How Bitcoin Works


Introduction to How Bitcoin Works
This is an artist's visual representation of the digital cryptocurrency, Bitcoin. Bitcoin itself has no physical presence. Dan Kitwood/Getty Images

It's a bit like money ... and it's a bit like a financial bubble. It's Bitcoin, and it may be giving us a glimpse of the future of money.

Bitcoin is a type of virtual currency brought to life by the internet, very powerful computers and the willingness of lot of people looking to embrace new forms of monetary exchange.

Bitcoin shares some similarities with real-world currencies, particularly its growing acceptance as a form of payment with more and more merchants, retailers and individuals, both online and offline. You can buy Microsoft products with Bitcoin, buy airline tickets through Expedia, or buy gift cards to superstores like Walmart.

Yet Bitcoin is also very different from traditional currencies. Unlike dollars or pounds, Bitcoin isn't backed by any government. It's a completely decentralized form of money. Bitcoin isn't linked to any sort of central banking system or issuing authority, and that's a big part of its appeal — instead of being swallowed into a system that's often sullied by human greed and manipulation, this currency exists in an online world driven by mathematics and clever encryption protocols.

You can use Bitcoin for all sorts of real transactions. To do so, you first buy bitcoins however you like, either through your credit card, a bank account or even anonymously with cash. Then your bitcoins are transferred directly into your Bitcoin wallet, and you can send and receive payments directly to a buyer or seller without the need for a typical go-between, such as a bank or credit card company.

By skipping the middleman in the transaction, you pay far less in associated fees. Each party in the deal can also maintain a much higher level of anonymity, which has both pros and cons for everyone involved. Think of Bitcoin as a digital equivalent of a cash transaction. If you're so inclined, it's a nearly untraceable way to do business.

Spending or receiving Bitcoin is as easy as sending an e-mail, and you can use your computer or your smartphone. That simplicity belies the fact that there's a whole lot of complicated math protecting all of these transactions to maintain their legitimacy and security.

Keep reading to see more about the mysterious rise of Bitcoin, as well as the inner workings of the network that keeps this so-called "cryptocurrency" alive and kicking.

Bitcoin's Backstory

The genesis of Bitcoin is the stuff of internet legend. In 2008, a person (or persons) working under the pseudonym Satoshi Nakamoto published a document outlining the feasibility of the Bitcoin concept. Nakamoto mentioned the 2008 financial crisis — as well as the failures of government-backed currencies and corruption of existing banking systems — as a motivating factor for inventing a new currency.

Bitcoin would be, according to its creators, a purer form of money, working for regular citizens of the world instead of being leveraged against them by the powers that be.

In 2009, Nakamoto released the first Bitcoin application, and also "mined" the first bitcoins for circulation. Then it was just a matter of spreading the word about this new currency.

To use Bitcoin, you need a Bitcoin wallet, which encrypts and maintains your bitcoin balance on your computer, smartphone or in the cloud. Then you can fill your wallet with bitcoins by using your bank account, credit card or other form of payment.

After that, it's just a matter of finding a vendor that will accept Bitcoin as payment. Although pickings were slim when Bitcoin first launched, these days there are many merchants that accept these newfangled coins. That includes restaurants, clothing stores, dentists and many others. Some people even use Bitcoin for property rental and vehicle purchases. The gift card website Gyft accepts payment in Bitcoin, letting you turn Bitcoin into store credit that can be spent at every major retailer and restaurant in America.

If you follow financial news at all, you already know that Bitcoin isn't just used for goods and services. A lot of the hype around Bitcoin has centered around speculation. That is, people are using online currency exchanges like Coinbase to invest their real-world dollars and yen in Bitcoin hoping that the latter will appreciate in value. Already, fortunes have been made (and surrendered) as the value of Bitcoin has careened all over the charts.

But how does this invisible, virtual currency wield so much financial power? How can a brand-new type of money be a workable concept? Well, it's complicated. Keep reading and you'll see how Bitcoin comes to life.

