Category Archives: Understanding

Understanding Bitcoin Mining Difficulty

You have probably heard of the term ‘”mining difficulty”, and perhaps you’ve encountered the terms pool difficulty and network difficulty. Perhaps you are a bit confused as to what these terms mean and why the pool difficulty always seems to be so much lower than the network difficulty.

You may even wonder why on earth anyone would want to increase their pool difficulty voluntarily? Well, if you want to learn about these topics, you’ve come to the right article.

I’m going to simplify several aspects of this explanation to make it as easy to understand as possible without compromising the core idea.

What is Mining Difficulty?

Bitcoin and its related cryptocurrencies have an amazing ability for self-balance. You’ll see this throughout the system, but one place where you see it often is in the mining difficulty. The mining difficulty determines how difficult it is to solve a block, but that may not tell you much so I’ll try to elaborate on what that means.

I’ll have to be a bit technical, though, but I’ll try to keep it simple.

Mining is the process of trying to find a hash value for a block of transactions. You need to understand what this means to understand mining difficulty.

Building and Solving Blocks

When a miner starts running, it will wait for new transactions in the Bitcoin network. It will then add those transactions into a block of data. Every miner does this, although for pools, the pool will accept the transactions and build the block for you.

Example: Alice sends Bobs 1฿, which she does through her wallet by signing a transaction using her private key. She then broadcasts that transaction to the network, and as soon as the transaction has propagated through the miners in the network, Bob will see that there is an incoming transaction of 1฿ coming to his wallet.

However, the transaction will still be unconfirmed, it has simply been added to the blocks that miners will try to solve.

Miners will continuously try to solve this block of data. The process of solving is a cryptographical task which involves generating a hash for the block. For Bitcoin and several other cryptocoins, the hash algorithm used is SHA-256, and for Litecoin and Novacoin, the algorithm is Scrypt.

A hash is essentially a checksum that is unique for the underlying data (the data is called the message) so that if the message changes, so does the checksum. For example, you can have a hash value for a file or document (the message), and because the hash will be unique for the message, you can verify that the message has not been modified since the hash was generated. If someone tampered with the message, the checksum will change too.

The benefit of a hash is that it is impossible to predict what it will be in advance without actually performing the computations to generate the hash. However, it is very easy to verify that a hash belongs to a message, simply by repeating the hashing computation and seeing that the results are the same.

Solving a block means that the miners try to find a hash value for the current block of transactions that is below a certain limit. This limit is determined by the current difficulty of the Bitcoin network. The higher the difficulty, the lower the hash value must be.

Because it is impossible to predict the result of a hashing computation without doing the computation, the only way to find a hash that has a value below a certain limit is thus to perform a lot of hashing computations.

So,” you ask, “hashing is fine, but if the block or message does not change unless new transactions come in, why would a miner need to generate thousands or millions or billions of hashes? Wouldn’t the hash always remain the same?

Great question! Of course, if the block remained the same, the hash value would also be the same. That’s why miners add a nonce to the data. A nonce is just a random piece of data, in Bitcoin’s case it is an incremental number, that the miner adds to the block to create a unique message. It does this for every computation.

Example: For simplicity’s sake, let’s say the block or message was AAAA. The miner will add a nonce value to the block, say 1, and generate a hash from AAAA1. If the hash value for that message is not below a certain limit, it will increase the nonce value to 2, and generate a new hash from that message (AAAA2). This goes on and on until you finds a nonce that combined with the current block message yields a value under a certain limit.

Once you find a hash value below the certain limit, you have solved the block and can submit the solution to the network and claim your reward. You actually create this reward money yourself, but the other nodes in the network will only allow you to spend it after it has been verified in the network. Verification means that your creation transaction must be part of a solved block.

Once you have solved the block, though, everyone will start solving a new block by collecting new transactions, adding nonces, and solving hashes. Also, at this point, Alice’s transaction, being part of the block you just solved, is considered to be confirmed once. Bob can choose to accept only one verification, or may wait around for other blocks to be solved to further secure that there is no possible way that there is anything wrong with the transaction.

The ‘certain limit’ comes back to haunt us, but that too is relatively simple to explain.

Why Difficulty Changes

Because the output of a hashing computation is more or less random, the chance of the hash value being below a certain limit becomes increasingly less likely the lower that limit is. The Bitcoin network adjusts the difficulty automatically to ensure that a block is solved around every ten minutes.

Let me illustrate with an example.

Let’s say, for the sake of simplicity, that the hash value range is 1 to 1000, and the difficulty starts at 1, meaning the difficulty is 1000/1 or just 1000. Also for the sake of simplicity, let’s say you manage to calculate 1 hash per minute.

