Understanding Bitcoin

Bitcoin is hailed by some as the future of money and dismissed by some as a ponzi scheme. Why is it in the news these days? How does it work? Is it something new? This article tries to answer these questions.

What is Bitcoin?
  • It is digital currency or electronic currency. You can’t go to an ATM and take out a Bitcoin, or put one in a cash register. Bitcoins live in online wallets, which are accessed via a computer.
  • It’s the first decentralized electronic currency i.e it not controlled or regulated by a single organization or government.
  • It is not backed by any commodity such as gold or silver nor is it pegged to any currency.
  • It is based on a concept called Cryptography the science of writing in secret code. Cryptography  protects information by transforming it (encrypting it) into an unreadable format, called cipher text. Only those who possess a secret key can decipher (or decrypt) the message into plain text.In data and telecommunications, cryptography is necessary when communicating over any untrusted medium, which includes just about any network, particularly the Internet.
  • It is completely distributed. The network,called as Peer to Peer (P2P), is made up of users no bank or payment processor is required between users. As each system interact directly with the others and there is no hierarchy or controlling network.

Website for bitcoin is  bitcoin.org/en. Our article Currency covers  World currency,  Indian Rupee,History of money, Kinds of Money etc.

What makes one bitcoin?

BTC is the common unit of Bitcoin currency like  USD for US dollar($). One bitcoin is subdivided into 100 million smaller units called satoshis, defined by eight decimal points. Products or services that accept bitcoins as payment may accept .025 BTC, .00000643 BTC.  Name of some of the fractions are :

  • 0.01 BTC = 1 cBTC = 1 centibitcoin (also referred to as bitcent)
  • 0.001 BTC = 1 mBTC = 1 millibitcoin (also referred to as mbit (pronounced em-bit) or millibit or even bitmill)
  • 0.000 001 BTC = 1 μBTC = 1 microbitcoin (also referred to as ubit (pronounced yu-bit) or microbit)

In pictures bitcoins is shown as  B with two vertical lines like in US dollar for example :

Bitcoin

Bitcoin

How is Bitcoin used?

You can’t go to an ATM and take out a Bitcoin, or put one in a cash register. Bitcoins live in online wallets, which are accessed via a computer. You need to install a wallet which will download onto your computer or iPhone. Upon installation, the wallet gives you an address, a unique 34-character combination of letters and numbers which works as an account number  for example, 1EDRfpadJ8cYpCZEnmq3UQ4NinxQo6JQcp.  So when Peter wants to send money to Joyce, he asks Joyce for her address and sends the money to that address. The rest of the world is simply told that 1 Bitcoin has been sent to Joyce’s address. The Bitcoins appear in Joyce’s account almost immediately.  The process of sending is shown in picture below (Ref: BlueTreeHost How to send Bitcoins?)

Bitcoin send payment

How to send Bitcoin

Examples of Bitcoin wallets are :

Some tech-savvy companies such as WordPress(which makes blogging tools) have started accepting payments in Bitcoins.

A bitcoin can be exchanged for real currency and vice versa at bitcoin exchanges like Mt.Gox.

Is Bitcoin something new?

No Bitcoin has been around since 2009.

Who created concept of Bitcoin?

The identity of those responsible for inventing Bitcoin remains a mystery. A programmer or group of programmers going by the name of Satoshi Nakamoto, from Japan, published the original specifications for it in a series of posts on a cryptography e-mail list in late 2008.. Towards the end of 2010 Satoshi left the project saying he had moved on to other things. The creator of Bitcoin never revealed his identity and simply left his invention to the world.

Since 2010, the Bitcoin community has grown with many developers working on the project. On September 27th 2012, the Bitcoin Foundation was created in an effort to standardize, protect, and promote Bitcoin

 How many bitcoins will be there ?

