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How does Bitcoin work?

how bitcoin worksAs I've mentioned, it's not essential to understand exactly how Bitcoin works to use it. That said, knowledge is power and I personally find it fascinating.

Bitcoin is actually built on a much broader technological advance known as Blockchain.

What is Blockchain?

Blockchain technology is a super-secure way of publicly verifying the transfer of information between two parties.

When a transfer takes place, a block is added to the chain chronologically. Each block contains sets of data relating to the transaction, and also relates to the previous block with a cryptographically generated signature. It's this signature that locks (or chains) all the blocks together, so that a block can never be modified once it's created.

blockchain animation

Seen as a kind of public ledger, a Blockchain is stored in the cloud across thousands of computers around the world. The mix of the chain being decentralised and blocks bound together makes Blockchain technology practically unhackable.

Bitcoin was the first and most popular implementation of Blockchain. When you send some Bitcoin to another person, the transaction will be verified by lots of computers in the Bitcoin Blockchain and create a new block.

You can see a real example of a block here. This is a Bitcoin transaction I made. Note the “Confirmations” icon: 1,814 separate computers have already verified this transaction.

bitcoin valid

But in fact any form of transfer that requires validation can utilise the technology, anything from licensing music, sharing medical records to buying a house.

Ethereum is another kind of cryptocurrency that also goes beyond money to handle ‘smart contracts'. This means a legal document such as the transfer of Title Deeds can be quickly validated for a property sale, for example.

Even the British government are being encouraged to adopt Blockchain.

Whilst it's still early days, some experts predict that Blockchain technology will lead us into a “trust” revolution, following on from the industrial and informational revolutions.

Where do Bitcoins come from?

New Bitcoin is created as a result of ‘mining', which is conveniently also the way that every Bitcoin transaction is processed and verified.

For every transaction, mining computers must solve very complex mathematical problems and generate a 64 digit solution. Once solved, one block is added to the Bitcoin chain and the miner earns a certain amount of new Bitcoin as a reward.

The Bitcoin Blockchain is programmed to only ever release 21 million Bitcoins. Once they've all been mined no more will ever be created.

This is estimated to happen by July 2020. At time of writing there are over 16.7 million in existence (live count here).

What are the downsides of Bitcoin?

It's important to remember it's still very early days. All new technology comes with obstacles and trade-offs, just as we've seen with the internet and disruptors like Uber.

Some of Bicoin's disadvantages:

  • Great amount of price volatility in the short term
  • Built-in deflation could maintain volatility longer term (due to max. 21m BTCs)
  • It's a currency and a commodity, meaning people incentivised to hold rather than spend Bitcoin
  • Huge volume of transactions processed slows down verification (whole network upgrades needed)
  • No intrinsic value – just what someone else is prepared to pay (like gold)
  • No buyer protection
  • Used for criminal transactions as it's untraceable (like cash)
  • Not widely accepted yet
  • Possibility of governments prohibiting merchants from accepting Bitcoin
  • Lots of people working in finance will lose jobs

Why has Bitcoin got so popular?

In 2010 someone bought just two pizzas for 10,000 Bitcoin. Today those pizzas would be over £72 million.

The phenomenal growth follows Bitcoin becoming increasingly widespread, really hitting a tipping point in 2017 as its value surged by more than 880% in 12 months.

bitcoin charts

Bitcoin had the advantage of being the first cryptocurrency, but I don't think there's one specific reason why Bitcoin itself has become so popular.

Various political events have added to the mix since 2009, along with technological advances and media attention.

For example, HMRC, the European Court and Japan have recently recognised Bitcoin as a real currency, whilst Chinese investors are increasingly keen to move their money away from the control of Chinese government.

The financial crisis of 2008 undoubtedly also gave Bitcoin a big step up. Big banks revealed their vulnerabilities and many people lost trust in institutions.

It's inevitable

In 1988 The Economist predicted a world currency by 2018. The idea is nothing new!

the economist bitcoin 1988

Is something like Bitcoin not just the natural next stage of progression? Bitcoin offers a democratic, digital, fast, secure global currency.

‘Money' has already gone from grain to metals to paper to electronic (online banking, credit cards, PayPal etc). Perhaps we're on the cusp of going completely digital, and Bitcoin is taking the lead.

With all the advantages that Bitcoin (and Blockchain) carries – and that only 0.1% of the global population are participating so far – the momentum is likely to continue.

Best videos on Bitcoin and Blockchain

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