A First-Principles Approach to Bitcoin
Building a Means of Exchange from scratch
Article also available on Mirror
Bitcoin’s in the news again. This surprises many, but it shouldn’t surprise those who have been paying attention. People had been saying Bitcoin was dead for years, that it would never recover, that it was just a fad.
The way people talked, you would expect Bitcoin in 2020 to look like this:
But, instead, it looks more like this:
So why isn’t Bitcoin dead? Why do so many “experts” in the world continue to be so bad at predicting what will happen to it? What actually makes it special, if anything?
There are many different ways of understanding a subject. Most, when explaining Bitcoin, have used analogies. It is like gold. It is money, but digital. It is like a tulip. But most of you reading this probably still don’t really “get” Bitcoin — and don’t worry, I get that. Very few are adept at actually sitting down and explaining to you what Bitcoin is, how it works, and why it’s important. So, instead of using analogy, I’m going to use another technique. This technique is called First Principles, started by Aristotle, and made much more famous by Rocketship-making, electric car-engineering, neuron-implanting Elon Musk.
“I think it’s important to reason from first principles rather than by analogy. The normal way we conduct our lives is we reason by analogy. [With analogy] we are doing this because it’s like something else that was done, or it is like what other people are doing. [With first principles] you boil things down to the most fundamental truths… and then reason up from there.”
Elon Musk challenged the assumption that electric car batteries were very expensive, by asking what the batteries were made of, and how much those materials cost. Finding the materials to be much cheaper than batteries on the market, he realized that a great deal of the expense was a result of things other than their direct cost. And as a result, he was able to change it, and make them much cheaper.
First Principles takes what we know is possible and impossible, based on the constraints of the laws of physics, rules of logic, and materials — and builds up from there. It isn’t easy, and it can be tedious, uncertain, and takes a great deal of creativity. But thankfully, you don’t have to do it alone. You don’t have to invent Bitcoin from scratch — that work has already been done. Instead, we’ll look at the trail Bitcoin’s founder, Satoshi Nakamoto, blazed in order to bring us to where we are now. From a text document published online, to code executed by a handful of computers, to something consuming more power than Ireland and possessing a higher valuation than most Fortune 500 Companies.
“The famous flutings on the famous columns — what are they there for? To hide the joints in wood — when columns were made of wood, only these aren’t, they’re marble. The triglyphs, what are they? Wood. Wooden beams, the way they had to be laid when people began to build wooden shacks. Your Greeks took marble and they made copies of their wooden structures out of it, because others had done it that way. Then your masters of the Renaissance came along and made copies in plaster of copies in marble of copies in wood. Now here we are, making copies in steel and concrete of copies in plaster of copies in marble of copies in wood.”
-Howard Roark, the Fountainhead
This quote illustrates something true of everything, not just buildings. And this includes currency. The idea of money is based on older rules. Rules that made sense back then. But now, given our change in technology, no longer do. The current financial system is very similar to using steel to imitate wood. Not only is it not necessary, but it fails to see steel’s true potential — the ability to create skyscrapers.
If we were to build a currency using First Principles, what would it need? What does a currency fundamentally need? Before, it was assumed that a currency needed either an enforcer, such as a government, or to be based on some kind of material value. But these are assumptions. Fundamentally, we can build up what a currency must be using math and economic fundamentals. It must have limited supply. An infinite currency will not be worth anything. It must be fungible. If a $1 bill is worth more than another $1 bill, the currency breaks down by becoming too complicated as a means of exchange. You have to be able to retain your hold of it. In a more simpler term, you have to be able to own it. But ownership can be simplified to your ability to retain hold of whatever that thing is. If the US Government decides you don’t own your Dollars, you don’t have them anymore. Therefore, you have a limited hold of them. It must be easily transferable. Furniture would not make for a good currency, because it is not easily transferred. The lighter, the better. It must have verifiability. If it can be easily faked, it will diminish in value. It must have demand. If no one wants it, it will not be accepted as a form of payment. This is probably the most obvious law. Why it has demand isn’t important. It doesn’t matter if you want it for your own purposes, because you think it has utility, because you think others will value it, or because it’s shiny. All that matters is you want it.
