Bitcoin is hard to understand. Maybe that’s why there hasn’t been mass adoption. So how does Bitcoin work?
I’m a big believer in the adage ‘if you can’t explain something in a simple way, then you don’t really understand it yourself’. So here’s my simple understanding of how Bitcoin works.
(Disclosure: I bought some Bitcoin before I actually understood it. I don’t think that not understanding it means that you can’t invest a bit into Bitcoin but that’s the speculator in me!)
Before we get into how Bitcoin works, first think about how traditional currency works
Take the UK Pound Sterling.
Physically: If I want to give you £10, then I go to my ATM and take out £10 and give it to you.
Digitally: If I want to give you £10, then I log on to my account and transfer £10 from my account to your bank account.
In both cases, my bank will deduct £10 from my account.
The bank is a third party i.e someone different from the main parties to this transaction (the main parties are me and you).
Having another party to the transaction means that you have to trust this other party.
This is okay because, in my case, I trust HSBC.
I trust that it’s not going to run out of money or go bust.
I trust that it’s going to give me £10 when I need it and that it’s not going to deduct more than £10 for this transaction.
That’s a lot of trust. But what else are you going to do?
Equally, there’s a lot of good things about having a bank like HSBC (a third party) to handle your money and look after it: it’s convenient and safe.
What are the problems with traditional currency (also called fiat currency)?
My money is held in Pounds Sterling.
Main problems are:
1) Massive inconvenience re sending money abroad
If I want to send £100 to you in France, then my bank will charge me a flat fee to send this to you. It will also take a few days to reach you.
2) Loss of value of your money
My Government can reduce the value of my pounds by printing money (this puts more money into supply. If demand stays the same as before the new money came into supply, then the price of Sterling (the value of Sterling against other currencies like US dollars and Euros), will fall. Printing money has happened on a huge scale since 2008.
Think about how much worse this is in countries with hyper-inflation like Zimbabwe. Imagine that your money now only bought half of what it could buy yesterday? Or just 1% of what it could buy yesterday? This is why people in times of chaos throughout history have relied on gold to hold its value (remember this – it’s important).
The appetite for something new to avoid these problems with traditional fiat currencies
The idea for digital cash has been around since the 1990s (I think).
The thinking is that digital cash can be easy to send to anyone anywhere in the world and for free!
Also, digital cash that can’t be devalued by governments and financial institutions.
The major problem with digital currencies (until Bitcoin and Satoshi came along)
The major problem with digital currency was the Double Spend Problem.
The Double Spend Problem is:
Let’s use a fictional, made up digital currency called DCs.
Let’s say I have 100DCs in my DC account.
If I want to send you (Bob) 100DCs, then I make the transfer to you.
It should leave my account and yours (Bob) should increase by 100DCs.
So far so good.
But what happens if I’m a bit naughty and at the same time as my transfer to you (Bob), I also try to send 100DCs to Susan?
I don’t have 200DCs in my account. I only have 100DCs in my account. So one of the transfers should bounce or be rejected.
If one isn’t transferred, then I have been able to Double Spend.
In theory, I could do this multiple times, even 1,000s or millions of times. I could buy shoes, cars, watches, houses, all with money that I didn’t have.
Nobody would be able to trust that the system worked or that they would get their money from me.
The system would break down.
The solution to this problem wasn’t really a solution at all.
The solution would be to mirror the structure of transactions in traditional fiat currencies above, which was to introduce a third party to guarantee a degree of trust. I.e we’re back to intermediaries like banks, although in the case of digital currencies, we’d have companies which can fail or be dishonest.
And so the Double Spend Problem rumbled on….until 2008 when Satoshi Nakamoto came along and proposed the Blockchain.
Satoshi wanted to solve the Double Spend Problem without third parties to sit behind transactions.
He proposed a method that would enable trust in the currency with no central party.
He wanted to decentralise the trust element.
He did this through the blockchain.
What is the Bitcoin Blockchain?
The Bitcoin Blockchain is a structure that verifies and records transactions in a place that everyone can see.
Let’s update my example of DCs above to become Bitcoin.
So I have 100 Bitcoins (BTC). I send 100 BTCs to Bob (a transaction).
This transaction needs to be verified.
Verified to make sure that I actually have 100BTC in the first place and also that I haven’t double spent my 100BTC.
Who verifies this transactions? It’s other people involved in Bitcoins. i.e. fully decentralised!
How is this decentralisation achieved?
Satoshi decided that every transaction would be available for everyone who wanted to see, could see.
This is the famous ledger that you must have heard of.
Imagine from day one of Bitcoin, you see every Bitcoin that came into existence and also every transaction is made from using those Bitcoins. If everyone can see it, then everyone can trust it.
In Bitcoin, everyone has their own copy of the ledger.
Here’s a list of transactions:
- 100BTC come into existence and come to me.
- I send 10BTC to Bob.
- Bob sends 5BTC to Susan.
- Susan send 2BTC to Mark.
Each of these transactions must be verified in order to prevent Double Spending.
For example, for (3), it must be verified that Bob has 5BTC to be able to send Susan and that Susan received these 5BTC.
This verification is made by a person who checks all the above for (3).
They then give their stamp of approval and this transaction is added to the ledger.
To encourage accurate and correct verifications, people are encouraged or incentivised to compete to make the verification. People are incentivised to do this by be rewarded in Bitcoins. The verification process is called mining. They literally mine Bitcoin (like mining gold) by making accurate verifications of transactions made.
More about the ledger
Of course the ledger is going to become massive, pretty quickly. You can imagine that there’ll be billions and trillions of transactions made in Bitcoin if it succeeds as a currency.
Think of the Bitcoin ledger being the record of every single Bitcoin transaction ever made and also every transaction still to come.
This could have the potentially crippling problem where a naughty person (a bad actor), tries to rewrite the ledger.
Satoshi invented a solution to this called the Blockchain.
Think of a Block as a page within the ledger and the ledger as a chain of pages.
Changes to an earlier page would somehow invalidate the later pages.
This invalidation is achieved by cryptography.
Each transaction within a page (block) has its own unique stamp of letters and numbers. These strings of letters and numbers then go through a hashing process which produces an output of numbers and letters that can only be generated by the particular strings of letters and numbers that were in the transactions. The next block also does its own hashing which uses the hashing output of the previous block to generate its own unique hashing output. This ‘locks’ the later block to the earlier block and to all earlier blocks.
So if someone tries to rewrite the blockchain, we can see now that this would invalidate the whole blockchain as it would change the output of the rewritten block and all later blocks would no longer be validated.
This is the blockchain! What an incredible achievement!
Hopefully, that was pretty clear and easy to follow? Let me know if you didn’t understand any of this in the comments below and I’ll do my best to explain.
Further reading and viewing
The best introductions to Bitcoin that helped me were:
This video on how blockchain works:
To buy Bitcoins, check out my earlier post on the easiest way to buy Bitcoins.