You have probably heard of bitcoins. They are mentioned quite often in the media lately. But, you may not be sure what this so-called new form of currency actually is. So, we are featuring an article from the Investopedia staff published in Forbes magazine that does an excellent job of explaining the nature and use of bitcoins.
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“How Bitcoin Works”
By Investopedia Staff originally in Forbes magazine
Bitcoin is a digital currency that exists almost wholly in the virtual realm, unlike physical currencies like dollars and euros. A growing number of proponents support its use as an alternative currency that can pay for goods and services much like conventional currencies. Bitcoin is the first and easily the most popular cryptocurrency, or currency that uses cryptography1 (see “Definitions and Key Concepts” at end of article) to control its creation, administration and security.
Bitcoin was set up in 2009 by a mysterious individual or group with the pseudonym Satoshi Nakamoto, whose true identity is yet to be revealed and who left the project in 2010. It rocketed to prominence in 2013, when the value of a Bitcoin soared more than 10-fold in a two-month period, from $22 in February to a record $266 in April. At its peak, based on more than 10 million bitcoins issued, the cryptocurrency boasted a market value of over $2 billion.
Bitcoin Versus Conventional Currencies
Bitcoin differs from conventional currencies in some very fundamental ways, as noted below (for the sake of simplicity, we use the U.S. dollar as a proxy for conventional currencies).
•Bitcoin uses P2P technology without a central authority: Bitcoin is a decentralized currency managed by peer-to-peer technology (P2P2), without a central authority. All functions such as Bitcoin issuance, transaction processing and verification are carried out collectively by the network, without a central supervisor or agency to oversee operations. In contrast, a conventional currency is issued by a central bank as part of its mandate to manage national monetary policy. In the U.S., only the Federal Reserve has the power to issue dollars; it is also the central authority that conducts monetary policy, supervises banks, maintains financial system stability, and provides financial services to depository institutions.
•Bitcoin is primarily digital: Although physical Bitcoins are available from companies such as Casascius and BitBills, Bitcoin has been designed primarily to be a digital currency. Physical Bitcoins are somewhat of a novelty, and the very idea of a tangible form defeats the purpose of a digital currency, according to the most ardent supporters of the concept. Conversely, your dollars exist primarily in physical form; the balances that you hold at your bank and online brokerage can be converted into physical dollars within minutes if you so desire.
•Bitcoin has a maximum 21 million limit: The total number of Bitcoins that will be issued is capped at 21 million. The Bitcoin “mining”3 process presently creates 25 Bitcoins every 10 minutes (the number created will be halved every four years), so that limit will not be reached until the year 2140. While Bitcoin critics argue that the maximum limit is not large enough, supporters maintain that since each Bitcoin is divisible to eight decimal places, the number of fractional Bitcoins (called “satoshis”) – at 21 x 1014 – will be more than enough for all conceivable applications. Conventional currencies, on the other hand, can be issued without limit.
•Bitcoin is a complex product: The concepts of cryptocurrencies in general are abstruse and abstract, and understanding how and why Bitcoin works requires a fair degree of technological knowledge.
•Bitcoin has limited acceptance: It has limited acceptance so far and cannot be used at many brick-and-mortar storefronts, although that may eventually change if it continues to gain traction. The dollar, on the other hand, has near-universal acceptance as the world’s global reserve currency.
•Bitcoin transactions have limitations: A Bitcoin transaction can take as long as 10 minutes to confirm. Transactions are also irreversible and can only be refunded by the Bitcoin recipient. These limitations do not exist with conventional currencies, where debit and credit transactions are confirmed within seconds; certain transactions can also be reversed for valid reasons by the originator, without having to rely on the recipient’s largesse.
•Bitcoin balances are not insured: This means that if you lose your Bitcoins for any reason – for example, your hard drive crashes, or a hacker steals the digital wallet in which your Bitcoins are stored, or the Bitcoin exchange where you held a balance went out of business – you have little recourse. Currency balances held at banks, on the other hand, are insured against certain events such as bank failure by agencies like the Federal Deposit Insurance Corporation in the U.S.
How Bitcoin Works
Let’s say you want to test the Bitcoin waters. The first thing you need to do as a new user is install a digital wallet on your computer or mobile device. This wallet is simply a free, open-source software program that will generate your first and subsequent Bitcoin addresses. There are three types of wallets – a software wallet (installed on your computer), a mobile wallet (which resides on your mobile device) or a Web wallet (located on the website of a service provider that hosts bitcoins).
Bitcoin uses public key encryption4 techniques for security. This means that when a new Bitcoin address is created, a cryptographic key pair consisting of a public key and private key – which are essentially unique, long strings of letters and numbers – is generated.
Each address has its own Bitcoins balance, so all you need to do is acquire a number of Bitcoins that will be held at one of the addresses in your wallet. You can acquire Bitcoins through a number of ways – by buying them from a Bitcoin currency exchange such as Mt. Gox or Bitstamp, or through a service like BitInstant that enables fund transfers between Bitcoin exchanges and supports various payment mechanisms.
Note that all Bitcoin transactions are stored publicly and permanently on the Bitcoin network, which means that the balance and transactions of any Bitcoin address are visible to anyone. Experts therefore recommend that Bitcoin owners create a new address for each transaction as a means of ensuring privacy and enhancing security.
