What is Bitcoin, how does it work, and can it revolutionize government? Peter Van Valkenburg reports for the December issue of Townhall Magazine.

Bitcoin is going mainstream.

No longer the exclusive toy of fringe political movements, basement dwellers, and assorted ne'er do wells, Bitcoin’s gaining the sincere admiration of some heavy hitters in the world of technology, politics, and economics.

Where once it was just the likes of former-Rep. Ron Paul (R-TX) calling for Bitcoin to “be perfectly legal,” now Google’s CEO, Eric Schmidt, has called it a “remarkable cryptographic achievement” with “enormous value,” and former-Federal Reserve Chairman Ben Bernanke has said it “may hold long-term promise, particularly if the innovations promote a faster, more secure, and more efficient payment system.”

Hype aside, it’s important to understand just how these technologies work and why they could be a force for greater liberty and prosperity in our time.

What is Bitcoin and How Does It Work?

First off, Bitcoin is both a payments network on the Internet—that’s “Bitcoin” with a capital “B”—and the coins or tokens of value that flow through that network—“bitcoin(s)” with a lower case “B.” Bitcoin is correctly referred to as a decentralized cryptocurrency. Those words are packed with meaning. In order to understand Bitcoin, let’s look carefully at “decentralized,” “crypto,” and “currency” individually.

“Decentralized”

Decentralized, in this case, means that the currency is not controlled by a single entity, like a corporation, bank, or government. Instead, it is created and maintained by the interactions of many individual persons or businesses that join the Bitcoin network on the Internet.

This is not as strange as it may sound. The English language, like Bitcoin, is an extremely valuable tool but no single group or individual controls what is and isn't English. Words are invented by individuals and adopted, or not adopted, by the English-speaking world. Particular sentence structures may be improper at some points in history, as when a preposition is what a sentence ends with. But those rules may change, disappear—as with never start a sentence with “but”—or reappear depending on the attitudes and choices of the many individual speakers of English.

Bitcoin is like a language. Its users, the Bitcoin network, all use computer software that speaks the same language, the Bitcoin protocol, and if enough users decide to change the way it's spoken by tweaking their software, then the protocol changes. But because everyone on that network is invested in Bitcoin, it's extremely unlikely that any change would be adopted if that change made Bitcoin less secure. Just like English, there are plenty of people on the Bitcoin network ready to step in and criticize poor Bitcoin grammar, spelling, or the too-artful use of a word.

“Crypto”

The "crypto" in cryptocurrency isn't anything related to the Loch Ness Monster or the basement of a cathedral. It comes from "cryptography," the art and science of keeping secrets using math. Cryptography's been around since at least the ancient Romans, whose generals scrambled messages on scrolls to communicate in the field.

Public key cryptography is the particular, recent cryptographic innovation that has made things like Bitcoin possible, and it's also the technology used when you send your credit card information over the Internet to buy things on Amazon.

Public key cryptography allows Bitcoin users to see but not impersonate each other. Everyone with bitcoins has a public address. Think of it like an account number. Everyone on the network can see how many bitcoins are in all the different public addresses, but they can never impersonate the owner of another address in order to steal those coins. Each public address has a private key. Think of it like a password, and only the person with that password can move Bitcoins out of that account.

The full list of balances for all these accounts, from accounts holding tiny fractions of a Bitcoin to accounts with millions of dollars worth, is kept in a large publicly shared spreadsheet called the blockchain. When I give two of my Bitcoins to a friend, I'm really just using an app on my phone, called a Bitcoin wallet, to tell the Bitcoin network that my address is now two bitcoins poorer and my friend's address is now two bitcoins richer. The people on the network listen for my announcement, and some of those people, called miners, set their computers to compete to be the first to record those new balances in the blockchain—the list of all balances.

A miner will only record my transfer to my friend if I had at least two bitcoins in my address to begin with—otherwise I'd be sending money I didn't own—and the miner’s computer knows that I do—or don't— have those bitcoins because my initial balance was listed in the blockchain. The miner’s computer knows that I am the person that has the right to give up those bitcoins because I signed my announcement using my secret private key, something that only I have.

