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This post is the second in our three-post series on Bitcoin and Digital currencies. Our aim here at MMGA is to educate you on a technology that is not widely understood so that you can be prepared for what might come next.
Our three-part series has been designed to help the uninitiated understand ‘WHY’ Bitcoin was created, ‘HOW’ it works and finally ‘WHAT’ comes next and how to prepare your business for potentially huge disruption.
If you just found this series, you can find the other posts here:
- Post 1: Why Was Bitcoin Created and Why Should I Care?
- Post 3: Bitcoin & Blockchain – Where is This Headed? Preparing Your Business.
How Bitcoin Works
Our first post in this series looked at the reasons WHY Bitcoin was created in the first place. This should act as fantastic context for understanding HOW it works. Understanding the problems Bitcoin seeks to solve through the eyes of the person who created it undoubtedly allows you to better understand its design.
So, let’s dive in and try and explain how Bitcoin behaves and acts as sound money without the need for central authority. We have split this into three main concepts that you should seek to understand to make sense of Bitcoin.
- Maintaining Financial Records – The Blockchain
An obvious question to ask when it comes to Bitcoin is:
“Without a Bank or Government maintaining financial records how do we know who owns what?”
This is of course a primary challenge that Bitcoin has to overcome if it wants to be a suitable alternative to fiat currencies without using banks and financial intermediaries. But without these institutions how is record keeping possible and how can users all agree on which transactions have taken place?
The solution to this is Bitcoin’s Blockchain. The best analogy to use here is that of a ‘ledger’. In simple terms, this is exactly what a blockchain is. Just like a ledger, the blockchain records every Bitcoin transaction that has ever happened and stores it forever in chronological order.
“OK, great. But that doesn’t fully answer the question. Who maintains this ledger?”
Well the answer to that is simple: Anyone who chooses to. Bitcoin is a permission-less system. You can download the software, run a node and keep your own copy of Bitcoin’s Blockchain on your own PC.
Which leads us to the next obvious question…
“If everyone keeps their own record of the Blockchain, how do they stay in sync? How does everyone agree on the transactions that have taken place?
Well let’s use an example here to make this easier to understand. Let’s imagine Bob has decided to send 1 BTC to Alice. Of course, both Bob and Alice are aware of this. But what about the rest of the network? Well when Bob processes his transaction he simultaneously broadcasts it across the network. Provided that the transaction is valid other nodes will eventually pick it up and add it to their own records. This enables a decentralised infrastructure that allows everyone on the network to view and agree on transaction history in real-time.
- Ensuring Secure Transactions – Cryptography
Another important function that banks play in the current financial system is that they act as custodians for our money. They hold all the keys and are there to ensure that your funds are safe, cannot be stolen and cannot be spent by anybody else.
“Without these intermediaries how does Bitcoin ensure that only I can spend my funds?”
The answer here lies in Cryptography, or more precisely ‘Public-key cryptography’. It sounds complicated, and indeed elements of cryptography are particularly specialist. But don’t worry, you don’t need to be a mathematician to understand the basic principles.
With Bitcoin, there is no bank. The onus is on you the user to ‘Be Your Own Bank’. Let’s look at how this works.
When you want to start using Bitcoin one of the first things you will need to do is download some software called a ‘Wallet’. For the sake of simplicity, let’s think of this wallet as your very own bank. Your very own bank that you can run on a smartphone. Pretty amazing really.
Now this wallet (Bank) allows you to do some amazing things. Firstly, you can create as many public addresses (Bank Accounts) as you want. Every time you create a new public address (Bank Account) you also create a mathematically linked Private Key. It might be useful to think of this Private Key as being like your PIN number. It’s essentially a secret code that allows you access to your funds. If you ever want to transfer funds from a public address (bank account) you have created you will need to sign the transaction with the private key (pin number) that is associated with it. Without this private key you cannot sign transactions and cannot spend Bitcoins in that public address.
The mathematics and cryptography involved are very clever, but you only need understand the basic premise which is: You and only you control the private key that allows you to spend Bitcoins from your public address. Just like you and only you know the PIN number to your credit card.
Just as you would never reveal your PIN to anyone, in Bitcoin you would never reveal your private key. Without the private key it is impossible for your Bitcoin to be compromised. This system is infinitely more secure than the security offered by banks which regularly get hacked and lose funds and will inevitably continue to do so. The main difference is, you are now responsible, and it requires you to get used to the idea of being responsible for your own security.
- Processing Transactions & Monetary Supply – Mining
So, we have looked at how record keeping works on a decentralised blockchain and we have explored how funds can be spent and secured. This however still leaves some unanswered questions. Questions like “Who processes these transactions?” and “How are new Bitcoins created and who controls the money supply?”
These questions can be answered by the concept of ‘Mining’. As we have discussed above, users are continuously sending transactions around the network. These transactions will of course need to be validated, processed and included in the blockchain.
“Without a 3rd party like a bank doing this processing and validation work how does the Bitcoin network achieve this?”
