I have talked about bitcoins a number of times starting from offering a simplified explanation of what bitcoins are. In that article I asked our readers to think of bitcoins as data (type of 1s and 0s) characterized by a certain mathematical algorithm generated by a process called bitcoin mining and saved in a virtual wallet. That definition is wrong and the correct definition is explained in the subsequent paragraphs; although I take consolation from an article by a senior economist François R. Velde titled Bitcoin: A primer,  which also made the same mistake in defining bitcoins as a special type of a digital file. The article has this paragraph that states:
Bitcoin is not a claim to a physical object or to a currency; it aims to be itself a currency and replace the physical object with a computer file. When a physical object is exchanged, there is little doubt that the giver owns it and the recipient receives it (whether the object is what it seems to beâand not a counterfeitâhas always been a problem for money, but one that is mitigated in a variety of ways). A digital file is easily created and duplicated, so how do we avoid doubts about its authenticity as currency? The solution is basically recursive. Assume that my ownership of the file is ascertained. The bitcoin protocol ensures that the transaction by which I cede ownership of the bitcoin is validated by adding it to a record of all transactions. The recipientâs ownership is now validated.
So, if a bitcoin is not a computer/digital file generated using a special mathematical algorithm then what is it? And what does the mathematical algorithm that is used for bitcoin mining generate, when we clearly understand that the miners are rewarded with bitcoins? The answer to the first question will provide us with a clearer understanding of bitcoins and the answer to the second will make us appreciate the best property of bitcoin that can greatly improve our interactions and transactions as a society. For the fatal property of bitcoin, stay tuned until the end of this article.
What is a bitcoin?
This question has been answered by many people but I guess a clearer explanation, using an analogy that is easy to understand, will do the trick. Imagine you and ninety nine other friends of yours are the only members of a secret society. As a society you decree that business can only be done amongst yourselves – no one is allowed to trade with any individual outside this society – given that everything necessary for your survival in this world is owned by at least one member of the society. You will do your trade using a new currency you decide to call otonglo.
Instead of coming up with a coin or a paper to represent this otonglo, you unanimously agree that each and every one of you has been assigned, arbitrarily, a value of a thousand otonglos (allow me to assume otonglo as an English word hence I won’t italise it in subsequent mentions) – and you define one otonglo as the amount of money that can be exchanged for one hundred Kenya shillings if such an exchange were to happen. In essence therefore, the society has arbitrarily assigned each member a value worth shs 100,000. The money assigned to each member, I repeat, does not exist in paper or coin or in any asset but it exists by the mere fact that each member of the society has agreed to own them.
If a member of the society I will call Alice wants to trade with another member of the society called Bob, then Alice will tell Bob, “I want five kilograms of sugar and I give you five and a half otonglos for that”. Bob, being a member of the society, will accept to give Alice the five kilograms of sugar in exchange for Alice’s five and a half otongolos. In effect, Alice has 994.50 otonglos left whereas Bob’s otonglos has increased to 1005.50.
Double spending problem
Assuming that each member of the society had a way to not only eavesdrop in, record, and recall, the transaction that happened between Alice and Bob, then each member of the society would be in a position to appreciate that Bob is now worth 1005.50 otonglos whereas Alice is now worth 994.50 otonglos thereby preventing Alice from lying to any other member that she is still worth a thousand otonglos and also make it possible for Bob to convince any other member that he is now worth 1005.50 otonglos.
But without the ability to eavesdrop, record, and recall that particular transaction, then Alice would still approach another member of the society, let’s say Mary, and without reference to the otonglos given to Bob, have Mary give her services and goods believing that Alice is still worth a thousand otonglos. That way, Alice and any other member of the society would be in a position to spend the same otonglos over and again, a problem referred to as double spending problem – imagine if people are exchanging goods and services yet no one is spending anything for such exchanges!
The society, to enable members to eavesdrop in, record, and recall all transactions, may decide to use a computer networked program accessible to all at will where each transaction must be recorded. This program will enable all members to eavesdrop into every transaction, record the transaction, verify that the person saying that he/she has a specific number of otonglos indeed has those otonglos given the prior agreement and subsequent transactions, accept that intent thereby give the transaction a go ahead, then later record the transaction in the program’s ledger for future verifications. The legitimacy of otonglo as a means of exchange will thus be authenticated by the ability to verify and legitimate transactions in addition to prior agreement arrived at by the members of the society.
Now, from the analogy, replace the word “otonglo” with “bitcoin” and the word “society” with “global society”. The Wikipedia article on Bitcoins explains that bitcoins exist as I have given in the above analogy with the following words:
While wallets are often described as being a place to hold or store bitcoins, due to the nature of the system, bitcoins are inseparable from the block chain transaction ledger. Perhaps a better way to define a wallet is something “that stores the digital credentials for your bitcoin holdings” and allows you to access (and spend) them.
Earlier in the same article, Wikipedia had said:
Whereas a conventional ledger records the transfers of actual bills or promissory notes that exist apart from it, the block chain is the only place that bitcoins can be said to exist.
