Bitcoin: Back to the Basics

BitcoinThere are plenty of people in the media that rip on Bitcoin. That’s especially true in the Personal Finance world. It seems to be a pretty easy target because it’s price is volatile, there have been shady companies associated with it, and companies have mismanaged their Bitcoins. I’ll be the first to warn you against investing your life savings in Bitcoin. However, the biggest reason Bitcoin is attacked, is because people don’t understand WHY it exists. So, while I don’t know if Bitcoin’s value will stabilize or a different digital currency will rule the day in 10-15 years, Bitcoin does address a simple problem. To help explain that problem, I brought in a friend of mine, Mike Hearn to boil down what Bitcoin is, simply and succinctly. I have also added a few additional notes of my own at the end.

Imagine, for a moment, this transaction:

I go to a deli and buy a sandwich. I give the owner a $10 bill, he gives me a sandwich. I walk away, sandwich in hand, and the deli owner has my $10. I eat my sandwich, and it is delicious. Smoked turkey, some provolone, a little chipotle mayo, maybe toast it…

Sorry, I got sidetracked by sandwiches.

Back to finance:

That’s a pretty typical cash transaction, right? Dollars-for-sandwich. Two thousand years ago similar transactions were taking place, except instead of USD it was gold-for-gyros or whatever they ate in ancient Greece. Point being, the characteristics of in-person fiat transactions have been well-defined since, basically, the beginning of time.

So here are some attributes of that transaction:

  • After the purchase, I can’t call up a third-party and ask that the transaction be reversed. The cash transaction is final, and if I want my money back I must ask the merchant to refund my money.
  • The owner can’t identify me; he doesn’t have my name, address or zip code. I am completely anonymous to him – as I should be. All I bought was a sandwich.
  • The deli owner receives $10. Not $10 minus 30 cents + a 2.9% fee.
  • No “trust” is involved in the middle; I am not trusting a middleman to handle authorizing the transaction and passing along the money, and therefore no one must assume responsibility (and liability) for its completion.

Cash transactions are elegantly simple. They are a give-and-take in which no one other than the buyer and merchant are involved.

So now that I’ve laid that out, let’s try to make some similar transactions on the internet, shall we?

Example 1: I go on Amazon to buy something. Doesn’t matter what. Wool socks. I click purchase, but I’m in New York and Amazon is in Washington, so it asks for a credit card. I type in my AmEx number.

Example 2: I lost a bet and owe a friend in California $30. I go to Paypal.

Example 3: I outsource the development of my amazing mobile app to Malaysia. I wire money via Western Union.

Are you seeing the trend? Modern payments are remote, and at this point in time, the best way we’ve been able to assure that (a) the buyer has real money and (b) the merchant has received it is by entrusting a third party to verify these things. Remote transactions can’t be made without this middleman.

And this middleman adds significant cost.

The cost to them is infrastructure, fraud prevention, marketing and so on. The cost to us is information (to facilitate the middleman’s fraud prevention efforts) as well as an increase in raw purchase price, due to processing fees that are hidden in the price.

This really should not be an acceptable solution, but at the moment we have no other feasible option. By all rights that middleman should not have to be there, but due to technical minutia, it’s the only solution we’ve come up with to facilitate long-distance monetary transactions.

Until now. The dramatic reveal: Bitcoin.

There’s so much baggage associated with Bitcoin that I doubt anyone can hear its name without having some kind of pre-conceived opinion, so try to bear with me.

Bitcoin’s biggest technological achievement – the thing it solves that had literally not been mathematically solved prior to its invention – is how to achieve consensus among untrusted parties. In the case of our deli transaction, the “consensus” is that “I had $10, I sent the $10 to you, now you have the $10”.

The deli owner doesn’t have to “trust” me because the Bitcoin network will verify that I both had $10 (in bitcoins) and that I sent it to him. Similarly, I don’t have to trust the deli owner; I can see that his address received it. Before Bitcoin, it was Mastercard (or Visa, or AmEx) doing these steps, and charging 3% per transaction to do it.