Once you have created a Bitcoin address and have acquired Bitcoins, you can use them for an online transaction with a company that accepts Bitcoins as a payment mode. The company will send you the Bitcoin address to which you can send your Bitcoin payment. You direct the payment to that address; while the transaction takes place within seconds, verification can take 10 minutes or longer.
All Bitcoin transactions, without exception, are included in a shared public transaction log known as a “block chain”. This is to confirm that the party spending the Bitcoins really owns them, and also to prevent fraud and double-spending.
Why does transaction verification or confirmation take so long? Because the complex algorithms involved in Bitcoin mining (see description below) take time to solve, even with immense computing power at one’s disposal.
An Example of a Bitcoin Transaction
Let’s assume you want to make an online payment to a company – call it BitChamp – using 5 Bitcoins that you have in an address in your digital wallet. Here are the steps in the transaction:
1.BitChamp creates a new Bitcoin address and directs you to send your payment to it. This creates a private key (known only to BitChamp) and a public key (available to you and anyone else). Note that just as a seller does not need to know your physical identity if you pay cash, you do not need to disclose your real identity to BitChamp and can remain anonymous.
2.You instruct your Bitcoin client (the free Bitcoin software you first installed on your computer) to transfer 5 Bitcoins from your wallet to the BitChamp address. This is the transaction message.
3.Your Bitcoin client will electronically “sign” the transaction request with the private key of the address from where you are transferring the Bitcoins. Recall that your public key is available to anyone for signature verification.
4.Your transaction is broadcast to the Bitcoin network and will be verified in a few minutes. The 5 Bitcoins have been successfully transferred from your address to the BitChamp address.
Note that only the first two steps involve action by the seller and you respectively. The latter two steps are automatically executed by the Bitcoin client software and Bitcoin network. As well, storing the private key attached to an address safely and securely is of the utmost importance; otherwise, anyone who obtains the private key can control the Bitcoins at that address and use them fraudulently.
Bitcoin Pros and Cons
Bitcoin has a number of advantages:
•As the first cryptocurrency to capture the public imagination, Bitcoin has “first mover” advantage and a head start over the competition.
•Total issuance is limited to 21 million, so it is unlikely to be devalued because of the prospect of a massive influx of new bitcoins.
•As a decentralized currency, Bitcoin is free from government interference and manipulation.
•Transaction costs are much lower than with conventional currencies.
On the flip side, Bitcoin’s disadvantages include:•The price of a Bitcoin has been increasingly volatile, making it difficult to assess its real value and increasing the risk of losses for investors in the cryptocurrency.
•The relative anonymity of Bitcoin may encourage its use for illegal and illicit activities such as tax evasion, weapons procurement, gambling and circumvention of currency controls.
•The fact that bitcoins exist primarily in digital form renders them vulnerable to loss.
Bitcoin has made significant progress in its adoption and usage since it was unveiled in 2009. Its evolution over the next few years will determine whether this leading cryptocurrency will become an integral part of the global financial system, or whether it is destined to remain a niche player.
Definitions and Key Concepts
1 Cryptography refers to the practice and technique of using encryption for secure communication and transmission of data and information.
2 In a P2P network, a group of computers is connected to enable the sharing of resources and information by users, and there is no central location for the network. This is diametrically opposed to a typical client-server network, where the central server controls the level of access by users to shared network resources. Popular applications of the P2P concept are Skype and file-sharing services such as BitTorrent.
3 Bitcoin mining refers to the computationally-intensive task of generating Bitcoins. While any computer can be put to the task of Bitcoin mining by using a free mining application, in reality a great deal of computing power is required to solve the extremely complex algorithms involved and to share those solutions with the entire Bitcoin network. The mining process is quite complicated and involves advanced concepts such as cryptographic hashes and nonces.
In simple terms, Bitcoin miners use powerful computers to track and compile pending Bitcoin transactions every 10 minutes into a new block. These miners then set to work doing the intensive number-crunching required to verify all the transactions in the block. This is a competitive process, and the first miner to solve the algorithms and verify the transactions transmits the results to the entire Bitcoin network.
Upon confirmation by the rest of the network, the block is then added to the block chain. Each block includes a certain number of Bitcoins in a “coinbase” transaction that is paid out to the successful miner. This reward was set at 50 Bitcoins when the system first commenced operations in 2009, but was halved to 25 Bitcoins in November 2012, and will reduce by 50% approximately every four years.
4 Public key encryption combines a public key and a private key. While the public key is available to anyone, the matching private key is stored securely in the digital wallet and is generally password-protected. Each Bitcoin transaction is signed by the private key of the initiating user, providing mathematical proof that it has indeed originated from the owner of the address, and preventing the transaction from being altered once it has been issued. Since the key pair is mathematically related, any data or information encrypted with a private key may only be decrypted or deciphered with the corresponding public key and vice versa.
5 Double-spending means spending the same digital currency twice, something that is impossible with physical currencies.
(Disclaimer: The views in the above article are stictly those of the author. They do now necessarily represent those of FFN. Please use du diligence prior to applying the concepts, recommendations and/or in purchasing any productsor services from the author.) FFN Editors