Disclaimer: This is a very abstract, non-technical explanation. Some examples are used just to give a basic understanding and do not reflect actual processes.
What is Bitcoin?
Bitcoin is a rapidly rising digital currency, which is completely decentralised – there is no single entity or company controlling it. It is entirely under the control of all users. It can not be compared to any other payment system such as MasterCard, Visa, PayPal, or even traditional banks. These are corporate entities, which are controlled by governments and impose their own set of rules. Bitcoin is to the world of finance what the internet was to the world of information. You can not take down the internet, you can not censor the internet, and you can not forbid the internet – the same holds for Bitcoin.
The Bitcoin network is the single most powerful computer network on the planet. Currently it has a combined computing power of 4.85769523 zettaFLOPS. This equals to 4.857.695.230.000.000.000.000 mathematical operations per second!
What makes Bitcoin special?
Imagine you wanted to donate 2.71€ to a poor orphan in Kenya. With traditional payment methods this would seem laughable. The fees involved would outweigh the amount itself. Furthermore the recipient of the money needs to have access to a bank or an ATM in order to receive it. Even if the money was to arrive, it would probably take days. Finally you can not be entirely sure that the money will really arrive to the right recipient due to corruption, theft, or extortion.
These are just a few of the problems that Bitcoin solves.
– you are able to make “micro transactions”, worth less than a cent
– fees can be as low as just a percentage of a cent
– you do not rely on third parties, such as brokers, money agencies, or banks
– transactions are almost instant and require only a few minutes to be confirmed and become definite
– the system is pseudonymous: there are no names bound to accounts, which delivers a high level of identity protection
How secure is Bitcoin? Can it be hacked?
Really, really secure. The underlying technology relies on the very same cryptographic tools that keep the internet together. Some of these are also used to secure your funds in traditional banks and payment channels. The system is constantly updating and improving, ensuring a very high amount of protection.
You can not hack Bitcoin in the sense that you can not hack the internet. It is not a single entity. The entire system is made up of all billions of users working together to ensure that everybody plays by the rules. If someone does not conform – they are simply rejected.
OK, how exactly does it work?
At the heart of Bitcoin is the blockchain. This is a file containing all transactions ever made since its birth in 2008. It is constantly updating with thousands of new transactions being added every minute. This list of transactions is downloaded and synchronised across every single user on the Bitcoin network. Imagine it as a public ledger, being constantly updated and synchronised across millions of users. Every user owns a perfect copy of the entire transaction history of Bitcoin.
For example, imagine you own 1BTC and want to send some of it to a friend. Your current balance on the ledger will be 1BTC and your friend’s will be lets say 2BTC. If you send 0.5BTC to your friend on 28.08.2015 at 15:33PM, this transaction will be added to the ledger of every single user on the network. Everyone will know about this transaction and once confirmed it can never be deleted, modified, or reversed.
Your new balance will read 1BTC – 0.5BTC = 0.5BTC. Your friend’s balance will read 2BTC + 0.5BTC = 2.5BTC.
50 years from now everyone will still be able to see that on 28.08.2015 at 15:33PM this transaction was made. Again, there are no names involved, so while the transaction is publicly visible, nobody can identify the sender and the receiver.
How are Bitcoins generated? How many will exist?
Before I explain how new Bitcoins are generated, I need to talk a bit more about transaction confirmation (putting transactions on the ledger and making them definite). To keep it simple, imagine the confirmation process of new transactions as a lottery. Every user on the Bitcoin network can participate in the lottery, although more participants means proportionally smaller chances of winning. The lottery consists of repeatedly drawing numbers until one is drawn that meets some very specific conditions. This can only be done by pure trial and error – there is no way to cheat or get an unfair advantage. Once the lucky number is found, it is used to confirm a certain amount of transactions. As a reward the person who found it, gets to keep the transaction fees. Fee amounts are entirely up to the users, with higher fees usually leading to faster confirmation times. Since thousands of transactions are confirmed with one “lucky number”, all their fees add up as a reward – thus a fee of just a few cents is perfectly reasonable. Even zero-fee transactions will get confirmed, although this may take significantly longer.
In addition to keeping the transaction fees, every time a “lucky number” is drawn, the winner is also allowed to generate some Bitcoins “out of thin air” and keep them. This is how new Bitcoins are generated and flow into the system. All Bitcoins currently in existence were created by people winning the lottery. Importantly, this second reward is predetermined and cut in half every four years. Initially it was 50BTC, currently it is 25BTC and next year it will be only 12.5BTC. This means that unlike traditional money which is a subject to inflation, there is a fixed amount of Bitcoins that will ever exist – a controlled supply. In May 2140 the last Bitcoin reward will be created, leading to a total amount of 21 Million Bitcoins. Let those numbers not fool you; since the reward is continuously being halved 99% of all Bitcoins will be created somewhere around 2035. The following graph gives a clear picture of this.
To summarise this paragraph:
if you happen to find the magic number that is required to put transactions on the ledger
– you choose a few thousand transactions that should be confirmed
– you get all their fees (therefore you usually pick the transactions with the highest fees)
– you generate 25BTC for yourself
How much does it cost?
The price of Bitcoin is determined entirely by supply and demand. Because there can only be a fixed amount of 21 Million BTC, the price is expected to grow at least hand in hand with the rewards being halved. Importantly, Bitcoins can be divided into 1/100.000.000 (one hundred-millionth). This fraction is called 1 Satoshi, after the anonymous creator known by the pseudonym Satoshi Nakamoto. Therefore even if the price of one Bitcoin happens to surpass hundreds of thousands of euros or more, it can still be traded in much smaller quantities.
Note that Bitcoin is a financial phenomenon like nothing we have seen before. Although a very promising concept, it is still a “baby”. It is very volatile with prices jumping from 15$ in early 2013 to 1200$ in 2014 and falling down to 200$ in 2015.
Finally an interesting story.
The first publicly known purchase using Bitcoin was done in May 22 2010. On that day a programmer paid 10.000BTC for two pizzas worth a total of 20$. In 2014 at the all-time-high this amount of BTC equated to roughly 12.000.000$ (12 million). Today as of August 2015 they are still worth 2.330.000$.
This was a short introduction aimed to provide a basic idea of the advantages of Bitcoin, as well as how it works. In the next articles I will go into much more detail, explaining the exact underlying technology and the methods involved.
Here is a short 3 minute video that covers the basic concepts of Bitcoin.