How Bitcoin Works — Explained in 5 Minutes

Sania Khan
Dec 18, 2019 · 8 min read
Image for post
Image for post

At some point, the world will be at one financial infrastructure. In 2008, the U.S. economy collapsed and the rest of the world saw the same downward shift. Our economies are already linked and the economy is global. Bitcoin could very well be that solution for a single financial infrastructure. It is currently still in an experimental stage — year eleven of a global experiment but it seems to be working.

Bitcoin and cryptocurrencies make sense in a global sense. In the U.S., people trust the banking system and the payment system. However, in countries such as Argentina, Venezuela and India, inflation is extremely volatile and inefficient. What if currency wasn’t structured in this centralized way — where the government gets to print as much as it wants and the people fall victim to whatever their government decides — and instead, people can choose something that has been built for and by the people which allows you to hold your own money. Bitcoin is figuring out how to replace your bank with the ability to be empowered by owning your money.

For example in 2013, Cyprus’ bank depositors were forced to help pay for a eurozone rescue. Account holders at Bank of Cyprus lost almost half their money above the €100,000 level, receiving stock in the bank as compensation, and with capital controls — restrictions on withdrawals and transfers out of the country — people were prevented from taking their money out of Cyprus. The economy shrank 10% during the two years that capital controls were imposed.

In 2015, Greece experienced a slow motion bank run. Households and businesses withdrew a quarter of deposits, or €40 billion, from banks in the first half of 2015. In June 2015, Greece also imposed capital controls which prevented a collapse in the banking system but overall lost about €120 billion in deposits, or about half the total, compared with peak levels in 2008. Cryptocurrency allows you to be in control of your money.

Before we begin, let’s step back to the system that we generally take for granted — paper money or coins printed by the U.S. Mint on behest of the U.S. Treasury on behalf of the U.S. government. The one, five, 10, 20 and 100 bills are fairly new. Prior to the creation of the Federal Reserve, local banks were printing their own currency. During the civil war, there were 8,000 different currencies in circulation backed by gold stored at each bank. The Federal Reserve originally backed paper money with gold but then moved to fiat currency, where there was no longer a gold standard but rather value is maintained because the parties engaged in the exchange agree on its value.

Fiat currency has led to the possibility of bitcoin, which is legitimate and is valued at approximately $41 billion. The system, theory and practice behind it are all sound. The root of creating a new currency is just having enough people believing and saying that it’s currency. And then it’s currency. Right now, there are enough people buying and selling bitcoin, speculating and using bitcoins as a trade, that gives it its value. There are enough people out there accepting bitcoin that also gives it value.

Interestingly enough, the world’s first entirely digital, decentralized currency has a great origin story — no one knows who started it. In 2008, a mysterious pseudonym of Satoshi Nakamoto created the first blockchain database and authored a bitcoin white paper describing what bitcoin was, how it worked, and minted the first 50 bitcoins themselves. It was a ground breaking document because they solved a long standing problem that prevented digital currency to be established. The solution was an open peer to peer produced ledger which prevented anyone from copying and pasting the code that makes up your digital currency and using it again and again. The ledger must be kept by someone you trust and what bitcoin did was make the ledger entirely public so that everyone is working on the ledger. Keeping track of the ledger and the transfers of bitcoin from whom to whom, and mining new coins is done by everyone. So if you are part of the bitcoin network, you are also the authority on issuing it. It sounds very complex, until you break it down.

What is Bitcoin?

Bitcoin is virtual money that you can now use online to buy and sell things. There are a number of retailers who are accepting it, not just the deep web. There are even go in between companies that convert bitcoins into real dollars. If you want to buy things anonymously, you can use bitcoin, as a stand-in for cash. Or if you feel more comfortable after the financial crash, you can use bitcoin for safety net reasons as well.

How do you participate?

1. Buy

You can buy bitcoins with your credit card and use them to shop. You can use your bank account or use cash with a money gram type of service.

a. You set up your wallet — a digital account. The wallet is a software program.

b. Buy bitcoins, from a central currency exchange (e.g. coinbase) and bitcoins appear in your account. Use bitcoins to shop.

For example, overseas purchases through paypal can get very expensive. Bitcoin has no central authority so there’s no bank you are dealing with and therefore, no excessive fees charged.

Mt. Gox was a Tokyo-based cryptocurrency exchange that operated from 2010–2014, and was responsible for more than 70% of bitcoin transactions at its peak. The Mt. Gox hack infamously became the first major cryptocurrency exchange hack, with the hacked value of $460 million worth of bitcoin at the time. People who had kept their bitcoins in the Mt. Gox exchange, lost them.

2. Speculate

a. Buy and sell bitcoin, just like a stock.

The Winklevoss twins have $631m worth of bitcoin, and have made their money buying/ selling/ speculating on bitcoin.

3. Participate/ Mine

a. Since bitcoin is a peer to peer network, you can mine bitcoins. Similar to Skype or BitTorrent, there is no centralized mainframe and the entire functionality operates on the computers of the people who are part of the bitcoin network. Mining is essentially creating coins.

