What is Bitcoin and How Does it Work – Beginner’s Guide with Infographics
Cryptocurrencies and Bitcoin
Cryptocurrencies are all the rage right now. With the value of Bitcoin appreciating almost daily, one can’t help but wonder what is cryptocurrency and why is it getting so much traction?
Simply speaking, cryptocurrencies are a form of digital currency that makes use of modern-day cryptography in order to maintain their value. Bitcoin is a type of cryptocurrency just like the dollar is a type of normal currency. Bitcoin makes use of the blockchain technology which is basically a public ledger and the Bitcoin transactions are stored in form of ledger entry inside the Blockchain. Also unlike normal currency Bitcoins aren’t produced on a regular basis but rather the total number will always remain constant.
The ledger entry keeps track of all the transactions that, that particular bitcoin has been through, and is, at least theoretically, impossible to duplicate. Thus cryptocurrencies are oblivious to counterfeiting and overproducing. However, cryptocurrencies also raise an issue about use in illegal activities, and a lack of legitimacy in certain. Bitcoins at the moment seem to be the digital replacement of precious metals like gold and silver. For more details about Bitcoin, You can read these guides:
History and Invention
In 1998, a computer engineer named Wei Dai first thought up the idea of a new form of money. This new currency would use cryptography to control its creation and transactions, as opposed to using a central authority as an exchange. At the time, this was unfeasible, simply because computers were not fast or powerful enough.
But come 2009, a person named Satoshi Nakamoto published the first proof of concept of a cryptocurrency, and so Bitcoin was born. At this point, computers and the internet had gotten powerful enough to make this cryptocurrency feasible.
And now, Bitcoins have exploded onto the scene!
The chocolate guide to Bitcoin
Before we try to explain what Bitcoin or cryptocurrency is, it may be helpful to look at the problem that cryptocurrency tries to solve. So let’s dive into it. Suppose you have a piece of chocolate. Your nephew comes and asks for it, and you give it to him. He now has one piece of chocolate, and you have none. This is a basic transaction. There was no need for a third person to come and confirm that yes, you really did give him the chocolate.
Now, let’s assume that you have a digital piece of chocolate. Again, your nephew comes and asks for it. You give it to him. But here’s the thing. Since it’s a digital piece of chocolate, it is perfectly possible for you to have made several copies of it, emailed a few pieces to several family members and kept some for yourself. End result? The same piece of digital chocolate is now eaten by multiple people. This is called the double-spending problem, which is what cryptocurrency tries to solve.
The chocolate represents money, and if you’re using only digital currencies, it’s perfectly possible for someone to make money appear in accounts just by changing a few figures here and there. The same unit of currency can be sent to multiple people, or even uploaded to the net for a million people to get for free.
In order to avoid these kinds of issues, we tend to use third-party systems. Going back to the chocolate example, if you have a digital piece of chocolate, you might just call in your uncle, who will make sure that you send only the piece of chocolate that you have. Any other pieces of chocolate that you send will be marked fake. In order to simplify your uncle’s job tracking pieces of chocolate, he uses a ledger where he writes down all the chocolate transactions made by you or your nephew.
In this particular instance, the uncle is acting as a bank. The bank notes down all the transactions made by people through them and ensures fairness.
But here’s the issue. It is perfectly possible for your uncle to just add a few extra pieces of chocolate for your nephew, just by changing what he records in his ledger.
So how can we confirm the honesty of everyone involved in the transaction? Earlier, it used to be difficult. Now, not so much. What if all the people involved had their own ledger that you can check? You can put it into your ledger that you sent one piece of chocolate. Your nephew notes down that he received one piece of chocolate. But here’s the special thing that happens when you use cryptocurrencies. Not only do the two of you note down that this transaction happened, but so does everyone else in the world who is trading chocolate! This means that even if your nephew lies and writes down that he received 25 pieces of chocolate, it won’t matter because it will not match what every other ledger is saying. This means that any false transactions will be automatically invalidated!
This is what Cryptocurrency does. One of the core aspects of any cryptocurrency is that there is a limited number of coins that can ever exist. When it comes to Bitcoin, only 21 million bitcoins will ever exist. The technology underlying Bitcoins is similar to what has just explained above, although there are a few more aspects to it.
Bitcoins are electronic currency, also known as the cryptocurrency, which is a form of digital currency. They are backed by a peer-to-peer network that serves the dual purpose of validating each transaction as well as facilitating it. What this means is that all transactions are independently verified, and take place without intermediaries.
Most modern methods of sending or receiving money require the two parties involved to trust a third person for verification. Instead, Bitcoin relies on digital signatures and encryption to track every single transaction in the network. Bitcoins, as a digital currency can be used to buy things online without having to go through any intermediaries like banks or middlemen. Bitcoins are, for all intents and purposes, online cash.
How Does Bitcoin Work – Blockchain Technology
The main technology underlying Bitcoin is called blockchain technology. Blockchain is similar to an operating system, and Bitcoin is an application that runs on it, similar to how Windows and iOS are operating systems and applications like Office and Photoshop run on them.
So what is a Blockchain? Put simply, it is the continuously growing list of records of transactions or a public ledger. Going back to the above example, whenever any chocolate is traded, all the people trading note it down in their ledgers. Whenever a page of their ledgers is filled up, they set it aside and encrypt it. This encryption is the core of all Blockchain technology, it the basis on which the entire system works.
Encryption and Bitcoin Mining
The encryption works in a very specific way. There is a method of encrypting built into the technology called a hash function. What this hash function does is it takes a page of the transactions and uses every single character on it to generate a number. How it does that is unknown. But if the same data is fed into it, it will always give the same result. If the data fed into it is different, the number will be different.
Here’s an example. If you feed the number ‘4’ into the hash function, it will give the code g7e3, for example. If you feed the number 5, it will give p976f. The code doesn’t really matter right now. The point is that 4 will ALWAYS give g7e3, and 5 will ALWAYS give p976f. Similarly, pages of transactions will give the same result, and if they give a different result, it means they have been changed, and as such, should be distrusted.
Calculating this number is the first step of encryption. The second step is sealing the page. Assuming our page has the number 4 on it, which gives the result g7e3, the people on the network must solve a math problem, of the type: What kind of number or combination of letters, when added to the list of transactions and fed through the hash function, will give the result 123ABC?
In order to solve this problem, everybody in the network uses their computer to start trying to find the answer. The first person to find the answer seals the page with the code 123ABC. The code 123ABC is put on the next page of transactions too, so the list of transactions can be traced backward.
So why do people do all these calculations and sealing of pages? Very Simple. The first person to successfully seal the page of transactions earns a set number of Bitcoins for the computational resources he or she has provided. This process is called mining. When a page of transactions is sealed, it becomes a ‘block’. Each block is connected to the next one by the sealing number, creating a ‘chain of pages’, hence Blockchain. You can read more about Bitcoin Mining be checking these posts:
However, everyone doesn’t have the time, resources or computational power to mine Bitcoins. To that end, it is perfectly possible to buy and sell Bitcoins.
You can use your Bitcoin for online shopping, recharges, coffee shops, tickets etc. Many companies and online stores accept as payment and you can buy their product and services in exchange of Bitcoin. You can find the complete list here: List of Companies Who Accepts Bitcoin Payments