A pre-defined schedule limits the total number of bitcoins so there will only ever be about 21 million bitcoins created. Three-quarters of which by 2016, and all by 2140.The limit of 21 million bitcoins is “hard-wired” in to the protocol, and there will never be more bitcoins!

How are transactions validated? What if I use same Bitcoin for different transactions?

In real world if one uses currency/cheque/debit card/credit card then issuing authority validates the transaction. For example if one swipes a debit  of a bank, then the bank that issued the debit card validates if funds are available. But Bitcoin does not have a central authority so what will happen if a malicious user tries to spend same bitcoin to two different recipients at the same time(technically called as double spending).

Bitcoin is designed around the idea of a new form of money that uses cryptography to control its creation and transactions rather than relying on central authorities. The way Bitcoin works is that instead of having one central authority who secures and controls the money supply (like most governments do for their national currencies), this work is spread out all across the network. Most of the heavy lifting for Bitcoin is done by Miners.

Transactions are broadcast within seconds and verified. Miners confirms the transactions and lets you know. Every confirmation that transaction receives is more confidence that transaction will ultimately be accepted by the network.  It also collect the transactions on the network  into large bundles called blocks.  These blocks are strung together into one continuous, authoritative record called the block chain, which doesn’t permit any conflicting transactions. Block Chain is like  public legder of transactions, a decentralized and archived transaction log which is currently updated approximately every 10 minutes. Though transaction is public, parties involved are anonymous.   As a reward for their services, Bitcoin miners can collect transaction fees for the transactions they confirm along with newly created bitcoins. Infact that is how Bitcoins are created.

Currently, 25 new bitcoins are generated with every 10-minute block. This will be halved to 12.5 BTC during the year 2017 and halved continuously every 4 years after until a hard limit of 21 million bitcoins is reached during the year 2140 .

The infographic shows how Bitcoin transactions work (click on image to enlarge)

How bitcoin transactions work

How bitcoin transactions work

The following picture shows the wallet with transactions and confirmations. (Ref) For more images can see Armory screenshots

Bitcoin transactions

Bitcoin transactions

Summing up:

  • Bitcoins can be transferred between arbitrary nodes on the network.
  • Transactions are irreversible.
  • Transactions are broadcast within seconds and verified within 10 to 60 minutes.
  • Double spending is prevented by using a block chain.
  • Transaction processing and money issuance are carried out collectively through mining.
How does cryptography comes into play?

The integrity and the chronological order of the blockchain are enforced with cryptography.  To know more about cryptography one can read An Overview of Cryptography. In Bitcoins public key cryptography and hash cost-function are used. For details one can read How bitcoin works

When one sends some bitcoins to someone, he creates a message (transaction), attaching the new owner’s public key to the amount of coins, and signs it with his private key. When this transaction is broadcast to the bitcoin network, this lets everyone know that the new owner of these coins is the owner of the new key.The complete history of transactions is kept by everyone, so anyone can verify who is the current owner of any particular group of coins.The complete record of transactions is kept in the block chain, which is a sequence of records called blocks. All computers in the network have a copy of the block chain, which they keep updated by passing along new blocks to each other. In order to preserve the integrity of the block chain, each block in the chain confirms the integrity of the previous one, all the way back to the first one. Bitcoin blocks are identified by their hash, which takes input data which can be of practically any size, and transforms it, in an effectively-impossible to reverse or to predict way, into a relatively compact string.

What kind of software or hardware is required to be a miner?

Before coins were mined on normal PC’s. As the complexity increased, miners moved from CPU’s to GPU’s to keep up. Now though, mining using standard CPU’s and GPU’s costs more electricity than the coins are generally worth. So miners have moved to Application Specific Integrated Circuits ( ASIC’s) which are specially designed and programmed circuits tailored for the job. Bitcoin Wiki has comparison on mining hardware

How big is this bitcoin currency?

On Apr 13 around 11 million Bitcoins were in circulation.  You can Total bitcoins in circulation chart Statistics related to bitcoins can be found at blockchain.info/stats

How to get Bitcoins?

