Whilst there are many types of Digital Currency (also known as Cryptocurrency because they’re based on very secure cryptographic algorithms that make them extremely difficult to forge), the most widely known of them is Bitcoin.
To give you a beginner’s guide as to how these currencies and the technology behind them work, click through our conversational guide to Bitcoin.
We’ll be adding more educational resources in the coming months so please be sure to check back soon.
Put very simply it is a new form of money that works extremely well on the Internet.
No. Virtual currencies are generally tokens issued by a company for near-exclusive use on their site. Examples include loyalty or gift cards, air miles or mobile phone top-ups.
Bitcoin is a general purpose digital currency. It is programmable money.
Nothing like Bitcoin has ever existed before.
In a similar way that email revolutionised the postal service, Bitcoin can revolutionise financial services.
Bitcoin only started on 3 January 2009 – it is still very early days in its growth.
It represents a completely different form of money. There is a lot of potential for new forms of businesses to emerge which will affect the way we conduct business in the 21st century.
There is nothing to stop you creating one of those new businesses.
Yes. It is much easier than other online payment systems. In many cases you simply click a link and confirm that the transaction is correct. On smartphones people tend to use QR codes because it’s easier.
It’s like a barcode but made up of black and white squares. It stores information in a way that is easy for smartphones to read.
A great example is the Reddit Bitcoin Tipping Bot. After you’ve deposited some bitcoins into your tipping wallet you can then transfer those bitcoins to anyone (even if they’ve never heard of Bitcoin) just by entering a comment like this:
That command, which is specific to Reddit, will tip $0.5 (in bitcoins) to whoever you are replying to.
Yes. Bitcoin works extremely well on the Internet.
That’s fine. The Bitcoin money supply can easily handle a sum of that magnitude.
Bitcoin fees depend on the size of the data to be stored not the magnitude of the transaction involved. If the above was a simple transaction it should cost about $0.10.
No kidding – Bitcoin is extremely efficient.
Yes. Currently many services offering international remittances charge the person sending money home to their family significant amounts. Bitcoin greatly reduces this.
With Bitcoin an international remittance is as easy as sending an email.
The Bitcoin network has a capital “B”, while the tokens that represent value are called bitcoins with a small “b”.
The three-letter code is currently BTC but many believe that it will finally become XBT in the future. The Bitcoin community is currently working with the International Standards Committee to ratify XBT under ISO 4217.
In a sense. It is not owned or controlled by any organisation. There is no government or corporation backing it. It is not patented or copyrighted.
Regardless, it’s now being used by millions of people all over the world to conduct transactions. These people are the Bitcoin community. By reading this you are part of that community.
Think about when you log in to a website. Your user name and password are protected using cryptography – a very advanced branch of mathematics that protects secrets.
Bitcoin uses cryptography to prove to others that you, and only you, have the right to spend the funds under your control.
All of the cryptography in Bitcoin is well-known and used in countless other applications including banking systems. There is nothing new or special.
In short, if you trust mathematics, you can trust Bitcoin.
Yes. You don’t even have to know who they are. Also they don’t have to be connected to the Internet to receive bitcoins.
Obviously, you can receive bitcoins from anyone as well – perhaps as part of a crowdfunded project or a loyal fanbase.
Almost. When you want to receive money you would typically provide a Bitcoin address. It is a long string of letters and numbers that starts with either a 1 or a 3. Here’s an example:
You don’t have to. That’s the job of your Bitcoin wallet software. It looks after all your Bitcoin addresses in the same way that your email software keeps track of all your contact’s email addresses.
Yes. The most private way to use Bitcoin is to never re-use an address. Your Bitcoin wallet will take care of this for you.
Also, if you did find yourself actually typing one and made a mistake the wallet software will tell you that it is not valid.
Bitcoin is available for everyone. You can find Bitcoin wallets for Windows, Mac, Linux, Android, iPhone and pretty much everything else.
Many Bitcoin wallets are “open source” which means that developers can look at how they work and verify that there is nothing suspicious going on.
Some wallet providers will ask you to sign up, others don’t.
It is not a requirement of Bitcoin that you reveal your identity. In fact one of the prime goals of Bitcoin is to avoid revealing your identity to anyone, but still allow you to conduct a transaction. It is very like cash in that sense.
No. It is possible for someone with significant dedicated resources (governments, police agencies etc) to track your transactions by examining the public blockchain.
Overall, its anonymity is much closer to cash than to a credit card.
