When people say “Bitcoin” they are referring to one of two things.
1. A digital currency.
2. A payment system used for sending and receiving money online.
Typically the term is used to apply to the currency itself, but the payment system is every bit as important as the currency. Let me explain both.
Bitcoin as a Currency
Bitcoin is a digital, decentralized, peer to peer, pseudonymous currency based on cryptography. If that sentence made no sense to you, don’t worry - I’ll break it down for you.
Digital – Bitcoins exist only as code, they do not exist as anything physical. People can (and have) made physical representations of Bitcoin, but ultimately they are based in the digital world.
Decentralized – There is no central bank or institution that issues or controls Bitcoin. It is a group of individuals all over the world who run the program that keeps the monetary system running.
Peer to Peer – You control your own Bitcoin, and when you send Bitcoin to someone else, it goes directly to them. There are no banks or middlemen.
Pseudonymous – While all Bitcoin transactions are publically viewable in an open ledger called the Blockchain (we’ll get to that later), the sender and receiver are only known as a string of numbers and letters. If you’re careful about your identity, using Bitcoins can be done anonymously.
Based on Cryptography – The strength of Bitcoin as a digital currency lies in the code, which uses strong cryptography to ensure that the coins cannot be accessed without proper permission.
Bitcoin is the first digital currency that has these characteristics, and as a result it is the first digital currency to become widely adopted on the internet. As of June 2013, it is handling nearly 60,000 transactions each day, and this number is accelerating quickly.
Bitcoin as a Payment System
As a new digital currency, Bitcoin is impressive, but the truly revolutionary aspect of Bitcoin is in a new payment system. Before I explain this system, let me briefly describe one of the primary reasons why digital currencies have always failed in the past.
In the physical world, money can’t be in two places at once: once you spend it, it is inside store A’s cash register and it can’t be in store B’s cash register. With digital currency, this isn’t necessarily true. Since digital currency is computer code, the same money could actually reside in multiple places. This is obviously a huge problem, and would lead to rampant fraud.
However, we do transact huge amounts of money digitally today, so how come we don’t see more double spending? Well, we have services that take care of the problem, such as PayPal. They review all the transactions to ensure that the same money isn’t spent twice.
But there are substantial problems with using a centralized service to deal with the double spend problem. First, they are a single point of failure. This means that if PayPal were to have technical problems – or perhaps if they don’t like what you are trying to purchase – then you can’t move your money at all. Also, you have to pay them for their service, typically with fees that are 2% or even higher.
Bitcoin’s payment system solves the double spend problem, does it without relying on a single point of failure, and requires substantially smaller fees. It does this by using a public ledger called the Blockchain, which I’ll discuss in more detail later in the book.
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