I have been asked the question,”What is Bitcoin?” many times. The answer is very complicated, and often leads to incorrect assumptions, or misunderstandings, in both members of the digital currency community, as well as individuals in the general population. The Bitcoin Foundation has explained it quite well for those who understand the underlying ideas in cryptography and programming, as well as in a very simplified way for those who do not, which is available in the video at the bottom of this page, but it is difficult to find a detailed explanation for individuals without a background in mathematics or computing.
So, What Is Bitcoin? Or is it bitcoins?
Bitcoin is a decentralized, distributed digital currency, built on a peer-to-peer network, based on open source software, and creates a trustless payment system through “miners” confirming transactions, and recording them on a public ledger known as the “block chain”. Now, that is a mouthful, and very daunting to most people. However, if we break it all down, and take it one step at a time, it becomes much more clear.
Bitcoin vs. bitcoins
One source of confusion is the difference between how to use the word Bitcoin, or when to use bitcoins / bitcoin. While Bitcoin would always be capitalized at the start of a sentence, obviously, the consensus in the community is that one should use a capital B in Bitcoin when referring to the network, the community, the industry, or in almost any case where you aren’t referring to the currency directly. On the other hand, when one is referring to sending 2 bitcoins to someone, or paying in bitcoin, or mentioning how many bitcoins are mined in each block, it should be lowercase. In short, capital Bitcoin for the intangible ideas and structures in the Bitcoin world, and lowercase bitcoin when referring to the units of currency. The currency and the network are not the same.
Bitcoin is Decentralized and Distributed
The Bitcoin network has no central servers, and no individual, or group, that is in control. The network is composed of miners, which refers to individual computers running Bitcoin mining software. There is no restriction on who can mine, and thus the network is distributed across the world. However, while profitable Bitcoin mining is possible, and many miners make significant amounts of money by mining, this is not always the case. One should always use a Bitcoin mining calculator to determine if mining is right for you, or if a specific mining machine is worth it’s cost. There are even services offering Bitcoin cloud mining at this point, or sometimes Scrypt cloud mining that pays out in bitcoins. However, again, consult a calculator before purchasing any sort of cloud mining contract.
Many people are under the impression that the Bitcoin Foundation controls Bitcoin, but that simply is not true. The Bitcoin Foundation has implemented many improvements, fixed flaws, and contributed greatly to the development of Bitcoin, but that is only possible with consent of the network as a whole. Any proposed change to the Bitcoin software requires consensus from a supermajority of the miners. This was demonstrated in March of 2013, when a new version of Bitcoin, 0.80, implemented a bug fix, and caused transactions to be recorded in a way that was incompatible with the previous version 0.70. The vast majority of miners decided to stay with 0.70, or downgrade back to it, until this issue could be resolved effectively. While this was the result of an obvious problem, this method is applicable to any proposed change to the software. No one can force a change without consensus.
Bitcoin is a Cryptocurrency and a Digital Currency
Bitcoin is a digital currency, because it exists in digital form, and digital form alone (though physical coins with Bitcoin private keys built into them have been created). Bitcoin is a cryptocurrency because it is built a program that uses advanced cryptography for security and distribution.
Bitcoin is NOT a virtual currency. That is a term that is often used to describe Bitcoin, even by highly educated individuals, or respected sources. Unfortunately, they are incorrect in using the term “virtual currency”, as a virtual currency is a currency that is not meant to be used as a true currency, and is often only usable within extremely narrow scopes. Examples of virtual currencies would be in-game currencies for online video games, or “loyalty” style currencies such as airline frequent flier miles.
Unfortunately, lawmakers and regulators seem to not understand the difference, and have been passing laws, or creating regulations based on the term “virtual currency”, so fighting for the correct use of the term may be a lost cause.
Bitcoin Mining is the Process to Create New Coins, Secure the Network, and Verify Transactions
Bitcoin mining is actually not a very accurate name for what the mining machines are doing. Each mining machine is processing recent transactions that were sent through the Bitcoin network, verifying the transaction’s validity, and then adding it to a “block”. The blocks are similar to a container that is used to store the transactions, and come preloaded with bitcoins that will be rewarded to whichever miner, during the process of verifying these transactions, solves a complex math problem required to access the block. Once a block has been solved, a new block is generated, and miners begin to work on solving it.
