The creation of Bitcoin was right after the 2008 financial crisis, the most severe economic crisis since the Great Depression. This is not coincidental. The inventor of the Bitcoin cryptocurrency aimed at addressing people's disillusionment with financial institutions, whose epic failures in risk controls resulted in the 2008 financial crisis.
A fundamental role played by financial institutions is to be an intermediary entity and bring untrusting parties together to facilitate transactions. For example, a retail bank attracts residual money from individuals and lends to individuals or companies that need the money. The difference in interest paid to the money suppliers and borrowers is the fee a bank charges for providing the intermediary service. Financial institutions are very successful in providing these services and play a pivotal role in powering economies worldwide. However, there are many deficiencies associated with this business model. Here are some examples:
- Slow: It often takes days to complete a financial transaction. For instance, it takes three days (after an order is initially entered) to complete and settle a cross-border money transfer. To make it happen, multiple departments and application systems within an institution and across institutions have to work together to facilitate the transaction. Another example is stock trading. An investor hires a broker to enter an order to be routed to a stock exchange. Here, the broker is either a member of the exchange or routes the order to another intermediary institution with membership. After a match is found between a buyer and a seller at the exchange, the transaction details are recorded by two parties who send it to their back offices respectively. The back-office teams work with a clearing house for clearance and settlement. It takes T + 3 for both parties to complete the action of exchanging ownership of the security (stock) and the cash.
- Expensive: Financial intermediaries often charge hefty fees when providing these services. For example, a US bank could charge $10 to $30 USD to serve an individual by sending money from the US to a receiver in another country. In the case of stock trading, a full-service broker often charges tens of USD or more for a transaction. Even with a discount broker, an investor needs to pay $7 to $10 USD per transaction.
- Prone to be hacked: Since details on a customer and the transactions are saved in a centralized area within an institution, it is prone to being hacked and causing severe financial loss or leakage of confidential personal information about customers. Recently, there have been high-profile personal data leakage incidents at reputable companies such as JP Morgan (83 million accounts hacked in 2014), Target (up to 70 million customers' information hacked in 2013), and Equifax (148 million US consumers' information hacked in 2017).
- Not transparent: Financial institutions keep both detailed and aggregated information on transactions. However, most of the information is not open to the individual customer and this results in information imparity. In the example of cross-border money transfers, both the sender and receiver have to wait for three days to know whether the transaction has been completed successfully or not. If a transaction fails, a lengthy investigation has to be triggered. Imagine if the receiver was in an emergency and needed the funding immediately. Such a service is unsatisfactory despite the client having to pay a high fee.
With blockchain technology, the preceding problems are resolved elegantly. In the case of the Bitcoin blockchain, the underlying asset to be transferred is the digital coin, BTC. A cross-border BTC transaction can complete in no more than 1 hour. No settlement is needed since transaction and settlement are in one action. The cost of this transaction is a tiny fraction of a transfer via a bank. For example, a recent report published by the Bank of America (BoA) claims a transfer via blockchain costs 1/6000 of what BoA charges. However, for some clients, waiting an hour is still too long. Ripple, a payment provider for sending money globally, completes in under 1 minute.
The word Bitcoin often causes confusion as people use the word interchangeably for three things: the cryptocurrency, the blockchain, and the protocol. To avoid this confusion, we use BTC to refer to the cryptocurrency, and Bitcoin to refer to the blockchain and the corresponding network that uses the distributed ledger. For the protocol, we will fully spell out Bitcoin protocol or simply protocol.