Bitcoin allows digital transactions to return to the simplicity of cash. I’m going to repost the benefits of cash transactions. They all apply to Bitcoin:

  • After the purchase, I can’t call up a third-party and ask that the transaction be reversed. The cash transaction is final, and if I want my money back I must ask the merchant to refund my money.
  • The owner can’t identify me; he doesn’t have my name, address or zip code. I am completely anonymous to him – as I should be. All I bought was a sandwich.
  • The deli owner receives $10. Not $10 minus 30 cents + a 2.9% fee.
  • No “trust” is involved in the middle; I am not trusting a middleman to handle authorizing the transaction and passing along the money, and therefore no one must assume responsibility (and liability) for its completion.

Bitcoin is dollars-for-sandwiches simple, at a transaction level. I don’t need to give my name and address, because a corporation isn’t attempting to do fraud prevention. The merchant doesn’t need to pay 3% because a corporation doesn’t need to be able to cover chargebacks. Bitcoin is as close as we’ve come to digital cash, for better or worse.

You don’t need to be a libertarian government hater to appreciate Bitcoin. I appreciate it because I recognize how silly it is to involve a third-party company in every internet transaction – that is an utterly unnecessary cost. It’s a problem that can and should have been solvable with technology, in the same way email cut out the postal service. And Bitcoin solved it.

And this is just one of the benefits of Bitcoin. You can also send bitcoin anywhere in the world, instantaneously. You can keep a Bitcoin balance without a central bank (this is what appeals to the libertarian anarchists). The lack of fees means micropayments (e.g. if I wanted to tip you 10 cents) are not cost prohibitive.

And so on.

Bitcoin is portrayed by the media as a bizarre cult, or a speculative bubble. But at its core it’s just a series of technologies designed to make digital transactions feasible and frictionless without a third party. Even if Bitcoin’s current value (which is, indeed, totally speculative) falls to $0, it has still solved major technical problems that were unsolved before it existed.

Hey, it’s Mr. NYBudget again. I wanted to thank Mike yet again. Be sure to follow him on twitter: @mikehearn. For those of you who aren’t convinced, here is a quick list of other potential benefits of a currency like Bitcoin:

  • In economic turmoil, if a country’s currency is ever LESS stable than Bitcoin, there is incentive to adopt Bitcoin as it can still be used for goods and services while the country’s currency is in flux. Perhaps this is hard to imagine in the US and Europe, but these situations can arise in any number of countries, promoting the adoption of Bitcoin.
  • The anonymity of cash isn’t just for conspiracy theorists. If you had only used cash at Target, your personal info never would have been compromised when their system was hacked. Bitcoin currently has it’s own issues in the media with security, but those are generally due to the fact that companies like MtGox was poorly run and that Bitcoin is so new on the scene. Those should get ironed out.
  • All of the issues with illicit entities using Bitcoin are present in cash as well. Attacking Bitcoin for it’s place in the Silk Road story is similar to attacking cash for its role in the drug trade.

Bitcoin still has a long way to go and it may NOT succeed in the end, but digital currency in general has advantages. I just wanted to present the other side of the (Bit)coin.

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10 thoughts on “Bitcoin: Back to the Basics

  1. jlcollinsnh April 21, 2014 at 8:43 am

    Damn, I love me nice simple, clear explanations and this is exactly that.

    Not sure I’m ready to use Bitcoin just yet, but at least now I understand the need and thinking behind it. Both make great sense.

    Of course, here in the US those third party charges are built into the price of everything. So using Bitcoin, at least for now, only benefits the merchants who don’t have to pay the extra costs.

    In other countries where I’ve traveled credit cards are much less widely accepted and prices reflect cash transactions. If a merchant is willing to accept a card they charge, quite reasonably, an extra percentage to cover their costs and to compensate them for the extra hassle.

    Some Americans whine about this as they are so used to paying one price and don’t realize it has these fees built in. So this more rational system appears to them to be a rip off.

