What is a Bitcoin?
Bitcoin is a virtual currency, an electronic form of payment system. Transactions are made with no middle men, this means there exists no financial institutions like banks to oversee transactions or to regulate the currency. It was created by a person or possibly a group of people known only by the pseudonym “Satoshi Nakamoto”. As per Wikipedia, Satoshi is a male, Japanese given-name that has various meanings such as “wise”, “clear-thinking”, “quick-witted” or “intelligent history”, i.e. a person with intelligent ancestors. In Japanese, naka means “inside” or “relationship” and moto means “origin”.
More information on Bitcoins
As mentioned above, unlike regular currency transactions, Bitcoin transactions are not governed by a bank or any other central entity. This is why Bitcoin is also sometimes referred as decentralised currency. All Bitcoin transactions are validated and conducted by a P2P (Peer-to-Peer) network of individual host computers (known as “miners”) that communicate among each other using P2P technology, without any centralised servers. Therefore all Bitcoin transactions are stored publicly and permanently on the Bitcoin network.
All you need is a client software (Bitcoin wallet) installed on your computer or mobile device to store and transfer Bitcoins. It is also possible to store and transfer Bitcoins without installing any software on your computer using third party services (Bitcoin online wallet); in this case your Bitcoins will be stored on the third party’s servers. Once you have installed the client software or created a Bitcoin account with a third party Bitcoin online wallet provider, you will need to deposit some Bitcoin balance in your Bincoin wallet. This can be done through a Bitcoin currency exchange such as Mt. Gox where you can exchange your currency for Bitcoins. Numerous other Bitcoin exchanges are available in different countries.
All Bitcoin transactions without exception are stored in a shared public transaction log known as a block chain maintained by the miners. This is to confirm that the party sending the Bitcoins actually owns them. This system also prevents fraud and double spending.
How does Bitcoin work?
Let’s say Peter wants to transfer 50 Bitcoins to Paul. Peter would first create a transaction of 50 Bitcoins along with a small transaction fee (more on this later) and apply a digital signature to this transaction. This would help to authenticate Peter within the Bitcoin network. Next Peter would broadcast the transaction details to all the nodes (Miners) in the P2P network. At this point Paul receives the information that Peter has initiated a transaction and can validate Peter with the help of the digital signature. Now it is the job of the miners to take this transaction and compile them into a transaction block. A transaction block is a recording of the transactions that occur in a network. Another detail is added to this block by the node, this is regarding the reward in the form of Bitcoins the node receives for doing all this work. The node would also add a sequence of specially crafted numbers to the block. Creating this sequence of number takes a lot of computing and its difficulty level is regulated by the P2P network overtime. Each time a node is successful in generating this sequence of number, it is rewarded with a few Bitcoins. This process is known as mining.
Each of the blocks also contains previous transaction details; this means we ultimately have a chain of blocks also known as transaction block chain. Once a node is successful in creating a new transaction block, it is then appended to the transaction block chain; this action is then broadcasted over the network. This new transaction block is then verified by all the other nodes in the network and henceforth all new transaction blocks will be appended to this transaction block chain. At the end of this verification process, Paul receives the 50 Bitcoins sent by Peter. At this point Paul can use his newly acquired Bitcoins to purchase anything from a merchant accepting Bitcoins or he could exchange them to any traditional form of currency (as per market rates).
By keeping a record of all transactions, the block chain prevents double-spending and will deter a potential hacker as he would have to create a block chain larger than the one existing, this would mean he would have to do the amount of work done by all the other miners (since the dawn of Bitcoins) while creating the existing block chain.
As you can see the entire transaction is validated and approved by the Bitcoin P2P network without the intervention of any centralized entity.
What is Bitcoin mining?
Bitcoin contains a “difficulty factor” which is an arbitrary number that determines how hard it is to find a “winning” hash required to successfully mine for new Bitcoins. This process is known as mining and it is like creating Bitcoins from thin air. For conducting a transaction successfully miners receive a small amount of Bitcoins for the work they do. The “difficulty factor” increases overtime at a fixed rate making it more difficult to mine for new Bitcoins. The number of Bitcoins in the reward also reduces over time.
The base reward included in each block to encourage mining activity while Bitcoin was still in its early stages was 50 Bitcoins but every so often the reward is cut in half (currently at 25 coins) until eventually will be cut down to zero. Some transactions also pay a small transaction fee, which goes to the miners as well. Eventually these transaction fees will be the only reward for mining (once all Bitcoins have been mined), but the hope is that by that time there will be enough transactions (and therefore enough fees) to make it worthwhile.
At the time of writing this article 12,160,600 Bitcoins have already been mined and a remaining 8,839,400 are yet to be mined. At present, there is a limit of 21 million Bitcoins that can remain in circulation and it is estimated that the mining is halved every 4 years; which means by 2140 all Bitcoins would have been mined. And, that does not mean an end to Bitcoins and it simply means there would be no more new Bitcoins created and the total number of Bitcoins in circulation would remain at 21 million. So, the prediction is that as the years go by, the value of Bitcoins increase in their value as they become more difficult to mine. It may be argued that the 21 million limit is not high enough, but each Bitcoin is divisible to eight decimal places (known as “satoshis”) this should make it more than enough for all conceivable applications.
Most people participate in Bitcoin mining because using an existing PC, one can literally make money from the processing power already sitting beside your desk. Others get into it with a gold rush mentality, investing money into specially designed hardware for the purpose of mining. Many vendors have now popped up offering specially designed plug-in cards for PC’s with the only intention of bumping up the rate at which the coins are mined.
As it stands, mining solo is very nearly deprecated. The process of finding blocks is now so popular and the difficulty of finding a block is so high that it could take a very long period of time to generate any coins. While you could simply set a machine aside and have it run the algorithms endlessly, the energy cost and equipment deprecation will eventually cost more than the actual Bitcoins are worth. This has led to pooled mining, which is far more lucrative. Here a group of miners work together and then split the reward among themselves.
- Bitcoins are more anonymous than a bank account. You can make your own “wallet” on your computer without giving any personal information to set up your account. The number of wallets you can create is unlimited.
- As a decentralised currency, Bitcoin is free from government interference and manipulation.
- Transaction costs are much lower compared to conventional currencies. This will give sellers a competitive edge in the marketplace.
- A truly global currency as Bitcoin transfers directly go from source to destination, without going through any intermediate regulators.
- Bitcoin has skyrocketed in value (from $14 in January to $211 in November 2013), it is still prone to rollercoaster ups and downs.
- There is no guarantee that Bitcoins will be around in the future or whether they will retain their current value.
- The anonymity offered by Bitcoins may encourage its use for illegal and illicit activities.
Bitcoin fact: The single largest Bitcoin wallet on the internet is owned by the U.S. government. When the FBI shut down the Silk Road, an online black market, in October 2013 it also seized the accused owner’s Bitcoin assets and inadvertently became one of the wealthiest Bitcoin holders in the world.