Bitcoin, the digital currency, has been all over the news for years. But because it’s entirely digital and doesn’t necessarily correspond to any existing fiat currency, it’s not easy to understand for the newcomer. Let’s break down the basis of exactly what Bitcoin is, how it works, and its possible future in the global economy.
Editor’s Note: We want to make it very clear right up front that we are not recommending that you invest in Bitcoins. Its value fluctuates quite a bit, and it’s very likely that you may lose money.
How Bitcoin Works
In layman’s terms: Bitcoin is a digital currency. That’s a concept that might be more complex than you realize: it isn’t simply an assigned value of money stored in a digital account, like your bank account or credit line. Bitcoin has no corresponding physical element, like coins or paper bills (despite the popular image of an actual coin, above, to illustrate it). The value and verification of individual Bitcoins are provided by a global peer-to-peer network.
Bitcoins are blocks of ultra-secure data that are treated like money. Moving this data from one person or place to another and verifying the transaction, i.e. spending the money, requires computing power. Users called “miners” allow their computers to be used by the system to safely verify the individual transactions. Those users are rewarded with new Bitcoins for their contributions. Those users can then spend their new Bitcoins on goods and services, and the process repeats.
The advanced explanation: Imagine it as BitTorrent, the peer-to-peer network that you definitely didn’t use to download thousands of songs in the early 2000s. Except instead of moving files from one place to another, the Bitcoin network generates and verifies blocks of information that are expressed in the form of a proprietary currency.
Bitcoin and its many derivatives are known as cryptocurrencies. The system uses cryptography—extremely advanced cryptography called a blockchain—to generate new “coins” and verify the ones that are transferred from one user to another. The cryptographic sequences serve several purposes: making the transactions virtually impossible to fake, making “banks” or “wallets” of coins easily transferable as data, and authenticating the transfer of Bitcoin value from one person to another.
Before a Bitcoin can be spent, it has to be generated by the system, or “mined.” While a conventional currency needs to be minted or printed by a government, the mining aspect of Bitcoin is designed to make the system self-sustaining: people “mine” Bitcoins by providing processing power from their computers to the distributed network, which generates new blocks of data that contain the distributed global record of all transactions. The encoding and decoding process for these blocks requires an enormous amount of processing power, and the user who successfully generates the new block (or more accurately, the user whose system generated the randomized number that the system accepts as the new block) is rewarded with a number of Bitcoins, or with a portion of transaction fees.
In this way, the very process of moving Bitcoins from one user to another creates the demand for more processing power donated to the peer-to-peer network, which generates new Bitcoins that can then be spent. It’s a self-scaling, self-replicating system that generates wealth…or at least, generates cryptographic representations of value that correspond to wealth.
How Are Bitcoins Spent?
In layman’s terms: Imagine you’re buying a Coke at the supermarket with a debit card. The transaction has three elements: your card, corresponding to your bank account and your money, the bank itself that verifies the transaction and the transfer of money, and the store that accepts the money from the bank and finalizes the sale. A Bitcoin transaction has, broadly speaking, the same three components.
Each Bitcoin user stores the data that represents his or her amount of coins in a program called a wallet, consisting of a custom password and a connection to the Bitcoin system. The user sends a transaction request to another user, buying or selling, and both users agree. The peer-to-peer Bitcoin system verifies the transaction via the global network, transferring the value from one user to the next and inserting cryptographic checks and verification at many levels. There is no centralized bank or credit system: the peer-to-peer network completes the encrypted transaction with the help of Bitcoin miners.
The advanced explanation: The technical side of things is a bit more complex. Each new Bitcoin transaction is recorded and verified onto a new block of data in the blockchain. (The two parties in the exchange are represented by randomized numbers that make each transaction essentially anonymous, even as they’re being verified.) Each block in the chain includes cryptological code linking it to and verifying it for the previous block.
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In the conventional sense, Bitcoin transactions are incredibly secure. Thanks to complex cryptography at every step in the process, which can take quite a lot of time to verify (see below), it’s more or less impossible to fake a transaction from one person or organization to another. However, it is possible to “steal” bitcoins by discovering someone’s digital wallet and the password that they use to access it. If that information is found, via hacking or social engineering, a digital Bitcoin stash can dispensary without any way to trace the thief. Since Bitcoin isn’t regulated or secured in the same way your bank account or credit account is, that money is simply gone.
How Do You Turn Bitcoins Into “Real” Money, and Vice-Versa?
First of all, Bitcoin is real money, in the purely economic sense. It has value and can be traded for goods and services. It’s unlikely that you can pay your bills or buy groceries totally in Bitcoin (though those services do exist and they are growing), but you can buy a surprising amount of online goods with your Bitcoin wallet. At the moment, the biggest companies…