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BitcoinBy Lachlan Commins, Patterson Houen & Commins, Lawyers, Sydney.

So, what is Bitcoin? Bitcoin is something that you cannot truly ever understand unless you have had first-hand experience in using it. Here we provide a simple explanation of what it is… for beginners!

What is Bitcoin?

That’s right: Bitcoin (and all other cryptocurrencies) only exist on-line. So all those impressive images you may have seen of gold coins with the capital letter “B” engraved where the capital letter “S” would be on a gold dollar coin are phoney. That is, Bitcoin does not exist as real-world hard currency so you cannot exchange your on-line Bitcoin for a physical form of Bitcoin in the shape of a dollar coin. Sure these physical Bitcoin coins may actually exist somewhere as a collector’s item or as a prop, but they would have no use as a cryptocurrency.

What is digital money?

Digital money has been around for as a long as there has been on-line gaming. Even before this, board games like Monopoly and other off-line video games like Mario Bros. used ‘fake money’ for the purposes of gameplay. How many of you have collected a sizeable sum of Monopoly money during a game to secretly wish that you could convert it to ‘real-world’ money? How many of you can remember earning 10,000 gold coins during a level of Mario Bros. to fantasize that you could spend these coins in the real world?

The advent of on-line gaming has developed this concept of fake ‘game’ money further. Nearly every on-line game now allows the player the opportunity to earn points or credits within the game by achieving certain objectives. For instance, if a player reaches a certain level or stage within the game, or completes a particular level or stage within a certain timeframe or without making any mistakes, the player will be rewarded with a certain amount of points or credits. These points or credits can be used by the player within the game to obtain digital items which allow the player certain advantages.

These credits or points are not merely referred to within the game as something as mundane as ‘credits’ or ‘points’. Rather, they are referred to as something with a much more direct correlation with real-world currency or as something which evokes a sense of real-world value. The player may be rewarded with something like “Space Bucks” or “Blood Rubies” which allows the player to make “purchases” from within the in-game “shop” or “store”.

Accordingly, the likeness between on-line shopping for real-world items using real-world currency on websites such as Kogan or JB Hi-Fi is not too dissimilar from the process of making in-game purchases for digital items using in-game money. Both require the user to browse for items and to make a purchase using a form of designated ‘currency’.

The essential difference between these in-game forms of currency (digital money) and real-world money (fiat currency) is that only one can be used to trade and to buy actual items in the real word. No matter how many “Galactic Tokens” a player may have earned by playing hours and hours of Space Invaders, they could not therefore consider themselves as ‘rich’ by the standards of the real world. That is, even if this player had amassed over one billion Galactic Tokens, they would still struggle to use their mass bounty to buy something as insignificant as a bus ticket.

But what if this was not the case? What if these hard earned “Galactic Tokens” could be used in the real world? This is the concept that the mysterious creator of Bitcoin, Satoshi Nakamoto, held back in 2008; that is, what if digital currencies could be used in the same way and to the same effect as fiat currencies?

The transition from in-game currency to cryptocurrency

In order to understand the leap in technology and thinking between an in-game digital currency (such as “Galactic Tokens”) and a cryptocurrency (such as Bitcoin) you need to ask yourself this question: Would I ever accept an in-game currency as payment in the real-world for actual goods or services? The answer, would in most cases be a resounding “no”. But why is this so?

Essentially, the answer comes down to a lack of trust in the in-game currency as a means of exchange. That is, you would probably be willing to accept Aussie dollars, US dollars, the Euro, the Pound, or even Kiwi dollars. You may even be willing to accept an item of corresponding value in trade. But “Galactic Tokens”? What use would they be to you unless you intended to use them in the game to upgrade your spaceship? More importantly, how could you be sure, if you accepted them, that anyone else would be willing to accept them in turn from you? The answer is you could not.