Bitcoin relies on ‘miners’ to validate and process transactions and include them in the blockchain. Mining is one of the trickier concepts to understand and some elements get quite complex. Fortunately, you don’t need to understand every minute detail to get the main concepts that will enable you to understand how Bitcoin works. This simple explanation should give you the basic understanding you need:
- Anyone can be a Bitcoin miner (Bitcoin mining is as permission-less as transacting in Bitcoin).
- When users sign and send new Bitcoin transactions to the network they enter something called Bitcoin’s ‘Memory Pool’. This is simply a pool of all transactions that are yet to be confirmed and added to the blockchain.
- Miners around the world use their computing power to enter a ‘race’ to solve a cryptographic equation that is issued by Bitcoin’s protocol.
- The miner who wins the race and solves the problem first effectively ‘solves’ the next Bitcoin block. As part of this process the miner validates and processes unconfirmed transactions from the ‘Memory Pool’ and includes them in the next block.
- The miners don’t do this work for free. They are incentivised by the Bitcoin protocol. A miner who successfully mines a block automatically receives a Bitcoin reward. Coincidentally, these rewards are how new Bitcoins are created and issued.
- The race starts over. The next block is solved, miners validate and process more unconfirmed transactions from the ‘Memory Pool’ and include them in the next block. Wash, rinse, repeat.
Mining is a fantastic example of well designed economic incentives and game theory. No one single institution is responsible for processing transactions, miners cannot censor transactions and everything happening on the network is transparent ensuring all parties validate the actions of all other parties. It’s quite a remarkable creation.
Interestingly, the process of mining on the Bitcoin network allows us to predict the inflation rate of Bitcoin with astonishing accuracy. The Bitcoin protocol aims to add a new block of transactions to the blockchain every ten minutes. As we know this, and we know the block reward offered to miners for solving a block we can accurately predict the total supply of Bitcoins centuries into the future. This cannot be achieved with traditional currencies.
Important Concepts to Consider:
Taking you through the three concepts above should have greatly improved your understanding of how Bitcoin operates. Having said that, it undoubtedly leaves you with more questions than answers. This is quite natural for someone beginning to investigate Bitcoin and other digital currencies. This new asset lives somewhere at the intersection of technology, game theory and economics and challenges conventional wisdom in all three. To help address the typical questions raised by newcomers to Bitcoin we have pointed to some more important concepts at the heart of how Bitcoin works:
- Bitcoin has a ‘hard cap’ of 21 million Bitcoins. There will never be more in existence. The reward miners receive for solving a block will halve every 4 years until there is a total of 21m BTC in circulation, giving us perfectly predictable supply. But that doesn’t seem to be enough for global commerce, right? It’s a strange concept at first but consider that Bitcoin, being digital, is divisible to 8 decimal places. With that in mind it is easer to understand that ’21 million’ is really an arbitrary figure. If the cap was 10 million you would still be able to send 0.0000000…. Bitcoin to make a small value purchase.
- The inflation rate of Bitcoin is entirely predictable. New money supply is not controlled by any one entity but rather by the Bitcoin protocol and the rate at which it rewards miners on the network. No one authority can change this protocol to suit themselves. We can determine what the inflation rate will be many years from now. Compare this to fiat currencies where the inflation rate and issuance of new money into the economy is entirely unpredictable and the power to wield this influence is concentrated amongst the financial ‘elite’.
- Bitcoin transactions cannot be censored. Bitcoin cannot be controlled, and the network is large enough now to be unable to be co-opted by any one entity no matter how powerful. Bitcoin is considered ‘anti-fragile’. You will often hear arguments that Bitcoin will be regulated into oblivion or that it will be ‘banned’ or destroyed and so on. Please understand that these arguments are not made with any significant understanding of Bitcoin. Bitcoin has a precise set of rules, at a protocol level, that no single party has the authority to change. Bitcoin’s protocol will continue to operate as intended despite the whims of any powerful entity. Banning Bitcoin is likely to be as successful as banning file sharing.
- Bitcoin is programmable money. This holds a lot of implications that we don’t have time to explore here. What it means is that you can create entirely new types of transactions, smart contracts and micro transactions that will allow new types of commerce that we have yet to observe in traditional markets.
Look at the image below to see how Bitcoin compares to fiat currencies and precious metals in terms of having the traits of ‘Good Money’:
The aim of this series of blog posts is not to convince you of the merits of Bitcoin but rather to correctly position this technology so that you may better understand it. The best way to do that is to compare it to fiat currencies and highlight the differences. Some of the concepts explained here are completely new both to computer science and economics and the technology is still advancing and changing. This can make it tricky to wrap your head around. Hopefully this simplified explanation goes some way to demystifying what exactly has so many people excited about it.
This is the second post in our three-part series. If you missed the first post or you’re ready to move on to the final post you can find the links below:
- Why Was Bitcoin Created and Why Should I Care?
- Bitcoin & Blockchain – Where is This Headed? Preparing Your Business.
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