How Bitcoin Works

I was going to write something along the lines of “Although the math works, I think it's safe to say that #Bitcoin has turned out not to work in the real world; what can we learn from this about what kinds of things work and don't work in the real world?”

But then that got me thinking about how Bitcoin actually works and doesn't work, because an obvious counter would be “whaddya mean it doesn't work??”. And that led to some thoughts that I felt like writing down sort of informally here; they're about “what determines the exchange value of Bitcoin, and why is that non-zero?”

Beanie Babies

One reason Bitcoin has a dollar value (for instance) is that people want to own some because they think they are likely to be able to sell them for more later on. In this way they are investments, or collectibles, like say Beanie Babies.

(Both have a certain limited fundamental value, in that Beanie Babies are cute furry things that one can curl up with and pet, and Bitcoin(s) are things that the cool kids own. The latter is considerably more contingent than the former. Also Bitcoin is fungible, so there's no rarity effect.)

Money Laundering

If I have a bunch of US Dollars or some other popular currency, that I acquired through doing crimes, and I want to break the chain of evidence between the crimes and the money, I can buy a bunch of Bitcoin with that currency, and then sell it again, taking more or less care to obfuscate my footprints in the blockchain as I do it. Especially if I am a middle-sized criminal organization large enough to not mind the transaction fees and small enough that Law Enforcement will not bother to do the potentially annoying effort required to trace the transactions, this is a good way to launder the money.

Note that in this case I don't care at all what the exchange value of Bitcoin is, just that it be positive. But an ongoing demand for Bitcoin for money laundering will keep the value at some non-zero value or other.

Value Support

Perhaps there is someone, let's call him Fred, who watches the value of Bitcoin, and has a floor value in mind, and if Bitcoin's value threatens to go below the floor value for too long, Fred does a thing. First Fred creates a new company, say “Global Cash Net Coin Biz” or “Joe's Quik Lube”, and has that company issue a bond with a face value of a few million US dollars; the company then sells the bond to Fred for, say, one dollar and other valuable consideration.

Having now a few million dollars of additional “reserves” in the form of “commercial paper” (also known as “other cash equivalents”), Fred uses that to issue himself a few million units of a “stablecoin” he controls which is nominally “cross my heart and swear to die” pinned to the value of the US dollar, and then uses those to buy enough Bitcoin to get the price back up above the floor value.

All of this activity and price resilience proves to the world that Bitcoin is a valuable asset, so the price stays up, and Bob's your Uncle.

Certain steps in this process would be, arguably, illegal. But as long as nothing goes wrong, everyone is better off! More or less!


So that's where Bitcoin's value comes from: Beanie Babies, money laundering, and financial fraud.

One might suggest that the same is true of the US dollar; the key difference, though, is that the USA exists, and will always require people to pay their taxes in those dollars. So there will be demand as long as the USA is a viable thing. Collectors and money launderers and Fred, on the other hand, could stop buying Bitcoin at any time, if something else as useful pops up.