Bitcoin – Money Decentralization (Understanding the Process)

Before you read this article bear in mind that it is written from a computer science rather than economy point of view, therefore, many of the “economic” details might be oversimplified.

Bitcoin is a type of a currency, used globally, and can be converted to US dollar, like any other currency we know (check Bitcoin Price using this tool). What makes Bitcoin interesting is that its birth brings to the world an old-new type of a monetary system that works in a decentralized manner. The term “decentralized monetary system" will be explained later on.

The two main aspects that make Bitcoin different from a modern monetary systems, like US Dollar or Euro, are the following:

1. Decentralization: There is no central entity that prints (mints) money, but rather the money is being mint by the crowd. This makes Bitcoin a decentralized system.
2. Anonymity: People who use Bitcoin hope that their identity would not be revealed, in contrast to the usual way we all buy commodity over the internet using our credit card, we have to supply our personal details to be verified against the bank who treats our account.

In this post we will cover only the decentralization aspect of Bitcoin, leaving the anonymity aspect for later posts.

Decentralization

To understand the term “decentralized monetary system” we first need to understand what a “centralized” system is. Informally, a centralized monetary system is a one in which some central authority, like the government, is responsible to all aspects of economy, including minting money, taking taxes on profits, allowing banks to handle accounts for the citizens, putting regulations and so on. Almost everything is based on government laws and policies. The vast majority of money transactions are passing thru one or more third party entities, like the banks, who then audits and store all the details for later disputes handling, accrediting and law enforcement monitoring purposes. 

Having the notion of a centralized monetary system in mind, we can now tell that a decentralized system is a one that is missing these central authority, and still, is able to work properly as if there indeed was a central authority behind. The requirement to “work properly” is a bit vague and depends on the financial and law policies that each country applies to its system. That is, in most of the countries, a monetary system that works properly should feature some form of a taxation, this also could be different from one country to another. However, in all countries (or federations), a decent and controllable money minting procedure is a crucial and a pivotal property for the monetary system to have. The Bitcoin system is said to have this last property; whether is it features other important properties (like taxation, regulation, etc.) is subject to interpretation and maybe adaptation of newer sophisticated versions of the system. Before learning how bit-coins are generated, let’s take a closer look at how money was perceived during the history.

 If we look at the monetary systems used throughout history, we can observe that at the beginning of trade people used a decentralized system, later they switched to a centralized one, and nowadays the cryptographic community is making enormous efforts to switch it back to a decentralized form, with a more modern twist. An overview of the monetary system approaches over the history follows:

Old history: Decentralized Commodity System

This is a simple system in which a gram of gold is worth simply a gram of gold, where gold is the base exchange tool and therefore was called gold-standard (later on, the silver-standard and double-standard were developed). There was an exchange rate from any substance to gold and vice versa. This way you could buy anything you need, by exchanging it with some other thing of yours that has the same gold-value. This kind of a system was possible because everyone was aware of the rarity of gold, which made it valuable. There was no need of an authority to declare that this amount of gold is actually worth this amount of wood etc., instead, the value of products was derived from their actual physical value, therefore, it is considered as a decentralized system.

Recent history: A Centralized Commodity-Backed Money

This is one step toward the money system that we know today. In a commodity-backed system a customer doesn't buy food by giving some amount of gold to the seller, rather, it holds a note, or a certificate, that was signed by the bank, which states that the bank reserves some amount of gold in its cellars. Whoever holds this note can redeem it later by handing it to the bank, hence, this note is transferable and can be used to pay for food or any other goods. In that sense, we refer to the bank as the centralized point in the system, it reserves gold bricks for his clients and put his signature on the notes. A crucial point here is the role of the bank, if you are playing in this game you must trust it and be able to tell if a note that someone pay you with has a valid or a forged signature.

Modern: Centralized “Fiat” Money

This is the money we know from our daily use. As the commodity-backed money, this monetary system also uses notes and coins. However, in a Fiat money, these notes and coins do not represent any actual material like gold or silver. These notes are only valuable because of a governmental decree; for instance, if you sell hot dogs at the streets of New York then you must accept the US dollar as an object to exchange hot dogs with. You do not accept US dollars because of their physical value (it is just a piece of paper after all), but merely because the government forces you to accept it. This way, the government made the US dollars the most fungible objects these days (it became more useful than a brick of gold). As explained, these notes are substantially worth nothing, but due to regulation, they're worth the number that is written on them (this number is also called their “face value” by the economist jargon). The above also clarifies the reason that this type of money is called “Fiat”, the word fiat came from Latin and means “let it be done” or  “it shall be” used in a sense of an order or decree.

Future: Decentralized Blockchain

It is easier to understand what a blockchain is and how it works by an analogy to a bank account. If you have a bank account, then you probably know that you can query about your account balance and also see all transactions that are related to it, i.e. transactions for either earned or spent money. The bank stores this information in its private notebook (or database) and makes it ready  for client queries. The only interface to that notebook is via the bank, meaning that you cannot check the balance of your friend’s account. Assume that the notebook that the bank uses has an infinite number of pages, that is, it is never gets to an “out-of-paper” problem. The
bank begins to fill its notebook from the first page, numbered 1, and continues toward higher page numbers.

The bank follows the following two auditing rules very carefully:

1. Irreversibility - If the bank is currently writing a transaction entry to page X then it never goes back and change some page with a number lower than X.
2. Latency - If it is currently writing to page X then the transactions appear on page X are not yet valid and thus cannot rely on them when clients query about their balance (this rule reflect the real life behavior of our account, we need to wait for a while till we essentially see a transaction that we made). 