The solution to a block is not static, so the chance of solving a block does not increase over time. Each transaction that is added to a block changes it’s solution, and the number of possible solutions to a block is controlled by “difficulty“, which is essentially just an arbitrary way of making the problem more complicated by decreasing the likelihood that any single solution is correct.
A bitcoin is technically just a value determined by the record of every transaction in the past. The “coins” that are in a block are really just an address with a preassigned value. Once the block is solved, this value can be included in it’s first transaction, into the miner’s wallet. Due to this, a bitcoin cannot be counterfeit, as it would have no point of origin.
Bitcoin is Built on a Peer-to-peer Network
The underlying architecture that the Bitcoin network is built on. This is what allows it to be decentralized, as the users of the software transmit data directly between one another.
In a server based, centralized network, all data must pass to and from a server. That creates a corruptible weakpoint, as if the server(s) go offline, or are manipulated, the entire network is at risk.
In a peer-to-peer network, there is no point of weakness. As long as there are peers on the network, then the network continues to function.
Bitcoin Uses Open Source Software
In order for a computer to use the code that has been written, the code must be “compiled”, which is the process that creates files, written in machine code, from source code. In closed source programs, the creator of the code does not allow it’s users to view the source code. Instead, the machine code is the only form provided, and the source code is kept private. This means that the users cannot be sure of exactly how the program functions.
However, in open source software, the creator provides the source code directly. As a result, other programmers can analyze the code to verify that it only functions as it should. This also allows anyone in the community to modify the program, build on it, or offer suggestions to improve the official code.
Even if an individual cannot read or write the language a program is written in, open source code provides safety through the eyes of the community as a whole.
Bitcoin Creates a Trustless Payment System
This is exactly as it sounds. Bitcoin is a payment system that does not require trust. Traditional payment systems require multiple layers of trust.
First, there is trust in the government that is backing the currency. While this seems completely natural to many people, as this is how most currencies have functioned in recent decades, this was not the norm for most of history. Before the creation of fiat currencies, currencies were either composed of, or backed by, a physical good with known worth. This removed trust from the equation, at least on the governmental level. However, for transactions that cannot be easily completed in person, there was always a second level of trust.
The second level of trust is a payment processing company. This is generally a bank. The bank stores an individual’s funds, and promises to transfer them to the party that the individual would like to pay. This is not ideal, because banks are corruptible, as has been observed many times throughout history.
The idea of a trustless system has been around for a very long time, but every attempt in the past failed. The way to verify the authenticity of a payment was a problem that previous decentralized systems were unable to provide, and centralized systems were vulnerable to fraud from the managers, or seizure of funds by the government. Bitcoin is the first system to solve this issue, by virtue of the block chain.
Unfortunately, while the Bitcoin network itself is trustless, that is not always true when attempting to exchange it for traditional currencies, as they required centralized entry/exit points that are controlled in such a way that many opt to use large exchanges or payment processing companies to transfer their bitcoins to fiat, or to other digital currencies. Most of the large exchanges seem safe, have been around for years, and have built a reputation of reliability and honesty. Even with a few bumps here and there, companies such as Bitstamp, Cryptsy, Coinbase, Bitpay, and others are generally trusted by the community. Unfortunately, the one-time largest Bitcoin exchange, Mt. Gox, was also trusted at one time, and it’s collapse cost it’s users hundreds of thousands of bitcoins, or the equivalent of hundreds of millions of dollars.
Bitcoin Unleashed The Block Chain
The public ledger that contains a list of every block that has been solved, and thus every transaction. As previously mentioned, each block contains new bitcoins, and has a record of recent transactions stored in it, but also contains a reference to the previous block. This reference creates a link, and using this link, connects all blocks into a chain stretching back to the first block. Using the block chain, it is possible to automatically, or manually, verify any transaction, as the difference of input transactions and output transactions provides an accurate value for every wallet address.
The block chain is the truly revolutionary part of the Bitcoin network. It solved a networking problem, outlined in 1980, known as the “Byzantine General’s Problem.” by using a modified Hashcash proof-of-work system. The details of this are beyond the scope of this page, but will be outlined in a more technical explanation later.
Video courtesy of Weusecoins.com