Bitcoin for Dummies
Explaining Bitcoin So You Can Actually Understand It
To start, do not let the title of this piece make you feel any less of a human being or think that you are in fact a bitcoin dummy. That is not the case! Bitcoin is complex. There have been several very intelligent computer programmers and system developers (We are talking people who have invented the very technology that allows us to even get online!) who are on record as saying that they even have trouble understanding Bitcoin fully.
Introduction to Bitcoin
Bitcoin is the first ever invented digital currency. It works the basis of the blockchain technology. It is continuously being created through a process called mining that involves computers solving cryptographic puzzles. Each block has its own cryptographic puzzle, and the unique solution represents 1 Bitcoin and the current state of all pending transactions.
- Bitcoin is a digital currency.
- Using encryption techniques is how it is created and how transactions are verified as legitimate and recorded to the ledger.
- Operating independently of a central bank means that there is no person, company, government agency or any other single entity that controls bitcoin, it is governed by the very people who use it.
But before we can delve into the peculiarities of Bitcoin we need to lay some foundations.
What is Cryptography?
Imagine you have a letter, cut it to little pieces and scramble them. By doing so you are encrypting the information that is contained in the letter. Meaning that when someone stumbles upon the scattered pieces, they would not be able to understand anything. That is until they decipher, decrypt the message by placing the pieces in the right order. This visualization of sorting algorithms explains the process best.
What is Blockchain?
Blockchain quite resembles a database. However, while traditional databases have a couple of locations where the information is hosted, blockchain hosts the information on each computer on the network. Hence the term decentralized.
Traditional banking works like Microsoft Office Documents and blockchain is like Google Docs. For the sake of simplicity let us assume that there is one spreadsheet that contains the state of all accounts balances and transactions.
If Sally sends John 10$ via a bank wire.
To reflect this transaction Sally’s bank credits her account in the spreadsheet, then the file would be sent to John’s bank to make their changes and then sent back to Sally’s bank so that they both have the updated version of the spreadsheet. Although there is no such spreadsheet, bank settlements operate in relatively the same manner – a lot of files being exchanged to reflect every transaction.
With blockchain when Sally tells her bank to send 10 BTC to John, the two banks simply both edit the Google spreadsheet and without any time wasted on exchanging files, the transaction is recorded.
If you have ever edited a Google spreadsheet simultaneously with many people, you would know that it will start bugging, the new information is just too much to be reflected at once. Therefore, the network separates the whole spreadsheet (there is no actual spreadsheet we are continuing the example) into smaller blocks of information that can be more easily processed.
Want a quick and condensed guide about the Blockchain Technology? Read our Blockchain Guide
What is Bitcoin?
The Oxford English Dictionary defines Bitcoin as “a type of digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank”
However, this definition is for the whole system of Bitcoin. Each Bitcoin is nothing more than a 12-digit code that is encrypted.
Bitcoin is a Digital Currency! What is a Digital Currency?
A digital currency is money that has no physical form. Reach into your pocket, wallet or wherever it is you keep your dollars, Euros, Yen, Rupies, etc.. and pull out the equivalent of 1 US Dollar, or even a quarter, dime, nickel or penny. Hold it. Look at it. Feel it. That is called fiat, which is the currency of your nation (or some nation depending on what you may have.)
With digital currency, you cannot hold it. You cannot feel it. You cannot look at it. It only exists as a number entry in a transaction ledger on a network somewhere. Now, while this may make some people shun digital currencies, they are simply being childish and sort of ignorant. Think about it. Most people simply swipe a card and their money is magically moved from there account into the account of the store that they are paying, right? So technically, we all use digital currency already, we just have the ability to actually get some of the money to put in our pockets or respective money holding places.
A Really Deep Understanding of Money in General
Then to get even more technical about it, the money you may have in your pocket is nothing more than cheap paper and ink or cheap metals that have been stamped by a machine. It technically is not worth anything. It is nothing more than a marker that says you have the rights to spend the amount indicated on the bill or coin and the bill or coin simply is a guarantee from the national bank who issues it that they will cover the debt.
If you owed someone five dollars and wrote them an IOU on a piece of paper, it is no different than a 5-dollar bill in the sense that the money you have is nothing more than an IOU from the national bank who issued your particular currency. I can go to the store right now and buy a ream of copy paper, the 500-sheet pack for about $7 USD. You can fit 4 US Dollar bills of any denomination on each sheet, so if I used 100-dollar bills, that would be $200,000.00 USD. Does that make the paper worth $200,000.00 USD? I think not. So why would the paper that the national bank prints currency on be worth anything more? Well, it isn’t.