You generate a hash, and the chance of your hash value being below 1000 is 100%. Thus you ‘solve’ the block very easily because every hash value will match.

However, let’s say the difficulty increases to 4. Now you have to find a hash value that is below 1000/4, or 250. Suddenly, the chance of finding a hash is just 25%. Still, you manage on average to find a hash after 4 minutes.

Let’s further say that we increase the difficulty to 100, so you have to find a value that is below 10. In this case, on average, you will only be able to solve a hash every 100 minutes.

Finally, you decide to bring a friend over to help calculate. Your friend, strangely enough, is exactly as quick as you are to calculate hashes, so now you have a hash rate of 2 hashes per minute. With this, you manage to solve the 100 difficulty hash at just 50 minutes.

Bitcoin does not like any of these situations because it wants a new block to be solved every 10 minutes. Thus, the network will adjust the difficulty so that with the number of people trying to solve a block, combined they are able to solve one block every ten minutes.

In our example, because you and your friend solves 2 hashes per minute, that means the difficulty should be 20. If your friend falls asleep of prefers to play Xbox instead, your rate of solving drops to 1 per minute again, and the network difficulty adjusts down to 10 again. If two of your friends drop by, the difficulty increases again to keep the whole system in a beautiful balance.

Note: The numbers aren’t this simple in reality, but this serves as an easy to understand example.

Oh, and other coins have different rates of distribution, but the principle works the same. Litecoin, for example, wants a new block solved every 2.5 minutes.

Pool Difficulty

I you are mining in a pool, you may have seen another kind of difficulty, which is the pool difficulty. The pool difficulty is usually much lower than the network difficulty.

To understand this, you need to understand how a pool works.

When a miner starts working for a pool, the pool server will send the block to each miner and ask it to start solving it. However, instead of having the miner solve a block with the network difficulty, the pool sets another, much lower difficulty. The miner then has a much easier task of finding a hash value that is below that share, and can thus submit their nonce values much quicker.

Of course, it doesn’t help anyone to solve a block with much lower difficulty than the network because the network won’t accept it as a solution to the block. Thus, when the solutions from the miners come into the pool, the pool checks to see whether the solution is above the network difficulty, and if not, it simply discards the value. If the miner solution is correct and above the network hash value required, the pool can submit the solution to the network, receive the reward, and distribute that reward to the pool miners as appropriate.

Let me again show this with an example.

You and four friends, Alice, Bob, Charlie, and Donna, decide to mine for Bitcoin. However, rather than each of you trying to mine alone, and after all, Charlie is really bad at math, so he probably wouldn’t be able to make much at all, you decide to pool your efforts.

You nominate Charlie as the pool ‘master’, and the network difficulty is 200, meaning you need to find a number that is below 5 (in the range 1-1000 as in the previous example).

You, Alice, Bob, and Donna starts calculating hashes at a rate of 1 hash per minute. However, you submit your solutions to Charlie even if the hash value is below 100 (meaning a difficulty of 10).

Why would you do that? Well, every solution that has a number over 100 is guaranteed to be a wrong solution, so you can just throw them away. However, you have proven that you have done some work, so Charlie records your submission for later sharing of the reward.

Charlie not being as good with math, can now simply check the solutions you, Alice, Bob, and Donna submit, and see whether the value you submit is below 5 too. If not, he can simply throw away the result, and wait for the next result to come in.

At some point, Alice comes up with a solution of 3. Now Charlie sees that the number is below the network difficulty and thus submits the solution to the network. Of course, depending on how you agree to share the rewards, you all get a piece of the reward, even if Alice was the one to find the correct solution.

Here’s a trick question for you: Why doesn’t Alice just keep the solution in her pocket and take the whole reward herself? After all, she finds the right number and can easily submit it herself rather than sending it to Charlie for sharing with the others.

Bitcoin has a trick up its sleeve to prevent that from happening. You see, included in the block message that the pool generates is the transaction that sends the reward to Charlie. Thus, if Alive submits the solution herself, that’s fine, because Charlie still gets the money. If Alice changes the address to her own then her solution is no longer valid, and won’t be accepted in the network.

Clever, eh?

I hope this makes it easier to understand how mining and mining difficulty works, but feel free to ask questions or leave feedback in the comments below.

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Why Do We Need More Than One Cryptocoin?

I wrote a bit about the differences between the various currencies here:

http://coin.furuknap.net/bitcoin-litecoin-whatcoin-oh-my/

However, I may not have spent enough time explaining the rationale behind why there is a need for multiple currencies.

Here’s the thing; most of the cryptocurrencies have different characteristics that make them useful in different situations and for different purposes.

