Bitcoin in Brief
Bitcoin is frequently described as a “digital currency.” While that description is accurate, it can be misleading as it is both too broad and too narrow. It is too broad because Bitcoin is a very particular kind of digital currency called a cryptocurrency (indeed, it is the first of its kind). On the other hand it is too narrow because although currency is one aspect of the Bitcoin system, Bitcoin is more broadly an Internet protocol with many applications beyond payments or money transfer, such as recording property titles and authenticating documents. Bitcoin’s unique peer-to-peer properties allow it to simultaneously serve as a currency and a distributed ledger system.
Virtual or digital currencies are nothing new. From in-game currencies, like World of Warcraft Gold or Linden Dollars, to vendor-specific currencies like Facebook Credits, Microsoft Points, or even airline miles, digital currencies have been around for well over a decade. Even the dollars in one’s PayPal account are essentially digital currency. Bitcoin is unique from the digital currencies that preceded it because it does not require a central authority, such as a company or government, to issue bitcoins or verify transfers between individuals. Instead, Bitcoin employs secure communication techniques (cryptography) and peer-to-peer networking to eliminate the need for third parties. Comparing Bitcoin to traditional payments and money transfer systems helps explain the distinction.
Before the introduction of the Bitcoin system in 2009, online transactions always required a trusted third-party intermediary. For example, if Alice wanted to send $100 to Bob over the Internet, she would have had to rely on a third-party service like PayPal or MasterCard. Intermediaries like PayPal keep a ledger of account holders’ balances. When Alice sends Bob $100, PayPal deducts the amount from her account and adds it to Bob’s account.
Without such intermediaries, digital money could be spent twice. Imagine there are no intermediaries with ledgers, and digital cash is simply a computer file, just as digital documents, such as photos or Word documents are computer files. Alice could send $100 to Bob by attaching a money file to a message. But just as with email, sending an attachment does not remove it from one’s computer. Alice would retain a perfect copy of the money file after she had sent it. She could then easily send the same $100 to Charlie. In computer science, this is known as the “double-spending” problem. Until Bitcoin, it could only be solved by employing a ledger-keeping trusted third party.
Bitcoin’s invention is revolutionary because for the first time the double-spending problem can be solved without the need for a third party. Bitcoin does this by distributing the necessary ledger among all the users of the system through a peer-to-peer network. Every transaction that occurs in the Bitcoin network is registered in a distributed public ledger called the “block chain.” New transactions are checked against the block chain to ensure that the same bitcoins have not been previously spent, thus eliminating the double-spending problem. The global peer-to-peer network, composed of thousands of users, takes the place of an intermediary; Alice and Bob can transact online without PayPal.
Transactions are verified and secured through the clever use of public-key cryptography. Public-key cryptography requires that each user be assigned two “keys,” one private key that is kept secret like a password, and one public key that can be shared with the world. The mathematical relationship between a given public key and the corresponding private key allows users to verify bitcoin ownership (that is, that the owner holds the private key) by simply checking a public key using the Bitcoin software. Let’s say Alice wants to transfer one bitcoin to Bob. She creates a message to the network, called a “transaction,” stating that she would like to transfer 1 BTC from her public address to Bob’s public address. She then “signs” it with her private key and broadcasts the message over the network. By looking at Alice’s public key, anyone can verify that the transaction was indeed signed with her private key, that it is an authentic exchange, and that Bob is the new owner of the funds. The transaction—and thus the transfer of ownership of the bitcoins—is recorded, time-stamped, and displayed in one “block” of the block chain by a network of voluntary “miners” that contribute their computer’s processing power to the system. This process ensures that all computers in the network have a verified record of all transactions within the Bitcoin network that is updated by miners roughly every ten minutes.
Transactions on the Bitcoin network are not denominated in dollars or any other country’s currency as they are on PayPal, but are instead denominated in bitcoins. This makes Bitcoin a virtual currency in addition to a decentralized public ledger. The value of the currency is not derived from gold or government fiat, but from the value that people assign to it. The dollar value of a bitcoin is determined on an open market, just like the exchange rate between different world currencies. The number of bitcoins that are issued—that is, the size of the money supply—is not determined by any person, company, or central bank, but instead grows at an algorithmically pre-determined rate baked into the protocol.
For these reasons, Bitcoin is unlike any digital currency that preceded it. Bitcoin is not just a virtual unit of account, but also a decentralized system for transferring value. It is a cryptocurrency, which means that a central authority does not issue the currency nor verify its transactions. Transactions are instead recorded in a decentralized and distributed public ledger and are cryptographically verifiable. Bitcoin was the world’s first cryptocurrency, and since its invention other cryptocurrencies have emulated its model.
Several coins also popped out of this innovation called Altcoins. Compumatrix for example created a virtual currency called Compuceeds which has taken into account not to repeat inherent flaws of Bitcoin. It may still be based on Bitcoin but it doesn’t require users to spend too much energy or electricity to produce it, it is non-volatile in value since the community agrees to respect a base rate, and it has chosen not to make the Compumatrix blockchain public. How this becomes an advantage will be posted on my next article.