May 6, 2021 Reading Time: 7 minutes

In hindsight, the rise of cryptocurrencies appears to have begun with the introduction of bitcoin in 2009. Earlier cryptocurrencies had been launched in the 1990s, but they failed to take hold. David Chaum’s DigiCash is widely thought to have been ahead of its time. Chaum founded his company at the start of the decade, well before the rise of e-commerce. By 1998, it had filed for bankruptcy. More generally, early “digital-cash firms made a fatal miscalculation,” Julia Pitta wrote for Forbes in 1999. “They figured, wrongly it turns out, that consumers would be leery of using credit cards on the Web and would demand tight security and ironclad privacy.”

It was not clear, at first, that bitcoin would be any different. Perhaps fearing the fate of e-gold creator Douglas Jackson, bitcoin’s designer(s) adopted a pseudonym––the now-famous Satoshi Nakamoto––and shared the upstart open source project in email to the Cryptography Mailing List on January 8, 2009. Nakamoto had circulated a white paper explaining the technical details a few months before. Congratulatory replies soon followed, but there was little indication that bitcoin would quickly become a household name. It was little more than a novelty discussed by a handful of programmers on the Internet.

Over the nine months that followed, bitcoin was basically worthless. Transactions consisted of mere test spends by the few programmers interested in bitcoin at the time in order to work out bugs in the protocol. No one was handing over valuable goods or services for bitcoin. There were no market exchange rates with the dollar, euro, or other currencies. Indeed, there were no exchanges to facilitate currency exchange.

The first positive-price transaction for bitcoin appears to have occurred in early October 2009. On October 5, a user employing the username New Liberty Standard estimated that it cost roughly $1 to produce 1,309.03 bitcoin. Seven days later, he purchased 5,050 bitcoin from Martti Malmi for $5.05, settling the transaction via PayPal. The price of bitcoin, in other words, stood at just $0.0010. 

Prior to March 2010, users interested in exchanging traditional currencies for bitcoin were limited to ad hoc exchanges, typically organized via message boards. Then, on March 16, The Bitcoin Market became operational, providing a central location on the Internet to exchange bitcoin for dollars. The first posted bid, submitted by the site-creator dwdollar, put the price of bitcoin at $0.0067.

In addition to helping users acquire or offload bitcoin, the new exchange also made it easier to assess the exchange value of bitcoin. If you know, for example, that a host of users are willing to pay $0.50 to $0.75 for 100 bitcoin, you can use that information to figure out how much other goods and services routinely priced in dollars are worth in terms of bitcoin. The new exchange, therefore, makes it easier for users to buy and sell goods and services with bitcoin.

On May 22, 2010, a Jacksonville, FL-based programmer named Laszlo Hanyecz made what many believe to be the first purchase of goods or services with bitcoin. In a post to the BitcoinTalk forum on May 18, Hanyecz offered to purchase two pizzas for 10,000 bitcoin. The implicit exchange rate was generous. The Bitcoin Market valued 10,000 bitcoin at around $41 at the time. But, initially, there were no takers. “I just think it would be interesting if I could say that I paid for a pizza in bitcoins,” Hanyecz posted on May 21. The following day, he posted photos of two large pizzas from Papa John’s. Together, he and a user named jercos, who had facilitated the transaction, showed that bitcoin could be used to acquire goods and services in the real world.

As word of the upstart cryptocurrency spread, so too did its value. A Slashdot article published on July 11 introduced bitcoin to a host of new users. The exchange rate increased from $0.008 on July 12 to $0.080 on July 17. On July 18, Jed McCaleb launched the popular exchange site MtGox and, by November 6, one bitcoin was trading for $0.50 on the site. Keir Thomas profiled bitcoin for PC World on December 10. “Bitcoins are worth taking a look at,” he wrote. In the years that followed, many people did. On December 3, 2013, one bitcoin was worth $1,078.

Today, there are few people who have not heard about bitcoin. And, yet, just as few people seem to understand how it works. Perhaps that is to be expected. The way in which the bitcoin protocol processes transactions is new and fundamentally different from traditional payment mechanisms. Whereas traditional payment mechanisms employ decentralized or centralized clearing mechanisms, bitcoin transactions are processed via a distributed clearing mechanism.

Consider a cash transaction. When you pay for a Coke with cash, the transaction is cleared by you and the merchant. You debit your account by removing the dollar from your wallet and handing it to the merchant. The merchant credits her account by accepting the dollar from you and placing it in the cash register. Since cash is physical, and no longer in your possession, you cannot spend that dollar again. That dollar now belongs to the merchant, who can spend it as she sees fit.

