What is Bitcoin (BTC) – A short introduction.
In short, Bitcoin is the first decentralized digital currency (or Cryptocurrency), founded by Satoshi Nakamoto (The man, the group, the legend?). It works as a worldwide payment system without the governance of a central bank or institution. Instead, transactions takes place between users directly, making it a Peer-to-peer network. Each of these transactions is verified by a network of nodes through the use of cryptography, which is a process known as Bitcoin mining. The transactions are then recorded in a public distributed ledger called The Blockchain. People can access this blockchain and see the amount of Bitcoins they have by using Bitcoin wallets.
-> Okay, but what does this really mean? Let’s look at the five major terms of this explanation in more detail.
Bitcoin, beaing a digital currency or Cryptocurrency, isn’t physically printed. There isn’t one central authority that governs the currency and makes up the rules. In this way it’s also not possible to simply produce/print extra units of this Cryptocurrency, thus devaluing it. Instead, almost every Cryptocurrency has a limit, and for Bitcoin this limit is 21 million coins. This means that after that, the number of Bitcoins won’t grow, so inflation won’t be a problem.
-> Instead of being supervised by one central authority, transactions happen directly between peers within a Peer-to-peer network.
Transactions occur directly between users (or peers), thus making it peer-to-peer. Each user has a public and a private key (stored in a so-called Bitcoin wallet). Anyone can see the public key, but the private key is secret. When you send a Bitcoin, you (the sender) ‘signs’ the transaction with your private key, which applies a mathematical function. This function creates a certificate that proves the Bitcoins came from you. With the help of your public key, the other party (or receiver) can check if the transaction is really from you and if nothing has changed ‘underway’.
-> So is there anyone else checking if everything goes right and if there is nobody trying to mess with the system? Yes there is, and they are called the Bitcoin miners.
Note 1: With a private Bitcion wallet (for example a desktop wallet or hardware wallet), you are totally in control of your Bitcoins. When using a web wallet or leaving your Bitcoins on an exchange, you are dependent on their security model. If they get hacked, you can lose all your money. The best way to counter this is by splitting up large amounts of Bitcoins (or other Cryptocurrency) amongst different wallets (read more below).
Bitcoin miners ensure the correct sequence of executing transactions and verify/confirm them (this verification prevents double spending attacks). Every time a calculation is solved (read, a block of transactions is confirmed and attached to a chain), the person or group responsible for solving it is awarded 25 Bitcoins. This is the only way to “create” new Bitcoins and has a limit of 21 million coins. When all 21 million coins are reached, miners will probably work for fees which can be added to each transaction. This will however mean that, the faster you want your transaction to be handled, the higher the fee will be you’ll have to pay.
To control the mining, there is a built-in mechanism in Bitcoin that automatically makes the approval of a block last a certain time. The better the mining equipment becomes, the harder this built-in mechanism makes it to approve a block (created to combat Moore’s law and executed every 2016 blocks), keeping the approval time around 10 minutes. Without this security, every transaction would be instant. The constant race to mine blocks is the cause that it has gotten so hard to mine (and the reason that it has such a terrible impact on the environment). That’s why these days you need special (costly) equipment to even be able to make a profit with Bitcoin mining.
-> Bitcoin miners literally confirm blocks of transactions and add them to a chain. Blocks … to a chain… Blockchain?!
Note 2: Because of the arithmetic calculations (takes roughly 10 minutes per block) and the huge amount of Bitcoin transactions that need to be processed these days, the Bitcoin network can be a bit congested and slow at times. If you don’t plan to hold on to your Bitcoin but are going to trade it for other Cryptocurrencies, I would suggest opting for Ethereum as your initial Cryptocurrency as processing time is lower. More on Cryptocurrency trading on the home page.
Note 3: It is possible to make a “zero-confirmation” transaction, making the transaction instantaneous as there are no miners in between. However there is no form of control in this setup and it is only advisable for low value transactions where the risk of fraud isn’t as great. Most Cryptocurrency exchanges don’t except this form of transaction.
Bitcoin stores details of every single transaction that ever happened in the network in a huge version of a general ledger, called the Blockchain. This blockchain is broadcast to every node (or peer) in the network. The Bitcoin miners make sure that there is only ONE correct version of this blockchain.
As said before, each block in the blockchain contains a certain amount of transactions. Each of these transactions is stored as an input (sender Bitcoin address = sender public key), an amount, and an output (receiver Bitcoin address = receiver public key). As explained before, it is the Bitcion miners who uphold the correctness of the blockchain. They confirm a block of transactions and attach it to the Blockchain. This confirmation is done by creating a hash (also called a Proof-of-Work algorithm or POW, takes about 10 minutes per block for Bitcoins, see Bitcion mining) of the current block + the hash of a previous block. Because each block’s hash is produced using the hash of the block before it, it becomes a digital version of a wax seal. It confirms that this block, and every block before it, is legitimate.
Because the ledger is publicly available, anyone can track how much Bitcoins are stored on a certain Bitcoin address (=public key). They just don’t know who is behind this address because it is not directly linked to you as a person. Off course, if anyone ever manages to link your Bitcoin address to you, they know how much Bitcoins you own.
A solution for this is to use different addresses to store your Bitcoins. But newer Cryptocurrencies like Monero (…) or Verge (XVG) offer built-in technologies that take care of this anonymity problem for you. This immediately explains their success on the black market.
-> Luckily for you, you don’t need to worry about all this technical stuff. It’s all taken care of by Bitcoin wallets.
A wallet can be seen as a kind of bank account. It takes care of storing your public and private keys, which you need to access your Bitcoin address and spend your funds (see the peer-to-peer network). Different wallets will provide different levels of security. Some act like everyday spending accounts and are comparable to a traditional leather wallet. Others just act as a storage and tout military-grade protections. Your options are:
- An online web-based wallet: Your Bitcoins are stored online, together with your public and private keys. The disadvantage is that this leaves you dependent on the security model of the company owning this web wallet. Some of these wallets use multi-factoring authentication, others just use an ID + password. Sites like Coinbase (buy Bitcoins) or Binance (exchange Bitcoins for other Cryptocurrencies) also act as web wallets.
- A software wallet (“hot” storage): these wallets are stored on the hard drive of your computer. The wallet holds you public and private key + a download of the entire Bitcoin blockchain (The general ledger from the Blockchain topic). This is needed to be able to perform transactions, as these are based on previous transactions (you can only spend what you receive, and this is all recorded in the Blockchain).
- A mobile wallet (“hot” storage): Desktop-based wallets aren’t useful when you are trying to pay for something in a physical store. This is where mobile wallets come in. They run as an app on your smartphone and enable you to pay for things directly with your phone. Because you don’t want to download the full Bitcoin Blockchain on your mobile data plan, these wallets are often designed with SPV (Simplified Payment Verification).
- An offline hardware wallet (“cold” storage): These are dedicated devices that can hold private keys electronically and facilitate payments.
- A paper wallet (“Cold” storage): A paper wallet is a generated Bitcoin address with the images of 2 QR-codes (one for the public key and one for the private key). The benefit here is that the keys are not stored digitally and are not subject to cyber-attacks or hardware failures. Using the paper wallet as a back-up of your digital wallet is never a bad idea!
Our advice is to pick a combination of a hot wallet (making it easier to spend Bitcoins) and a cold wallet (more secure, use it for the bulk of your Bitcoins). But whichever wallet you choose, always make sure that you never share passwords, private keys, etc. and that you have a back-up of the complete wallet. Bitcoin is an awesome technology, but if you lose your Bitcoins or someone is able to take them from you, it’s close to impossible to ever get them back!