At the moment, the primary ‘differences’ (better or worse is yet to be decided) between Litecoins and Bitcoins are the mining algorithms and the speed of block solving and thus transaction.

The actual amount of coins, although different, is rather irrelevant; both LTC and BTC can be divided into 1 billionth of a coin, and they can even be further subdivided if required and approved by the network. Further, they both represent 100% of their respective markets, and fewer coins just mean that each coin is relatively more valuable.

So, why not agree on just one? Why does the world need two, much less multiple currencies at all?

What matters long-term is more important. Having two or more cryptocurrencies means they can evolve in various directions to suit what society needs. If society changes (more/less online trade, more/less demand for physical monetary units, more/less trust, etc) then different coins will be suited differently to those needs, and the market has better options.

Technically, the world doesn’t _need_ more than one currency, whether fiat or crypto, but the problem is that shortcomings in how that money can handle transactions means that society becomes limited in what it can do.

The stock market is an example of this; traditional fiat currencies lack the ability to represent a share of something, so one invents a new ‘currency’ (stocks) to fill that need. Rather han having $100 worth of a company, you may have 10 shares, and these shares independently of what you paid for them represent a certain percentage ownership of the company. It’s a value, although it’s not a physical currency bill that you can go down to the Deli and use to buy a sandwich.

Similar things will happen to cryptocurrencies, where each coin can be technically adapted to suit a rising need. A new idea of colored coins come to mind as a way that cryptocoins can represent stock, showing how the community can think of new and innovative ways to use money and represent value.

Think of how may ways you store value today. You may have a house, some physical currency, a bank account, maybe some shares in a company, a couple of funds through your 401K, and similar.

Each of these measures of value represent different needs and characteristics and you use them for different purposes. You may calculate them into a common denominator (like US Dollars, Euros, or Bitcoins) but that only serves to give a translated representation of the value. You house isn’t an amount of US dollars any more than your US dollars is an amount of Bitcoins.

As such, Litecoins represent evolution and increases the adaptability of cryptocurrencies in general. They are not better or worse than other currencies, any more than fish are better than birds; they are just different.

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Understanding Bitcoins: Making Money!

No, this isn’t about SharePoint, like my blog usually is. So sue me! It’s my blog and I do whatever I please, so suck it up rather than complain.

In this series, I’ll explain what Bitcoins are, how they work, and offer some thoughts and opinions. Feel free to leave comments or questions, and I’ll try to respond.

In this part, I’ll tell you how Bitcoins appear, and even how you can make your own money for free. No, it’s not an April fools joke; you can actually create your very own Bitcoins.

Sounds fishy? Read on and I’ll explain how it works, and more importantly, why it works.

Refer to the bottom of this article for other parts of the series.

Make you Own Money!

One very unique characteristic of Bitcoins is that you can make them yourself through a process called mining. I’m certain that sounds dubious at first, so let me explain briefly how that works. I’ll write this as simply as possible, so there will be some shortcuts that may make analogies inaccurate, but the principles are sound. If you want further information, check out the Bitcoin wiki.

Bitcoins creation is based on a concept called proof-of-work, which means that to get them you need to prove that you have done something. In the world of Bitcoins, that ‘something’ is generating hashes, which is a cryptographic tasks based on the fact that a hash is difficult to reverse but easy to create. This, in fact, is a key factor in all modern cryptography; a task is easy to verify but difficult to do.

Note: If you don’t care about the details, think of it like this; it is very difficult to predict a dice roll before the roll, but very easy to verify afterwards whether the prediction was right.

In Bitcoin terminology, the difficult task is to generate a cryptographic hash which has certain properties from a data ‘block’ of transactions. You can’t reverse engineer a hash, but you can easily verify whether it is correct once you have it. In Bitcoin, the properties of the hash which makes it a valid solution is that the hash should be lower than a certain global ‘target’, and since there is no known way to start with the hash and reverse it back to its source, you are forced to calculate a huge number of hashes to find the ones that ‘solve’ the particular block by being lower than the target.

The target is somewhat important here, because it determines the difficulty of solving new blocks. The Bitcoin network is designed to let the entire world solve approximately six blocks per hour. Of course, as computers become faster, the ability to solve hashes greatly increases, so to keep the rate steady, the Bitcoin network changes the difficulty my modifying the target required in the hash. So, if more computing power is thrown at ‘mining’, the difficulty increases, leaving the rate at a steady six per hour for the entire world.If fewer people mine, the difficulty decreases, and the rate is still steady.

When solving a hash for a given block, the ‘solver’ gets a reward in Bitcoins from the network. That reward is designed to decrease over time, but is currently at 25 BTC. In other words, if you solve one of these blocks and finds the right hash, you get 25 BTC.

