How Bitcoin works: An introduction to cryptocurrency

• July 20, 2014
• General

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Bitcoin is currently at the stage in its development where you won’t find people who have never heard of it, but very few know much about it. In fact, it is one of several digital currencies that are based on complex cryptographic methods. We’ll glaze over those methods for simplicity’s sake so you can figure out how Bitcoin works.

Another thing to note is that there are now several “copycat” or otherwise similar digital currencies to Bitcoin, collectively known as cryptocurrencies. These are known as such because they use cryptography to make an all-digital currency viable in terms of its security. While each has its differences, this introduction will teach you enough that you’ll be well on your way to understanding how other cryptocurrencies work as well.

The absolute basics

Before we delve into the little bit of detail that we’ll get to shortly, I want to give an even more basic outline. In some ways, Bitcoin could end up feeling not that different from PayPal or your credit card when making purchases online. You’ll have some bitcoin, there will be a price of a good or service, you’ll send that much bitcoin to the vendor.

The most obvious difference is that your online purchase wouldn’t be a digitized version of an exchange of bills and/or coins. The “real” currency is what you are exchanging, rather than arranging for a middle man such as PayPal or your credit card company to make the exchange for you.

With Bitcoin, you can’t go to the bank to withdraw your bitcoins. Now, you could _ex_change your bitcoins for US Dollars or another currency, but in that case you would no longer own bitcoins but rather you would have sold them for “fiat money,” ie. regular money. Some merchants that have recently started accepting Bitcoin like Expedia are using a service that automatically converts the received bitcoins into USD, much like they would do if they accepted Canadian Dollars as payment.

This brings us to another one of the most basic things to know about Bitcoin: nobody “owns” it. There is no chief regulator nor is there a business behind it. It is basically a protocol that was considered attractive enough that people adopted it and its existence is now predicated on the millions of people that use it. It is decentralized, like the Internet. The Internet isn’t a place and nobody owns it. It only exists due to the billions of computers that want to communicate with one another.

How do you impersonate someone? You steal their Bitcoin wallet credentials. A wallet is, as you would think, the “place” you keep your money. Each wallet has at least one address, which is a string of letters and numbers that will appear random at first glance. The way you use the wallet is by proving that it belongs to you by providing a private key, which is basically a very strong password that you do not get to choose yourself. This is because your private key is mathematically related to the wallet address.

The brilliance behind the cryptography here is that while your private key is mathematically related to the wallet address, you cannot learn the private key just by knowing the wallet address, which is public. On the other hand, the private key can be used to reproduce all of the wallet addresses associated with it if you were to forget it for some reason. When applying a signature, as I mentioned earlier, you are appending a signal to your Bitcoin transaction that the proper private key was used to authorize the transfer of funds.

What is the challenge related to theft, then? One of the benefits of Bitcoin is that you do not need to associate your real-life identity with your wallet(s). True anonymity is unlikely, at least if you ever plan to exchange to USD or use Bitcoin to have something sent to you, but there is no formal process of verifying a person’s identity and attaching it to their Bitcoin wallets. This is why you can create a theoretically limitless amount of wallets and wallet addresses without any issue.

However, that means that the private key is the sole factor in determining access to a given wallet. If the private key is stolen, the victim has no more ability to use the funds than the thief does. A thief will immediately transfer the bitcoins to a different account before the victim will realize what happened. A pickpocket wouldn’t walk around with their hand in your pocket, would they?

We will certainly see businesses pop up that will insure users against theft and loss by tying real-life identities to accounts. Perhaps we’ll even see these businesses put a waiting period on transactions to enable a chargeback-like feature. Of course, when business get into control of the currency, the key advantages of low fees and decentralization are lost.

Look for future articles from us on how to stay secure when using Bitcoin.

Other resources to learn about Bitcoin

Still don’t get it? I understand. This is complicated stuff. Here are some great resources to learn about Bitcoin.

• Infographic about how a Bitcoin transaction works
• CoinDesk’s Beginner’s Guide to Bitcoin
• Bitcoin.org
• Bitcoin Wiki

Have another good idea for a resource to add to the list? Let us know in the comments!

• bitcoin
• cryptocurrency
• cryptography
• finance
• money
• privacy
• security

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