The problem that Bitcoin solves is the reversibility of electronic payments. In the seminal Bitcoin whitepaper, Satoshi Nakamoto wrote,
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments…
Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes…
With the possibility of reversal, the need for trust spreads… A certain percentage of fraud is accepted as unavoidable.
These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
The solution that Nakamoto devised to solve the problem of reversible payments was,
… an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.
The result was Bitcoin, which has continued to deliver as a solution to the reversibility problem since it went live over eight years ago. The means by which Nakamoto solved the reversibility problem was by eliminating the need for a trusted third party that could willingly or unwillingly reverse transactions. In place of a trusted third party, Nakamoto used a chain of cryptographically-signed transactions secured by proof-of-work to order and validate payments. And thus, the blockchain was born.
Today, the blockchain is used to securely order and validate more than just payments. People have figured out how to use the blockchain as a way to prove that a digital file existed at a certain point in time, creating a so-called “proof-of-existence“. People are also exploring how to use the blockchain to track ownership of all kinds of digital assets including domain names, game tokens, stocks and other financial instruments, and even real property titles.
The reason that people are using Bitcoin for these transactions instead of any other system for recording ownership information is precisely because of Bitcoin’s security. At the time of this writing, Bitcoin block makers, or “miners”, collectively calculate over 30 billion SHA-256 hashes per second at a cost of approximately $15,000 per block using hundreds of millions of dollars worth of bitcoin “mining” computers. It would thus be extremely expensive to reverse a transaction with even one confirmation, ensuring strong security for transactions that are included in a block added to the most difficult valid blockchain.
For users to benefit from all this security, they must run their own full node and verify that their transactions are included in the most difficult valid blockchain. Then they can decide based on their risk preferences when to consider their payments “settled” based on how many confirmations they have. The more confirmations a given transaction has, the less likely it is to be reversed.
If you need strong assurances that when you receive a payment, that it can’t be easily reversed, then Bitcoin can solve your problem. If you need to be certain that when you create a record of ownership or proof-of-existence, that it will still be there when you go back to find it in ten years, then Bitcoin can solve your problem. But if your problem doesn’t need sealed-in-stone-forever security, and you can get away with using a plain old database to record your transactions, then Bitcoin – and the blockchain – isn’t for you.
Addendum: what about bitcoin (the currency)?
When Satoshi created Bitcoin, he really created two distinctly valuable products that by necessity are joined at the hip: the first blockchain, and the first cryptocurrency. If the blockchain was created to solve the reversibility problem, then bitcoin was created to solve the blockchain’s incentive problem.
The proofs-of-work that are used to secure the blockchain require energy to create, and energy costs money. Since Bitcoin could not rely on any third parties to operate, no third party payment mechanism could be used to pay miners for the energy they spent generating proofs-of-work. A new payment mechanism had to be created – bitcoin.
By paying miners using a currency that is issued and transferred exclusively by the blockchain, Nakamoto provided an incentive to miners to protect the integrity of the chain. If any miners attempt to subvert the integrity of the blockchain by colluding to reverse transactions, then they would also subvert the value of the block reward, throwing away money on the table and threatening their investment in specialized mining computers.
The bitcoin currency therefore ensures that incentives are aligned between miners and users so that the implicit promise of irreversibility is upheld. Even after all the bitcoin is mined, miners will continue to prefer to be paid in bitcoin for transaction fees because it is a highly liquid digital asset free of counterparty risk.
Although bitcoin solves interesting problems on its own – such as providing a new “safe-haven” asset class to investors – its value is derived entirely from the security of the blockchain and the ability for users to easily verify that security. Without these properties, bitcoin as a currency would be no more interesting than WoW Gold or Linden Dollars. It’s important to remember that bitcoin is a means to an end, and not the end itself: an irreversible electronic payment system.
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