How does the bitcoin network function?

1. Transactions are released in 10 minute blocks. Every 10 minutes, 12.5 coins are released. A block is a group of transactions across the bitcoin network. A group of people team up to handle these transactions, similar to how American Express pays someone to handle their transactions.

2. The block is a math problem for a computer to work out. Everyone on the network gets the same block, and whoever completes the math problem is able to get the newly minted bitcoins, or the “reward.”

3. The block is a group of transactions and these transactions are written down in the ledger (e.g. what coin got transferred to what person). Those are usually the fees that you are paying Amex for. These transactions are encrypted and that block is a difficult math problem. This peer to peer ledger, where all computers check each other’s work, is a blockchain.

There are diminishing returns — every four years, the coins per block are cut in half. In 2008, the reward started with 50 coins, then was cut to 25 coins in 2012 and since 2017, the reward has been 12.5 coins. In addition, math problems have become increasingly more difficult. You can still make money mining but due to diminishing returns, it takes a lot more computing power for a relatively lower reward. Usually people team up with others and share the 12.5 coins due to the increasing computing power needed.

The innovation behind this solution is that mining allows for three important things:

1. Satisfies transactions — everyone works together in a big group to make sure the transactions are good, and keeps the ledger up to date.

2. Releases more money into the system — coins are released over the years and the steady rise in bitcoins prevents central banks to flood the market to devalue what’s out there. The last bitcoin will be mined in 2140, at which time there will be 21 million bitcoins in existence.

3. Keeps the system secure — using the peer to peer network, the system checks differences in the ledger and makes sure all transactions match. When a computer finds the solution of the math problem that unlocks that block, it is shared with every other computer in the network to verify that this ledger is accurate. Transfer of bitcoins and transactions can take a long time because it goes across the entire network.

Things to watch out for:

1. Converting bitcoins into real cash (e.g. bitspin and bitpay) can be dangerous and not secure. Hackers have been successful getting into this area (e.g. Mt. Gox). These currency exchanges are not banks and therefore a bad place to keep your virtual currency. Because this is a decentralized system, anywhere where people have stored bitcoins is a target for hackers. If the currency exchange goes under, your bitcoins will also.

2. You want a physically removable backup of the bitcoin wallet or account (e.g. flash drive, removable hard drive, etc.). In case your currency exchange platform goes under or computer crashes, it’s important to have an account of your bitcoins for ownership records.

3. Very wide fluctuation in prices so speculators can gain the system — it lost more than half its value after surging 2000% in just 12 months to a record high of above $19,000 in December 2017. The U.S. government is trying to get coordinated in its efforts to regulate Bitcoin. Historically, non-government issued currencies haven’t been allowed to exist. Bitcoin can be seen helping the economy thrive with economic growth — not competitive to the U.S. dollar but competitive with the U.S. banking system.

4. The “deep web” is not accessible to just anyone — you must have a Tor special software to access it but it allows you to be entirely anonymous on the internet. Unfortunately, drug dealers, hitmen, kidnappers, robbers, arsonists and tax avoidance schemers are all here and paying using bitcoins. All of this would not be possible if it were not for bitcoin.

5. The Bitcoin market is extremely liquid now. If you want to sell at market price, and if you put in a sell order, there will be a buyer. The market size of cryptocurrencies was $200m 6 years ago, and now approximately $850b. It is projected to display robust growth of 11.9% from 2019–2024.

Conclusion

History doesn’t repeat itself but it does rhyme. Bitcoin feels similar to the internet bubble of 2000, where there was something valid but it was early. Many of those pre-bubble companies are no longer around which is a risk that could also happen with many cryptocurrencies. There will be a boom and bust cycle. Only the major stable players would survive, which isn’t necessarily a bad thing.

There is a lot of demand of this new asset class, and it would supply the world with a new freedom. However, there will be friction and overcoming roadblocks of whether bitcoin provides enough value or promise. Scaling problems will potentially be solved over time. We will need transactions to be valuable to people rather than speculative, and that is slowly starting to happen. It’s an exciting time and there are a lot of unknowns but we are at the beginning stages of seeing how blockchain works.

References

Greece: A Case Study in Capital Controls. The Wall Street Journal. June 15, 2017.

How Bitcoin Works. Stuff You Should Know Podcast. June 17, 2013.

Primer on Crypto and Blockchain. Inspired Money with Andy Wang. March 20, 2018.

The Startup

Medium's largest active publication, followed by +730K people. Follow to join our community.

Medium is an open platform where 170 million readers come to find insightful and dynamic thinking. Here, expert and undiscovered voices alike dive into the heart of any topic and bring new ideas to the surface. Learn more

Follow the writers, publications, and topics that matter to you, and you’ll see them on your homepage and in your inbox. Explore

If you have a story to tell, knowledge to share, or a perspective to offer — welcome home. It’s easy and free to post your thinking on any topic. Write on Medium

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store