What Are Cryptocurrencies: A Brief History of Bitcoin

In the realm of economics, there are plenty of terms that might confuse the layperson, but most of us probably know what the word "money" means. "Cryptocurrency," by contrast, can be baffling. It's money, but not government-backed money? It gets mined almost magically by a process that does nothing else of value? How does that work?

Given the level of investor interest in cryptocurrencies, for this episode of Motley Fool Answers, Alison Southwick and Robert Brokamp brought in Motley Fool analyst Aaron Bush to give their listeners the lowdown. In this segment, he takes us back to the beginning of bitcoin, in 2008, when the mysterious Satoshi Nakamoto turned blockchain technology -- yes, he'll explain that, too -- into a way of safely storing and transferring value.

A full transcript follows the video.

This video was recorded on Nov. 21, 2017.

Alison Southwick: Let's go back to the beginning, and it all goes back to a person named Satoshi Nakamoto. Or is it a person? Or a bunch of people? We don't know!

Aaron Bush: It's a mystery!

Southwick: Let's help unlock this mystery. We're not going to solve the mystery, but you can at least explain the mystery for us.

Bush: Satoshi Nakamoto, whoever he or she is, or they are, came up with the idea of bitcoin in 2008. It went live in 2009. For about 20 years or so, people [have been] trying to create a currency that is native to the internet. This was a dream of libertarians at the time. It was a way to bypass an intermediary. People were upset with the central bank[s], and so this was viewed as a way around that. If you can create your own currency native to the internet, you can set all of the rules yourself with computer code. You can create something new in a way to bypass the system. Create a new economy of sorts.

Southwick: And this was September of 2008, so this is at a pretty low ebb in Americans' feelings of happiness with their government and money.

Bush: Absolutely. I think the timing was important, but really it just came down to the technological breakthrough that just happened to match with that time.

Southwick: And this is, if I'm correct, blockchain.

Bush: Correct.

Southwick: Here we go. Here's another one of those buzzwords you're going to see, people, blockchain. And blockchain is...

Bush: The easiest way to look at a blockchain is saying it's like a database. Or it's like an accounting ledger. It's a database that you put entries into but can't take anything out of. If you want to make any changes, you have to put in another entry.

Southwick: Like [the] Constitution.

Bush: In a sense.

Southwick: Right? We have to [create] amendments and then [create] amendments to amend amendments. I probably should not have interrupted you with that, but I instantly made the connection. It's a permanent record.

Bush: Yes. It's a permanent record of all transactions in the past. It's a [permanent] record of who owned what and when. With that you can do all sorts of interesting things.

Southwick: One of the interesting things was bitcoin. That's been the most successful interesting thing. Later on, I do want to talk about some of the broader implications of what blockchain can do for us, because I think that might be more exciting for long-term investors than bitcoin, but we're still going to focus right now on bitcoin. He, she, whatever, Satoshi Nakamoto wrote this paper [about creating] this permanent ledger, but this permanent ledger is housed on [the computers of many different people].

Bush: Right, and that's what makes this special. There's nothing special about a database that can keep track of things.

Southwick: Yes, it's not blowing my mind.

Bush: We can all do that. But this one is distributed. It lives in computers around the world. Anyone can install bitcoin software and become a node in the bitcoin network. When this entire network can be run distributed, that's very different from a computer network being run in a centralized way. That was the breakthrough... being able to run in a distributed way that's also secure for the first time.

Southwick: I don't want to get too much into the weeds of mining, because, woof, that gets kind of crazy, but essentially how new bitcoins are created... Actually, you should probably explain it. How are new bitcoins created?

Bush: You touched the word mining. There are miners. These are the people who are running the nodes on the bitcoin network. [The computers of these people] are solving increasingly difficult math problems. They're trying to find a random sequence of numbers. The winner gets whatever new bitcoin is released, and this happens about every 10 minutes or so. They're competing to win the new bitcoin. Right now, there are about 16 million bitcoins in circulation and there will be 21 million over time. These miners compete to win over the new blocks of bitcoin and that's what adds new bitcoins to the network.

They also are the ones who verify transactions across the network, so they serve two main purposes. One is to create the currency, and the other one is to verify everything that goes across it. Doing that provides the incentive for them to keep the network running. The incentive that keeps bitcoin functioning is built right into the code and the miners are the ones who make that possible.

Southwick: If I'm someone at home thinking, "I'm going to install this software and then I'm going to start mining bitcoins on my computer," that's easy peasy, right?

Bush: Not so much. It used to be. In the very early days, any of us could have bitcoin running on our computer right in front of us, right now, and be competing for bitcoin or verifying those transactions. As the market has become more competitive, it's become increasingly difficult for any one person to win in any of those given competitions. Now we're seeing fleets of supercomputers dueling it out to see who can win the network and run those big money operations.

Southwick: Massive computing power.

Robert Brokamp: Is there any sort of arbiter here? For example, they're solving these math problems. Who's creating the math problems?

Bush: It's built into the code. That gets pretty complex with the security.

Southwick: This is where we say, "Don't worry about it."

Brokamp: OK, got it.

Bush: It's called a cryptographic hash function for short.

Southwick: My favorite hash function.

Bush: The shortest way to explain that is it's very difficult to find the answer, but once you find the answer it's very easy to verify. And whatever the problem was is just set in the code from the very beginning.

Brokamp: Got you.

Southwick: Do you? Do you really?

Brokamp: Here's the thing about it. Crypto means secret or hidden in Greek, so already built into this whole system is some sort of mystery. It's created by this person who may or may not exist. The whole thing is just so sci-fi, and it just feels like something out of a novel.