation and young age.  All those issues will be fixed with time.

– Bitcoin is clearly fungible, portable, durable and cognizable, like money should be.

– Bitcoin is not however commodity money nor fiat money. But the historical definition of money cannot be kept immutable in the face of technological advancements. Clearly, a digital form of money is nowadays recognized. However, if one can easily accept all forms of digital money which are either derived from fiat or derived from commodities, with regard to Bitcoin one must go a step further. Indeed, before Bitcoin no form of money was built solely upon “trust”. Yes, because what stands behind Bitcoin is not a government nor a commodity with intrinsic value. Therefore Bitcoin relies solely upon the trust that users, investors, miners and consumers put into it. For that reason, it is very important to analyze what “trust” means.

The Trust in Money

We have two forms of trust in money: objective or intrinsic trust and subjective or extrinsic trust. The former is the form of trust that one has in commodity money. One trusts that mother nature has made gold scarce enough and costly to extract as to ensure a limited supply. One trusts its scarcity, objectively. This form of trust is intrinsic in precious metals´ nature. Then you have the form of trust in fiat moneys, which is subjective, is extrinsic, meaning that you have to trust groups of individuals or societies – such as governments or authorities such as central bankers – to act in a way that does not jeopardize the governments´ finances and its fiat money. The Bank of England for instance, clarifies that the trust in the fiat GBP is instilled by (i) measures to avoid counterfeiting and (ii) low monetary inflation… Simply put, you trust that the government will not abuse the printing presses and – in short – will be able to pay its debts and remain solvent. If this type of “government instilled trust” is what solely backs up fiat moneys, do then people have more reasons to trust their governments (i.e. fiat money) or a mathematical algorithm (i.e. Bitcoin)? The question is by no means a small one.

One can hardly refute that an objective-intrinsic form of trust is far superior to a subjective-extrinsic trust. The latter can only be rated according to its historical record. Unfortunately, the historical record of fiat moneys is pretty poor. The answer is yet again in Cicero’s magistra vitae. Because history proves ultimately that, when humans have incentives – such as governments, politicians and the financial elites have in creating new money – they will always behave accordingly. The result is that no fiat currency in history has ever survived its inevitable debasement. There will always be another Roosevelt, another Nixon, more LTCM´s, more Lehman, more bailouts, more QE… Let’s not forget that this form of “subjective” trust can be easily lost and when that has happened in history, the results have been the collapses of past empires – or in modern times – the hyperinflations of the Weimar Republic, Argentina, Zimbabwe or Venezuela.

That is the fundamental reason why a mathematical algorithm – which ensures no duplication and double-spending as well as security and transparency in a distributed ledger – is intrinsically objectively trustworthy, while States and their fiat currencies are not. And that is a huge argument in favour of Bitcoin.