Note: The reward is halved for every 210,000 blocks, so the next time it is halved, which happens in late 2016, the reward will be 12,5 BTC for a block.

Start Your Engines, or Don’t Bother

All of this means that you can start mining for Bitcoins by solving hashes right now. Your CPU is just sitting there doing nothing, and those wasted cycles can be used to generate Bitcoins which you can then use to purchase things or trade for other currencies like US dollars, Euros, Rupees, or Norwegian Kroner.

However, keep this in mind: Solving a particular block is very difficult on average. If you use a regular CPU then you may spend years before you are able to solve your first block and get the coveted 25 BTC (or even lower at a later date).

If you have a graphics card of some power, however, your ability to solve blocks greatly increases, by a factor of tens or maybe hundreds. The reason behind this is somewhat technical, but think of it in the way that a GPU is purposely built to solve massive amounts of simple calculations at the same time while your CPU is designed to solve many different tasks at once like manage memory, control hardware, and so on. Your GPUs ability to solve simple tasks at an astonishing rate means that it can generate hashes much faster than your CPU.

Check the resources section at the end of this article for information on mining, including software you need to mine.

However, you still will find that it will take a very long time to solve a block. There’s no accurate way to predict this because whether you find the right hash is simply a matter of luck, but as an example, on my Radeon HD6950 graphics card, having a fairly powerful GPU, it seems to take around 250 days to solve one block at the current difficulty. Again, not that this is completely random, so I may go for decades without finding a single one or I may find ten over the next hour.

There’s one other factor to put into the calculations. Because Bitcoins are rapidly becoming popular, several companies have made and are in the process of launching purpose built machines containing dedicated chips called ASICs that solve Bitcoin blocks at a rate that dwarves any current GPU. For a few hundred US dollars, you can soon buy Bitcoin ASIC machines that solve hashes at 300 times the speed of my current CPU, this reducing the time taken on average to just a few days.

Note: Remember that the rate of creation is steady so when these new monster ASIC machines enter the network, the rate at which current CPUs and GPUs can solve blocks go down rapidly. Because the difficulty increases, the ASIC machines won’t be as lucrative as the initial numbers may indicate.

Those were the bad news regarding mining, so let’s wrap up with some good news.

To counter the increasing difficulty of solo mining, several groups have formed mining pools. A mining pool works by having a large groups of people solve hashes together. When one of the participant in the pool solve the block, the reward gets distributed to all participants. Thus, instead of having to wait maybe months or years for a large reward, each participants get rapid but much smaller rewards. In fact, because the rate at which blocks are solved is steady, you can expect to get paid several times per day.

I’ve joined a pool called Slush’s pool, which is so far a stable and functional pool with a large enough group that it makes sense to participate and rewards are frequent. However, there are many other pools out there, so you may consider picking another one.

I’m Impatient – Give Me Bitcoins Now!

So, you want to get some Bitcoins, huh? Well, if you can’t wait around for mining to give you the huge piles of cash you’re unlikely to ever get, the alternative is to buy them. Again, this works just like any other currency; you exchange your money for other types of money.

The major difference is that, thus far, no traditional banks offers exchanges to Bitcoins. There are Bitcoin exchanges that partner with banks, like Bitcoin Central, but you can’t just go into any brick and mortar bank branch and ask to get Bitcoins moved to your wallet, at least not yet.

One reason for this is the irreversibility of transactions in Bitcoin. Where a traditional bank can reverse a credit card charge, once a BTC transaction has taken place, there’s no way to change it. Because banks and credit card companies in most civilized countries have responsibility for the charges made, this irreversibility doesn’t sit well with them.

This will probably be resolved at some point as digital currencies become more popular, but there are already ways for you to buy Bitcoins. I use Coinbase.com, a site that allows me to fund my Bitcoin balance directly from my US bank, but other exchanges offer similar funding options too. Very few offer the ability to pay with credit cards, though, for the reasons mentioned above.

Note: Be vary of anyone trading Bitcoins in reversible transactions and never sell Bitcoins using reversible transactions (including bank transfer, PayPal, credit card, and so on) to people you don’t know. Anyone can simply reverse the charges leaving you without money and without Bitcoins.

Getting Bitcoins take time because nobody wants to risk selling Bitcoins using a reversible transaction. You should always expect to prepay for your Bitcoins unless your marketplace of choice offers a direct link to your bank (like Coinbase).

Before You Jump Into Bitcoins

A word of caution, though. Bitcoins at the time of this writing (early April 2013), has seen an amazing rise in value and is currently trading at over US$100 per BTC. This may or may not be a bubble, and as for any investment, there’s always a risk that things can go terribly wrong. Don’t buy Bitcoins as an investment until you know about the risks involved in any currency speculation.