One Complicated Coin

One Complicated Coin
A photographer's conception of cryptocurrency, done with a little '80s style. Koron/Getty Images

Bitcoins aren't like gold. No one can dig them out of the ground. They're not like paper money, either. No central authority prints hard-to-counterfeit, tangible Bitcoin bills for circulation. Instead, Bitcoin depends entirely on a decentralized computer network and some amazing feats of cryptography.

For starters, understand that the entire Bitcoin system runs on a P2P (peer-to-peer) network. This P2P architecture is similar to file-sharing networks like those that allow people to freely distribute data of all kinds, including copyrighted music, movies and more. It's a resilient system.

In other words, there isn't a central computer hub running all of the Bitcoin-related processes. Instead, each Bitcoin user's computer is part of the network, collectively sharing the computing burden of generating bitcoins and logging their transactions. It's this decentralized nature that makes Bitcoin impervious (so far) to government meddling, free of regulation and monitoring.

Before anyone can even use a bitcoin, the coins must be mined by a so-called Bitcoin mining process. Any computer can begin mining for bitcoins by using a free mining application. Mining requires the entire network of Bitcoin-participant computers to do a set amount of work before being rewarded with a bitcoin.

Basically, that work means a whole lot of number crunching — and the spoils go to the owner of the computer that completes the set of number crunching at hand. Some people invest many thousands of dollars in very powerful computers just to mine bitcoins. Mining has become a computing arms race, and only those at the leading edge stand to gain anything in the way of profit.

The exact amount of work required is variable. The network adjusts that workload so that the number of bitcoins rises at a steady, predetermined rate. It will continue to do so until the number of bitcoins in circulation reaches its ultimate number, which is 21 million. Currently, the mining process creates 25 bitcoins every 10 minutes. Every four years, the number of coins that can be mined will be halved, until the capped limit of coins is reached in the year 2140. After that point, the number of bitcoins in circulation will be static.

As we explained, you hold your own bitcoins in a digital wallet. When you send or receive coins, they are verified by a digital signature, called a public-encryption key, which prevents counterfeiting and makes coins recognizable to the network. In truth, you hold no actual bitcoins in your wallet, just the public encryption keys associated with each of your Bitcoin transactions.

One of the main features of Bitcoin — and all virtual currencies — is that the decentralized network shares an open ledger (called the blockchain) of all Bitcoin transactions. The blockchain provides a trustworthy and redundant way of maintaining the number of bitcoins in circulation.

All of this works thanks to Bitcoin's ingenious open-source (that is, viewable to everyone) code. Open-source software is commonly used by programmers who are opposed to corporate profiteering and control. Any skilled programmer can see how Bitcoin's programming works, and that's OK — it's not the code that protects transactions. Instead, it's the shared blockchain ledger that verifies the legitimacy of each transfer.

A Question of Money

Once you have a stash of Bitcoin in your wallet, you can leave it there and hope that it appreciates in value. Or you can cash it out into local currency.

If you store Bitcoin on your computer, it's imperative to remember that there's no central company with a backup of your wallet. That means you have to create a backup record of your balance. It's best to store that record on a device such as a flash memory drive that can you keep in a safe location. Otherwise, if your hard drive dies and takes your wallet down with it, you'd lose your Bitcoin savings.

Another option is to use an online Bitcoin wallet that stores all of your encryption keys in the cloud. The advantage of an online wallet is that you don't have to worry about constantly backing up your data, but the downside is that you're putting your Bitcoin security in the hands of a third party. If they lose your keys, there's no way to get your Bitcoin back.

Bitcoin transactions are irreversible and generally fast, but not instantaneous like credit cards. Because the Bitcoin verification process must share data regarding the transaction with the entire network, sometimes you'll wait minutes before a payment is completed.

A big advantage of Bitcoin is its lack of transaction fees. Because there are no national or international regulations for Bitcoin, you can transfer the virtual currency into or out of any country without the steep wire fees that banks and services like Western Union charge. And because the system has no governing authority, your account has no limits and can never be frozen.

