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How the Bitcoin Protocol Actually Works

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The Bitcoin protocol is still evolving, which makes understanding how it works even more complicated.

Bitcoin is gaining heavy momentum today as well as other cryptocurrency options like Litecoin. This article will go into a quick overview of Bitcoin as a generalization and then go deeper into how it actually works from a technical perspective.

What Is Bitcoin?

Bitcoin is a peer-to-peer payment technology that operates without a centralized bank or authority. The peer-to-peer network of users manages the transactions as well as the creation and distribution of bitcoins. Bitcoin is a digital currency, but also a user-run system. There is no exchanging of physical or digital dollars or notes, but with all transactions taking place in a block chain or ledger, and once complete, the transaction shows the new balance in your Bitcoin wallet. There are many benefits to a digital currency, as well as some cons that need to be ironed out over time.

How Does Bitcoin Work on the Surface?

One of the first things you need to do is get a Bitcoin wallet. This will give you a unique identifier that will allow people to send you bitcoins. This is important, and just like any other wallet, it is important to secure it and make sure you do not lose your wallet or information. Basically, the wallet is a piece of software or an application that runs on your computer or mobile device. Once you have your wallet, you can proceed to acquire bitcoins. You can gain these from other users or businesses, or purchase them from an exchange. It is important to note that the value of a bitcoin is highly volatile and changes often. Lastly, you can spend bitcoins as long as you have the other party’s hashtag or unique identifier. More and more people and businesses are using bitcoins, but it is still growing market.

How Does Bitcoin Protocol Work Below the Surface?

The technical nuts and bolts of the Bitcoin protocol are very detailed and difficult to explain. There are numerous blog posts that try to either oversimplify the technical side or dive too deep. In this article, we’ll attempt to go somewhere in the middle to give you a good base understanding.

Serial Numbers and Transactions

When using bitcoins, you essentially send a bitcoin with a serial number to another person or business. This is similar to sending someone money over PayPal. The key differences are that with Bitcoin, you send to a hashed account number instead of an email address and that the currency is bitcoin instead of dollars or another physical currency. On top of that, the transactions are verified in a completely different manner. Transactions begin with User A submitting an intent to send X bitcoins with serial number 1234567 to User B (UserID: Hashname ABj28djB). That transaction goes to the block chain, where a hash or algorithm (explained below) will need to be solved. Once solved, User B can accept the payment and officially "sign" the transaction, marking it as complete.

The Users Are Essentially the Bank

When sending bitcoins to others or receiving bitcoins yourself, a transaction is created and that transaction goes into a public ledger, or in Bitcoin terminology, a block chain. This is where all transactions are recorded and can be seen by everyone. This way, everyone can check the validity of the transaction. Bitcoin uses a very difficult validation process to ensure security and rule out fraud from people that make multiple transactions with the same coin or by using the coins of others. To be validated, a complex puzzle for each transaction must be solved. This puzzle is in a hashtag format, which requires a great deal of computer power to reach a resolution. These are solved by different users of the Bitcoin network in a process called Bitcoin mining.


Bitcoin Mining

As described above, Bitcoin mining takes a lot of processing power by a number of users who work in a group and are rewarded with bitcoins for completing a block of transactions. This alone will not be sustainable over time, as the number of mining users will go up, lowering bitcoin distribution. The system allows for fees to be applied basically as a payment to the miners, usually in pennies to complete the work more quickly. This has the possibility to rise, but for now, it is very small and keeps the network of miners working.

How Can Someone Mine?

In the past, becoming a Bitcoin miner simply required setting up a personal computer to offer its services. Now, specific hardware and software are required. These devices have unique hardware with very high computing power to work through more transactions quickly. The location to get started with mining is Bitcoin Mining. This site goes into heavy detail about the different requirements and work involved. The specific mining hardware is currently provided by Butterfly Labs and Avalon. The purpose of these machines are specifically for Bitcoin mining, and the cheapest model is currently priced at $274. However, there also are much more powerful miners available, such as the 30GH/s ASIC model or the similar Butterfly Model. The higher-end models are able to work through transactions more quickly, raising the likelihood of gaining bitcoins. The software is free and runs on the different mining machines and is located by BFGminer and CGMiner. There is debate on whether the profitability of mining will last over many years to maintain the system, as the profit percentages are set to decrease in 2017 and every four years after that.

Transaction Complete

So once the transaction is validated by the miners and everything is confirmed, the user can accept payment. The question here is when to accept payment. An average block confirmation takes roughly 10 minutes. At this point, it is written in, but full confirmation requires that the block be six places back in the block chain. Users can accept payment if they trust the user after one block or roughly ten minutes, or wait an hour for full confirmation. Right now, this is one of the pitfalls of the system. To be a peer-to peer-network and as secure as possible, confirmation takes significantly more time than other current systems. Once complete, the addition or subtraction of bitcoins shows in your wallet.

Pros of Bitcoin

  • A digital currency does not require the cost of manufacturing physical currency, and therefore should be a cheaper alternative.
  • Fees and transactions either cost nothing or next to nothing right now. In comparison to using other formats, a much larger percentage of the value is removed when making transactions.
  • Bitcoin has capped the amount of coins that can ever be created. This will eventually help with keeping a true value of the currency. The U.S. government, for example, can always just create more money out of thin air if they so desire. When doing this, they add more money to the system, which essentially lowers the value of the money you have.
  • It can be used across borders. Bitcoins are not a currency to one specific country or region, but are a currency for anyone. There is no longer a need to have to worry about changing from Euros to dollars and having fees taken out. The money crosses borders without a mess.

Cons of Bitcoin

  • Bitcoin is still relatively new, and thus, the price of a coin or its value is highly volatile. The value of a coin can fluctuate frequently and in large amounts over short periods of time. It is advised to spend your coins near the time of purchase to lower the possibility of losing value. However, many are using it as a means to invest in the future of Bitcoin by holding on to their coins for the future.
  • Confirmation can be a lengthy process. As discussed in the article, it takes a significant amount of time for the process to complete. Thus, instant transactions or even acceptance of only one confirmation can be risky.
  • Bitcoin is still new, and therefore experimental. There is always the possibility that the currency could fall apart. It does not appear to be going away anytime soon, but the possibility is there.

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Cody Flynn
Cody Flynn

Cody Flynn is an IT professional at a Fortune 500 company. He is also a freelance writer discussing collaboration and his adventure trying the Google platform from a Microsoft background.