Bitcoin Basics: Understanding what are Bitcoins, a Payment Solution, Currency, or Both?

In our second installment of ‘Bitcoin Basics’ we answer the question of “What are Bitcoins?” Invented by Satoshi Nakamoto in

In our second installment of ‘Bitcoin Basics’ we answer the question of “What are Bitcoins?”

Invented by Satoshi Nakamoto in 2008 and going live in 2009, bitcoins are a peer to peer (P2P) electronic payment system (you can read Nakamoto’s founding white paper here: Bitcoin: A Peer-to-Peer Electronic Cash System).  When creating bitcoins, Nakamoto envisioned a P2P network that was based on an electronic currency that would work without the need of a financial intermediary.  His goal was to find a way to remove the middleman firms from internet based transactions as they increased costs.  In his opinion, financial intermediaries of payment transfers only existed to provide a ‘trusted third party” to process payments (think banks processing checks and credit card networks handling consumer and merchant transactions.  Therefore, if you could provide a direct P2P transfer system that could be trusted, it would remove the need of a third party and the additional costs.

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Nakamoto wasn’t the first to attempt to provide a digital currency solution, but his innovation was the creation of the trusted network.  The problem with any digital good is its ability to be copied and sent to multiple parties.  With money, that doesn’t work so well since a digital currency could be spent twice.

Enter the Blockchain

To provide a solution, Nakamoto created a universal accounting ledger called the blockchain and bitcoins as the digital currency as the payment type used on the blockchain.  Using the blockchain, all bitcoin payments are reported onto this universal ledger that verifies that one user hasn’t spent his/her digital currency twice.

When new bitcoins are created, each unit of currency has its own identifying numeric number.  Also, each user has a unique bitcoin address of which bitcoins are attributed to.  Therefore, you can have Bitcoin #123 owned by wallet ABC.  When owner ABC sends bitcoin #123 to DEF, the transaction is sent to the blockchain for verification which then enters in the ledger that bitcoin #123 is owned by DEF.   IF ABC  tries to send the same bitcoins again, the universal ledger rejects the transaction. (More on identification below)

Who Runs the Blockchain Ledger?

So, you are probably thinking that this blockchain is the “trusted third party” that Nakamoto didn’t want to have.  Well, yes and no.  The blockchain isn’t owned or managed by any one entity, but is powered by volunteered computer power from multiple computer sources.  These sources jointly host and run the ledger on their computers and verify new transactions around every ten minutes.

To provide an incentive, Nakamoto created the bitcoin system which rewards the network source which solves a cryptographic mathematical problem.  Called bitcoin miners, these are the people that provide the networking power to maintain the blockchain ledger and receive new bitcoins.  According to the formula, a total of 21 million bitcoins will be dispersed over a period of every 10 minutes until 2140. However, as time passes, the rate of bitcoin creation slows, with every four years the amount decreasing by 50 percent.

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The total result is a decentralized ‘central’ blockchain that verifies also transactions but isn’t controlled by any single entity.  The blockchain also provides a method for issuing new bitcoins into circulation.

Identity

As mentioned above, each user and bitcoin is identified on the bitcoin network. Explaining more in-depth what we wrote earlier, when the blockchain creates new currency, each bitcoin is issued its own identifier string. Users on the other hand aren’t ID’d on the block chain. Rather than individuals being recorded on the block chain, users create bitcoin wallets, with each one having its own identifier alphanumeric string. Wallets are free and easy to create, and are available as downloadable products, mobile apps, or cloud based.

To receive bitcoins, users send each other their wallet address. In the sender’s wallet, they enter the receiver’s wallet ID, and amount of bitcoins to send. The transaction is sent to the block chain, and within 10 minutes becomes confirmed. At that point the payment becomes irreversible.

For a visual look, our Bitcoin Basics partners at 99Bitcoins put together this great illustrative video

Makes Sense?

The reality is that like any new technology, it takes a bit of using it to fully grasp the idea.  In bitcoin’s case, we are talking about a replacement for money, where everyone understands cash, and most people are familiar with credit cards.  Therefore, coming up with a new payment system means one has to believe in alternatives to what they are doing now.

But just like making a wire transfer or paying PayPal for the first time, when it comes to bitcoinThe best way to learn about bitcoins is to try them out.  You don’t have to fork down hundreds of dollars to buy a whole bitcoin, and can buy them in fractions.  When you are ready, learn where and how to buy them here.

 

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