Bitcoin is more correctly described as the first decentralized digital currency. It is the largest of its kind in terms of total market value. Bitcoins are created as a reward for payment processing work in which users offer their computing power to verify and record payments into a public ledger.
Public-key Cryptography: To understand Bitcoin, you need to understand the principle of public-key cryptography. While the details are complicated, it essentially means that each user that wishes to communicate with another user has two keys (groups of numbers). One key is public; everyone can see this series of numbers. Another is private; only the individual user has this key.
Here’s an example of how public-key cryptography is used. To send a secret letter, Alice would encrypt the letter using the public key of Betty. Alice then sends this letter along. Betty receives the letter, and then decrypts it using her private key.
The reason public-key cryptography is powerful is because it doesn’t matter if someone else – let’s say Charlie – intercepts the letter. Without the private key that only Betty has, he can’t decrypt it. This technology allows everyone to see the encrypted letter, but only the intended recipient can actually read it.
Millions of Deposit Boxes: How does Bitcoin use public-key cryptography? Earlier I mentioned the blockchain – a public record of all Bitcoin transactions. Think of the blockchain as having millions of safety deposit boxes, made out of bulletproof glass. The boxes have varying amounts of Bitcoin inside them, but are securely locked. Even though everyone can see what each box contains, only the owners can unlock them.
These deposit boxes are called the public keys – everyone can see the numbers (also called an address), and the amount within the boxes. The owners of each deposit box access their Bitcoin using their private key. While everyone can see the deposit boxes, and the amount of Bitcoin inside, only the owners of the private key can use the money.
In our earlier example, Alice sent Betty a message that only Betty could read. Bitcoin works the same way, except we aren’t sending letters but instead information telling your deposit box to give some of your Bitcoin to another deposit box.
To use the example again, here’s how it works. Alice wants to send 1 BTC to Betty, so she sends out a message to the entire network. This message includes Betty’s public address (the location of her deposit box), the amount of Bitcoin she wants to send to Betty, and a digital signature that verifies she is the owner of the private key to her own deposit box.
When Alice sends this message to the network, other network users verify that this message is accurate. If all the numbers match up, then the transaction gets put into a block (a collection of other transactions), and this block eventually gets published in the blockchain. Once that occurs, the rest of the network recognizes that Alice’s deposit box is 1.0 BTC smaller than before, and Betty’s deposit box has grown by 1.0 BTC. Since the blockchain is a public ledger that extends all the way back to the first Bitcoin transaction, it knows the exact amount of Bitcoin in every deposit box that exists.
Mining for Coins: Now you understand how transactions take place, but you might be wondering where Bitcoins even come from in the first place. Remember how I mentioned some network users verify the transactions are accurate, and then include them in a block to be published to the entire network? This process requires significant computing power, so why would other users be willing to do this? Because they are rewarded with Bitcoin!
Devoting your computer to processing transactions is called mining. Miners verify transactions, and as they are doing so they are looking for the solution to a mathematical problem. If they are the first to find the answer, the code allows them to publish the block of transactions to the rest of the network.
Whoever publishes the block gets a reward, currently set at 25 BTC. This reward halves every few years, so that the amount of Bitcoin never grows too quickly. Also, as more people devote more computing power to the network in order to increase the chance of getting a block reward, the difficulty of mining increases. The code automatically adjusts the difficulty of the mathematical problem so that a new block is mined approximately every 10 minutes.
A Chain of Blocks: One more important thing to mention about the blocks – they are built on each other in a chain (hence the term blockchain). It is imperative to have a continuous and chronological record of all transactions; this ensures the amounts of each and every deposit box have been accounted for. In order to do this, each block has two additional elements apart from the transactions. One is a much-shortened snapshot of all previous blocks, called a hash.
This hash ensures that the blockchain is building on the previous blocks, all the way back to the original block (called the genesis block). The second aspect is the answer to the complicated math problem the miners need to solve. The next block cannot be mined until the problem has been solved, ensuring that blocks are created in chronological order. As of June 2013, there have been more than 238,000 blocks published in the blockchain.
In this way, the Bitcoin ecosystem keeps evolving. Transactions get compiled into new blocks, the blocks are published to the rest of the network in a continuous chain, miners get rewards for their work, and those new Bitcoins are used for transactions, starting the cycle over again.
Network Verification: How is this system kept in check? After all, Alice could send a message saying that she has 5.0 BTC to send to Betty, even though her deposit box only has 2.0 BTC. There are many ways that dishonest users could attempt to trick the system, but fortunately it’s virtually impossible.
This is because Bitcoin is a decentralized system where all transactions are public, and require verification from the rest of the network. If Alice tried to send more coins than she had, the recipient would immediately check the balance of the account, recognize this, and reject the transaction. It would never make its way into the block, and the rest of the network would never even see the false transaction. This verification is done in the code of the Bitcoin program itself, so it is nearly instant.