It is the large database that contains all the transactions ever made using Bitcoin. New transactions are gathered up into a group called a block. Each new block references the one before forming a chain.
At present the blockchain is about 12Gb and growing every 10 minutes.
You don’t have to. As a normal user of Bitcoin you are only interested in the parts of the blockchain that contain your transactions. That small portion is about 25Mb.
Normally people running websites that accept Bitcoin – merchants – would make sure they maintain a complete copy of the blockchain to avoid doublespends.
That is where you get to spend the same money twice with different people. It was a common problem with digital money before Bitcoin solved it.
In the past there have been many attempts at making digital money. They have all failed because they all required trust in someone. Usually this was a company or government that checked all the transactions going through their system to ensure that no-one was doublespending.
That’s what Bitcoin does. Everyone who downloads the full blockchain is contributing to the overall security of the blockchain. Everyone is continuously checking everyone else. Nobody trusts anyone, but everyone trusts the mathematics.
Yes. It uses a very similar approach to sharing the big database file that is the blockchain. Anyone running the Bitcoin software is known as a node or peer.
Anyone can offer up a block for acceptance by the Bitcoin network. To create blocks you simply run some software called a Bitcoin miner. If your block is accepted you get a reward.
Sure. To get a block accepted you have to prove that you have checked all the transactions in it are valid and that you have expended a certain amount of effort in securing it.
Bitcoin uses cryptography to create a number that is unique to the block. It is impossible to know in advance what the number will be since even the slightest change in the block will produce a completely different number.
Remember that there are millions of computers out there running Bitcoin mining software. They are all in competition with each other trying to get their blocks accepted so that they can claim their reward.
Yes. Once a miner has secured a block, they send it to other nodes in the Bitcoin network for verification. It is trivial to verify that the target has been achieved and that all the transactions have not been tampered with.
That’s the analogy. You could extend it a little to say that Bitcoin is a digital element that is rarer than gold.
Yes. There will only ever be 21 million bitcoins produced and they only exist here on Earth. It will take until about the year 2140 to get them all.
Yes – it’s not exact but near enough. Bitcoin restricts the number of blocks that can be mined to about 1 every 10 minutes using the difficulty. This results in a controlled release of new bitcoins via the coinbase.
Over 12 million.
Bitcoins are released in steadily decreasing numbers. Every 210,000 blocks the number of new bitcoins released by mining a block is halved.
Quite so. Fortunately bitcoins are infinitely divisible since they are merely numbers. At present the Bitcoin network keeps track of them to 8 decimal places.
Thus the total number of units in the Bitcoin system is 2.1 quadrillion (2,100 trillion) which is enough for the global cash economy.
Of course, even a fraction of a single bitcoin is sufficient since it is infinitely divisible.
Since everyone is in competition with everyone else there could be multiple competing blocks being built. The rule is that the Bitcoin network will always accept the longest chain with the highest difficulty level as the final answer.
Blocks that are no longer on the longest chain are called orphaned blocks. The transactions that are contained within them are no longer considered to be valid and are dropped from the Bitcoin network.
Yes, in the worst case scenario. However, it is much more likely that the transaction has been copied into a block on the longer chain.
While there is a lot of activity at the head of the blockchain it very rapidly decreases the older a block gets. By the time a block is 6 layers deep into the blockchain it can be considered to be irreversible.
Typically each confirmation takes about 10 minutes. Therefore in about an hour any transaction is irreversible.
No. Bitcoin is very like cash. Once you’ve spent it that’s it.
Yes. With Bitcoin a merchant gets paid within an hour for their goods and services. If the merchant is willing to reduce the number of confirmations (such as with low value items) then they can get their money quicker.
No. Bitcoin is free to receive, and incurs a small transaction fee to send. This is sometimes called the “miner’s fee” and it is used to pay for the securing and eternal storage of your transaction across millions of computers on the Internet.
The fees are added to the coinbase which is paid to an address owned by the miner. They are not redeemable for 120 blocks.
Bitcoin uses the metric system to denote amounts. 1mXBT is a thousandth of a bitcoin and is called a milli (like millimeter). 1µXBT is a millionth of a bitcoin and is called a mike (like micrometer).
No-one knows. The name Satoshi Nakamoto is definitely a pseudonym and may represent a single person or, more likely, a group of people.
As a guess it could be that as an anonymous figurehead Satoshi can do no wrong. Or perhaps Satoshi felt that the project was sufficiently developed to hand it over to others to take forward.
Most well established businesses are looking for repeat business so are not trying to defraud you. That said, “buyer beware” is the key phrase when dealing with any online merchant.
