Last updated on 27th Sep 2020, Blog, Tutorials
Bitcoin emerged out of the 2008 global economic crisis when big banks were caught misusing borrowers’ money, manipulating the system, and charging exorbitant fees. To address such issues, Bitcoin creators wanted to put the owners of bitcoins in-charge of the transactions, eliminate the middleman, cut high interest rates and transaction fees, and make transactions transparent. They created a distributed network system, where people could control their funds in a transparent way.
Bitcoin has grown rapidly and spread far in a relatively short period of time. Across the world, companies from a large jewelry chain in the US, to a private hospital in Poland, accept bitcoin currency. Multi-billion dollar corporations such as Dell, PayPal, Microsoft, Expedia, etc., are dealing in bitcoins. Websites promote bitcoins, magazines are publishing bitcoin news, and forums are discussing cryptocurrencies and trading in bitcoins. Bitcoin has its own Application Programming Interface (API), price index, trading exchanges and exchange rate.
However, there are issues with bitcoins such as hackers breaking into accounts, high volatility of bitcoins, and long transaction delays. Elsewhere, particularly people in third world countries find Bitcoins as a reliable channel for transacting money bypassing pesky intermediaries.
How to use Bitcoins?
We can make bitcoin transactions as we do with our familiar fiat currencies. While we use Bitcoin, the purchaser is actually referenced to our digital signature, which is a security code encrypted with sixteen different symbols. The purchaser decrypts the code with his device to get the cryptocurrency. Therefore we can say that cryptocurrency is an exchange of digital information that permits us to buy or sell goods and services.
The transaction is secured and made trustworthy by running it on a peer-to-peer network that is akin to a file-sharing system.
How does Bitcoin handle double spending problem?
For digital cash system, a payment network necessarily should have valid accounts, balances and transaction records. The biggest bottleneck common to every payment network is the double spending problem which is the case when same money is used multiple times to do transactions.
To prevent double spending, all transactions have to be recorded and validated every time in a central server where all the balance records are kept. However, in a decentralized network, every node on the network has to do the job of a server; it has to maintain list of transactions and balance records. Thus, it is compulsory for all nodes/entities in the network to keep a consensus about all these records. This was achieved by using the blockchain technology in bitcoins.
So we can say that bitcoins like other cryptocurrencies are mere token entries stored in the decentralized databases that keep consensus of all balance and account records. It is to be noted that cryptography is used extensively to secure the consensus records. Bitcoins and other cryptocurrencies are secured by math and logic more than anything else.
Bitcoins and cyptocurrencies have gained recognition and adoption based on their perceived value by their creators and users.
Bitcoin works on the same concept, the more people participate; the more value is created.
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History of Bitcoins
The first Bitcoin protocol and proof of concept was published in a Whitepaper in 2009 by a shadowy individual or group under the pseudonym Satoshi Nakamoto. Eventually Nakamoto, who remained mysterious, left the project in late 2010. Other developers took over and the Bitcoin community has since grown exponentially.
While Satoshi Nakamoto’s real identity remains shrouded in mystery, it is on record that he communicated extensively in Bitcoin’s early days. Let us speculate on questions like when he started working on Bitcoin, to what extent he was inspired by similar ideas and what was the motivation for bitcoin.
Creation of the first bitcoin domain
It is believed that Satoshi started coding Bitcoin around May 2007. He is said to have registered the domain bitcoin.org in August 2008. Around that time, he started sending emails to a few individuals he thought might be interested in the idea of bitcoins.
In October 2008, he publicly published a white paper that dwelt on the Bitcoin protocol, and released the Bitcoin code as well. Then he stayed in contact for about two years, during which he interacted actively in forums, communicated with several developers and later he also submitted patches to the initial code. He maintained the source code along with other developers, tackling issues as they happened. By December 2010, as others had slowly taken over, he quietly left the scene.
The entities involved in the implementation and maintenance of Bitcoins are −
- The Blockchain platform
- Cryptographic algorithms
- Bitcoin miners which are computers or specialized machines that mint the currency and make possible transactions
- People who participate in the transactions and thus help to move the payment system
The philosophy of Bitcoin, and in general, of all cryptocurrencies is that they are distributed systems where there is no central entity that manages the activities such as transactions, among others. It is a peer-to-peer (p2p) system that operates at the level of participants.
We shall now see how a new block of bitcoin transaction is created.
A bitcoin miner creates a block by using the following steps −
- 1. Gathering pending transactions, preferentially those with transaction fees first, and then the free ones
- 2. Verifying the transactions for their validity
- 3. Solving a hashing problem
According to the statistics, in October, 2015, blockchain.info site stated that, the average number of transactions per block was 411, and as of May 2018, the current number of pending unconfirmed transactions is around 2495.