But, why would a miner spend the effort to write my transaction in the ledger? The miner does this because she can put 25 new bitcoins in her own public address if she's the first to record all the transactions that take place within a 10-minute period, and also the first to solve a difficult math problem that was set up by the last miner to win the reward. In short, miners compete to honestly record transactions across the network so that the network will reward them with new bitcoins. That, in total, is how Bitcoin works. There’s a big public ledger describing who has which bitcoins—the blockchain. There are miners who update that ledger in return for rewards of new bitcoins. And the only person who can ask for the ledger to show that bitcoins have moved from one address to another is the person with the private key to the public address that holds those coins.

“Currency”

Now that we’ve talked about how bitcoins can be sent and received, one big question still remains: Why is a bitcoin valuable? The answer is surprisingly simple. It’s valuable because it is scarce and demanded. People demand bitcoin for all sorts of reasons: They might want to invest in it because they expect the price to rise; they might want to hold some in order to buy products on the Internet; or, send it to a friend to satisfy a debt.

Bitcoin is scarce because there are only so many bitcoins that exist in the world. As discussed, bitcoins can only be sent by people who already hold them in their public address. You can’t just print up new bitcoins in order to send them; someone needs to send them to you first, or you need to buy them from an exchange. Miners, it’s true, are rewarded with new bitcoins whenever they faithfully list new transactions on the blockchain. These rewards, however, are set to diminish as time goes on, and ultimately only about 21 million bitcoins will ever exist.

Not as Hard to Use as It Sounds

Bitcoin's not as difficult to use as all this explanation may suggest. It’s true that until recently a bitcoin was pretty complicated to purchase, hold, or send. That’s mostly because it was a new technological innovation made by savvy people without too much attention paid to the user experience. The same thing could have been said about the Internet in 1995, but today that’s clearly not the case.

The Internet became easy to use because innovative companies built web browsers like Netscape, Firefox, and Chrome. These programs connected to the Internet and could display information on the network as visual layouts, webpages, rather than raw computer code or ordinary text. Eventually, other companies built graphics-rich websites that a user could visit with her browser in order to read, watch, and interact with content, all without even thinking about the complicated networks of ones and zeros that lay beneath it.

The same thing is now happening with Bitcoin. A number of companies and software designers have started making Bitcoin as easy to use as online banking and shopping websites. The communication on the Bitcoin network looks the same, a bunch of seemingly random letters, numbers, and math, but the user sees a webpage or smartphone app attractively displaying their bitcoin balance alongside a button to cash out that balance into dollars sent to their bank account, and another button to send or request payment in bitcoins from a friend.

Giving the Fed Some Healthy Competition

Bitcoin is not replacing the dollar bill, and probably never will. It can, however, compete. Central banks hold a great deal of power. Increasing the money supply of a central bank like the Fed can cheapen the dollars in the pockets of every American. By failing to conform its behavior to market expectations, a central bank can cause shocks to the economy. Advocates seeking to “audit the Fed” want to use transparency to help rein in these abuses, if and when they emerge.

Oversight is, however, not a silver bullet. Monetary theory is complicated stuff, and it’s difficult to say who might even be qualified to authoritatively criticize certain decisions.

A better alternative is having alternatives.

If Americans can easily use Bitcoin rather than dollars then that’s all the more incentive for the Fed to get it right and not screw around. Debase the dollar and you’ll only lose dollar-users to the bitcoin market. Until virtual currency, the only viable alternative to dollars was using foreign currency from other nations. Trouble is, not many corner stores in downtown Des Moines take Brazilian real or Vietnamese dong as payment. Moreover, foreign currencies merely repeat the dilemma with dollars: If the Federal Reserve Bank of Chicago has questionable credibility then it’s doubtful the central bank of India or—more obviously—Zimbabwe would be much of an improvement.

Bitcoin should be celebrated for bringing real alternatives to otherwise monopolistic money printers, and—just maybe—giving Federal Reserve Chair Janet Yellen another reason to get it right.

Terrorists are Not Impressed

The ease with which Bitcoin can be transmitted overseas seemingly makes it an attractive choice for those sending funds to international criminals or, worse, terrorists. Thus far, however, that threat has yet to materialize. Edward Lowery, special agent for the American Secret Service, recently testified before the Senate Committee on Homeland Security and Governmental Affairs on the subject of virtual currency and crime. He observed that “within what we see in our investigations, the online cybercriminals, the high-level international cybercriminals we are talking about, have not, by and large, gravitated towards the peer-to-peer crypto-currencies such as Bitcoin.”

