How Does Bitcoin Work?

3 January, 2009. The most important date in modern history that most people don’t know about.

The Times’ headline that day:

Chancellor on brink of second bailout for the banks.’

We were deep in the trenches of 2008’s global debt crisis. The global banking system was on a tightrope. One of history’s biggest financial crises had set markets alight, displaced John Doe’s savings, and brought central authorities to their knees.

It was on this date the mysterious and elusive Satoshi Nakamoto released a white paper titled ‘Bitcoin: A Peer-to-Peer Electronic Cash System’. This was the genesis of the world’s first meaningful ‘cryptocurrency’. One he would call ‘bitcoin’.

We know this date is bitcoin’s inception, as there is a little surprise buried in the extra data of this genesis block (we’ll explain ‘blocks’ in a moment).

Bitcoin buyer’s guide: everything you need to know to buy your first bitcoin today

This extra data reads, ‘The Times 03/Jan/2009 Chancellor on brink of second bailout for banks’. These are the beginnings of bitcoin. The first consequential cryptocurrency, which set in motion one of the most disruptive events traditional banking and finance has ever seen.

Bitcoin, in its purest description — from the Satoshi Nakamoto white paper itself — is ‘a purely peer-to-peer version of electronic cash’. It’s a payments system that avoids going through financial institutions. It’s the anti-financial system. It’s an alternative to the way we currently buy and sell things, transfer money around the world, and build our financial wealth.

Its aim is to reduce the barriers, costs, and borders of global finance. It was — and is — for everyone, to benefit everyone. Not just the elite, not just the powerful and already wealthy. It’s the libertarian, anti-establishment, alternative digital financial system.

The revolutionary tech behind Bitcoin

Jamie dimon bitcoin

If you’ve heard about bitcoin, chances are that you’ve also heard of a ‘blockchain’. It was probably heralded as ‘the next internet’, or ‘the biggest revolution since the combustion engine’. Both of those comparisons are valid.

Blockchains are revolutionary.

Blockchain, at its core, is a system of recording, transferring and verifying information. It’s like one independent auditor recording each and every transaction, one by one, to make up a ledger of everything.

Think about it like a giant notebook recording every transaction ever made. When a new transaction is added to the notebook, the wider community of ‘nodes’ (computers which are connected to the bitcoin network) verifies this new transaction, confirming it in the process. In approving the latest transaction, it’s assumed instantly that every record that comes before it is also approved (which it is).

For example, I transfer you one bitcoin; that then creates a digital signature — which is secured with cryptography known as a ‘hash’. This new digital signature is added to a whole long line of digital signatures from all the previous bitcoin movements that have ever taken place. Hence this distributed ledger — known as the blockchain — is one giant, automated verification system that proves and confirms every single bitcoin transaction that has and will ever take place.

This verification process, known as ‘confirmation’, underpins the entire Bitcoin system.

Where does Bitcoin come from?

‘Mining’ is just the term for verifying and maintaining the flow of records on the blockchain. Its known as mining because the specialised computers that ‘mine’ are rewarded for this function by receiving — for every block they ‘mine’— bitcoins. A bit like digging for gold and getting a nugget at the end of the day.

As miners mine more blocks, there are fewer left to mine. The design of the Bitcoin system ensures that only a finite number of coins will ever be in circulation. The total number of mineable coins is 21 million.

Right now, 16 million are in circulation. And with every 210,000 blocks, the mining reward halves.

It originally was a reward of 50 coins. After the first 210,000 blocks (10.5 million coins), the reward dropped to 25 coins. After the next 210,000 blocks (5.25 million), the reward dropped to 12 coins. The reward is currently 12 coins and, after another 210,000, the reward will be six, then three, and so on until all coins are in circulation. 

In the early days, you could mine Bitcoin from your PC at home. And many people did. While certainly no easy task, if you knew a bit of programming, you could mint a small fortune.

But as the price increased, and the mining reward got larger (in dollar terms), specialised computers emerged that could complete the ‘Proof of Work’ (block verification) puzzles quicker. These we call ASICs (application-specific integrated circuits) because their chips are specifically made to mine bitcoin.

Bitcoin mining became an ASIC arms race, which eventually put mining out of reach for ordinary enthusiasts, or even home-based mining businesses.

Today bitcoin is mined in massive warehouses, usually in places which have access to cheap electricity like China or Iceland.