Reward and cost per bitcoin transaction
Assuming that one bitcoin is worth $400, the reward of 25 bitcoins per block is worth around $10,000, ignoring negligible amount of transaction fees. Taking average number of transactions per second as 2, and the number of transactions per block as 1200, the reward per transaction works out to $8.33. It is found that the cost of electricity consumed in mining is close to the reward which makes mining bitcoins not so profitable. The basic problem of mining as of now, is the 1 MB limit on block size which makes it possible to have at most only 10 transactions per second.
Confirmation of a bitcoin transaction
A transaction is considered to have received n confirmations if it has been published in a block in the block chain, and n-1 more blocks have also been added. A transaction is normally considered “confirmed” once it has six confirmations. Newly created Bitcoins are considered confirmed after they have received about a hundred confirmations.
How does Bitcoin have value?
It is the common consensus, belief and the perception that gives value to the bitcoin. All the participants in this system have consensus on the following −
- immutability and integrity of the blockchain
- security and validity of the payments
- rules of the system
Bitcoin was the first practical implementation of blockchain technology and is currently the most significant triple entry bookkeeping system globally. In a bitcoin ecosystem, access to entire source code is available to everyone always and any one can review or modify the code. The authenticity of each transaction is secured by digital signatures of the sending parties thus ensuring that all users have complete control over sending bitcoins.
Thus, leaving a little room for fraud, no chargebacks and no identifying information that could be hacked resulting in identity theft.
Here is a list of some of the entities who accept Bitcoins −
- 1. WordPress
- 2. Namecheap
- 3. Microsoft
- 4. Dell Computers
- 5. Archive.org
- 6. Bitpay
- 7. Bitspend.net
Features of bitcoins
One of the most direct benefits of Bitcoins is that they are out of purview of governments, banks and other intermediaries who cannot interrupt user transactions or freeze Bitcoin accounts. The users experience greater freedom vis-à-vis dealing in national currencies. There cannot be inflation in case of bitcoins by printing more money as in the case of fiat currencies. By design, the number of bitcoins that can be minted is limited.
Since there is no way to identify, track or intercept bitcoin transactions, one of the major advantages of bitcoin usage is that taxes are not added onto any purchases.
Bitcoin transactions are relatively faster as compared to bank transfers in traditional currencies. Bitcoin transactions are done with nominal or sometimes zero transaction charges. These transactions are anonymous with no names involved. Every transaction is a public record which anyone can see. Your private key is the only link between you and your bitcoins. As long as the private key is secure, your money is safe. It is very easy to send and receive bitcoins because of ease of operation of bitcoin accounts.
Small amounts of bitcoin that are used as alternative units are: millibitcoin (1 mBTC = 0.001 BTC), and satoshi (1 sat =0.000001 BTC) which is a millionth of a biticoin in value.
You can use different wallets and tools for transacting in bitcoins.
Drawbacks of bitcoins
Let us examine the cons or drawbacks of bitcoins. These limitations of bitcoins make them less attractive and makes us seek better options. We have to somehow overcome or eliminate these limitations of bitcoins to make them user friendly.
- 1. Bitcoins are a new emerging currency whose work is still in progress.
- 2. Their value is highly volatile and unstable seeing wild fluctuations.
- 3. It is internet-based, without which it cannot function.
- 4. It is totally virtual currency and money can be lost due to computer breakdown or the absence or failure of a backup.
- 5. Losing your private key can result in losing your bitcoins.
- 6. There is no way that the transactions can be reversed or cancelled once completed.
- 7. There can be misuse of anonymity of bitcoin transactions for criminal activities.
- 8. The benefits of bitcoins are skewed highly in favor of early adopters.
- 9. Bitcoin can be replaced with a better similar product and there is uncertainty regarding its continuation over a long period of time.
- 10. Governments can ban bitcoins and make transactions in bitcoins difficult.
- 11. The slowness of transaction verification is also an issue.
- 12. The current version of bitcoins is not fit to handle very high volume of transactions.
The process of creating or minting bitcoins is difficult to hack and this gives security to bitcoins. Another layer of security is the provision that every transaction has to be verified before being validated. This verification is effected through “mining”. Mining is a process where some high-level computing like SHA256 decoding is done to verify transfers of bitcoins.
Bitcoins are stored in a “digital wallet”, which exists either on a user’s computer or on the cloud. The wallet is a type of virtual bank account that facilitates users to send or receive bitcoins, pay for goods and services or save their money.