These two rules mean that the page X is the only one which is writable (able to be written) but not readable (since the bank cannot rely on what’s written to it) whereas pages 1,2,...,(X-1) are readable but could not be rewritten.

An additional key matter pertains to transaction fees: Each time a bank processes a transaction from Alice to Bob, Alice remits a certain sum to the bank as a service charge. This sum isn't set by the bank as conventionally done, but instead operates on a completely free-market principle. Alice informs the bank about the transaction she intends to carry out and the service charge she's prepared to pay; the larger the fee, the greater the likelihood it will be included in the page the bank is presently recording, signifying that the transaction will be confirmed sooner.

Just decentralize it!

The above concludes the way a centralized system would work. Let’s see how a decentralized version should work. Decentralization of the system means that we need to achieve a reliable way to store the previous transactions, but without a central bank that controls everything. Also, it is important to note that if there is no trusted central entity (like the bank, or government) then we need to find a technique by which everyone agree on some object that is valuable, like note and coins, but this time we require it to be some digital form of data. In the following, we first deal with decentralization of the notebook and then show how valuable digital objects (our money) are created in the system.

So, instead of a bank, we have a bunch of clerks who potentially can process Alice's transaction. Alice knows only few of them. When Alice wants to transfer money to Bob she sends the transaction information to every clerk she knows. This information consists of Bob’s account number, amount of money to transfer and amount of commission fee she is ready to pay for the service. At least one of the clerks, namely, Clair, has got this message and found the commission amount mentioned in it sufficient. In order to actually receive this mentioned commission, Clair has to write down that transaction to the page she is currently editing, and then, when there is no more room in the page Clair tries to append this new page to the common notebook that is shared between all clerks. Clair does so because she needs every other clerk to agree that she processed the transactions written to the page and thus she is entitled to all commission fees mentioned in it; when everyone agrees, all the transactions in the page are considered as valid and Clair is said to earn her commission fees.

As you might observed, the task of adding a new page of transactions to the notebook and make everyone agreeing on it is not an easy one. To see why, assume that Dan, another clerk who received Alice’s transaction information, is trying to add his page to the notebook at the same time, where his page also contains the same transaction from Alice to Bob. Alice’s transaction must not be processed twice of course, since if it is being processed twice then she loses money that she didn’t meant to spent. Who, then, is entitled for Alice's commission fee? Clair or Dan? The answer is simple: Whoever is faster. If Clair processes her page first and manages to convince everyone else that she did so then her page will get into the notebook, this requires Dan to edit his page because the transaction from Alice to Bob is already in the notebook and cannot be written twice.

In real life, processing a transaction by a computer is an easy task and doing it by a normal computer will require only few milliseconds (or even less), this will cause a tough race between Clair and Dan and a situation in which part of the clerks are convinced by Clair and another part are convinced by Dan is very easy to happen. Transactions processing must be taking some longer period of time, in a way that allows everyone to be convinced by only one clerk. This is done using a puzzle: For every page that is to be added to the notebook by some clerk, there is a unique random puzzle, that is immensely difficult to solve. The fact that the puzzle is a unique and random for each page, and the page that Clair is processing is slightly different from the page that Dan is processing (both contain Alice’s transaction though) then their puzzles are different and thus one of them will find a solution first, meaning that it will have enough time to convince everyone else to agree on its page.

So we know how does money can be transferred, and also how can a clerk make some money from commission fees. But what is actually this money, and how Alice obtained this amount of money that she transfers to Bob in the first place?

We already can tell that the money does not come in a physical form, since we don’t trust any central entity to create money and spread it among the mass. To answer this question, we now refer to the clerks described above and call them “miners”. This name reflects the hard work that they are doing, i.e. trying to find a solution to an extremely difficult problem, in an analogy to a real miner that is trying to find a metal under the ground.

It is remain to explain how money is generated. As you can imagine, the miners are the ones who bring new money to the world. They invest a huge amount of work because the system gives them an incentive to do so: They earn from the transaction fees, but also earn some fixed amount of money for each page they add to the notebook; this fixed amount is practically huge and currently is equal to ~13K$. We should pay attention to an important property of bitcoin - a miner might earn nothing from his hard work. The miners follow a necessary rule: Only one miner, whoever finds a solution to a puzzle first, is not only entitled to have the commission fees, but also receives some fixed amount of brand new digital coins, that are immediately created especially for it. In fact, this fixed amount of money is another transfer that the miner put in the page, the transfer destination is its own choice, most likely to be its own address.

Put it all together

Alice, who wanted to perform a transaction of money to Bob could actually be anyone with a Wallet app on her phone or PC. The wallet is a program that stores bitcoin on your computer and also tracks the IP addresses of the miners. The miners who sit behind these IP addresses are notified whenever we command our wallet program to transfer money to someone; also, the wallet polls these addresses about new created pages in order to check whether money has just transferred to it (meaning that someone has just payed you money).

Once you notify the miners about the transaction you are willing to perform, they try to add it to the next page and find a solution for the puzzle associated with that page, the first miner who find a solution earns your transaction fee along with the fixed amount of money.

Finally, let’s refer all the above components with the names given to them by the Bitcoin community: A page which contains a bunch of transactions is actually called a “block” of transactions, therefore, a notebook is actually called a “block-chain”, since it is a chain of ordered blocks, each of which contains a bunch of transactions that are all already validated. The extremely difficult puzzle that the miners are trying to solve is actually finding a specific form of output of a cryptographic hash function such that the output is in a specific range (this is a subject to a new post and would be explained in the next post). Also, since the miners are required to perform a huge amount of trial-and-errors in order to find a solution to the puzzle, it is said that they are actually proving that they have worked hard, hence this is called PoW - proof of work.