It's at this point that many people wonder about the legitimacy of Bitcoin. How can a currency just appear overnight on the internet and have actual value? Economists might offer a long, philosophical explanation about the history of money, but the short answer is this: all currencies have value only because people believe that they have value.

Bitcoin is no different in that regard. It's been embraced by libertarian-minded activists, financial speculators and people who simply no longer trust government-backed banking systems. These people trust the mathematics and encryption of the Bitcoin system, and their trust has proven contagious, lending even more legitimacy to this virtual currency.

More than a Bit Scary

Bitcoin is slowly gaining more legitimacy. But, there's the matter of people really trusting a currency. And that's where this new currency gets scary.

Rampant speculation has turned the valuation of Bitcoin into a neck-snapping roller coaster ride. In 2010, a unit of 1 bitcoin was worth just a few cents. Over the next few years, Bitcoin's value rose and fell from hundreds of dollars to just a handful. But nothing quite prepared investors for 2017, during which wild Bitcoin speculation drove the price of a single bitcoin from less than $1,000 to over $16,000 [source: Russo].

To many observers, the surging popularity and price of Bitcoin looks a whole lot like the dot-com and housing bubbles. Economists warn that the Bitcoin bubble, like all bubbles, will eventually burst and take a lot of fortunes with it. From this angle, Bitcoin sounds like a currency built only for suckers and speculators.

There's also the fact that online currency exchanges continue to be a hub for most Bitcoin transfers. The exchanges are necessary, of course, because they help you convert Bitcoin to and from local currency. However, in a system that's supposed to be decentralized, these exchanges offer up a tasty target for government regulators and malicious computer hackers.

Hackers, for example, may not yet be able to exploit Bitcoin's elegant blockchain technology to create fake coins or fraudulent transactions. But they can definitely attack the exchanges, which are as vulnerable as any other kind of website. In one widely publicized incident, hackers launched a DDoS (distributed denial-of-service) attack on the popular exchange Mt. Gox in 2014, which resulted in the loss of 850,000 bitcoins [source: Gibbs]. Chaos ensued and Bitcoin's value plummeted.

Bitcoins are definitely a high-risk asset. And as you're about to see, there are other potential downsides to the Bitcoin system.

Bitcoin's Extralegal Activities

If Bitcoin seems a bit anarchist, well, that's because it is. Bitcoin dodges the traditional paradigm in which government regulators control and manipulate the money supply.

With Bitcoin, people all over the world can engage in online gambling, which the U.S. federal government seriously disapproves of. Bitcoin was also infamously and irrevocably linked to Silk Road, a black market website where people could anonymously purchase about anything, including illegal drugs. The original Silk Road was shut down in 2013 and its founder sentenced to life in prison, but plenty of Silk Road-style marketplaces have since popped up on the dark web [source: Greenberg].

Bitcoin's reputation was soiled by these early associations with Silk Road and other criminal networks. Media reports frequently highlighted the role of Bitcoin on the dark web. Need a kidnapper or hired gun? How about some compromising pictures of your political enemy? With enough Bitcoin and some investigative work, you could potentially find the right person for any job [source: Buterin].

But as more cryptocurrencies have entered the market, criminals are relying less on Bitcoin. In fact, Bitcoin's much-heralded anonymity can be compromised by law enforcement, pushing more cybercriminals to switch to fully encrypted currencies like monero and dash [source: Cheng].

The relative anonymity of Bitcoin and other cryptocurrencies is also a boon for tax evasion. Traditionally, hiding your assets in some offshore account takes some real legwork. With Bitcoin, though, you can potentially stash millions of dollars in your digital wallet safely out of view of all tax collectors, and you could complete this process in just an afternoon.

Governments and concerned citizens obviously take issue with these sorts of underhanded internet shenanigans. Governments don't want citizens skimping on taxes, and their drug-enforcement agencies understandably aren't happy about people finding high-tech ways to skirt their laws.

In spite of these sort of legal or ethical concerns, and even though their value is crazily unpredictable, Bitcoin has endured. That leaves a lot of economists and consumers wondering just what's in store for the future of currency.