Well then, that brings me to something very interesting about Bitcoin.
Let’s take it step by step.
From previous transactions that have been paid to me in earlier confirmed blocks.
Yes. The sum of all bitcoins paid into Bitcoin addresses that you own is your total balance.
For that you need to know a little more cryptography – specifically something called public and private keys.
Here’s a quick overview of the principle.
In the world of cryptography, the padlock is called the “public key” because it is out in the open (public) and only a single private key will unlock anything protected by it.
Also, in cryptography a “key” is just a very large number. So we have a “public very large number”, and a “private very large number”.
Yes. With the private key you can work out the public key, but you can’t go backwards.
Almost. Since the public key is a very large number it is compressed (like zipping up a file) to reduce the space on the blockchain. The compression process also hides the public key which comes in handy later.
This is the final piece of the Bitcoin puzzle. The private key is used to sign transactions.
Yes, except it cannot be forged.
A Bitcoin transaction is made up of inputs coming from earlier transactions that gave you bitcoins. Those earlier transactions have outputs that point to your addresses.
Exactly. When you create a new transaction you gather up the unspent outputs from various parent transactions to make up the money you need.
Yes. Imagine you have received 1.5 bitcoins (1.5 XBT) each from 10 different sources giving a total of 15 XBT spread over 10 outputs.
You need to produce the public key associated with each address for the outputs. You’ll remember that it was hidden behind some compression so only you have it to hand the first time it gets used.
In cryptography, public and private keys are linked. If someone knows the public key they can verify a signature made by a private key is correct. This gives conclusive proof that you own the address and that you made this new transaction to spend of the contents.
You started this signing thing to answer the simple question of a merchant going bad. I don’t see an answer to that.
Now that you understand inputs and how they can be signed to authorise payments to outputs, it is easy to imagine if that process was made a little more complex.
Exactly. The usual scenario is that Alice and Bob want to make a trade, but they don’t trust each other. However, they both trust Trent who has no interest in either Alice or Bob’s affairs.
Actually very little, but often people want to really understand what they are using. It helps to know what is going on under the covers at a basic level.
This is the amazing thing about Bitcoin. You barely need to know anything to use it, but the more questions you ask the more you learn.
Bitcoin has been designed as a deflationary currency, so it has a strictly limited money supply.
Broadly speaking, a deflationary currency is one that increases in value over time. Goods and services priced in a deflationary currency will therefore tend to reduce in price – all other things being equal.
The price will be less because the purchasing power of Bitcoin is expected to increase over time because the money supply is limited.
That’s entirely your choice. Nobody is making you spend any.
We cannot give financial advice, but a general observation is that since the purchasing power of bitcoins is intended to increase over time then it could act as a simple savings scheme.
There is that possibility. Nothing like Bitcoin has ever existed before – it is a huge economic experiment.
A bitcoin has no physical presence – it is just a number in a transaction in the blockchain. A number by itself has no intrinsic value.
Yes. Or even a part of one. If you only have a single Satoshi (the smallest unit in Bitcoin) you will see the value of your investment change in accordance with the overall network.
Quite rightly. By holding Bitcoin you are taking a huge risk that it won’t crash to zero leaving you with nothing.
Often they will accept payment in Bitcoin and then immediately cash out to their local currency. There are companies that perform this service for a small fee which is lower than a typical credit card processing fee.
Not really. The bitcoins are usually sold via an online Bitcoin exchange and then used again by someone who wishes to hold bitcoins.
There are many ways to obtain bitcoins, just as there are many ways to obtain any foreign currency. However it is quite common to use an online Bitcoin exchange.
Only in broad terms because every exchange is different. Overall it goes like this:
At this point you own bitcoins, but they are under the control of the exchange. You should move them into your own Bitcoin wallet as soon as possible.
Bear in mind that most banks charge a fee for a wire transfer, and the exchange also charges a fee for each trade. It is generally better to use an exchange for larger transactions.
Unlikely. Both those payment methods are reversible through chargebacks. Any merchant selling you bitcoins through those channels is taking a huge risk that you won’t issue a chargeback within 180 days.
Most merchants would be unwilling to take that risk with anyone other than a trusted customer.
Not a problem. There are many people who provide such a service through a site called Local Bitcoins. Always be cautious when meeting with strangers though.
We’ve only just launched our website. We will be adding more and more useful resources over the coming months that will help you on your way. Please be sure to check back for updates.
Hopefully this explanation has helped you and inspired you to learn more.