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

Found this article valuable? Want to show your appreciation? Here are some options:

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b) Donate Bitcoins! I love Bitcoins, and you can donate if you'd like by clicking the button below.
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Other posts of the series

  1. Understanding Bitcoins: What Is it and How Does it Work?
  2. Understanding Bitcoins: Making Money!
  3. Understanding Bitcoins: Bitcoin, Litecoin, Whatcoin? Oh My!
  4. Understanding Bitcoins: Cryptocurrency Mining Equipment and Preparation

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