Bitcoin Explained Simply – Valentin

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Everything you don’t understand about money, combined with everything you don’t understand about computersthat is how the British comedian, John Oliver, summed up Bitcoin.

Understanding Bitcoin with an intuitive example

I firmly believe that when introducing someone to a new, rather complicated concept such as Bitcoin, three basic rules have to be followed:

  1. Explanations should be made relying solely on words and expressions, part of our day to day communication. “Cryptography”, “digital token” and “blockchain” are certainly not present in the life of your average Joe. Imagine doctor informing his patient the cephalgia (headache) might be caused by torticollis (wry, stiff neck, neck muscles being twisted), myopia (short-sightedness) or combination of both.
  2. Further, the introductory article should provide an overview of the topic. Bringing in too many details early on would only lead to confusion.
  3. Last but not least, I find it useful when the newly introduced concept is compared to already widely known one. In this current case, Bitcoin is to be matched to the existing banking system.

The aim of this post is to explain Bitcoin in layman language with the help of an intuitive example. It will lay out the fundamentals, which then can be easily expanded upon.

Bartering is still around, but if you want to be a complete citizen of the world, you have to use an established currency, such as the US Dollar, Euro, Bulgarian Lev or Polish Zloty. While distinct in their recognition and popularity, all accepted and known currencies are issued by a government in conjunction with institutions and regulators.

Collection of various traditional fiat currencies. Image Credit: Vlad Ivantcov / Fotolia

It is also highly likely, that at one point you get the necessity to become part of the banking system. That is fine and statistics confirm it – as per the latest financial inclusion report from the World Bank, there is continued growth in account ownership with some 70% from all adults having a bank account. Having this trend in mind, banks serve as gateway to people, looking for inclusion within the modern financial system. When you become a customer, unique bank account number is allocated to you, which is controlled by proving identity and ownership – would it be by showing ID in the branch, or through password and other online security means. Once a customer, you can perform common transactions such as wire transfers and card payments. For its role of moving the money between sender and recipient, the bank collects fees – one of its multiple income streams.

This is of course overly simplified explanation of how the current financial system functions. The reality is much more grim, with banks being stubborn, inflexible and slow in adapting innovation. This likely has to do with them being subject to strict regulations and supervision by governments and higher financial institutions. That is a reasonable practice – at the end of the day, more and more people trust banks with their (life) savings and some $5 trillion are being moved daily through international transfers alone. The efficiency of these supervisory authorities remains questionable, having in mind that Lehman Brothers, the 4th largest investment bank in the US at the time, went bust in 2008 due to being overexposed to the unhealthy real estate market. It is worth reminding here that Lehman’s demise resulted in worldwide financial crisis. What is more, the entities supervising the banks are usually the ones responsible for the creation of money too, with their success being debatable again.

Bitcoin (BTC) is a digital currency with the idea behind it being published for the first time in 2008 by Satoshi Nakamoto – anonymous author or a group of authors. In contrast to the above mentioned traditional fiat currencies, it is not supervised by a set of authorities and there is no main issuer. At its core, Bitcoin is software, protocol, a computer code, that defines the rules how coins are created and transacted. For example, the Bitcoin protocol imposes that there will ever be a maximum of 21 million Bitcoins. What is more, their issuance is regular and scheduled, with the last one to be minted around 2140. The supply of established fiat currencies is infinite, and printing more of them (inflation) usually leads to decline of their purchasing power. A simple explanation of the logic behind can be found here.

Transactions & Issuance of Bitcoin

Payments with Bitcoin are also handled by its core protocol. Transactions are simultaneously sent to all participants, essentially computers, supporting the Bitcoin network. They function as bookkeepers and record all valid transactions and balances in a public accounting book. A copy of that book is held by every participant supporting the network, and there are currently about 10 000 of them. Even if one thousand decide to leave, the rest will keep on recording payments. At the same time, if a bad actor decides to manipulate the entries in his balance sheet, the rest of the network will isolate that fraudulent accounting book due to inconsistencies with the ones of the rest of the supporters.

As mentioned earlier, banks serve as trusted mediator for payments with traditional fiat currencies. In order to function, Bitcoin also requires middlemen. These are called miners. Miners are essentially very powerful computers and have two key tasks — (1) for a small fee, they collect pending transactions and broadcast them to the receiving parties and the bookkeepers and (2) take part in the creation of new coins. Currently, every 10 minutes, 12.5 BTC are put into circulation, which get divided among the participating miners. Bitcoin’s protocol is set in such a way, that the mining reward will drop in half every 4 years – it will decrease to 6.25 BTC in 2020, 3.125 BTC in 2024 and it will keep on halving until the last Bitcoin is out, some 120 years from today.

Bitcoin Mining Operations. Image credit: Christinne Muschi / Reuters

Generation & Control of Bitcoin Address

In a similar fashion to banks, Bitcoin also features accounts. The first Bitcoin account to ever receive a transaction for example looks like this : 1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa. As mentioned in a previous paragraph, all movements across the Bitcoin network are stored in a public accounting book. You can review the current balance, incoming & outgoing transactions of that same address. This throughout information is present for every possible Bitcoin account. To gain control over a certain address, you need the password associated with it. The trick here is, that it is not the user who came up with it. Once again, this is all done with the help of Bitcoin’s protocol. Every Bitcoin address has password already allocated to it, which also consists of numbers and letters, but is 64 characters in length.

I would recommend to play around with this website and generate a few addresses. Write down both your public key (basically your account number, IBAN, visible to everyone) and private key (the password which controls the generated address.) Try to access your Bitcoin address by importing your private key in the “Validate or Decrypt” tab just to get a better understanding of how it really works. If you are worried that someone might steal your Bitcoins by randomly generating the same account and respectively password as yours, do not be. There are about 10⁴⁸ Bitcoin addresses – that is a number consisting of 49 numbers! While such scenario is theoretically possible, you have better statistical chances to become a president.

To sum up, Bitcoin is online payment system with its own digital currency, created by the anonymous Satoshi Nakamoto some 11 years ago. It is basically a computer code, which strictly defines how the experimental system functions – from the generation of addresses and exercising control over them, to the exact methodology of how miners process payments and take part in the planned issuance of Bitcoins. The network is supported by an ever growing number of participants (computers) scattered across the globe, which work together to prevent fraudulent activities and manipulations.

While I am confident that this overview will serve good to people who are just starting with Bitcoin, I also know that it will make them ask even more questions. My advice is to work your way up systematically, and not to rush into technicalities or blindly buy Bitcoin. It is strongly recommended to properly research the following topics, until I manage to find the time needed to cover them:
1. (Dis)advantages of Bitcoin over fiat currencies / the traditional banking system.
2. How to securely generate Bitcoin wallets / addresses and measures to keep your funds safe.

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