What actually is this Bitcoin thing and how does it work?

Written by lee johnson
What actually is this Bitcoin thing and how does it work?
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Bitcoin is a new type of digital currency. “Inventing” money initially sounds about as reliable as trying to spend Monopoly-notes in a supermarket, but the truth is that all currencies ultimately dependent on trust. If – for some unknown reason – the entire world (including people in Britain) ceased to accept your pounds, they would instantly become worthless. Conversely, if everybody decided that bottle-caps were the most valuable things in the universe, they would turn from trash into treasure overnight. Ultimately, all currency is built on our grand delusion that the pieces of paper and the metallic coins we pass around are actually worth having, and as such, bitcoin is effectively a currency like any other. But how does it work, is it reliable, and could you physically hold a bitcoin?

Understanding Bitcoin

What actually is this Bitcoin thing and how does it work?
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The core thing to understand about Bitcoin is that it’s a decentralised currency, which means that no banks or governments are in control of it. Technically speaking, a bitcoin is a mathematical token, but physical bitcoins do exist (although the actual coin is merely a container for the key numerical identifier). Contrary to what you may have heard, Bitcoin isn’t an easy way to make money with your computer; it’s simply a currency like any other except without the reliance on a few higher-ups in financial institutions to play fair. You can send money to individuals or pay for goods and services (from people who accept them, of course) like you would with any other currency.

Open source

What actually is this Bitcoin thing and how does it work?
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The open-source nature of Bitcoin is one of its biggest selling-points. The “client” you use to handle your transactions is created by the community, and the code is available for anybody to view and improve as needed. In essence, this means that nobody profits from the currency in the same way as high-up bankers make money from your reliance on their system.

Strong cryptography

What actually is this Bitcoin thing and how does it work?
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Pumping money into a burgeoning digitized economy seems like an inherently risky proposition. Since a bitcoin is just a string of numbers, it stands to reason that they would be easy to steal. However, the Bitcoin system uses encryption much like that employed in military and governmental agencies. In other words, your bank is just as likely to be compromised as the Bitcoin system, but the Bitcoin system has the advantage of being open source. If anything puts the currency at risk, it can and will be upgraded. Additionally, your personal Bitcoin address is single-use, and the entire thing is anonymous – you don’t need an email address or any personal information to set up an address.

Fast transactions

What actually is this Bitcoin thing and how does it work?
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Because transactions are made peer-to-peer through the internet with no centralized authority, payments (particularly international ones) are much quicker and more affordable than traditional bank transfers. A transaction typically takes around 10 minutes to process, and the fees are kept to an absolute minimum, making it one of the cheapest – if not the cheapest – way to move money around.

Coin creation and the maximum number of bitcoins

What actually is this Bitcoin thing and how does it work?
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Bitcoins are created by users running a computer program which is essentially solving a mathematical problem. This problem has its difficulty carefully set so that the creation of new bitcoins continues at a roughly steady rate. The solution to the problem is placed into a “block” alongside a collection of the most recent Bitcoin transactions from across the network, which is publicly shared for the reward of a fixed amount of bitcoins. As of December 2013, each created block pays a block reward of 25 bitcoin, but this reward is cut in half around every four years. There will never be more than 21 million bitcoin in existence.

The basic Bitcoin payment

What actually is this Bitcoin thing and how does it work?
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A Bitcoin address has two keys, one which is public and one which is private. The public key is used to verify that the transaction came from a particular sender and the private key is used by the sender to verify that a payment is authorised to go ahead by them. To process a payment, the payer obtains the payee’s address, adds this address along with a set amount of bitcoin to a transaction message, verifies that they are processing the payments using their private key, and announces the public key so the digital signature can be verified. The transaction is then shared publicly on the network so it can be logged.

The double-spending problem

What actually is this Bitcoin thing and how does it work?
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What if the sender decides to try to use the same bitcoin twice? The public sharing of the transaction basically involves sending the transaction details to as many other users as possible, all of whom have access to the master record of the “blocks” of transactions. This means that after any transaction, a formidable number of people have the information confirming that a specific amount of bitcoin has been transferred to another user. The blocks are designed so that if anything is changed, any block after it has to be recalculated. The master “chain” of blocks is protected by the entire network, and in the event of multiple new branches of the chain, the longest branch is used. The result of this is that a would-be double-spender would need more computing power than the entire communal network to beat the system.

Bitcoin wallets

What actually is this Bitcoin thing and how does it work?
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A Bitcoin “wallet” is analogous to an ordinary wallet in that it stores money for its use when you want to make or receive payments. These wallets can be downloaded to your computer in software form (with the open source Original Bitcoin Client being a notable option) or your mobile phone, and you can also just use an online option. The full Bitcoin Client will take some time (around a day) to synchronise with the network at first, but it’s more secure than the easier to use online versions. If you want to make or receive Bitcoin payments, you’ll need some form of wallet.

Mining bitcoins

What actually is this Bitcoin thing and how does it work?
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“Mining” is the process of solving a mathematical problem in order to add to the secure master-record of transactions. This is often touted as the way to make money with Bitcoin, but in reality the computing power required often means that you’ll need a dedicated machine to really stand much of a chance of making anything, and even then it probably won’t be a profitable venture. Many people use mining pools, which are groups of people all working to solve the problem and thereby create a new block, before splitting the reward. This makes it more likely you’ll receive regular payments than if you were doing it individually, but the payments will be smaller. Generally speaking, people usually get involved with mining out of passion for the idea as opposed to a desire to get rich quick.

Getting bitcoins without mining

What actually is this Bitcoin thing and how does it work?
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You can get bitcoins without dedicating a computer processor to the task of mining. You can use a Bitcoin exchange to buy bitcoins (local directories are often an easier and more secure approach because you can trade in person for cash) or use a service which enables direct currency exchanges for bitcoin. Alternatively, completing surveys or making purchases at participating companies can net you a small amount of bitcoin.

Exchange rates

What actually is this Bitcoin thing and how does it work?
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The Bitcoin exchange rate varies quite rapidly, but at the time of writing (December 2013), a single bitcoin (1 BTC) is worth £640. This is extremely likely to change in future, and like any economy there is an inherent amount of uncertainty about which way things will go.

How much can I split a bitcoin?

What actually is this Bitcoin thing and how does it work?
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When a single bitcoin is worth a lot of money, you probably won’t want to spend it all in one go! Since Bitcoin works on a decimal system, it can be pretty much be split up as much as you like. The smallest allowed division of a bitcoin is up to eight decimal places, meaning you can pay as little as 0.00000001 BTC (called one “satoshi”) to another user or to purchase a product or pay for a service.

The economic side

What actually is this Bitcoin thing and how does it work?
(Photo: Flickr: zcopley, via Compfight)

Many economic quandaries arise out of Bitcoin, and these often revolve around what will happen when the amount of bitcoins in circulation reaches the limit, or if somebody hoarded significant sums of currency. There are some well-founded criticisms – for example, if a bitcoin is lost it cannot be replaced (unless it’s found again), so eventually the number of bitcoins will decrease and the value will likely continue to increase. Additionally, hoarding of bitcoins could increase the price for the same reason, but both of these situations will likely not become such a significant issue until new bitcoins cease to be mined in around the year 2140.

Where can I use bitcoins?

What actually is this Bitcoin thing and how does it work?
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The Bitcoin is the currency of choice in many shady corners of the deep web, but it’s increasingly being used by ordinary businesses and websites too. There are directories of traders available on the Bitcoin Wiki, online auction houses using Bitcoin and options to transform bitcoins into gift cards for popular stores and websites. Additionally, you can also exchange your bitcoins back into your home currency.

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