How trustless is bitcoin, really? How are trustless transactions executed on the bitcoin network?
The bitcoin network is designed in such a way that it makes it possible to complete financial transactions without the need for trust. The payee can’t default on the payment because the transaction is verified by the whole network—a large number of independently-operated servers all over the world.
Here’s how bitcoin makes trustless transactions possible.
Bitcoin Is Based on Verification Instead of Trust
How trustless is bitcoin, really? Bitcoin is based on a system of complete verification, which eliminates the need for trust. Many other types of transactions require a degree of trust: If someone writes you a check, you’ll only accept it as payment if you trust that their check won’t bounce. If someone pays you with a credit card, the credit card company acts as a trusted third party, verifying her credit and guaranteeing payment of her debts. But that means the credit card company can block any transaction that it disapproves of, even if the payer and the payee both approve of it. But with bitcoin, there’s no need to trust either the payer or a third party because of its system of complete verification.
Complete verification means that the network first checks to make sure the payer can make the payment (they have sufficient funds in their account) and then irreversibly transfers the funds, ensuring that the payer does make the payment. Furthermore, these checks are performed not just by a single payment processor, but by a majority of the network. To default on a payment or make a fraudulent payment, the payer would have to gain control of a majority of the entire bitcoin network, which, as we’ve discussed, would be virtually impossible. This is how the network ensures that the payer can’t default, eliminating the need for trust.
Ammous points out that this is ideal for settlements between parties located in different countries, who might have limited options for enforcing an agreement to pay. It also means that all bitcoin transactions are final, irreversible, and immune to third-party stipulations, much like paying someone in cash or gold.
But, as Ammous concedes, this approach also creates a large amount of redundancy (relative to using a trusted third party like a credit card company) since each transaction is independently verified by a majority of the entire network, not just a single server. This redundancy reduces the efficiency and speed of processing transactions.
|The Barbell Model and the Tradeoff Between Safety and Efficiency
The tradeoff between efficiency and safety isn’t unique to bitcoin, but rather is a principle that applies broadly to finance and life in general. Every action that you can take, whether it’s making an investment, launching a business venture, traveling on vacation, or something else carries a certain amount of risk—or, equivalently, a certain amount of trust. Trust and risk are closely related because most risks boil down to someone or something failing to perform the way you trusted that they would. In almost every case, there are ways of mitigating the risk, but they come at a cost.
For example, if you’re investing in stocks, you can reduce your risk of losing money by diversifying your portfolio. This works because it’s much less likely that many companies will fail or lose value at once than that a single company’s stock price will plummet. But it also reduces your potential to profit, because it’s also much less likely that all your stocks will grow exponentially than that just one of them will.
Bitcoin’s network works in a similar manner by having each transaction verified by many different nodes all over the world. It’s possible that one person operating a node or even a cluster of nodes would try to falsify a transaction, but it’s virtually impossible to get a majority of nodes on the entire network to approve it.
There are many possible strategies for managing the tradeoff between risk or safety and efficiency or profit. In Antifragile, Nassim Taleb recommends using the “barbell” model, where you organize all your assets, projects, and so forth into two groups: a high-risk group and a low-risk group (with the two groups kept at a distance from each other, like the weights on either end of a barbell). For example, you might invest 80% of your savings in low-risk securities like treasury bonds and term certificates, while you invest the other 20% in high-risk stocks.
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- Why bitcoin has the potential to replace the gold standard
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