How do bitcoin transactions work?
Every bitcoin account consists of a public key which works like a bitcoin address and a private key. Anyone can send you bitcoins if he/she knows your public key. To spend bitcoins, you have to use your private key for authentication. Every bitcoin transaction appears on the bitcoin network. The miners confirm the transactions after verification to validate them.
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An example of a bitcoin address is as follows −
There are 2160 or about 1048possible addresses.
The corresponding private key is as given below −
Private keys are of 256-bit length. There are about 1077 possible private keys.
How to send bitcoins?
In the previous section we have seen how a bitcoin transaction works. Now, we shall discuss how to send bitcoins.
To buy some merchandise or pay for some services, you will have to send bitcoins to the address of vendor. To receive bitcoins, you will have to share your address with the vendor.
Following is the process of sending bitcoins to someone −
- Copy the vendor’s address and open your bitcoin wallet.
- Click on the “Send coins” tab and enter the address in the ‘Pay to’ field to which you want to send bitcoins.
- If you have to send bitcoins to the same person or a group several times, you can create a label so as to find them in the address book.
- Enter amount in the next field and click send to complete the operation.
In the mining process, all transactions are collected in a container called block. A new block is created in about every 10 minutes. In case of small payments or transactions with trusted peers, confirmations may not be necessary. However, for large transactions to be considered safe, the norm is 6 confirmations.
Anonymity of Bitcoin transactions
The level of anonymity can be customized depending on the requirement. Every transaction from one address to another address is public. The analysis of the transactions through their addresses or public keys whose records are public is called traffic analysis. The larger the transfer the easier the traffic analysis.
To increase anonymity, mixing services are used. It is also advisable to create a new public key or new address for every transaction to ramp up security and anonymity. From the point of view of a user, Bitcoin is nothing but a mobile app or software that makes available a personal Bitcoin wallet which allows a user to send and receive bitcoins. However, at the backend, the Bitcoin network shares a humongous public ledger called the “block chain”. This ledger carries the record of every transaction ever processed that makes it possible for a user’s system to verify the validity of each transaction.
The need of consensus for compatibility
In order to maintain compatibility with each other, all users of Bitcoins have to use the software following the same rules. Bitcoin can only work correctly as long as there is a complete consensus among all the users. Thus, it is imperative that all users and developers maintain and protect this consensus.
Securing a blockchain
Bitcoins are not stored on your computer unless you host a node on the network. You carry a clone of the ledger which is secure as each block is hashed before being appended to the chain. This means, changing even one bit of any data on the previous blocks changes the hash of the ledger which marks it as counterfeit.
Hash function is an irreversible function that is used extensively in cryptography; the output of this function is shorter than the input. Validation of bitcoin transactions is just a process of quickly checking the keys like finding if the sender has the private key that can unlock any record in the ledger/blockchain.
The following is a list of applications of bitcoins
- Bitcoins are being used to buy goods and services as more and more stores across the world are accepting bitcoin payments.
- Bitcoin transactions provide a customized level of anonymity and it is relatively difficult to trace their trail. So bitcoins are being used to transact anonymously.
- International payments can be made easily and cheaply as bitcoins are not related to any country or subject to any government regulation.
- There is the freedom of the fact that there is no need of permission from any authority for your transactions.
- Bitcoins provide a way to transact securely online as they use very strong cryptographic algorithms.
- Users and businesses like bitcoin payments because there are no credit card fees to pay.
- Bitcoins can be as an investment, expecting that their value will appreciate significantly in future.
- Bitcoins can be used to gamble on online sites like SatoshiDice, RoyalBitcoin, Bitzino, Peerbet, etc.
- Bitcoins are being used to shop online as increasing numbers of vendors are allowing bitcoin transactions. Users now can make payments in bitcoins on their smartphones through bitcoin wallet apps.
- Unlike credit card or bank payments, there is no need to provide personal information to complete the transactions. So the hassle of providing identity can be avoided.
Since Bitcoin is a new emerging technology which is underway, unforeseen developments can make its existence and continuation difficult. Concerning its security and future, there are numerous questions which no one can answer. How far can we trust Bitcoins? Are they a bubble that is going to burst? Are they a passing phenomenon and a fad that would fizzle out over a period of time? Or are they going to stay put and perhaps dominate other currencies in future?
As of now, bitcoins are mostly unregulated, however this may change. Governments are worried about losing taxes and control over the currency. They may bring legislations to regulate bitcoin which may hugely impact the advantages that bitcoins have over other currencies. The volatility of bitcoin prices is one huge issue. The wild fluctuations in its index is sign of such volatility. In recent years, bitcoin prices have risen exponentially and after some corrections have dipped but still they are on the high side. Many expect that the price will further increase.