Why are criminals reticent to use Bitcoin? Ultimately it’s hard to say, but the fully public ledger might have something to do with it. Bitcoins move from public address to public address on the blockchain. Those public addresses are just long strings of random numbers and letters that uniquely identify particular holders of coins. The name of that holder, however, is not public. In other words, Bitcoin, like many fine novels, is pseudonymous.

This doesn’t mean, however, that it’s particularly easy to hide one’s transfers from authorities. At some point in a string of transactions the bitcoin will often need to be exchanged for dollars, pesos, or rupees. Exchange services generally collect a great deal of data about their users including credit card numbers, bank accounts, names, addresses, and IP addresses. Therefore it can be easy to put a name and location to a public address that purchased bitcoins on an exchange.

If the authorities have reason to suspect this person, then transfers to and from his address can be investigated. If the users of those linked addresses ever purchased bitcoins on an exchange, spent bitcoins with an online merchant that captured their computer’s IP address, or spent coins at a physical merchant that had security cameras, then they too can be identified. Gradually, police and counterterrorism agents might be able to identify an entire network of users. At this point the authorities would have perfect visibility into all the transactions and funding mechanisms used by the particular criminal network. The agents can now wait until a transaction indicates an opportune time and place to arrest a network participant and repeat the procedure for each linked suspect.

This stands in stark contrast to centralized money transmitters that keep closed books and locate in obscure jurisdictions to avoid the scrutiny of regulators and law enforcement. It stands in even starker contrast to plain old cash, good-old greenbacks, which leave no record of transactions, not even a pseudonymous one. In the world of crime, cash—preferably a whole pallet of it in the belly of a container ship with a less than honorable captain—remains king.

Bitcoin and Smaller Government

As revolutionary as Bitcoin already is, many of the truly thrilling uses of cryptocurrency are still on the horizon. These innovations are collectively referred to as Bitcoin 2.0 and they have tremendous potential to bolster commerce, liberty, and free exchange.

The Bitcoin protocol uses blockchains to transmit value authoritatively from one public address to another. But the blockchain is, essentially, nothing more than an open, trusted ledger. Accordingly, blockchains could be used to create authoritative records for any purpose. A blockchain could be used to build a decentralized property registry where users can publically store and transfer title to their cars or their homes. The keys to many vehicles already have embedded chips and use cryptography to prevent unauthorized access. Using a blockchain, the key-code could be transferred from seller to buyer as a digital asset over the Internet. When the buyer sends bitcoin to the seller, the buyer can automatically receive, in return, an ignition code and the ability to start the car with his smartphone.

A blockchain could also be used to create and transfer tokens that represent shares of a corporation, a stake in the outcome of a civil suit, or the payout on an insurance policy. Blockchains can even be used to memorialize and automatically carry out complicated contracts between individuals. The language of a bitcoin transaction can be more advanced than “Alice sends two bitcoins to Bob.” It can include agreements by multiple parties, at designated dates, and times. For example, ”Alice commits two bitcoins to Bob UNLESS Bob fails to deliver his car to Alice by November 1st at noon, AND Charlie, the arbitrator, agrees that the failure is Bob’s fault.”

These technologies would lower the cost of governance. A humble country lawyer with some Bitcoin-coding knowledge could help the owner of a small business sell shares of her company to investors without a stock exchange, or help a couple transfer the deed to their house without costly title insurance companies. The same lawyer could build contracts for a local businessman that would self-enforce, automatically adjusting grain prices to reflect global markets or automatically demanding a resolution from an appointed arbitrator if the parties disagreed.

Putting the power of these governance tools into the hands of local lawyers and entrepreneurs reduces our dependence on large, inefficient central governments and corporations to validate and enforce our agreements or property rights.

The future of governance with Bitcoin 2.0 looks less like the bureaucratic expansion of the late 20th century and more like the common law systems of earlier centuries. Peace and order are maintained not because a centralized authority is surveilling and policing the land, but, instead, because virtuous individuals are able to establish trust within their communities using the local legal tools of smart contracts and smart property, while the less-than-virtuous suffer as mathematical systems of agreement and ownership become ever more resistant to fraud and manipulation.





Peter Van Valkenburg is the director of research for the Coin Center, a non-profit dedicated to issues facing cryptocurrency technologies, such as Bitcoin.