There are a variety of ways to acquire bitcoins:

  • Accept bitcoins as payment for goods or services.
  • Buy bitcoins are the Bitcoin Exchanges
  • There are several services where you can trade them for traditional currency.
  • Find someone to trade cash for bitcoins in-person through a local directory.
  • Participate in a mining pool.
  • If you have a lot of mining hardware, you can solo mine and attempt to create a new block (currently yields 25 bitcoins plus transaction fees).
Why Bitcoin can be used for illicit transactions?

As bitcoin can be exchanged between anonymous parties it has made them a favored currency for illicit activities with little trace. Bitcoin is already a popular currency on what’s called Silk Road, a website accessible only through anonymous Internet connections that acts as a marketplace for many illegal substances such as drugs.

Any thief can create a new address, send your money to their account, and use the web of anonymity to send the cash around the world before you might even notice it’s missing.

Why is bitcoin in news?

The Bitcoin is not backed by any commodity nor is it pegged to any currency. It derives its value from demand and supply economics.  They only have value in exchange and have no inherent value. If everyone suddenly stopped accepting your dollars, euros or bitcoins, the “bubble” would burst and their value would drop to zero. The USD value of a bitcoin increased ten-fold in early 2013 from $13/BTC on January 1 to $190/BTC on April 9th, three months later. Suggested reasons for the rise in price included the European sovereign-debt crisis – particularly the 2012–2013 Cypriot financial crisis. Quoting from journal’s Bitcoin or bit-con? Meet the crypto-currency that’s taking over the internet

The attraction behind leaving your savings in a bank – in theory at least – is that your money is safe there. If you leave your money in a mattress, and your house burns down, you’re out of luck – but even if a bank is robbed, or collapses altogether, the bank and government will work together so you won’t be left out of pocket.

The Cyprus bailout changed all of that, with the groundbreaking – and widely reviled – proposal to take a slice out of people’s bank accounts. Those with balances under €100,000 – the amount ‘guaranteed’ under EU law – would lose 6.75 per cent of their savings. Naturally, people ran to the ATMs, trying to get their money out before the levy kicked in.

That got people wondering: is there anywhere where we can leave our money, where it isn’t vulnerable to some sort of tax or levy – somewhere where money is untouchable?

People started talking about Bitcoin again, and the price started to balloon – but on a way bigger scale than in 2011. This time the media coverage was mainstream – and the more people who learned about Bitcoin, the more people decided to use it as a safe haven, and the more people tried to make a quick buck.A week before Cyprus, you could buy 1 Bitcoin for about €35. A week after Cyprus, it cost €75.

The value of Bitcoin in dollar terms soared to more than $200 from mere cents at its inception. On 10-11 Apr 2013, the value then slumped from as high as $266 to as low as $84, as shown in picture below from bitcoincharts on value of Bitcoin in US dollar on Mt.Gox . The flood was so fierce that MtGox, the most popular exchange website, decided to shut down for 12 hours in an effort to restore calm.

Bitcoin bubble burst

Bitcoin bubble burst

This was not the first time that Bitcoin lost it’s value. It happened in 2011 also as shown in picture below from

Bitcoin bubble burst of 2011

Bitcoin bubble burst of 2011

References : Bitcoin website bitcoin.org/en, Bitcoin Wiki FAQ, Bloomberg’s Explaining Bitcoin Without Buzzwords, Journal’s Bitcoin or bit-con? Meet the crypto-currency that’s taking over the internet, Bullion baron’s Bitcoin Bubble or New Virtual Currency Paradigm?, Infographics like What is Bitcoin, What is Bitcoins and how do they avoid taxes,Bitcoin 101

Related posts:

How will bitcoin evolve?Will it really become the future of money or will it’s bubble burst, only time will tell. What do you think of bitcoin?What about it’s recent rise and fall? Is it a ponzi scheme?

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