Favoring Growth Factors
The things that favor the growth of bitcoin adoption are as follows −
- 1. There are limited number of bitcoins.
- 2. The awareness about bitcoins is growing and so their acceptance and adoption.
- 3. The number of bitcoin transactions is increasing day by day.
- 4. A large number of wealthy people do not want government’s regulations on their wealth and would rather prefer storing in bitcoins.
Next halving is scheduled to occur in 2020. This will further decrease the rate of supply of bitcoins while bitcoin usage would have increased manifold by 2020. As of now, the number of bitcoin transactions is way behind the number of credit card transactions and the former has to significantly increase to realize the full potential of bitcoins.
Some of the issues which have to be tackled to help bitcoin’s growth are as follows −
- Bitcoin transaction time or the time required to get confirmations is still on the high side as compared to credit or debit card transactions.
- The security of Bitcoins has become a major issue. As the usage of Bitcoin is increasing, hacking of bitcoin wallets and even exchanges has been more widespread.
- As of now Bitcoins are too technical for common people and are not so user friendly. It is difficult for people to understand why bitcoin prices are so volatile, why transaction time is so high and how they should safeguard their bitcoins.
Governments of several countries including India are discouraging legal use of Bitcoins as they understand that Bitcoin is a parallel financial system beyond their control. However, countries like Japan, Australia and several European countries have made Bitcoin legal as they realized that they cannot stop the usage of bitcoins. Some countries have banned bitcoin exchanges. People are using global exchanges to hide their transactions. Meanwhile India and China have been discouraging Bitcoin transactions. China has tried to ban all Bitcoin Exchanges in their country while India has not banned any exchange. Zebpay and Unocoin are Bitcoin Exchanges that are under operation in India. They require submission of KYC documents before executing any Buy or Sell transaction.
How do I buy Bitcoin?
You know how does Bitcoin work, what it is, what it’s good for and what it’s bad for. The only thing left is to know how to buy it. So, how do you buy Bitcoin?
There are three main options.
- This is the simplest way, but you normally must use your identity. This means using your name, address and a passport/driving license. Fees for broker exchanges normally cost between 1-5% but it depends on your location on how you pay.
- The good thing is, you can pay using bank transfer, debit/credit card, and even PayPal. I recommend Coinbase because it’s easy to use, reliable and you can use PayPal. If you don’t live in Europe, Australia or North America though, I recommend Coinmama.
- Using a broker exchange is a bit like when you go to a travel agent to convert your local currency into a foreign currency (like USD for JPY, for example). However, with Coinbase and Coinmama, etc., the broker is converting your local currency into Bitcoin.
P2P (Peer-to-Peer) Exchanges
- 1. These are like broker exchanges, but they don’t use a middleman — there is no broker. For example, John can send money to Amy, and Amy will send John some Bitcoin. There is no broker, so they pay no fees!
- 2. Amy will always have to pay John the Bitcoin because P2P exchanges use an escrow service. When John asks Amy for the Bitcoin, the Bitcoin is sent into the escrow. When John pays Amy his money, the escrow sends John his money. John and Amy have no control over the escrow, so it is always fair. And fair trade is one of the essentials on understanding how does Bitcoin work.
- 3. Some sellers on P2P exchanges will ask you for ID, but some sellers won’t. So, it is possible to use P2P exchanges to buy Bitcoin anonymously. You can even pay in cash (paper money)!
- 4. You can also pay with bank transfer! I recommend using the LocalBitcoins.
- 5. Bitcoin ATMs
- 6. This is the least common way to buy Bitcoin. There are not many Bitcoin ATMs in the world, so you will have to use this map to see if there is one near you. If there is, you can go to it and buy your Bitcoin using cash, but the fees are expensive — 5-10%.
- 7. To learn more about Bitcoin ATMs, P2P exchanges and broker exchanges, read our How to Buy Bitcoin guide. In that guide, I give you full instructions on setting up your wallet, verifying your identity and buying Bitcoin with each payment method.
The invention of Bitcoin is only the beginning. Some people are using Bitcoin and other cryptocurrencies instead of banks, but it still hasn’t completely replaced banks. What are your thoughts? Do you think that Bitcoin will replace banks? Or does it need to improve first?
By answering the above questions, you can test what you have learned in this guide. You can also try to answer the question “how does Bitcoin work?” in just three sentences. Try it — it’ll help you remember what you’ve learned.
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