Bitcoinist Book Club: “The Bitcoin Standard” (Chapter 8, Part 2, Proof-Of-Work)

To understand Bitcoin, people need to understand Proof-Of-Work. It might be the most crucial aspect of the network. Proof-Of-Work provides security, resolves the issuance problem, and guarantees “a ledger of ownership and transactions that is beyond dispute.” And that’s just the beginning. How does Proof-Of-Work accomplish all that? That’s what this section is all about.

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However, before we get into it… 

About The Coolest Book Club On Earth

The Bitcoinist Book Club has two different use cases: 

1.- For the superstar-executive-investor on the run, we’ll summarize the must-read books for cryptocurrency enthusiasts. One by one. Chapter by chapter. We read them so you don’t have to, and give you just the meaty bits. 

2.- For the meditative bookworm who’s here for the research, we’ll provide liner notes to accompany your reading. After our book club finishes with the book, you can always come back to refresh the concepts and find crucial quotes. 

Everybody wins.

So far, we’ve covered:

• Prologue and Chapter 1
• Primitive Moneys (Chapter 2)
• Why Gold? (Chapter 3, Part 1) 
• History (Chapter 3, Part 2) 
• Gold Standard (Chapter 4, Part 1) 
• Government Money (Chapter 4, Part 2) 
• Money and Hyperinflation (Chapter 4, Part 3)
• Time Preference (Chapter 5, Part 1) 
• Capital Accumulation (Chapter 5, Part 2)
• Price (Chapter 6, Part 1)
• Unsound Money (Chapter 6, Part 2)
• Economic Thought (Chapter 7, Part 1)
• Inflation (Chapter 7, Part 2)
• Digital Money (Chapter 8, Part 1)

And now, let’s go back to, The Bitcoin Standard: “Chapter 8, Part 2: Proof-Of-Work”

This asymmetry concept is crucial, the whole Bitcoin network relies on this:

“The security of Bitcoin lies in the asymmetry between the cost of solving the proof-of-work necessary to commit a transaction to the ledger and the cost of verifying its validity. It costs ever-increasing quantities of electricity and processing power to record transactions, but the cost of verifying the validity of the transactions is close to zero and will remain at that level no matter how much Bitcoin grows.”

The Bitcoin adage “Don’t trust. Verify” comes from this fact:

“This highly complex iterative process has grown to require vastquantities of processing power and electricity but produces a ledger of ownership and transactions that is beyond dispute, without having to rely on the trustworthiness of any single third party. Bitcoin is built on 100% verification and 0% trust.”

Notice how “The Bitcoin Standard” admits to Proof-Of-Work’s energy use. That energy is crucial for the system to succeed, because it literally represents the network’s security. The higher the hashrate, the harder it’s for a bad actor to take control of it. And at current levels, it’s almost impossible for a single actor to acquire the amount of energy and equipment necessary to do so.

How does the system work, though?

“In Bitcoin members of the network would broadcast their transaction to all network members, who would verify that the sender has the balance necessary for the transaction, and credit it to the recipient. To the extent that the digital coins exist, they are simply entries on a ledger, and a verified transaction changes the ownership of the coins on the ledger from the sender to the recipient.”

Who Keeps Bitcoin Honest?

The short answer is economic incentives. The long answer is: 

“What keeps Bitcoin nodes honest, individually, is that if they were dishonest, they would be discovered immediately, making dishonesty exactly as effective as doing nothing but involving a higher cost. Collectively, what prevents a majority from colluding to be dishonest is that if they were to succeed in compromising the integrity of the ledger of transactions, the entire value proposition of Bitcoin would be destroyed and the bitcoin tokens’ value would collapse to nothing.”

Economic incentives are also what keep the system going. “Users, miners, and node operators are all rewarded economically from interacting with Bitcoin.” All are an important part of the Proof-Of-Work system, but none are essential. The system keeps working regardless.

Another crucial concept Satoshi Nakamoto brought into the world is digital scarcity. “Bitcoin is the first example of a digital good whose transfer stops it from being owned by the sender.” What does that imply?

“Until the invention of Bitcoin, scarcity was always relative, never absolute. It is a common misconception to imagine that any physical good is finite, or absolutely scarce, because the limit on the quantity we can produce of any good is never its prevalence in the planet, but the effort and time dedicated to producing it.”

BTC price chart for 02/09/2022 on Coinbase | Source: BTC/USD on TradingView.com

Supply, Value, and Transactions

As original cypherpunk Hal Finney said, “Every day that goes by and Bitcoin hasn’t collapsed due to legal or technical problems, that brings new information to the market. It increases the chance of Bitcoin’s eventual success and justifies a higher price.” We said that Proof-Of-Work solves the issuance problem. This is how it does it:

“While for the first few years of Bitcoin’s existence the supply growth was very high, and the guarantee that the supply schedule would not be altered was not entirely credible, as time went by the supply growth rate dropped and the credibility of the network in maintaining this supply schedule has increased and continues to rise with each passing day in which no serious changes are made to the network.”

The real-world cost the production of Bitcoin has is also crucial. “Because new coins are only produced with the issuance of a new block, and each new block requires the solving of the proof-of-work problems, there is a real cost to the production of new bitcoins.” The miners also respond to economic incentives:

“Because miners who verify transactions are rewarded with bitcoins, these miners have a strong vested interest in maintaining the integrity of the network, which in turn causes the value of the currency to rise.”

Where Does The Volatility Come From?

As long as Bitcoin remains in the appreciation stage, there will be volatility. However, it’s expected to retract as adoption advances.

“Bitcoin’s volatility derives from the fact that its supply is utterly inflexible and not responsive to demand changes, because it is programmed to grow at a predetermined rate. For any regular commodity, the variation in demand will affect the production decisions of producers of the commodity: an increase in demand causes them to increase their production, moderating the rise in the price and allowing them to increase their profitability, while a decrease in demand would cause producers to decrease their supply and allow them to minimize losses.”

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This whole thing, this system, this network, is in part possible thanks to Proof-Of-Work.

“It is perhaps one of the most remarkable achievements of the Internet that an online economy that spontaneously and voluntarily emerged around a network designed by an anonymous programmer has grown, in nine years, to hold more value than is held in the money supply of most nation-states and national currencies.”

It’s nothing short of a miracle, that this thing exists. And it’s working 24/ 7, 365.

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