Take a $5 bill out of your wallet. Now get a blank piece of paper and write on it “Bank of Champsee $20”. (Don’t worry, as the governor of the Bank of Champsee I give you full authorization to do that). Take both pieces of paper to your local coffee shop and order a coffee. When the cashier asks you to pay, hold out both notes and say, “Take either one and keep the change.” Which note did the cashier take?
I’m going to go out on a limb and say it was probably the $5 bill and not the Bank of Champsee $20 bill. Why? An economist can give you a full answer to that, but fundamentally the coffee shop took the US dollar bill because their employees would accept that bill as payment for their services. Their landlord would accept that bill towards their rent, their suppliers…well you get the picture.
Now both the US dollar bill and the Champsee dollar bill are just pieces of paper with something printed on them, but other people place value on the US dollar bill and are willing to exchange goods and services for it.
I grew up in Canada. Whenever we crossed the border into the United States, many shops would accept our Canadian money as payment. Why is that? Their employees, landlord, etc. wouldn’t accept that as payment for their services just like the Bank of Champsee notes. Well, their bank would give them US dollars in exchange for the Canadian dollars that I gave them. The bank could then turn around and get US dollars from people who wanted the Canadian dollars and make a small profit on it. Many stores accepted Canadian dollars at favorable exchange rates to entice us to go down there. Therefore, he coffee shop owner that had accepted my Canadian dollars could turn around and use them to purchase a sweater he wanted at a store accepting Canadian money at par instead of exchanging it at the bank.
Let’s pretend that your coffee shop is a client of mine and I accept Bank of Champsee notes for my services. Would the coffee shop now accept the Bank of Champsee money? Possibly, at least until they collected enough of it to pay for my services. Their employees, landlord, etc. still wouldn’t accept it as payment for their services, but I will.
Now let’s say that the coffee shop no longer needs my services, however, their landlord is also a client of mine. She might accept Bank of Champsee dollars as payment for rent. In turn, the owner of the coffee shop as well as other tenants of the landlord might accept Bank of Champsee money as payment for their services. If I had enough clients, their would be a small economy accepting my money. People who didn’t need my services and even other web developers might transact in my money, because it had value as currency.
Bitcoin works similarly to the Bank of Champsee notes. They only have value in so far as someone is willing to accept them for goods or services. There are a handful of companies that accept Bitcoins as payment, however, my sense is that they are immediately turning around and converting them to US dollars. Accepting Bitcoin is more a promotional gimmick than anything else. At the moment, Bitcoin has more parallels to the Dutch Tulip Mania than that of a currency. It has value because of the novelty.
From the example above, you may be asking yourself why on earth would any of my clients accept BoC money instead of US dollars even if I’m accepting them both as payment? I can’t really think of a lot of good reasons. It might be easier to conceal if you wanted to avoid the government knowing about it.
Let’s say that I realized that letting people make their own BoC notes wasn’t all that smart and, perhaps, I should print some up and hand them out instead. However, I wasn’t just going to give them to you; I would make you answer a skill testing question. At first, I would give out $100 bills and ask you questions like ‘what is 1+1.’ As time went on, I gave smaller amounts out and I made the questions harder.
Furthermore, let’s say that we were having a problem with counterfeiting in that no one was willing to accept BoC notes without someone verifying that they were real. My solution to that was that when I gave someone notes, I would ask you to find 5 people who needed verification of their notes in order to complete their transactions.
As time went on, as there were more and more transactions occurring and fewer notes being created, you would find that when you were looking for your 5 transactions to verify, there were dozens of people looking for verification. Therefore you decide that you would verify the people who were the highest bidder for your services. So I go into a coffee shop, say that I would like to pay with a BoC note. We then put the word out for someone to verify my note. We start to offer progressively more money until someone comes by and verifies it. At that point, we can finally complete our transaction and I can finally drink my coffee.
That’s how Bitcoin works. Now Bitcoin should not be confused with the Blockchain which is the technology underlying it. Blockchain has a number of potential applications which I’ll cover in another post.