Bitcoin is Just the Beginning

Bitcoin is Just the Beginning
Is the world ready to embrace Bitcoin's decentralized currency model? R.Tsubin/Getty Images

The sharp peaks and valleys in Bitcoin's value are clear warning signs that this new cryptocurrency is anything but stable. Until more people actually use the currency to buy things, as opposed to speculating in the currency itself, it's difficult to say what role Bitcoin will play in the future economy.

Is the world really ready to ditch our centuries-old paper and coin, government-backed monetary systems for a purely digital currency? Or will the blockchain technology behind Bitcoin prove more revolutionary than the currency itself?

Bitcoin's success as a speculative commodity has opened the floodgates to hundreds of new cryptocurrencies, each competing for a niche in the market. As we mentioned earlier, some differentiate themselves by their deep encryption and anonymity. Others boast faster transaction processing speeds. But the most promising Bitcoin alternative to date is something called Ethereum.

Ethereum is less of a pure currency than a full-service financial platform. Unlike Bitcoin, you can't use Ethereum's currency (called ether) to buy stuff in the real world. The real power of Ethereum comes from its next-generation blockchain technology and robust programming language. Economists are excited about the potential for Ethereum to usher in an era of "programmable money" and "smart contracts" that run on cryptocurrencies. Again, the underlying blockchain technology may be the game-changer, not the currencies themselves.

Whether it's Bitcoin, monero, dollars or euros, our global economy requires all of us to trust a system of currency that makes sense. Perhaps the future of money is going to be a lot more fluid, with electronic transactions processed on a secure, decentralized blockchain in every currency imaginable.

But before that happens, Bitcoin and other cryptocurrencies will need to address their energy problem. All of the computing power required to mine and verify Bitcoin leaves a huge carbon footprint. Environmental watchdogs calculate that a single Bitcoin transaction consumes as much energy as nine US homes burn through in a full day [source: Digiconomist].

