Alternative Payments: What is Bitcoin and How Does it Work?
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Bitcoin is an electronic currency and payment system based on cryptographic algorithms to enable secure and irreversible direct transactions between parties. It is different from other currencies as it is fully decentralized and does not rely on a central issuer. This means it is not backed by a country or government as conventional currencies are.
Bitcoin was first introduced in 2008 by Satoshi Nakamoto’s Whitepaper: “Bitcoin: A Peer-to-Peer Electronic Cash System”. He also developed the first version of the open source Bitcoin client which was used to start the Bitcoin Network in 2009. Bitcoin is not the first concept of a digital currency based on an asymmetric cryptographic algorithm but it is the first real-world proof of concept of that idea on a large scale.
How does it work?
The Bitcoin network is created by a peer-to-peer (public key infrastructure and uses digital signatures to verify transactions. Using the Bitcoin software, users can generate asymmetric key pairs: a private key that he has to be kept secret and a public key that can be shared. The public part of the key pair is used as the Bitcoin address. Bitcoins (abbrev. BTC) are transferred between these Bitcoin addresses.
A Bitcoin transaction consists of the senders address, the receivers address, and of course the amount of Bitcoins. The sending party signs the transaction with its private key. The transaction is then broadcast to all nodes of the Bitcoin Network. Due to the asymmetric encryption every Bitcoin client can easily verify the transaction but only the user that has access to the private part of the key can create a valid transaction for that Bitcoin address.
This means that only the user that has access to the private key of a Bitcoin address has access to the amount of Bitcoins assigned to that address. The key pairs are stored in the so-called Bitcoin Wallet. A loss of the Bitcoin Wallet (and thus the private keys) results in a loss of the assigned Bitcoins – as would be the case with a real wallet.
The Bitcoin block chain
Bitcoin clients collect and store valid transactions into blocks. A block contains all valid transactions that have not yet been stored and a reference to its predecessor block. Because of the reference to the prior block, the collection of all blocks forms the Bitcoin block chain which is distributed to all clients in the network.
To create a valid block it has to be signed with the solution to a mathematical difficult problem. The problem is a proof-of-work system that confirms transactions and prevents double spending. An attacker could only change the transaction history if he has more computation power that the rest of the Bitcoin network.
Each block generates a certain amount of Bitcoins as a reward for the client that solves the problem and creates the block. The process of competing to solve the current block is called Bitcoin Mining. The difficulty of the problem is adjusted by the network so that on average a block is generated every 10 minutes.
Wrap-up
Bitcoin information portal weusecoins has created a nice video explaining Bitcoin. Enjoy!
bitcoin charts
Bitcoin is really a relatively new project under active development. As such, its developers caution that users must treat it as experimental software.