Since there wasn’t a global meeting for the members of the global society (you and me) to be assigned a certain arbitrary number of bitcoins, the way Bitcoin System works is a bit different from the analogy I gave above.
The first people who had a “meeting” and agreed to consider bitcoins as a currency assigned themselves some bitcoins alright, but they also agreed that new entrants will be accepted into the network, not just to be assigned bitcoins, but to help in the verification of transactions. The acceptance of this non-existence currency (bitcoin is simply an agreement that someone has so and so bitcoins) and the verification of transactions is what make bitcoins legitimate.
The process of verifying bitcoin transactions is what is called bitcoin mining. Given that those who participate in the verification of transactions are given bitcoins as a reward, the process of verification is not a walk in the park – one has to first of all solve a complex mathematical problem using a specified mathematical algorithm, then s/he can and then do a verification. This is meant to allow only one person to verify one transaction at a time then add that transaction to the public ledger known as block chain from where members of bitcoin society can re-verify that a new transaction is not a previous transaction being repeated; in other words, verify that someone is not trying to spend the same bitcoins twice).
The best property of bitcoins
The existence of this public ledger or block chain gives bitcoins a special property, the Triple Entry Accounting principle. Let’s go back to our analogy: when Alice transacts with Bob, and given that their society has this computerized way of eavesdropping in, recording, and recalling that particular transaction, then the recording of that transaction not only exists in Alice’s Books (wallet) and Bob’s Books but also in the computerized Books or ledger from where every member of the society can verify that that particular transaction did take place – and that it was a legitimate transaction. At any given time therefore, every member of the society is aware of Alice’s (her pseudonym in Bitcoin System) balances in her books of accounts and of every other member of the society for that matter.
This same principle applies to bitcoins. If today you create a virtual wallet and purchase some bitcoins or pay for goods and services using bitcoins, then the transaction is recorded in both your books of accounts (credit), the second party’s books of accounts (debit) and in the block chain. The addition of the block chain as “books of accounts” means therefore that the accounting principle applicable for every transaction is not the traditional Double Entry Principle but a new generation of accounting principle that is starting to gain prominence amongst accountants known as Triple Entry. For more information about Triple Entry as an accounting principle, you may start by reading the article Triple Entry Accounting by Ian Grigg. There is also the article on How Bitcoin Could Revolutionise Accountancy by Nick Chowdrey that has further insights on this unique property of bitcoins.
When I wrote the article Six reasons why we must popularize bitcoins in Kenya, I said,
There are two properties inherent in the bitcoin system that will help eliminate corruption in a global scale. Actually one reason why bitcoin was conceived was the economic meltdown that happened in US and Europe in 2007/2008 largely due to corruption in Wall Street. The two properties that make Bitcoin a suitable system to tackle corruption are the storage of all transaction in a public ledger called blockchain that can be verified at any time by anyone from anywhere and the triple accounting principle for recording every transaction made. I will explore these two properties in a future article â stay tuned.
And this is that future article I mentioned. The unique properties of bitcoins that will allow for the society to largely do away with corruption is the fact that we have a public ledger from which every single transaction can be verified.
Given that bitcoins offers anonymity, its use as a tool to fight corruption might not be easy. However, government oriented corruptions can be fought by requiring every government office or official to disclose the bitcoin addresses associated with them and with any particular transaction to be carried out. Transcend with Dave writes:
In the blockchain there is transparency and accountability but there is no human judgment so theoretically there are no human errors.
“Can you imagine if courts of law were administered by such a machine without human emotion? There would be no corruption â just the facts. You could not bribe the judge or appoint your brother-in-law.* Government could not exempt itself from the same laws.â Martin Armstrong
The fatal property of bitcoins
Bitcoins will one day die unless a key property of the currency is changed. This is not to scare you as this death cannot come before the year 2140 and certainly Bitcoins can survive past the year 2400 but still bitcoin will one day die.
The property of bitcoins that will kill the successful digital currency is the systems design that provides that no more than 21 million bitcoins shall ever be mined. As as to date, there are over 13 million bitcoins in circulation which represents about 62% of total bitcoins that will ever exist.These 13 million bitcoins are held by some addresses – access to which are in sole control of some human beings. Most of these human beings who have access to these addresses, will die within then next 50 or so years.
If Alice, for example, has control of addresses that have been assigned a million bitcoins, and further assuming that Alice has kept the passwords to her addresses to herself, then if she meets a road accident in the next two seconds the bitcoins she holds in her addresses shall have been lost – forever. Essentially therefore, by the time we reach the 21 million bitcoins mark, we shall have had 1 million bitcoins less thanks to the sudden death of Alice.
I want to be generous enough and assume that the human beings having access to today’s active addresses with the over 13 million bitcoins will only have 30% of the total bitcoins in existence by the time the last one of them dies tacked in their addresses (70% of the bitcoins shall have been acquired by new and younger people who will live to transfer them to future generations). Then by the time the last man dies there shall be 30 percent of the 13 million bitcoins removed from circulation; which represents about 4 million bitcoins – thus it is wise to assume that by the time the last bitcoin is mined, there shall be more than 4 million bitcoins lost hence less than 17 million bitcoins shall be in circulation.
