When I was starting my journey to understand this technology I found the literature on the subject dry and the information available online often misleading. I decided to write a simple story to explain Bitcoin’s fundamentals in technology and economics without getting into the weeds. The story itself is free of any technical jargon and I hope it’s accessible to everyone, even if the reader doesn’t have a background in technology. I did add some side notes as the story progressed to connect the dots between the analogy and real life, just in case the reader feels inclined to get deeper into a particular subject.
As a clarification, when I use the word “Bitcoin” with capital “B” I’m referring to the technology that supports the cryptocurrency. When instead I use the term “bitcoin” with lowercase “b”, I’m referring only to the cryptocurrency. BTC is the acronym of bitcoin, same as CAD is the acronym for the Canadian dollar.
Dragoncoins and the Dragon Kingdom
Let’s imagine three ten year old kids, John, Peter and George, that during a break between classes decide to create a kingdom just for them: the “Dragon Kingdom”. The first order of business for the kingdom is to create its own currency that the kids name “dragoncoin”. The purpose of the currency is nothing more than to exchange small goods between them like candies, cookies and stickers.
They decide that in total there’s going to be 120 dragoncoins. The kids look around trying to pick something that could play the role of coins but they fail to find 120 things of the same type that could be used. Instead they agree to use Max’s notebook as a ledger where they will keep track of every transaction done with dragoncoins.
Side note: Similar to dragoncoin, bitcoin doesn’t have physical coins and bills. Bitcoin only exists in digital form stored in a distributed database. The notebook in this case is just an analogy of a database.
The first logical step would be to distribute the 120 dragoncoins equally among the three of them but George doesn’t agree. The people of the Dragon Kingdom need to work to earn dragoncoins, much as how their parents work to get money in real life. Because George likes magic tricks, he always carries around a deck of cards. He proposes a game similar to “guess the card” that could be used to simulate “working” to earn dragoncoins.
Side note: In Bitcoin new coins are created by miners using an algorithm called proof-of-work that requires powerful computers. Computers “work” to generate new bitcoins.
To make the game reasonably complex but not overburden, George selects only half of the cards from the deck, hearts and spades. George takes these 26 cards (a deck has 52), extends them face down and asks Peter to pick one and look at it without showing it to anyone else. George explains to Peter that he’s going to try to guess his card and that Peter is only allowed to reply “Yes” if the guess is correct or “No” otherwise. The reward for guessing the card correctly would be 10 dragoncoins. But here’s the kicker: George is allowed to try to guess the card as many times as he wants. If he’s lucky he would be able to guess the card in the first try but if he’s unlucky he might need to try 26 times.
Side note: The proof-of-work algorithm requires a computer to guess a number within a certain range. The only known way to “guess” the number is by trying every possible combination until a number within the range is found. This is due to how hash functions work but that’s beyond this article. Contrary to our example that has only 26 possible values, solving the proof-of-work challenge is so hard that a regular computer might take (theoretically) hundreds of years to guess a correct number.
John is not so sure about this game. Having an unlimited number of attempts would mean that they will always guess the number eventually and get the reward. “That’s not fun”, John says. To this George replies, “do you think our parents go to work to have fun? No, they do it to get money. The people of the Dragon Kingdom need to work to get paid”. The kids arrive at a compromise to make “working” a little fun at least. Each one of them will have 5 minutes to play the game as many times they want. If one of them is lucky and guesses the card faster on average than his peers, that kid will earn more dragoncoins and will become the richest man in the kingdom. The kids start playing taking 5 minutes turns guessing the card and writing down the results in John’s notebook to keep track of how many coins each one is earning.
Side note: Two computers with the same processing power could solve the “proof-of-work” challenge in less or more time depending if they are lucky or not. Luck in this case is distributed randomly and over a long period of time both computers will create the same amount of bitcoin. To be able to create more bitcoins than other computers in the network, one has to increase the processing power significantly.
At the end of the school day, and after playing to “work” for a while to earn dragoncoins, John’s notebook reflects that he has 30 coins, Peter 10 and George 10. John notices that George brought his favourite cookie as a snack and asks him if he will be willing to sell it for 20 dragoncoins. George accepts, as that will make him the richest man in the kingdom. John gets the cookie and writes down in his notebook the transaction. The school day ends and the three kids go home.
Side note: The first known commercial transaction made with bitcoin happened in 2010 when two pizzas were bought in exchange for 10.000 bitcoins. At today’s exchange rate ($32000 per BTC) each pizza would have cost 160 million US dollars!
Once at home, John starts thinking what to do to earn dragoncoins faster than his friends. He was lucky the first day and was able to guess the card faster than Peter and George on average. That allowed him to accumulate more dragoncoins and to purchase George’s cookie. Tomorrow he might not be as lucky.
John is the only one keeping track of dragoncoins creation and transactions. What if he just adds a new line that says that he won an extra 10 dragoncoins without having to “work” for it? He’s pretty sure his friends will not remember tomorrow every single transaction that happened the previous day. Besides, the notebook is his, he can do whatever he wants with it.
Side note: Bitcoin is the first distributed system that was designed to survive not only when nodes are down but when nodes try to cheat. The latter can be overcome only if the rogue nodes represent less than 51% of the total processing power of the network. The possibility of rogue nodes exceeding this threshold is known as the “51% attack”.
The next day, the three friends get together again during a recess and right off the bat, John offers again 20 dragoncoins for George’s cookie. George thinks for a moment and realizes that with 50 dragoncoins he will be far ahead of his friends because both Peter and John have only 10 coins each. “Wait a minute, you don’t have 20 coins, you should only have 10 left” says George. Puzzled he asks John to show him the notebook to verify all transactions from the previous day. John refuses for a moment trying to come up with some silly excuses but his friends are having none of it. John concedes and with a mischievous smile confesses that he added money for him in the notebook and promises to erase the false transaction.
