Bitcoin has been all over the news lately. But because it’s an entirely digital currency and doesn’t necessarily correspond to any existing formal currency, it’s not easy to understand for newcomers.
What is Bitcoin?
Bitcoin is a digital currency. It enables people to send and receive money across the Internet without a third party such as a bank. Bitcoin doesn’t have a corresponding physical element e.g. paper bills or coins. That being said, it isn’t simply an assigned value of money stored in a digital account. A global peer-to-peer network provides the value and verification of individual Bitcoins. This is similar to how torrent websites work. Except instead of transferring files from one place to another, the Bitcoin network generates and verifies blocks of information that are expressed in the form of a proprietary currency.
How does it work?
As a new Bitcoin user the first thing you have to do is install a Bitcoin wallet on your computer or mobile phone. It will generate your first Bitcoin address and you can create more whenever you need to. You can disclose your addresses to people you wish to pay or vice versa. This works similar to email, except that Bitcoin address should only be used once.
Balances – Block chain
The block chain is a shared public ledger on which the entire Bitcoin network relies. All confirmed transactions are included in the block chain. This way, Bitcoin wallets can calculate their spendable balance and new transactions can be verified to be spending Bitcoins that are actually owned by the spender. The integrity and the chronological order of the block chain are enforced with cryptography. (The branch of mathematics that enables the creation of mathematical proofs that provide high levels of security.)
Transactions – Private keys
A transaction is a transfer of value between Bitcoin wallets that gets included in the block chain. Bitcoin wallets keep a secret piece of data called a ‘private key’ or ‘seed’, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet. The signature (a mathematical mechanism that allows someone to prove ownership) also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and usually begin to be confirmed by the network in the following 10 minutes, through a process called ‘mining’.
Processing – Mining
Mining is a distributed consensus system that is used to confirm waiting transactions by including them in the block chain. It enforces a chronological order in the block chain, protects the neutrality of the network, and allows different computers to agree on the state of the system. In order to be confirmed, transactions must be packed in a ‘block’ (a record in the block chain that contains and confirms many waiting transactions) that fits very strict cryptographic rules that will be verified by the network. These rules prevent previous blocks from being modified because doing so would invalidate all following blocks. Mining also creates the equivalent of a competitive lottery that prevents any individual from easily adding new blocks consecutively in the block chain. This way, no individuals can control what is included in the block chain or replace parts of the block chain to roll back their own spends.
How are Bitcoins spent?
Imagine you are buying a loaf of bread from a supermarket with a debit card. The transaction has three elements; the card, corresponding to the bank account and the money, the bank itself that verifies the transaction and the transfer of money, and the store that accepts the money from the bank and finalizes the sale. A Bitcoin transaction has, broadly speaking, the same three components.
Each Bitcoin user stores the data that represents his or her amount of coins in a program called a wallet, consisting of a custom password and a connection to the Bitcoin system. The user sends a transaction request to another user, buying or selling, and both users agree. The peer-to-peer Bitcoin system verifies the transaction via the global network, transferring the value from one user to the next and inserting cryptographic checks and verification at many levels. There is no centralized bank or credit system: the peer-to-peer network completed the encrypted transaction with the help of Bitcoin miners.