Cash, in other words, is processed using a decentralized clearing mechanism.  A decentralized payment is cleared by the parties to the exchange. No trusted third party is required to process the transaction. Indeed, no one other than the parties to the transaction even needs to know that the transaction occurred.

Suppose, instead, you were to purchase that Coke by writing a check or swiping your debit card. In this case, your bank will debit your account and transfer the funds to the merchant’s bank. The merchant’s bank will credit her account. The funds, in this case, are digital. Unlike physical cash, digital balances could be duplicated and spent again. However, the banking system generally prevents that from happening. Once funds have been transferred, they are considered final––meaning the sender no longer has access to the funds.

Checks and debit card payments are processed using a centralized clearing mechanism. A bank or other financial institution acts as a trusted third party to process the transaction. Indeed, such transactions often involve multiple levels of centralized clearing. The transaction between your bank and the merchant’s bank, for example, might be cleared by the Federal Reserve’s FedWire. The Fed debits your bank’s account and credits the account of the merchant’s bank. Centralized clearing requires routing the transaction––and, hence, information about the transaction––through one or more trusted third parties. As such, they tend to offer less financial privacy than other payment mechanisms.

Bitcoin employs neither a decentralized nor centralized clearing mechanism. Instead, it processes transactions using a distributed clearing mechanism. With distributed clearing, payments are processed by the network as a whole. Typically, distributed networks amount to a shared ledger, which denotes who owns what, and a protocol for updating that ledger. In many cases, any individual user is capable of debiting and crediting accounts on the ledger. Changes to the ledger are only recognized as legitimate, however, when they have been confirmed by the network of users in accordance with the protocol.

If you were to pay for that Coke with bitcoin, you would announce the transaction to the network by signing a balance of bitcoin with your private key, thereby confirming ownership, and identifying the merchant by her public key. In practice, this often amounts to scanning a QR code with a bitcoin wallet mobile app. Your transaction is then bundled together with other recent transactions and the computers running the bitcoin protocol race to process the entire block of transactions. Once the block of transactions has been processed, the ledger is updated to reflect the various debits and credits required by the transactions in the block. The shared ledger is known as a blockchain because each block of transactions is chained to the previous block, producing a long chain of transaction blocks corresponding to all of the transactions that have been made and certified as legitimate up until that point.

While it is convenient to think about a single shared ledger, or blockchain, indicating how much bitcoin is in each account, there are in fact multiple versions of that shared ledger at any point in time. The bitcoin protocol resolves this issue by recognizing the longest blockchain as legitimate. As a result, those running the bitcoin protocol will typically abandon shorter blockchains in order to build on the longest blockchain. Any transaction that has been included in a shorter blockchain but not in the longer, legitimate blockchain is added to a subsequent block of transactions to be processed.

Recall that, with cash, one need not worry about a balance being spent more than once since spending requires relinquishing ownership of the physical asset; with checks and debit cards, a bank or banking system ensures that ownership of the digital asset is relinquished when spent. Two features of the bitcoin protocol combine to prevent double spending. First, it is computationally difficult to process transactions. In order to add a block of transactions to the blockchain, a computer must be the first to solve for the input corresponding to the given hashed output. Since a brute force approach is the best any computer can do, each computer  effectively has a random chance of being the first to process a batch of transactions proportionate to its share of the bitcoin system’s computing power. Second, as noted above, the bitcoin protocol recognizes the longest blockchain as legitimate. In order to execute a double spend, therefore, one would not only need to pass an illegitimate transaction as legitimate; he would also have to continue processing transactions at a faster rate than than the rest of the network in order to ensure the blockchain supporting his illegitimate transaction remained the longest. Unless a user enjoys a majority of the computing power on the system, such a feat would be incredibly unlikely. Knowing this in advance leaves little incentive to attempt a double spend attack in the first place. 

The blockchain technology at bitcoin’s core provides a new and fundamentally different way to process payments. It relies on neither decentralized nor centralized clearing. Instead, it processes transactions over a distributed network. And, by solving the double spending problem without recourse to a trusted third party, it has the potential to offer a degree of financial privacy comparable to decentralized payment mechanisms like cash. For these reasons, bitcoin has gained much support. Whether bitcoin will become routine in retail transactions, remain limited to niche uses, or be abandoned altogether remains to be seen.

William J. Luther

William J. Luther

William J. Luther is the Director of AIER’s Sound Money Project and an Associate Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular writings have appeared in The Economist, Forbes, and U.S. News & World Report. His work has been featured by major media outlets, including NPR, Wall Street Journal, The Guardian, TIME Magazine, National Review, Fox Nation, and VICE News. Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011.

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