If you have never stopped to really think about it, do so now. That money in your piggy bank is nothing more than a guarantee from the Federal Reserve (if you are in the U.S.), or national bank of some nation that you are entitled to that much of the gold* that they own, and that you have the rights to trade that guarantee for goods and service and upon doing so, the receiver of the money will then inherit the same guarantee for the same value that is shown on the piece of paper or metal coin.
You Are the bank… Sort of
So, in all reality, the only real difference that Bitcoin offers is that it does not have a physical marker, or guarantee in the form of a mass printed, regulated piece of paper guaranteeing the holder to the value of the Bitcoin.
That actually sounds horrible. No guarantee that you have a right to the Bitcoin in the national bank? Well, you don’t need it. Nope. Not at all. Why, you may ask? Why would you risk not having that guarantee? Well, because you have the actual Bitcoin. Th national bank doesn’t have it, in fact, no bank or any other person or business has it. You have it. You hold it and when you send it to someone, it goes directly from you to them. When you receive it from someone, you get it directly from them. So, there is no guarantee needed. You have the actual bitcoin in your hands, err, well, figuratively speaking of course.
The balance of your bitcoin wallet is public record. The encryption methods used, which will be explained in later chapters, ensures that any and all transactions are legitimate and that the balance are absolutely correct. Don’t worry though, while the ledger of balances is public record, your identity is not. More on that later. While an explanation of how it all works is the focus of this entire piece, I will try and put it into perspective for you:
The technology that ensures that all balances and transactions are valid and legitimate is so ingenious, so technologically advanced that every single one of the 50 United States, as well as the Federal Government of the United States, Governments of the entire European Union, China, Japan, South Africa, The United Arab Emirates and many more nations have legislation either already voted into law or are in the process of putting into law, statutes that integrate the technology with the government and how it does day to day business.
That Wraps Up Digital Currency
So, hopefully you have an idea of what bitcoin is by now, but i will spell it out for you anyways; Bitcoin is money. It isn’t money you can touch with your hands and it isn’t money that a bank or government holds or controls, but it is money. It can be used to buy things online from Microsoft, Dell, Walmart, Overstock and thousands of other retailers. You can use it in the United States to pay the IRS and other government entities and you can send it to anyone who accepts it personally. The difference between bitcoin and the money in your pocket is that bitcoin is the same value in North America, as it is in all of Europe, Asia, Africa, South America, Australia and even Antarctica. That includes every single Island, Atoll or other landmass and hell, even all of the pacific, Atlantic, Indian, Arctic and Antarctic Oceans as well. Basically, everywhere on the planet earth that you can go, Bitcoin will be worth the same exact amount.
*The gold reference is being used as a generalization. The national banks of the world hold more than just gold to determine their total wealth. It should be understood that other commodities, such as a nation’s chief exports, silver and other valuables are also used to back currency.
Who invented Bitcoin?
The simple answer? No one knows for sure. Someone, who was using the name of Satoshi Nakamoto is the creator of bitcoin. Whether that is a single person, a group of people, a man, a woman or someone who is gender neutral is simply not known. However, since the name that was used is a Japanese male’s name, Satoshi Nakamoto will be referred to as “he” or “him”, since typing Satoshi Nakamoto at every reference is simply horrible grammar.
There lies a shroud of mystery behind Satoshi Nakamoto. It is a great mystery that has the entire community enthralled. There have been a few educated guesses as to his actual identity and even one man from Australia who has claimed that he is the creator of Bitcoin, but there is no definitive proof. All that is known for sure is that he is a genius who had an ingenious idea and he implemented it in such a technologically advanced way, that there is nothing to even compare it to that has ever been done.
Science Fiction from the Future
To try and put this in perspective for you, imagine when you were a child and watched Star Trek. Those hand-held communicators were science fiction for us at the time. 25-30 years later, we carry around mobile phones that not only communicate, but play videos, music, talk to us, provide virtual reality, etc.… Science fiction turned into reality.
Well, Bitcoin, in comparison is like The Guardians of the Galaxy movies. Yeah, they just came out recently, no, we cannot even fathom being able to travel through space with a fox, intelligent plant or any of the other stuff in the movies. Depending on where you get your scientific information from, we are somewhere between 100 years and never being able to accomplish that stuff, so Bitcoin is like 100 years away, at least, from reality.