If the 17 million bitcoins shall be in hands of some one billion people by that year (2140), and assuming that the life span of those 1 billion people from the time of acquiring bitcoin to the time of their individual death shall be 50 years, and then assuming further that the assumed 30% bitcoin holding rate (in the individual’s wallets) shall remain unchanged, then we can assume that by the year 2190 over 5 million bitcoins shall have been removed from circulation – leaving less than 12 million bitcoins in circulation.
You can play around with the holding rate and average lifespan of people, but just as the rate for bitcoin mining is constantly declining, the rate of loss of bitcoins due to death, computer crashes (depending on how bitcoin is stored) and other unknown factors will also constantly increase until number of bitcoins in circulation become zero.To prevent this, then the Bitcoin network needs to rethink of the upper limit requirement for bitcoins. The Bitcoin System should allow for perpetual generation of bitcoins in relation to demand of bitcoins vis a vis number of bitcoins in circulation – especially now that a central authority is undesirable. A central authority would easily regulate issuance and distribution of bitcoins.
To begin with, know that the account unit used at the blockchain level is the Satoshi. One Satoshi is 0.00000001 bitcoins, or put another way one bitcoin equals 100,000,000 Satoshis. So there are actually 1,334,955,000,000,000 Satoshi units issued today with a total of just under 2,100,000,000,000,000 Satoshi units by the time all bitcoins are issued.
Over time Satoshis will be lost, certainly. While that’s bad for the person who lost them it’s of little consequence to Bitcoin. As coins are lost, the value of the remaining coins rises. The level of security to protect coins is roughly proportional to the value of the coins. Coinbase uses M of N security with paper wallets stored in multiple physical locations. Such security is relatively expensive but that’s because the value of the coins is much higher. It is expected that Coinbase will lose none of their vaulted coins each year. Whereas a typical user that uses Mycelium wallet might ignore the warning to make a backup since only “trivial” amounts will be stored on the phone. If that phone ends up getting wet or otherwise disabled and no backup had been made then those coins are stuck forever and can never be spent.
But if today that “trivial” amount is 0.1 bitcoins (or about 2,500 Ksh at today’s exchange rate), then a year from now that same “trivial” amount (2,500 Ksh) might only be 0.025 bitcoins if the exchange rate had spiked above its 2013 high water mark. In other words, fewer bitcoins are lost at a higher exchange rate than when at a lower rate.
Thanks for the great comment. I know that the values of bitcoins are likely to rise once supply declines, but the inherent problem with bitcoin’s upper limit of 21 million bitcoins (or 2.1 quadrillion satoshis) means there will be a time in the future the coins won’t exist at all.
This time can be 60 thousand years from now – 62014 to be precise assuming one bitcoin gets lost per day due to owners’ deaths or system crashes, but as long as there wouldn’t ever be continued mining of new bitcoins, the bitcoin community must prepare for the bitcoin’s doomsday.
Given that bitcoins aren’t really ANYTHING tangible (they are not even computer files), the upper limit is unnecessary. What needs to be done is to control rate of mining such that demand, supply, and continuity is all balanced.
By the way, how does coinbase intend to retrieve bitcoins of the dead who didn’t leave their passwords with anyone? Especially the dead who didn’t even care to tell anyone that they had bitcoins anywhere? Articles I have read say that it is next to impossible for these virtual wallets to retrieve users’ passwords.
Let’s say that 99.9999% of all bitcoins were lost, leaving just 1.0 bitcoin (100,000,00 Satoshis) remaining for use by all of humanity. Well before that happens the protocol would be modified to support decimalization, or sub-Satoshi units (e.g., 0.012 Satoshis).
So there would never be a crisis, even 60,000 years from now as you mention, where there are no units of the currency remaining that can be used.
Of course, the big risk with that is … are the coins not in use actually truly lost forever or have they just not been spent in a long time (where it was presumed they were lost). There would be huge volatility if we’re down to assuming something like 30% of all coins were lost and then all of a sudden one day half of them suddenly are spent (sent to exchanges during a selloff, for example).
The reason economists fear a currency with a fixed supply is not that there won’t be enough units remaining for use as a currency (decimalization long ago squashed that concern), but that this limited supply gives an incentive to speculate (or “hoard”, if you prefer that term) on the future purchasing power. What then happens is that Instead of spending (or investing) that money is saved (e.g., offline cold storage wallets) and thus total economic activity wlll decline. That may be bad for an economy dependent on growth (as all economies with fractional reserve are) but it’s not terribly harmful to the currency that competes against fiat. Of course, if there are economic opportunities for those funds that beats the expected return from sitting on them, then of course they will be invested. So while total economic activity might be lower in that scenario, the spending will be on productive uses (rather than on consumption / vanity that we see for most spending today).