Bitcoin is a peer-to-peer digital currency system that uses mathematical formulas (“cryptography”) in lieu of traditional, centralized financial institutions to protect users’ currency and verify and process transactions.
The currency was created in 2009 by an unidentified developer or group of developers operating under the alias Satoshi Naskomoto, who wrote this white paper describing the technology behind the system and the advantages Bitcoin offers in the marketplace.
The writer of the paper argues that a monetary system that depends upon a third party to verify transactions cannot make transactions irreversible, as said third-party must always mediate disputes. Moreover, the mediator charges for its services, and the cost of commerce rises.
Bitcoin employs two layers of verification: a user’s “wallet” and the Blockchain, a collective, public ledger that records every bitcoin transaction.
A wallet ties a specific amount of bitcoins to a specific user via two unique, encrypted “keys,” one public and one private. The private key contains a confidential “signature” which proves a user’s right to spend certain bitcoins. The public key derives from the private key by way of a mathematical process so complex it is impossible to reverse engineer. In other words, although a wallet’s public and private keys are linked, no user can deduce another user’s private from his/her public key.
The public key is hashed (read: condensed) to form an address. Like a physical address or an e-mail address, a bitcoin address is how users find and send things to one another. In order to maintain anonymity, it is recommended that users only use a given address once. In other words, users should generate a new address for each transaction. One wallet can contain multiple addresses, but the Bitcoin website advises that users spread their bitcoin stakes across multiple wallets so as to preserve anonymity.
A host of bitcoin wallet services, such as Electrum and Armory, offer an array of different types of wallets. Wallets can be stored on a desktop, a mobile device, a piece of hardware, or the internet. Some wallets store the entire blockchain, which currently consists of more than 100 GB of data, and is growing all the time, locally. Others store only the most recent blocks in the chain.
As mentioned, the blockchain a public ledger. Every ten minutes, a new “block” containing multiple transactions is published on the blockchain. Each block is marked with a timestamp, verifying that a user gave a certain amount of bitcoins to another user at a certain time.
The timestamp acts to prevent double spending, to which other decentralized exchange systems are inherently vulnerable. “Double spending” is the practice of spending the same currency in multiple transactions. If transaction records are private, and no authority has access to them, those dealing in an abstract form of currency like electronic payment cannot verify that a buyer has not already spent the funds he is appropriating for a given purchase. The blockchain, on the other hand, checks time stamps and rejects any transaction User A makes with User C using bitcoins he/she has already transferred to user B.
When a transaction is submitted to the blockchain, bitcoin “miners” use computing power to work to solve a “proof-of-work” problem that allows for the block to be added to the chain. The miner whose computers first solve the “proof-of-work” problem is rewarded in bitcoins. Thus, new bitcoins enter circulation.
By ensuring that a certain amount of work must be done to create a new block and new bitcoins, the system guards against an overload of requests and prevents inflation. As bitcoin’s popularity increases, more and more people will become miners. As more and more people become miners, it will be harder and harder to solve the “proof-of-work” problem. This method ensures that bitcoins are created at a decelerating pace.
Bitcoin’s founders only allowed for 21 million bitcoins to be mined. So, like any commodity, bitcoins are finite, cannot be obtained without work.
In an effort to preserve decentralization, bitcoin mining is open to anyone with an internet connection and the appropriate hardware.