How
does Bitcoin (BTC) work?
·
There are three types
of people in this world:
the producer, the consumer,
and the middleman.
· If we want to sell a book on Amazon, we must pay a big 40-50% fee.
This is the same in almost every industry! The middleman
always takes a big part of the producer’s money.
To understand how does
Bitcoin work, it's important to know why it was created.
Bitcoin was invented to remove one type of middleman — the banks. If we need to transfer $5000 from my
country to friend in the United Kingdom, the money must go through a bank in my
country. They take a fee for processing. Once the money reaches the bank in the
UK, friend’s bank charges a fee, too.
It is not just the fees that are the problem, it’s the data they store.
Banks store lots of private data about their customers. Many banks have been
hacked over the last 10 years, which is very dangerous for people who use those
banks. This is why it is important to understand how does Bitcoin work.
Unlike Bitcoin, banks can freeze/block peoples’ accounts whenever
they want. They have too much control over the people that use the banks, and they have abused their power.
Banks played a big role in the financial crisis of 2008, too. Bitcoin started in 2009,
just after that crisis. Many people believe
that the crisis was one of the reasons for creating Bitcoin.
The solution was to build a
system that has no single authority (like a bank). A single authority shouldn’t be given the power to control people. The banks
and the governments controlled the currencies, so a new currency had to be created.
Bitcoin is the solution: it has no single authority. That means no banks, no
PayPal, no government to be able to tell the bank to freeze your account. It’s great, right? The question on everybody’s mind
now must be ‘how does bitcoin work?’.
How Bitcoin Works?
The
creator of Bitcoin made three main concepts for Bitcoin that
are essential in understanding the principles of Bitcoin:
- Cryptography
- Supply and Demand
- Decentralized Networks
Decentralized Networks
·
When
you go to your internet browser and type in ‘www.google.com’, your
computer starts a conversation with Google’s computers. Then,
both computers start talking to each other and your browser shows images,
buttons, etc. If Google’s
servers were down for some reason, you wouldn’t
be able to see these images and buttons. This is because the data is stored on
a centralized network — it’s
in one place.
·
To understand how Bitcoin works, it's essential to figure out what's a decentralized network.
In a decentralized network,
the data is everywhere. If Google used a
decentralized network, you would still be able to see the data, because it is
everywhere, and not just in one place. This
means that Google would never go offline!
Cryptography
·
In World War II, cryptography was used
a lot. It converted radio messages into code that nobody could read. To read
it, you would need to convert back to the original message. To do that, you
needed a key. It was possible through mathematical
formulas!
·
Bitcoin
uses cryptography in the same way. Instead
of converting radio messages, Bitcoin uses cryptography to convert transaction data. That is
why Bitcoin is called a cryptocurrency. Knowing that takes you one step closer to understanding how
does Bitcoin work.
·
Bitcoin does this
using the blockchain. Bitcoin’s creator invented the blockchain
technology!
Supply
and Demand
·
Last week, when John visited
the bakery, only one cake was left. Four other people wanted it, too. Normally,
the cake only costs $2. But because 4 other people wanted the cake, he had to
pay $10 for it.
·
This is the main concept
of supply and demand:
when something is limited, it has more value.
The more people that want it, the more the price of it will go up.
Bitcoin uses this
same concept. The supply of Bitcoin is limited.
Bitcoin is produced at a fixed rate, which will decrease
over time — it halves every four years. Bitcoin
has a limit of 21 million coins; once there are 21 million Bitcoins, no more
coins can be created. How many Bitcoins are there at the
moment? Well, currently (27.07.20), there are 18.5
million Bitcoins created. We've
still got a long, long way to go before it reaches 21 million!
Bitcoin transactions are
grouped together and stored in blocks. These blocks are linked back
to one another in a series. This is why it is
called a blockchain.
Transaction in the block has a public key written on it.
If it is my Bitcoin, it will
be my private key that is written on it. Because each block is connected to the
block before it, no Bitcoin can be spent twice.
How does Bitcoin work with some real-life examples?
If someone tried to send the same Bitcoin
twice, this is what would happen:
1. Mr. Aakash sends Mr. Rajesh a Bitcoin;
2. The transaction is stored in a block on the blockchain;
3. The next day, Mr. Aakash tries to send the same Bitcoin to someone else;
4. The Bitcoin transaction goes into the
current block on the blockchain;
5. The computers running the blockchain check the last block that the Bitcoin was used in;
6. In the last block that the Bitcoin was used in, the transaction says that the
Bitcoin was sent to Mr. Rajesh’s public key.
Can Someone Fake My
Identity?
When you
create a Bitcoin wallet (to
store your Bitcoin), you receive a public key and a private key.
Public keys and private keys are a set of long numbers and letters; they are like your username and password.
Both are very
important for truly understanding how does Bitcoin
work.
People
need your public key if
they want to send money to you. Because it is just a set of numbers and digits,
nobody needs to know your name or email address, etc. This makes Bitcoin users anonymous!
As for your private
key, you should never let anyone see it. On the blockchain,
your private key is your
identity. You use your private key to access your Bitcoin. If
someone sees it, they can steal all your Bitcoin — so be very careful!
What If
Someone Tries to Tamper the Blocks?
If
someone tries to change the transaction data in one of the blocks, it will only
change it on their own version, just like a Microsoft Word document that’s stored on your computer.
This is
one of the key elements of how does Bitcoin work. To make the change go onto
the shared database so that it’s on everybody’s
version, they will need to control 51%
of the computers in the network.
What If
Someone Controls 51% of the Computers In the Network?
This is
technically possible, but it is near
impossible to achieve. Even if someone hacked 51% of the
computers in the network (also
known as nodes), there is another layer of security that gets in
their way.
To add
new blocks to the blockchain, they must be mined. This process is called mining because
the nodes that do it are rewarded with Bitcoin — like gold miners being rewarded with gold.
In
mining, the nodes must process Bitcoin transactions and verify that they are
real. To do this, they must solve a mathematical problem. When the problem is
solved, the block of transactions is verified, and a new block is created. Each
block has a new problem and a new solution for miners to find.
The
Advantages of Bitcoin
✓ International payments are a lot faster than banks;
✓ Fees are low;
✓ Blockchain — near impossible to hack;
✓ Decentralized — cannot be shut down at a single point;
✓ Transparent — you don’t have to trust anyone;
✓ Anonymous — you don’t need to use your name;
✓ Powered by the community — the fees are shared instead of
going to a single point (i.e. a
bank or PayPal);
✓ No verification for new users — anyone can use it.
The
Disadvantages of Bitcoin
✗ Mining uses lots of electricity;
✗ Not as fast as other cryptocurrencies;
✗ Fees change a lot;
✗ Anonymous — used for crime;
✗ Difficult to use — private keys, public keys, etc.