Few subjects are as hotly debated – and as seldom understood – as Bitcoin and the rise of cryptocurrencies.
Bitcoin serves as peer to peer money and is not controlled by any central authority. Bitcoin, as both a currency and a financial system all on its own, eliminates the need for a ‘middleman’ or ‘institution’ to recognise trust and verify transactions between parties. In this regard, Bitcoin is an alternative to our currency financial system.
Bitcoin achieves this new independence through new technology and a reliance on incredibly complicated mathematical proof – called cryptography.
Since no single administrator is responsible for the maintenance or backing of Bitcoin, transactions issued in Bitcoin are verified and recorded in a public distributed ledger. This public ledger is called a Blockchain.
How does a blockchain work?
A Blockchain, as first outlined by the anonymous author Satoshi Nakamoto, is essentially a public ledger that is distributed and maintained by computers all around the world through the internet.
In modern context, a bank of one’s choice might hold a copy of the ledger that represents the flow of financial transactions through one’s account, the Blockchain instead is a shared public ledger that the entire Bitcoin network relies on.
The Blockchain draws its name from its underlying data structure that consists of 1-megabyte files called ‘Blocks’, which are essentially ledgers themselves. Blocks are ‘Chained’ together through a complex mathematical proof.
The Blockchain is a form of ledger that – rather than being kept by a bank – is instead shared between Bitcoin ‘miners’ and ‘nodes’ around the world.
All network nodes (computers running Bitcoin software) have the potential to access the Blockchain and view authenticated transactions without barriers that prevent access (such as a bank charging for its services in maintaining a transaction history).
The Blockchain instead relies on cryptography (the art of writing or solving codes) as its proof, instead of relying on a third party to authenticate and verify all pending transactions before they take place.
The process of authenticating pending transactions and collecting them into a block to include in the Blockchain is called “Mining”. This process is performed by members of the Bitcoin community who are called “Miners”.
Mining draws its name from the metaphor that Miners receive Bitcoin as a reward in a similar fashion to how rare commodities, such as gold, are mined from the ground. Miners are computer users with incredibly powerful hardware that solve complex mathematical problems to cryptographically verify a block of transactions, and then connect them to all previous transactions in the Bitcoin network.
Miners serve the Bitcoin community by securing the network. The process of solving the cryptographic proof for a block is extremely resource intensive. By winning the race to mine 1-megabyte ‘blocks’ of transactions, Miners receive a ‘bounty’ or ‘reward’ in Bitcoin. This is also how new Bitcoins are allocated and enter the system.
When transacting in Bitcoin, parties leverage what is called a “Bitcoin Wallet” to exchange denominations in Bitcoin (BTC). Bitcoin Wallets provide their users with both a Public Key (the address from which one sends, or from which one receives Bitcoin) as well as a Private Key.
A Private Key is an incredibly important ‘signature’ for Bitcoin users, which is used to confirm pending transactions by giving a mathematical proof that they originated from the owner of the wallet in question.
When a user wishes to transact in Bitcoin, their intention is signaled on the Blockchain by submitting a transaction signed with the user’s private key. The Bitcoin network then validates the transaction by checking that the to and from addresses are valid, that the private key is valid, and that it has access to enough funds to perform the transaction. The transaction usually confirmed on the network within the following ten minutes.
Bitcoin, as a financial system, is designed to self-regulate. A malicious transaction requires so much computation (and thus electricity) that in almost all cases it is more profitable to use that same compute power to secure the network instead and collect the block reward. This is what prevents actors from attacking the network and preserves the Blockchain from recording malicious or fraudulent entries.
Users around the world can either obtain Bitcoin as a reward for mining and securing the network, receive the cryptocurrency as a gift or as tender for services rendered, or can buy Bitcoin from an online currency exchange of their choice.
As with the emergence of any new technology, several misconceptions surround Bitcoin that do not accurately describe how the Bitcoin network (or cryptocurrencies in general) operate.
CoinInsider explains that, despite popular rumour, it is not feasibly possible to ‘hack’ the Bitcoin network and fraudulently create or issue Bitcoins; this would require the ‘consensus’ of every single node around the world to do. Similarly to how one’s physical wallet might be stolen with currency inside, however, Bitcoin Wallets may have various vulnerabilities depending on their issuer and origin and Wallets themselves can be attacked.
Transacting parties are relatively – though not completely – anonymous, as the Blockchain does not illustrate the names of parties but instead provides a random list of numbers and letters to depict transacting parties.
Whereas one might rely on a bank to secure the privacy of one’s bank account (a private ledger), all computers on the Bitcoin network have the potential to view the Blockchain and can usually see each Wallet’s balance.
Further, all transactions are further visible on the Bitcoin network. Even though the names of transacting parties are not disclosed on the network when exchanging Bitcoin, sophisticated analysis of the blockchain could allow third parties to trace flows through the network.
The future of currency?
Bitcoin offers an amazing alternative to the traditional banking system, relies on immutable mathematical proof for its foundation, and for the first time in human history offers a decentralized currency where trust between two parties can be scaled to the level where a global community has equal access to a global monetary system that is natively digital.
Bitcoin’s success will, in the future, be determined by how many people and markets around the world are prepared to accept it as a de-facto digital currency, and how banks and other regulators around the world might perceive the Bitcoin network as a threat to their sovereignty and very existence.