Public-key Cryptography: To understand Bitcoin, you need to understand the principle of public-key cryptography. While the details are complicated, it essentially means that each user that wishes to communicate with another user has two keys (groups of numbers). One key is public; everyone can see this series of numbers. Another is private; only the individual user has this key.
Here’s an example of how public-key cryptography is used. To send a secret letter, Alice would encrypt the letter using the public key of Betty. Alice then sends this letter along. Betty receives the letter, and then decrypts it using her private key.
The reason public-key cryptography is powerful is because it doesn’t matter if someone else – let’s say Charlie – intercepts the letter. Without the private key that only Betty has, he can’t decrypt it. This technology allows everyone to see the encrypted letter, but only the intended recipient can actually read it.
Millions of Deposit Boxes: How does Bitcoin use public-key cryptography? Earlier I mentioned the blockchain – a public record of all Bitcoin transactions. Think of the blockchain as having millions of safety deposit boxes, made out of bulletproof glass. The boxes have varying amounts of Bitcoin inside them, but are securely locked. Even though everyone can see what each box contains, only the owners can unlock them.
These deposit boxes are called the public keys – everyone can see the numbers (also called an address), and the amount within the boxes. The owners of each deposit box access their Bitcoin using their private key. While everyone can see the deposit boxes, and the amount of Bitcoin inside, only the owners of the private key can use the money.
In our earlier example, Alice sent Betty a message that only Betty could read. Bitcoin works the same way, except we aren’t sending letters but instead information telling your deposit box to give some of your Bitcoin to another deposit box.
To use the example again, here’s how it works. Alice wants to send 1 BTC to Betty, so she sends out a message to the entire network. This message includes Betty’s public address (the location of her deposit box), the amount of Bitcoin she wants to send to Betty, and a digital signature that verifies she is the owner of the private key to her own deposit box.
When Alice sends this message to the network, other network users verify that this message is accurate. If all the numbers match up, then the transaction gets put into a block (a collection of other transactions), and this block eventually gets published in the blockchain. Once that occurs, the rest of the network recognizes that Alice’s deposit box is 1.0 BTC smaller than before, and Betty’s deposit box has grown by 1.0 BTC. Since the blockchain is a public ledger that extends all the way back to the first Bitcoin transaction, it knows the exact amount of Bitcoin in every deposit box that exists.
Mining for Coins: Now you understand how transactions take place, but you might be wondering where Bitcoins even come from in the first place. Remember how I mentioned some network users verify the transactions are accurate, and then include them in a block to be published to the entire network? This process requires significant computing power, so why would other users be willing to do this? Because they are rewarded with Bitcoin!
Devoting your computer to processing transactions is called mining. Miners verify transactions, and as they are doing so they are looking for the solution to a mathematical problem. If they are the first to find the answer, the code allows them to publish the block of transactions to the rest of the network.
Whoever publishes the block gets a reward, currently set at 25 BTC. This reward halves every few years, so that the amount of Bitcoin never grows too quickly. Also, as more people devote more computing power to the network in order to increase the chance of getting a block reward, the difficulty of mining increases. The code automatically adjusts the difficulty of the mathematical problem so that a new block is mined approximately every 10 minutes.
A Chain of Blocks: One more important thing to mention about the blocks – they are built on each other in a chain (hence the term blockchain). It is imperative to have a continuous and chronological record of all transactions; this ensures the amounts of each and every deposit box have been accounted for. In order to do this, each block has two additional elements apart from the transactions. One is a much-shortened snapshot of all previous blocks, called a hash.
This hash ensures that the blockchain is building on the previous blocks, all the way back to the original block (called the genesis block). The second aspect is the answer to the complicated math problem the miners need to solve. The next block cannot be mined until the problem has been solved, ensuring that blocks are created in chronological order. As of June 2013, there have been more than 238,000 blocks published in the blockchain.
In this way, the Bitcoin ecosystem keeps evolving. Transactions get compiled into new blocks, the blocks are published to the rest of the network in a continuous chain, miners get rewards for their work, and those new Bitcoins are used for transactions, starting the cycle over again.
Network Verification: How is this system kept in check? After all, Alice could send a message saying that she has 5.0 BTC to send to Betty, even though her deposit box only has 2.0 BTC. There are many ways that dishonest users could attempt to trick the system, but fortunately it’s virtually impossible.
This is because Bitcoin is a decentralized system where all transactions are public, and require verification from the rest of the network. If Alice tried to send more coins than she had, the recipient would immediately check the balance of the account, recognize this, and reject the transaction. It would never make its way into the block, and the rest of the network would never even see the false transaction. This verification is done in the code of the Bitcoin program itself, so it is nearly instant.
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