Related Articles

Sources

  • Anderson, Nate. "Mining Bitcoins Takes Power, but is it an Environmental Disaster?" Ars Technica. April 14, 2013. (April 15, 2013) http://arstechnica.com/business/2013/04/mining-bitcoins-takes-power-but-is-it-an-environmental-disaster/
  • Bitcoin. "Some Things You Need to Know." (April 15, 2013) http://bitcoin.org/en/you-need-to-know
  • Brown, Eric. "Is Bitcoin Mining an 'Environmental Disaster'? In Short, No." International Business Times. April 14, 2013. (April 15, 2013) http://www.ibtimes.com/bitcoin-mining-environmental-disaster-short-no-1191035
  • Chappell, Bill. "Bitcoin Surpasses $200 Mark, Continuing 'Epic' Rise." NPR. Apr. 9, 2013. (April 15, 2013) http://www.npr.org/blogs/thetwo-way/2013/04/09/176708504/bitcoin-surpasses-200-mark-continuing-epic-rise
  • Cheng, Evelyn. "Dark web finds bitcoin increasingly more of a problem than a help, tries other digital currencies." CNBC. Aug. 29, 2017 (Dec. 7, 2017) https://www.cnbc.com/2017/08/29/dark-web-finds-bitcoin-increasingly-more-of-a-problem-than-a-help-tries-other-digital-currencies.html
  • Copeland, Michael V. "What's Riskier than Bitcoins? Bitcoin Companies." Wired. Apr. 19, 2013. (April 20, 2013) http://www.wired.com/business/2013/04/whats-riskier-than-bitcoins-bitcoin-companies/
  • Dachis, Adam. "Ask LH: What is Bitcoin and How Can I Use it?" Lifehacker. Mar. 27, 2013. (April 15, 2013) http://www.lifehacker.com.au/2013/03/ask-lh-what-is-bitcoin-and-how-can-i-use-it/
  • Digiconomist. "Bitcoin Energy Consumption Index" (Dec. 7, 2017) https://digiconomist.net/bitcoin-energy-consumption
  • The Economist. "A Bit Expensive." Mar. 19, 2013. (April 15, 2013) http://www.economist.com/blogs/graphicdetail/2013/03/daily-chart-12
  • The Economist. "Monetarists Anonymous." Sept. 29, 2012. (April 15, 2013) http://www.economist.com/node/21563752
  • Farviar, Cyrus. "Is Online Gambling Legal if Bitcoins, Not Dollars, Are at Stake?" NPR. Feb. 6, 2013. (April 15, 2013) http://www.npr.org/blogs/alltechconsidered/2013/02/06/171182974/is-online-gambling-legal-if-bitcoins-not-dollars-are-at-stake
  • Forbes, Steve. "Bitcoin: Whatever It Is, It's Not Money!" Forbes. Apr. 16, 2013. (April 20, 2013) http://www.forbes.com/sites/steveforbes/2013/04/16/bitcoin-whatever-it-is-its-not-money/
  • Gibbs, Samuel. "Bitcoin: $64m in cryptocurrency stolen in 'sophisticated' hack, exchange says." The Guardian. Dec. 7, 2017 https://www.wired.com/2017/05/silk-road-creators-life-sentence-actually-boosted-dark-web-drug-sales/
  • Greenberg, Andy. "Founder of Drug Site Silk Road Says Bitcoin Booms and Busts Won't Kill His Black Market." Forbes. Apr. 16, 2013. (April 20, 2013) http://www.forbes.com/sites/andygreenberg/2013/04/16/founder-of-drug-site-silk-road-says-bitcoin-booms-and-busts-wont-kill-his-black-market/
  • Greenberg, Andy. "The Silk Road Creator's Life Sentence Actually Boosted Dark Web Drug Sales." Wired. May 23, 2017 (Dec. 7, 2017) https://www.wired.com/2017/05/silk-road-creators-life-sentence-actually-boosted-dark-web-drug-sales/
  • Irwin, Neil. "Bitcoin is Ludicrous, but It Tells Us Something Important about the Nature of Money." Washington Post. Apr. 12, 2013. (April 15, 2013) http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/12/bitcoin-is-ludicrous-but-it-tells-us-something-important-about-the-nature-of-money/
  • Krugman, Paul. "The Antisocial Network." New York Times. Apr. 14, 2013. (April 15, 2013) http://www.nytimes.com/2013/04/15/opinion/krugman-the-antisocial-network.html?_r=0
  • McMillan, Robert. "Hackers Pull off $12,000 Bitcoin Heist." Wired.com. Mar. 7, 2013. (April 15, 2013) http://www.wired.com/wiredenterprise/2013/03/digital-thieves-pull-off-12000-bitcoin-heist/
  • Melendez, Eleazar David. "Bitcoin Celebrated as Way to Avoid Taxes." Huffington Post. Apr. 16, 2013. (April 20, 2013) http://www.huffingtonpost.com/2013/04/16/bitcoin-taxes_n_3093182.html
  • Petronzio, Matt. "8 Vendors that You Didn't Know Accepted Bitcoins." Mashable. Mar. 29, 2013. (April 15, 2013) http://mashable.com/2013/03/29/bitcoin-vendors/
  • Russo, Camila. "Bitcoin Exchanges are Buckling While the Prices Surge Past $16,000." Bloomberg Technology. Dec. 6, 2017 (Dec. 7, 2017) https://www.bloomberg.com/news/articles/2017-12-07/bitcoin-soars-through-14-000-mark-up-more-than-40-this-month
  • Say, My. "Bitcoin and the Future of Money. " Forbes. Apr. 15, 2013. (April 20, 2013) http://www.forbes.com/sites/groupthink/2013/04/15/bitcoin-and-the-future-of-money/
  • Sidel, Robin. "Bitcoin Investors Hang on for the Ride." Wall Street Journal. Apr. 16, 2013. (April 20, 2013) http://online.wsj.com/article/SB10001424127887324345804578426692340390104.html
  • Simonite, Tom. "Bitcoin Isn't the Only Cryptocurrency in Town." Mashable. Apr. 15, 2013. (April 20, 2013) http://mashable.com/2013/04/15/bitcoin-cryptocurrency/