In the history of financial arrangements, the system that worked before a formal currency setup was barter, where people could exchange goods with each other, considered to be of equivalent value mutually by the participants of the transaction. But soon this system became problematic, as this system requires that the person you need something from must also need something from you, which is quite a rare scenario (we shall call it the coordination problem). For example, if Alice wants an object X from Bob, but Bob does not want anything from Alice, instead Bob wants an object Y that is held by Carol, but Carol does not want anything from Bob, instead she wants the object Z held by Alice. Now if X, Y and Z are considered to be of equivalent value mutually by Alice, Bob and Carol, then problem is solved! We can coordinate these three people, make them meet together and they can then carry out the transaction. This was a cycle involving only 3 people. Once the number of people and their desires and needs increase to a huge number, this coordination becomes extremely difficult.
To solve this problem of coordination, two systems emerged:
- credit system: Considering the example above, if Bob gives the object X to Alice, and Alice does not give Bob anything in return, then Alice now owes Bob a favor of equivalent value. This is recorded by both Alice and Bob. Although Alice is happy now that she got what she needed, but now she is in debt, which she would like to pay off. So now as she knows Bob is looking for object Y, which is with Carol, and is of equivalent value to X, which she took from Bob; she would now go to Carol and exchange Z (which she has) for Y, then she would go back to Bob and give him Y to pay off the due debt.
- cash system: In the cash system, the above problem will be solved as follows. Initially everyone has some amount of cash (let's say it's notes that represent some value). Now Alice would buy X from Bob directly without owing him anything using her cash. Next, Bob can exchange that cash with Carol for Y, and then Carol can exchange the cash with Alice for Z. In the end, it would be like nobody lost or gained anything extra, no money went haywire and everyone got what they wanted.
Both the above systems have their cons. In a credit system, every time a transaction occurs, the person giving away some favor is taking a risk as there's a chance that the other person just goes away and never comes back to settle the debt. In the cash system, the problem is bootstrapping, where everyone needs to start with some amount of cash initially to be able to start trading, but the advantage is that no one has to worry about debts, and we can be precise about the value of each favor as it helps us use numbers to determine the worth of objects. Another advantage of cash is that it provides better anonymity (compare using cash vs a credit card), the credit card has your personal information recorded with a central authority (a bank) and thus that central authority can easily track your spends, while paying in cash does not bring the bank into picture and you have better anonymity.
Bitcoin is not as anonymous as cash, but it's close. We don't have to create a profile with our personal information to be able to do transactions in bitcoin, but our transactions recorded in the public ledger can be linked with crafty algorithms to reveal our identity if we are not very careful.
Coming to the definition of bitcoin, it is a digital crypto-currency in which cryptography regulates both the generation of new units and verification of transactions of the currency, hence the name crypto-currency.
There are several reasons why bitcoin seems to be a better system to use as a currency for all transactions.
- Central authorities or governments cannot take away the currency (nobody to force the ban of certain denominations of the currency - demonetization heh!)
- No charge-backs, i.e. once bitcoins have been sent, they are not coming back without the recipient's consent. This makes it difficult to commit frauds as with credit cards, where people pay and then contact the credit card company to make a charge-back, effectively reversing the transaction.
- The biggest advantage is that you do not have to provide any secret information for any kind of transaction, thus nobody can steal your payment information from merchants if you are careful enough.
- For the regular currency, governments can print more in case of events like huge national debts (which causes inflation and the value of the currency drops). I have a very limited idea about inflation and how things work here but the point I'm trying to make is that bitcoin is much resistant to the inflation problem as the system is designed to have a maximum number of coins (This bitcoin-stackexchange question explains this a bit more clearly.)
- No third party identities need to be trusted with bitcoin. For the regular currency, one needs to trust the bank, the payment processor (if any), and sometimes the merchant too, as most of the times these organizations need important information from us. But because bitcoin is decentralized, we need not trust anyone but ourselves in the system for using it. To make a transaction, we form the transaction and sign it digitally with a cryptographic function and then an unknown miner verifies this transaction (to be talked about in detail in further articles). The merchant doesn't even need to know who you are!
- No other digital cash system exists where your account is not owned by some higher authority. Any online wallet for example, if decides someday that your account has been misused, can freeze all assets of that account without consulting you, and it is upon the account holder to do all formalities needed to reverse this action.
- Most national governments are skeptical about us producing our own money (we have quite the technologically advanced printers and other equipment available now for home use in order to print our own money). But with bitcoin, creating your own money is encouraged! We can buy bitcoin on the market, as well as mine our own.
The next article talks about an overview of the architectural setup that forms the foundation for bitcoin. After all, the reasons mentioned above require a lot of explanation, don't they?