I am not a financial advisor and you should not listen to any financial advice I give you. Really. My personal opinion is that Bitcoins are extremely cool and I enjoy learning more and more about the technology. It’s equally fascinating from a technical point of view as observing how Bitcoins work in society.

I’ll offer further thoughts and ideas for Bitcoins in future posts in this series.

Once you’ve gotten your Bitcoins, however, you can immediately start using them and enjoy low rates for transactions (free is as low as it gets), quick transfers, security, potential anonymity, and, of course, being part of the cool gang 🙂

Want More Bitcoin Information?

Check out these resources on how to get Bitcoins.

Bitcoin Wiki on Mining

GUI Miner for Windows

Install this to start mining. Make sure you have updated OpenCL drivers (graphics driver). I also highly recommend joining a mining pool first (see links below)

Slush’s Mining Pool

BTC Guild – Largest mining pool

Mining Pool Comparisons

Coinbase.com, my preferred purchase site

MTGox – Largest BTC Exchange

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Understanding Bitcoins: What Is it and How Does it Work?

This isn’t even remotely SharePoint related, but I’ll still blog it. It’s my blog, dammit!

If you have no idea what Bitcoins are, it’s a way for you to make your own money. Really. Oh, and it’s free, as in beer.

Read on and I’ll tell you more.

In this series, I’ll explain what Bitcoins are, how they work, why they work, and how you can make your own money. First, I’m going to explain what Bitcoins are and how they work, and you can check the bottom of the article for more parts on the other topics.

What are Bitcoins?

A Bitcoin, or BTC, is a digital currency that solves a number of issues with existing national currencies (also called fiat currencies). It is the currency world’s equivalent of what the internet is to information; a distributed, tamper-resistant, decentralized, secure, and potentially anonymous way to handle money.

Bitcoins are becoming increasingly popular as a currency and you can already pay with Bitcoins on several sites and stores, such as Reddit and WordPress.com (plus many, many, many others). In addition, there are many currency exchanges that allow you to trade Bitcoins for traditional currencies and exchange it for ‘real’ money.

Note: I’m contemplating whether to start accepting Bitcoins as payment for my training and professional services and for USP Journal, and although the jury is still out, I’m leaning towards at least trying it for a while. I’ve added a Bitcoin donation option at the bottom of my blog articles for starters.

Unlike fiat currencies, though, there is no central authority behind the currency. The existence of Bitcoins relies solely on the thousands of users that participate in the network, which they do by running a Bitcoin client that allows them to store, send, and receive Bitcoins from others through a Bitcoin wallet.

Every transaction in the Bitcoin network is public, but the wallets are completely anonymous. In fact, you can even generate wallets yourself and all clients I’ve used allow you to do so easily. These wallets contain your Bitcoins, so you may think of them as similar to bank accounts, except you don’t have to be a bank or even a customer of one to have a wallet.

When I say that transactions are public, this is a key component to both the security and the stability of the Bitcoin network. Transactions are cryptographically signed and broadcast to the network, which then validates each transaction, and each transaction becomes part of the global chain of transactions which after it has been verified cannot be changed. Thus, you can’t ‘trick’ the system in any way because neither you nor the recipient is solely responsible for validating a transaction like you have in traditional banking, for example.

I’ll leave the finer details on how this works for a possible future post.

Is it Fake Money?

When I try to explain Bitcoins to people, the first thing people say is that “it’s not real money, it’s not backed by anything”.

Well, sunshine, nor is any other major currency in the world; it is backed only by demand and trust in the system, which is why fiat currencies like the US dollar or Euro fluctuate wildly depending on whether people trust the stability and demand of the currency. In fact, it’s been decades since the US dollar was backed by anything but the market’s demand for it; you can’t just go to the Federal Reserve and trade your US dollars for gold, for example, nor can you swap your Euros, your Norwegian Krone, or your Indian Rupees for anything but products and services or other currencies.

Bitcoins are no more real or fake than US dollars or Euros, although it is in much lower circulation. Think of it so far as a minor currency in that respect, like Norwegian Kroner. Only demand for the characteristics of Norwegian Kroner make it a viable alternative for representing value, and it’s only because society agrees somehow to ‘trust’ a currency to some extent that you can even say you have value when you hold a currency.

You can’t take a Norwegian Krone and buy stuff in Boston, and although you may get a bank to exchange it for US dollars, that’s going to cost you fees, and the bank decides the exchange rate. For Bitcoins, most transactions are completely free and it costs nothing to own a wallet either, so your money remains in your ‘account’ forever. On the flip-side, you don’t earn interest either, at least not until someone comes up with a banking system that can lend people BTC in the more traditional sense.

What Gives Bitcoins Value?

