What is Bitcoin and how does it work?

Bitcoin is a new form of internet money that is fundamentally different from existing currencies. It is decentralised, meaning it isn’t controlled by any single company or person, and all transactions are peer-to-peer. The history of all transactions is continually being verified by powerful computers, so it is impossible to change once a transaction has been accepted.

There are many benefits to this approach. There is no single entity that can manipulate it in any way, meaning there is no central authority like a government or institution controlling its supply and distribution. Similarly, since it is purely digital, open and peer-to-peer, anybody can buy bitcoin, and send any amount of money, cheaply and quickly, to anybody else, anywhere in the world.

The transactions that occur within the network are also validated by users. These users are rewarded in bitcoin for contributing their computing power to maintaining and validating the network. This process (called proof-of-work) also secures the network and helps it operate.

What about the double-spending problem associated with transactions?

Anybody can buy bitcoin, and send any amount of money, cheaply and quickly, to anybody else, anywhere in the world.

Double-spending is essentially what it sounds like; it is the act of trying to send a specific amount of money, say $50, to two people at the same time. We know that only one person can receive this $50, otherwise you’d be making the other $50 out of thin air.

The Bitcoin network solves this problem by validating all transactions before accepting them. If a certain amount of money is attempted to be sent twice in succession, the first transaction will be accepted as there are sufficient funds for it to proceed, but the second transaction trying to spend the same amount of bitcoin will be rejected by the network as it conflicts with the first, verified transaction.

Dilbert on Bitcoin

Let’s dive a little further to understand the way in which bitcoin transactions work and what this means for the rest of the network.

Think of the transaction process similar to sending an email. Where anybody with an internet connection can send and receive email, they can do the same with bitcoins.

A user can send money by using a Bitcoin wallet. To do this, you use a private key (password) to access a public address (where the bitcoins you control are stored). Think of this process as logging in to your email account. Once you log in, you can send bitcoin like you send a message: the amount of bitcoin you would like to send is selected, and the address of the recipient is added. The transaction is then sent, and goes into a queue, awaiting validation.

The real magic of bitcoin happens during the validation process.

What is bitcoin mining?

All bitcoin transactions are validated and then listed publicly for all to see by computational mathematics conducted by virtual miners. The transactions are listed in a ‘block’ (think of each block as an individual ledger), are time stamped, and cannot be altered. They therefore become immutable.

In Bitcoin’s case, all completed blocks are linked to new blocks that are being opened every ~10 minutes. Each block contains the history of the previous block, which in turn creates a chain of information. Hence the term ‘blockchain' (learn more about blockchain here).

This information is publicly available for anybody to see. If a new pending transaction appears to be out of sorts from the prior recorded transactions, it will be rejected by the vast community of miners that are responsible for validating each new transaction.

Once transactions are secured within the blockchain, the information on each of the blocks becomes near impossible to alter once added to this pubic ledger. To change a single block of information would require changing the history in each of the blocks up the chain.

When a block is completed, the computers validating the transactions get rewarded by mining some bitcoin. The newly mined bitcoin is then added at the beginning of each new block, thereby informing the rest of the community that some additional bitcoins have been added into circulation.

Furthermore, the elegant proof-of-work algorithm that Bitcoin is built upon was designed to be adaptable to the amount of computing power attempting to validate each and every transaction. Therefore, no matter how many or how few computers are being used to make these cryptographic calculations, a set number of bitcoins will enter circulation approximately every 10 minutes. So you can’t just add more computers and get more bitcoin.

The code ensures that the amount of new bitcoins which can be mined is halved approximately every 4 years. So, at the beginning (2008) 50 bitcoins were entering circulation every 10 minutes.

This figure has halved twice since then, allowing miners to add 12.5 bitcoins each time a new block is added (time of writing is 2018). This figure will halve again in 2020 where there will only be 6.25 bitcoins mined every 10 minutes, and so on, until there is a maximum of 21 million bitcoins in circulation (ending in the year 2140).

Based on this, it’ll take roughly 36 years to mine the last bitcoin.

Zoolander mining

Retention of value

There will never be any more bitcoins created after this. This is very unlike traditional forms of currency, where governments are able to print more into circulation to deal with economic stresses.

Printing more cash and pouring it into an economy results in reducing its worth over time. Therefore, a dollar today (regardless of country) will always be worth more than a dollar in the future.

Bitcoin is therefore immune from the effects of inflation because its supply is capped. In fact, bitcoin is deflationary because it is likely that there will be far fewer than 21 million bitcoins due to lost accounts or incorrect transaction that have taken place over the years.

Summary

The ledger, the distributed database - it’s called a blockchain - is held in the cloud by all the parties involved. It can’t be broken by any of them. It’s cryptographically too strong. You would have to compromise the entire network to take over Bitcoin.
- Naval Ravikant

Bitcoin is everything that traditional currency is not. It is not controlled by any single entity, but is instead maintained by all the users and developers in a trustless network. It is tamper proof, and verifiable by all that are willing to look.

However, It’s not without drawbacks; because of its decentralised nature, a user will never have asset insurance like that built into the traditional financial system.

It therefore throws back the onus on the user.

The key advantage to this is that the user has total control and ownership of this form of internet money.

This means that a transaction cannot be stopped by any person or entity.

An account cannot be seized or frozen by a central authority.

No form of censorship or permission can be forced upon it.

It is a new way of thinking, but Bitcoin and internet money is simply the beginning.


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