Where to keep your Bitcoin

The first step to getting bitcoin is getting yourself a ‘wallet’

A bitcoin wallet is a digital wallet where you store bitcoin. Simple. There’s a number of choices for wallets, but most of them perform the same function. They can receive, store and send bitcoin.

With a wallet set up, you’re ready to receive some bitcoin. You will note in your wallet that you have a receiving address. This is made up of a bunch of randomly-generated numbers and letters.

It might look something like:

141ZdQfF6q55ySTC1HXMJLWNoRY4WEbr7qx.

The reason for the complexity is that Bitcoin also functions anonymously. So, while your transaction might be easily found on the blockchain, it would only appear as above.

No name, no address, and no personally-identifiable information.

This is another exciting feature of Bitcoin; it’s extremely difficult to track transactions to any one individual. This, as you can imagine, causes its fair share of headaches for governments and regulators. But there’s nothing illegal about owning bitcoin.

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Security and anonymity

Most government regulators and taxation departments still barely have any idea how to treat bitcoin. There is no CEO of Bitcoin, no board of directors, no shareholders or centralised decision makers of any kind.

There are just stakeholders.

The so-called ‘Bitcoin Community’ are the anonymous participants that make the whole system work. The way in which Bitcoin attains this quasi-anonymity is via the use of what is known as private keys (a form of encryption).

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In that way, only the holder of a private key can have access to the corresponding wallet that the private key opens. Each wallet also has a public key, which is the address that users use to make transactions. But privacy can be maintained as the public keys are unidentifiable to anyone but the user. And as long as private keys are kept private, then no third party can access a wallet.

By using this method of public and private keys, third parties and counterparties can be removed from the flow of payments from one to another. This enable peers (you, me and anyone else) on the network to send payments and make transactions.

We can do this with safety and security as the network which records the transactions ‘signs’ these transactions using public keys to verify the transfer from one ‘wallet’ to another. And this process of signing and confirming transactions within the network means that the network is 100% accurate and foolproof.

The network itself becomes the trusted source — but as the network is distributed amongst the users, everyone is a part of the inbuilt trust of the network.

In short, with Bitcoin you simply make transactions through its network, which is known as a ‘blockchain’. In making transactions through the blockchain from one location to another, no bank, no government, no third party or intermediaries touches it, sees it or has anything to do with it.

It is completely peer-to-peer, and it is (mostly) anonymous.

Bitcoin’s not the only one

When you think of cryptocurrency, you’re probably thinking about bitcoin. Fair enough; it was the catalyst for the crypto-boom. It’s the biggest and most valuable crypto out there.

But it’s not the only one.

ethereum price

Ethereum, Litecoin, dogecoin — a crypto that started out as a joke — and many other lesser-known cryptos, are all viable investments. Most coins out there now are utilising the blockchain for myriad other purposes. MaidSafe, for example, are using their safecoins to, as stated on their information page, ‘do for the internet what bitcoin did for money’.

In other words, they’re trying to decentralise and add an impenetrable layer of security to your data.

There are many, many altcoins available today, almost all of which are seeking to fulfil some perceived need in society. Very few try to compete with bitcoin as an alternative currency.

Some altcoins allow for the anonymous sharing of private data. For example, so that medical researchers can get large-scale statistical information about peoples’ health, without being able to connect those statistics to individuals and violate their privacy.

Others try to create marketplaces. Such as buying and selling electricity between homeowners with solar panels — others without — and the grid in general, all without the need for an active middleman. The cryptocurrency itself acts as the middleman, vastly reducing costs.

The unique mix of public, un-editable recording of information, accountability, and often the potential for individual anonymity, have created a wealth of possibilities. All of these would not have been possible without bitcoin blazing the trail for blockchain in public consciousness.

But as an alternative digital currency, bitcoin still hasn’t been beat.

To wrap it up

So, as you can tell, bitcoin is not as complicated as some would have you believe. It’s the modern alternative to a frankly archaic financial system. It’s the payments system for a connected world, one where transactions are verified instantly and ubiquitously.

Thanks to blockchain technology, our increasing data production — data that includes all of our payment and personal information — is now more secure, and has more freedom, than ever before. No longer are banks — who we’re not even sure we can trust anymore — your only option for transactable finance.

You can read all our latest articles about bitcoin and blockchain here.

 

Money Morning Australia