The only thing that gives value to Bitcoins, just like any currency, is your ability to buy stuff with it, and let’s face it, the options for buying is still very limited compared to traditional currencies. That said, there are already hundreds of sites that accept Bitcoins and you can exchange your Bitcoins for traditional currencies like you can with any traditional money. The valuation of Bitcoins depends on demand, which in turn depends on the ability to exchange it for other things, just like for any other currency.

Bitcoins have some unique characteristics that make it competitive to fiat currencies, though.

First, the for fiat currencies, you trust the issuer (Federal Reserve in the US, European Central Bank in the EU, Norges Bank in Norway) to control the value of the currency. Only they can issue new money, and you trust them not to double the amount of dollars in circulation, for example, which would skyrocket inflation. As we have seen in recent years, in times of crisis, countries like the US issue more money into circulation, thus reducing the value of each dollar and increasing inflation, meaning your money is less valuable.

For Bitcoin, the supply of money is steady and accurately predictable down to almost the hour through as technique called controlled supply. There will only ever be 21 million BTC in existence, and these are distributed through a process called mining, a process, by the way, in which you can participate and thus make your own money. I’ll go into more detail on how this works in Part 2 of this series.

Through controlled supply, the rate at which new Bitcoins enters circulation is fixed and predictable, and ends somewhere around the year 2140 (as in over a hundred years from now). However, most of the Bitcoin will enter circulation much faster, and more than 99% of all Bitcoins will be in circulation by late 2032.

Thus, there is now way that inflation will reduce the value of your Bitcoins; in fact, a problem may actually be deflation, in which your money becomes so valuable that people don’t want to part with them, driving prices for goods and services paid in BTC down.

Second, Bitcoins are cryptographically secure, meaning there is no way to counterfeit money or fake transactions. In fact, you can’t really have physical money at all, which solves a lot of the problems with traditional money (loosing them, ‘black market’ trading, counterfeiting, wear and tear, and so on).

Technically, it is possible to ‘trick’ a transaction for a few seconds after it has happened, but it would be the equivalent of swiping your credit card and then taking the products and run before the transaction can be verified by the credit card company. A Bitcoin transaction is more secure than regular transactions because there is no way to reverse it after a few seconds, which works to secure both the buyer and the seller against chargeback, fake money, validation issues, and so on. For larger transactions, you can just wait a bit longer before you approve the purchase, just to be extra sure that nothing can go wrong.

Third, Bitcoins can be completely anonymous, which may sound sketchy at first, but is important in some situations. I’ll leave the discussion about whether anonymity is good or bad for a later post, or preferably a different forum, but I’d like to point out a couple of things regarding that anonymity.

Bitcoin anonymity is just a potential anonymity, and you have to take special measures to ensure your transactions are anonymous. Everything in Bitcoin is completely transparent.

Keep in mind that every single transaction is publicly completely visible to the entire Bitcoin network. Thus, if the identity of a wallet’s owner is known, everyone can see who that person sends Bitcoins to or receives money from.

Because of this, everyone can also see how much money is in each wallet. If you put your wallet address in public, well, everyone now knows how many Bitcoins you have in that wallet.

This transparency may freak you out at first, but there are ways around having everyone snoop into your financials. Nobody knows who owns each wallet by default. You don’t have to publish your wallet address, and even if you do, you can still have as many wallets as you care to generate, so you can simply have a ‘receiving wallet’ and a ‘storing wallet’ or even multiple layers of wallets, which makes tracking more difficult. In fact, a recommendation for those wanting to retain anonymity is to use a single wallet for every transaction you make, which may sound like a lot of work, but is actually quite easy.

Conclusion for Now

The bottom line is this: Bitcoins are ‘real’ money in the same way other currencies are ‘real’ money. Bitcoins have many unique properties which address many problems with fiat currencies, but whether they have a value depends on whether people want them and whether merchants accept them.

In the next part, I’ll talk about how Bitcoins come into existence, and how you can make your own Bitcoins, at home, using nothing but your computer, a bit of electricity, and some patience.

Want to learn more about how Bitcoins work? Here are some resources from the Bitcoin wiki:

Bitcoin Wallets

Bitcoin Transactions

Bitcoin Transaction Fees

Controlled Supply

Anonymity

Understanding Bitcoins: Bitcoin, Litecoin, Whatcoin? Oh My!

You’ve probably heard of Bitcoin by now, and at the time of this writing, meaning mid-April 2013, it’s currently experiencing a blossom that has caught everyone by surprise and made a lot of people very rich.

What you may not know, though, is that Bitcoin is just one of several emerging virtual currencies. Bitcoin is definitely the biggest, but it’s important to understand the other currencies too, especially if you plan on investing or mining coin.