Now build up from there. Satoshi started this by using core logic. That’s all computer programs really are. Executable logic. Can a currency be built up using nothing but logic? Start with limited supply. You can set a limit to how much of a thing you can have, setting constraints to how much of it is available at a time. Now fungibility. Make every unit of that thing indistinguishable from the other units. And allow it to be broken down to extremely-small units, in this case known as Satoshis.
So how do you retain hold of it? You can’t physically have it on hand. But here’s the first key component of Bitcoin, which makes it different from other currencies. You have a signature. This is a digital signature, in the form of what is called an encryption key. No one else has this key. No one else in the universe. Only you. And with it, you can prove you own your Bitcoin, and transfer it. With encryption, everyone can verify you are the owner, without knowing what your encryption key is. This is the art of encryption. Problems are hard to solve, such as breaking encryption, but easy to verify.
How a Signature Works
You are given what is called a public key. This key is an assortment of random digits and letters. It is unique, no one has the same one. This is what is called a hash. This is your public address, and anyone can send Bitcoin to you with it, and you can verify that you are the owner of the address by using your private key.
Your private key is a secret hash that are for your eyes only. By using it, you can ‘unlock’ your public address. This is how most encryption works. You can think of a public key as a puzzle. And only the private key can solve it. When you ‘unlock’ it, everyone can verify it was you who did it, without knowing how you did it. This is why it is called ‘hard to solve, but easy to verify’. The amount of brute-force computation needed to break your encrypted key would take the power of a very large government.
Now for transferability and verifiability. This was the difficult part. This was the part that needed insight. If I hand you a gold coin, you know you have it in your hand, and you know I no longer possess it. With paper currency, how do you know I didn’t make a copy of it? To prevent it, governments ban copies, search for them, and even prevent normal copiers from printing what’s on a dollar bill. But what can be done with code? Can anything be done using pure logic?
This is where a public ledger comes in, what separated Bitcoin from other digital currencies. I give you a Bitcoin. It’s written on my ledger that I give it to you. It’s written on your ledger, too. And your friends’ ledger. And their friends. Everyone has a copy, so you know it’s actually your Bitcoin now, and not my own. You can get a better idea of how this solves coordination failures here.
What a Blockchain Actually Is
A blockchain is composed of a chain of… blocks. These blocks are objects. And each object points to a previous block. In computer science, this is similar to a Singly Linked List.
A Singly Linked List is a ‘chain’ of nodes. These nodes are a type of object, and can store just about anything. For the technically savvy, this could be arrays, strings, ints, or anything else. All that matters is that each node is a chunk of data, with directions for where to find another piece of data. That other piece of data also has directions to another chunk of data. And so on. The directions tell the computer where to find the address the data it is pointing to. For this reason, they are called pointers. It is called ‘Singly Linked’ because each node only has one pointer. So they are all tied together using only one ‘chain’. At one end of the chain is a ‘tail’. At the other end is a ‘head’.
In the case of a blockchain, each block is a node in the Linked List, pointing to the previous block. Since pointers tell us where to find the data, the pointer is set to the hash of the entire previous block. This prevents people from altering the data, since any change to the hash, would result in a different address. And, as a result, it wouldn’t point to the previous block. The head is always the previous block to the current one, so that every miner knows where to start from. This chain goes all the way back to the Linked List’s ‘tail’, in this case known as a Genesis Block. This is where it all began. Bitcoin’s Genesis Block was way back in 2009. The key to understanding this is that blockchains are similar to Linked Lists, where each node is pointing backward in time.
So why is there demand for Bitcoin? Everything explained above is why there is demand for it. No one had created this before. For the first time, ownership didn’t need coercion. For the first time, money could be digital, verifiable, and without any central authority. The reason why the US Dollar has value is because it is enforced by the world’s largest military, and because the United States has been viewed as stable. But if the government fell tomorrow, so would the dollar. But every government on the planet could collapse into ruin, and nothing would change about Bitcoin. Since it is decentralized, as long as there are computers on the planet able to run the network, it will remain. This is why people want it. This is why Bitcoin has value.
So next time you read about US inflation, financial uncertainty, or the price of the Euro being in trouble, don’t be surprised if Bitcoin’s price starts rising. When older financial entities begin to fail, new ones take their place. It’s not a revolution that happens overnight. But it’s a revolution that’s been quietly happening for the past 10 years, and people are starting to notice.