This discrepancy in trust between in-game forms of digital money and real-word fiat currency comes down to the identity and authority of the third party regulator behind each form. In the case of fiat currencies, this is the central bank backed by the country’s government. That is, each Aussie dollar note and coin is certified and authenticated by the Reserve Bank of Australia which is given its legitimacy by the executive arm of the Australian government. To this extent, every merchant and consumer can be reasonably assured that any note or coin proffered as a means of exchange which has been inscribed with the Reserve Bank’s signature or stamp is legitimate.

The equivalent backers or certifiers of the “Galactic Token” on the other hand, are the developers of the Space Invaders game themselves. These developers are the authority which has created the “Galactic Token”; they are the authority which decide how many are to be released within the game and how they are to distributed; they are the authority which decide the value of the “Galactic Token” – whether it will cost 1,000 Galactic Tokens for a Spaceship upgrade or 10,000; pr whether it will cost $AUD10.00 to purchase 1,000 Galactic Tokens. Essentially, they fulfill the role that is assumed by the central bank in the regulation of fiat currency. They have the absolute licence and means to create, distribute and to regulate their digital currency. However, whilst the central bank is restricted by and answerable to the policies of central government, the developers are answerable only to themselves.

Bitcoin – overcoming the trust gap

Perhaps by now we have realised that anyone with a bit of technical nous can create and feasibly sell their own digital currency to anyone willing to buy it in exchange for real-world fiat currency or other items of real value. However, unless the digital currency is associated with a game and the potential buyer is a user or fan of that game, there would be few people willing or daring enough to so depart with their hard-earned money in such an exchange. That is, without a legitimate backing authority, the digital currency has no worth or value as a means of exchange in general commerce: it’s legitimacy cannot be verified; its value cannot be trusted; and its authority cannot be ascertained.

This is where Bitcoin leaps over the trust gap: it has bypassed altogether the requirement in a transaction for a third party authority or certifier. This concept is referred to in Bitcoin and cryptocurrencies circles as “peer-to-peer transactions”. Thus, rather than the currency being used in a transaction needing to be certified by a central bank or some other authority or entity as being “legitimate” or “legal tender”, Bitcoin – and other cryptocurrency – is given its certification and legitimacy by all other holders of Bitcoin, That is the authentication and legitimation process is decentralised and is undertaken by the thousands, millions or even billions of users who are concurrent holders of Bitcoin or other cryptocurrency. How is such a mammoth consensus task undertaken? By something called Blockchain.

Blockchain & Mining

Think of the Blockchain as being one million sets of eyes peering over your transaction in an act of verifying whether or not the Bitcoin on offer are legitimate. This is done by checking the Bitcoin against a vast ledger that has recorded the transactional history of every single Bitcoin in existence. If the Bitcoin on offer cannot be synced or correctly matched into this vast ledger system then they are not legitimate and the transaction will not proceed. Perhaps the Bitcoin on offer have already been spent by that person (referred to as “double spend”); or perhaps they were never “mined” in the first place (the process of creating new Bitcoin).

This verification process, however, is not undertaken by a single, centralised third party authority; rather it is undertaken by every single other holder of Bitcoin (hence the million or so “peering eyes” analogy) in a collective verification process referred to as “distributed ledger technology”.

The ability to create new Bitcoin has also been decentralised. This overcomes another trust and legitimacy gap as it prevents any single creator of the digital currency from undermining the value of the currency by essentially digitally ‘printing’ the currency at its own discretion. At this stage however, the process of mining Bitcoin is extremely difficult and involves vast amount of computational processing power; it can therefore only be undertaken by large organisations with adequate energy resources (in terms of electricity) at their disposal.

Future of Bitcoin and crytocurrencies

It is perhaps too soon to tell from a regulatory, legislative and even a social perspective whether or not Bitcoin and other cryptocurrencies will equal let alone replace the use of flat currencies as the standard means of monetary exchange. This disruptive technology will almost certainly, however, precipitate a steady movement by fiat currencies to becoming more decentralised in terms of their regulation and security. Soon, no doubt, fiat currencies will be backed by the BlockChain, and paper money will be a thing of the past.

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