In this article, part of the Understanding Bitcoin series, I’ll talk about each of the different cryptocurrencies and what distinguishes them from each other. I’ll focus mostly on the two largest, Bitcoin and Litecoin, and then give you a brief overview of some of the other cryptocurrencies out there.

Cryptocurrencies?

Let’s start with the basics. A cryptocurrency is a virtual currency that people use for various purchases. Currently, it’s used a lot of places online, but even offline brick-and-mortar stores are beginning to accept cryptocurrencies. This is especially true for Bitcoins.

There are already several cryptocurrencies in existence, each having slightly different characteristics and have uses in different scenarios. Which one will be used and which will die is a matter of great speculation, and as with all things that have a geeky nature, it’s often becoming a debate of passion. When I read these debates, I’m often reminded of Linux vs. Windows vs. Mac debates, or Android vs. iPhone, or similar debates where the underlying differences aren’t really that huge but people still get massively passionate about their particular favorite.

What most agree, though, is that digital currencies have a place in society now, and especially on the internet. With the democratic, global, and decentralized nature of cryptocoins, the ease of use for anyone, the inherent security and potential anonymity, as well as the technical abilities, cryptocurrencies are starting to look like a perfect model for internet heavy economies. Cryptocoins, although certainly not the only form of digital currency, seems to have the characteristics that users and society covets.

Cryptocurrencies work in much the same way as regular currencies and are in their simplest form nothing more. It’s money, and that’s really all you need to know. Whether the money is worth anything is up to society, if society adopts it as an accepted measure of value, then cryptocurrencies have value just like ‘hard’ (or fiat) currencies. Adoption is rising rapidly so there is evidence to support the idea that cryptocurrencies have merit and thus value.

On the flip-side, cryptocurrencies are extremely young and nobody really knows where they will go. The technology hasn’t been proven on a large scale and we know there are inherent problems that need to be resolved at some point. We do not know how governments around the world will react, although we do know that the US have declared digital money as just another foreign currency, giving it at least some credibility. We also have no way of determining value. Cryptocoins can take over online trade completely, and if so, even the current pricing is ridiculously low, or not exist at all in a year or two, in which case any value is overrated, even at one US cent per Bitcoin.

For the purposes of the rest of this article, I’m going to focus on two of the cryptocurrencies that derive from the open-source Bitcoin code. Bitcoin was the first of these currencies, but several other currencies have since appeared with different characteristics making them useful and beneficial in different situations. The other one is Litecoin.

Bitcoin (BTC)

Bitcoin was the first and remains by far the largest cryptocurrency. It is largest in market capitalization, acceptance by merchants, transactions, and mining power.

On the downside, Bitcoins’ size is starting to become a problem, or will shortly. For example, by design, a particular transaction block can be up to 1 Mb in size and must contain every transaction since the previous block was solved. This means that as more transactions happen, the block fills faster, and some transactions must wait until the next block, delaying transactions.

The mechanism designed to solve this is a voluntary transaction fee, which is added to the bonus of the block. As Bitcoin evolves and transactions increase, this voluntary transaction fee becomes the main revenue for mining operations, and if the market decides so, the fee will effectively be mandatory by giving low fee transactions less priority and slower transaction times, with a larger fee ensuring a faster transaction.

At the moment, mid-April 2013, BTC is seeing a rocket ride in terms of price. Be aware, though, that the actual value (as opposed to price) is still very undetermined and absolutely unknown. Anyone claiming to know is wrong at this point, whether they are warning against a bubble or hailing this as the most important thing on the planet.

Bitcoins have a fixed distribution rate and will end up with a maximum of 21 million coins. Most of those coins will be mined by 2032, though so after that (or even before) transaction fees will make up most of mining profitability. Bitcoins are mined using an SHA-256 based algorithm.

For Bitcoin based financial and investment services, there are currently both currency exchanges and stock markets, and other services from traditional financial markets are emerging. Still, because of the nature of Bitcoin, there is no government regulation or guarantees for these markets, so it is extremely risk to invest in BTC-based markets. The largest BTC/USD exchange by far is MTGox. Two other prominent currency markets are BTC-E and Vircurex, while MPEx (large, but expensive and somewhat difficult), BTC-T (smallest but easier), and Bitfunder corners the market on stock trades.

Litecoin (LTC)

Litecoin is the second largest cryptocurrency at this time, but is still much smaller than Bitcoin. Although the relative size varies in terms of market capitalization, at present the Litecoin economy is about 1/30 the size of Bitcoin.