    The real rip off is the system that adds 3% to the price and gives us 1% “cash back” if we use the “right” card. 🙂

    Great post! Thanks Mike and Mr. NYB

    • Mr NYBudget April 21, 2014 at 9:26 am

      Thank Jim! There are definitely down sides to using Bitcoin right not, before it has really stabilized, but I am definitely routing for it!

      That’s a great point as well. We Americans are getting ripped off every day and we don’t even know it!

  2. Phil April 21, 2014 at 10:57 am

    I’m still not sold on Bitcoin and just don’t trust it. I’ll wait to see how thjis develops in the future.
    Phil recently posted: Why the heck am I putting myself through this?My Profile

    • Mr NYBudget April 21, 2014 at 12:23 pm

      Fair enough – Bitcoin itself could succeed or could be ousted by someone doing it better. The idea behind digital currency, though is exciting!

  3. AverageJoe April 21, 2014 at 10:12 pm

    Love the explanation….very clear….and still not for me. Regulation, even though it absolutely sucks, makes sure that nobody can corner a market (like the Winkelvoss twins are doing with Bitcoin), and ensures liquidity. The beautiful nature of a lack of friction (Bitcoin’s calling card, in my book) also creates huge problems that allow others to possibly end up with complete control of my money.

    I’m a conspiracy theorist….but on the other side of the nut jobs who think we need to move to a bomb shelter and buy Bitcoins. I think those people (like Jenny McCarthy with immunizations) create lots of trouble that’ll need to be cleaned up later.

    The IRS probably put the final nail in the coffin a couple weeks ago when they declared Bitcoin to NOT be a currency, meaning that you’ll pay capital gains or losses on that sandwich in your example. Is this the US battling a rival currency? In my book, yes, BUT I don’t want the tax nightmare that comes now with buying my hamburger with Bitcoin.
    AverageJoe recently posted: $1,000,000 Is a Nice Start – STK 057My Profile

    • Mr NYBudget April 21, 2014 at 10:34 pm

      I agree that there are many problems with it, but I think we do people a disservice by dismissing it as a fad, a novelty, and a dangerous one at that. It may not be stable, but theoretically it addresses a very real a problem. Maybe a different digital currency will come and take its place and fix the problems and Bitcoin has, but digital currency is not just a a crazy dream from the twisted minds of computer engineers. It addresses a real issue that will need fixing, either by Bitcoin or a future digital currency. It is unfortunate that the general public hears Bitcoin, and immediately dismisses the idea as a volatile and ridiculous investment as opposed to understanding the reason why it was created and the problems with exchanging money over long distances.

      So, perhaps the important thing here is to focus on the issue of a lack of currency that can be transferred across the world. Forget the day-to-day news of Bitcoin for a moment and let’s acknowledge that there is a problem out there that needs to be fixed.

  4. Mr. Grump May 1, 2014 at 1:45 pm

    Whether or not Bitcoin, Mt. Gox or the Winklevoss twins survive the fluctuations of this new currency doesn’t really matter. The fact that something can (and probably will) be invented to fill this need is the interesting part. I imagine if you asked many Europeans 60 years ago (after WWII) many of them would have laughed real hard at the idea of a Euro. Even though I probably won’t invest one red cent into Bitcoin it does raise the question of whether or not a “universal” currency, digital or real can exist.
    Mr. Grump recently posted: 48 Hours in ParisMy Profile

    • Mr NYBudget May 1, 2014 at 1:55 pm

      Absolutely! It’s very intriguing and it doesn’t need to be Bitcoin that fills the void. Imagine traveling to a foreign country and not having to worry about exchanging your money or what to do with your leftover currency. There are so many real applications that I think a lot of personal finance bloggers miss because they are thinking about it from an investment standpoint.

  5. Jeffrey Ito April 6, 2017 at 7:09 pm

    Imagine if we were all living in space colonies. Bitcoin would make it far easier by eliminating location, speed and transactional factors. It would also make it more secure and ultimately easier to use.

    Great inspirational article!

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