Except that it’s not, it’s here already and was actually here before The Guardians of the Galaxy movie was. That is how technologically advanced and ingenious Satoshi Nakamoto is; was; might be again.
How it All Went Down
In October of 2008, Satoshi Nakamoto published the first bitcoin paper via a cryptology mailing list. This paper described Bitcoin in detail. The title of the paper was, Bitcoin: A Peer-to-Peer Electronic Cash System. On January 9, 2009, The Bitcoin software version 0.1 was released publicly on SourceForge.net.
Satoshi claimed that he was a male, living in japan and his profiles on the various forums and boards listed his birthdate as April 5, 1975. The first block (transaction verification) was mined by him on January the 3rd of 2009 and he left a text message within it that reads: ‘The Times 03/Jan/2009 Chancellor on brink of second bailout for banks‘ referring to an article in the New York Times that day. This has been dubbed, the Genesis Block and is timestamped at 18:15:05 GMT on January 3, 2009.
Satoshi Nakamoto or Houdini?
He handled all of the coding himself until mid-2010, when he handed over the project to the current lead developer, Gavin Andresen, distributed all of his digital assets, including domain names to other prominent members of the Newly Formed Bitcoin community and then simply vanished. His bitcoin Wallets have not had a single transaction since mid-2009 and currently contain approximately 1 million Bitcoins, valued at roughly 4.053 Billion US Dollars.
While you can search and find compelling stories that would prove to have discovered the true identity of Satoshi Nakamoto, in Newsweek, the New York Times, Investopedia and about a hundred other reliable Bitcoin news sources, the answer is still unknown. Whoever he or she is or they may be, bitcoin is a work of true and pure genius. There is no argument there.
How is digital currency created?
Each digit is unveiled by solving a cryptographic algorithm, or in simpler terms a something like a mathematical equation. The process of this calculation is called mining and is done by either processor-based operations or graphic-card based operations, performed by a large number of computers in complex installations. All of the transactions on the network are encrypted with a cryptographic puzzle that all participants race to solve. The solution of this puzzle creates and sets* the state of the network – all pending transactions and account balances. Once a computer on the network finds a solution it records the solution* on the blockchain; then all network participants update their ledgers. In the instant that this happens the information is set and sealed. No one can edit information on the blockchain unless their computational power is at least 51% of the whole network’s power, which almost impossible.
The money creation process of Bitcoin again involves solving cryptographic puzzles. We explained that the solution to the puzzle contains all transactional information; however, it also contains information about the digits of each Bitcoin. By helping people settle transactions, miners are also slowly uncovering the digits of new Bitcoins that would enter the system. There are only 21,000,000 Bitcoins. Once the last one has been mined there can be no further money creation.
How is its value determined?
When money was first created to determine its value, we used the gold standard. Each dollar or pound in circulation in the economy had a gold equivalent in the vault of the central bank. In other words, if someone went to the bank they could for their money get a certain amount of gold.
The value of bitcoin and other digital currency is backed by proof of work or computational power. The calculation of each BTC requires a certain amount of effort, think electricity, computers, software and rent. The network knows how much computational power is needed to uncover a Bitcoin, so once a computer calculates the 12-digit code, the network rewards miners for doing the needed amount of work.
Here comes the tricky part. Each next Bitcoin always requires a bit more computing power to be mined than the previous. As we said, each BTC can be mined only once. The first BTC mined requires only the solution to the algorithm, and that it is. However, for every next BTC to be mined, after calculating the code the computer has to go through all the previously mined BTCs and it has to check whether this one is a new BTC or not. The more BTC are mined, the more newly generated Bitcoin requires.
Currently, the value of BTC is determined by two factors. The first one is how hard is mining, i.e. how much computational power is required for the calculation and check with the database of existing BTCs. If before it took a couple of graphics cards to mine one BTC for a predefined period “x”, now it takes much more computing power to mine a BTC for the same “x” period. The other factor is Bitcoin’s attractiveness as an investment. Currently, most people do not use Bitcoin so much as a medium of exchange, than they use and perceive as an investment.
What happens when the last BTC is mined?
Then free markets take over. The value of Bitcoin would then be determined only by the amount people that will be willing to pay for it.
Image courtesy of Bitcoin.org and seats2meet
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