Side note: This is why Bitcoin was designed to be distributed. A centralized system gives too much power to the owner in detriment of the rest. Banks for example are centralized systems. Contrary to the notebook example, Bitcoin is immutable. Once accepted, transactions can never be deleted or changed.
George and Peter are furious, John is always trying to take advantage of them because he thinks he is smarter. George demands John to give him his notebook and that for now on, he will be the one taking notes of every transaction. John refuses and promises that he will never do it again, he asks them to trust him. The other kids know that they can’t trust John and besides, even if he never tries to cheat again he could one day just make a mistake and forget to write down a transaction or maybe write down the wrong number of coins. This time was easy to detect the problem because they have only played for a day and they could remember every transaction but, would they be able to discover the inconsistency after a couple of weeks?
Side note: Have you heard the term “trust but verify”? Bitcoin takes it a step further and changes the term to “don’t trust, always verify”. The computers of the network don’t trust each other since that would open the door for malicious actors trying to exploit the system. Bitcoin is known as a “trustless” network.
The kids argue for a while and finally decide that the best way to detect if someone cheated (or made a mistake) would be for each one of them to keep a copy of all the transactions on their own notebooks. At the end of each school day, the kids would get together to compare the transactions on their notebooks. If during the comparison they find that a transaction exists in one notebook that doesn’t exist in the other two then they will know who is cheating. That should be enough to deter John from cheating again as his ruse would be uncovered easily.
Side note: The Bitcoin network is made of multiple computers (nodes) connected between them. Each one of these computers has a copy of all the transactions made on the network. Every time a transaction is made, every computer verifies the validity of the transaction to detect irregularities. If a computer is detected cheating it’s simply ignored by the rest of the network effectively isolating it.
After a couple of weeks of playing to “work” by guessing the card and exchanging items using dragoncoins, the kids have accumulated hundreds of coins each. They have started to notice that the cost of the things they normally sell to each other have started to increase. For example, the snack that George always brings to school and that John always wants to buy, is now also Peter’s favourite. When John offered again 20 dragoncoins for George’s cookie, Peter offered 30. John doesn’t give up easily and increases his offer to 40. Peter gives up and John gets to buy his favourite cookie but this time at a higher price. The three kids have observed a similar situation with the stickers sold by Peter and the candies sold by John.
Side note: Bitcoin presents a curious economic scenario. Since its inception a decade ago, 18 million coins have been created. Logic dictates that as more money gets created the less purchasing power each coin should have. Bitcoin has shown the opposite behaviour as over time its purchasing power has increased exponentially. The story of the 160 million dollars pizza is a good example of this.
For the kids this situation presents an inconvenience as they need to keep adjusting the prices of everything and that’s annoying. Ideally they would like things to cost the same, that way buying and selling candies, stickers and cookies would be much easier. How can they prevent the increase of prices? At first they tried to fix the price of every item: cookies 40, stickers 60 and candies 30. This simple solution works well for a while but the temptation of outbid each other is too great. At the end of the day they are competing for the same cookie, sticker and candy. Eventually prices start to raise again and the kids understand that fixing prices doesn’t work.
Side note: Countries like the Soviet Union, Cuba and Venezuela tried for years to control inflation by fixing the price of every product and service. At the end this effort failed on all three countries and they were forced to abandon such policy after an ensuing economic meltdown.
Not knowing what to do, the kids ask their teacher for help at the end of the class. The teacher listens carefully and emits a diagnosis. The Dragon Kingdom is suffering from inflation. She proposes two possible ways to fix this. The first one is to increase the number of items they are willing to sell to each other in order for supply to meet demand. The second one is to stop creating new coins. Given that the kids can’t go to a store and buy more cookies, stickers and candies using dragoncoins they decide for the second option. No more playing the game “guess the card” to create and earn money.
Valerie and Ricky have shown interest in joining their game. John, Peter and George decide not to stop the guess the card game immediately as it wouldn’t be fair with the new future citizens of the kingdom. Valerie and Ricky should have the opportunity to earn money by simulating work just as they did. They instead find a compromise, every week they will reduce the amount of dragoncoins earned by playing the game until it reaches 0. So this week instead of the reward being 10 dragoncoins it will be 9, next week 8, the following week 7 and so on. Their hope is that as the money creation decreases, prices will stabilize.
Side note: Bitcoin code establishes that every 4 years (on average) the amount of new bitcoin generated by correctly solving the proof-of-work challenge will halve. As a consequence, at some point in the future the amount of bitcoin in circulation will cap at 21 million coins.
Back to Reality
The story of John, Peter and George help us understand fundamental concepts about Bitcoin’s technology and economy. Of course, many topics have been left out to make the narrative simple and the technical discussion accessible.
Bitcoin’s technical revolution is on allowing different nodes in a network (interconnected computers) to collaborate and reach consensus even when some of those nodes fail and become unresponsive or when some nodes are programmed to cheat. Bitcoin’s economic revolution is on devising an effective mechanism to limit the supply of the coin progressively until reaching 21 million coins. Not even gold has that property given that every year mining companies keep extracting more precious metal from the earth.
Even after 10 years of operation, Bitcoin can be considered to be in its early stages, specially when compared to any other national currency or even metals like gold and silver. Bitcoin has proven to be an extremely resilient system that has never been blocked or hacked and it’s not for lack of trying. 2021 is the year where Bitcoin’s economic policy could be put to test as more and more institutional investors look at it as a viable alternative to traditional stores of value. Bitcoin’s future depends on succeeding in this new challenge.