Note: Numbers are based on sizes from http://dustcoin.com/mining

Litecoins have some different characteristics from Bitcoins. First, it is mined using a slightly different algorithm, called Scrypt, which is more resistant to massive mining rigs than the SHA-256 based currencies. That means that even personal computers, provided they have sufficiently powerful graphic card, can still participate in profitable mining.

Note: For a mining operations guide, read the previous post in this series on cryptocurrency mining.

Litecoins like Bitcoins are limited in total number of coins too, but its limit is 84 million coins. This really has nothing to do with its price or value, and because Litecoins are generated at a much faster rate, it evens out in the long run.

When I say that the Litecoin economy is much smaller, I mean much smaller, not just in market capitalization but also in adoption. Adoption is growing, though, but it looks like the community and merchants are waiting to see whether Bitcoins take off. Few merchants accept Litecoins yet, at least compared to Bitcoin, so its circulation is mostly based on person to person transactions and not so much for purchasing products or services.

On the plus side, Litecoins have a faster rate of block generation. Where Bitcoin blocks are designed to appear every 10 minutes, Litecoin blocks appear every 2.5 minutes. This has the benefit of giving potentially quicker and cheaper transactions, although it doesn’t necessarily mean that it will be quicker or cheaper.

Also, as the largest of the alternative cryptocurrencies, it may take a place as a backup currency in case Bitcoin transactions have issues like high fees, slow transactions, or even technical issues. Adding support for Litecoins once a merchant has support for Bitcoins is easier than trying to add other backup payment alternatives.

At the moment, Litecoin price is tied closely to the price of Bitcoins, so a rise in Bitcoin price often lead to a rise in Litecoin price. Litecoins are mined using a Scrypt-based algorithm.

Note: You can see an exchange rate for LTC to BTC or USD on BTC-E http://btc-e.com/. MTGox, the largest Bitcoin exchange in the world, is rumored to introduce Litecoin support soon.

Other Cryptocurrencies

Bitcoin and Litecoin combined make up more than 99% of the market at the moment, but that doesn’t mean they are the only currencies available. Other currencies exist, perhaps with more obscure characteristics, and right now, nobody knows whether these will survive or grow alongside their bigger brothers.

Namecoin is a much smaller currency, even compared to Litecoin, having about 0.3% of the market share. It’s designed to work with identities, currently mainly through an alternate DNS system that allows for completely anonymous domain name registrations. Very much a currency and system for privacy freaks bit can also be used to provide secure identification services. Namecoins utilize merged mining, meaning they are mined alongside regular Bitcoin mining at no extra cost to the miner.

PPCoin is a somewhat different cryptocurrency that implements an alternative method of minting coins and securing transactions, called Proof of Stake (BTC and LTC uses Proof of Work). There are several benefits to this, and the details go beyond the scope of this article, but feel free to read up on it on the PPCoin Github wiki.

Devcoin is a coin designed to support open source development, where mining generates revenue for open source projects. 90% of coin generation goes to open-source projects, the distribution of which is done through bounties administered by a democratic voting process. Anyone can apply and three random administrators vote on whether to approve the project, thus giving revenue to the project.

Novacoin is a bit of a controversial coin due to allegations of fraud in the introduction of the coin. The founder allegedly pre-minded a lot of coins before the introduction, many or all of which were used in a bribe and later destroyed (read more). It is the only alternative coin that uses Scrypt for mining (like Litecoins) so it may be an alternative to Litecoins, should Litecoins need one.

Terracoin is a relatively new coin that has seen some recent troubles due to its similarity to the Bitcoin code. In short, the profitability of mining rose drastically in a short time, making it practically worthless for normal miners to support. The developers have taken steps to correct the issue, which may help the coin survive.

Freicoin is another very interesting but obscure currency with some pretty remarkable characteristics. For one, it effectively implements negative interest, meaning you need to spend your money unless it loses its value gradually through Demurrage. The argument for this is that holding money is bad and circulation is good, encouraging investors to invest and banks to loan rather than hoard money.

Why, Oh Why?

With all these different types of coin in existence, it’s pretty clear there will be confusion for many people. The risk is huge like we saw with Terracoin, that technical issues and exploitation may kill smaller coins completely. New and innovative algorithms may stall this or prevent it completely, but it’s still a very immature technology and subject to malicious intent, like most other technologies.

However, it also shows that there is innovation in the way money works and should work and what society wants from its currencies. Cryptocurrencies is a great tool for encouraging innovation in monetary scenarios.

Even more, we have only seen the start of this innovation, perhaps at the level where the web was around 1997 when it too was four years old (Bitcoin is four years in 2013). Nobody knows yet whether this is a passing fad or whether the world is ready for new ways of using money, but if nothing else, Bitcoin and its smaller siblings have already had an effect on people’s minds.

I’m rooting for the future!

.b