Cryptocurrency Explained

A Basic Explanation of Bitcoin

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There has been a lot of information circling the web about Bitcoin for the past decade and both good and bad news seems to increase year upon year. This leads to a lot of people wondering what Bitcoin actually is and how it really works. If you yourself are a complete beginner when it comes to Bitcoin, or you want to explain it to someone who is, then the below is for you:

We will use an example to begin. Let’s say there are 5 people sitting in a circle. Each person has 10 bottle caps, with only 50 of these bottle caps existing in total.

You and I are two of the people within this circle. I agree to give you 5 of my bottlecaps in exchange for a painting you own. Everyone within the circle sees this transaction take place as I pass you the bottle caps and you pass me your painting. All 5 of us now agree that I have 5 bottlecaps left and that you now have 15 bottle caps.

There are still only 50 bottle caps in existence within our circle, but I have transferred 5 of mine to you.

The above example works, because the bottle caps are physical items and I have been able to place them into your hand. Additionally, everyone in the circle has seen this transaction take place and acknowledges that you now have 15 bottle caps in your possession and I have 5. The same number of bottle caps remains within our circle and they are worth the same value as a result. However, you now hold more of them than I and the others in the circle do.

Now, let’s imagine that there are 5 of us, but we aren’t sitting in a circle, we are all in our homes, each with 10 bottle caps and only 50 of these caps existing in total and this time, they are digital bottle caps. The bottle caps aren’t tangible (they can’t be physically touched). If I pass you 5 digital bottle caps using our computers, how do you know that these bottle caps are real? How do you know that I didn’t make digital copies of the bottle caps on my computer and send them to someone else too, effectively spending the same caps twice? How do the other 3 people within our system even know this transaction took place, as they couldn’t see it? Could one or both of us be lying about the transaction to them? Once the bottle caps are no longer physical items and become digital, we suddenly lose trust in our system which worked so well before. There could be 50 bottle caps or there could be 5000, because one or all of us could be making digital copies of them.

The way we solve the issue of ensuring each person knows when a deal / transaction takes place, is by introducing a ledger (an accounting book, where all transactions are recorded). In our example above, this ledger would need to be digital and someone would need to be in control of it.

The problem with this, is that we require a third party; someone we trust, to keep control of our ledger. This may cost us money, or we may not trust this person at all; this third party could add more digital bottle caps to the ledger and keep them himself. The problem we are facing here is of trust on the internet.

How do we solve the issue of trust online?

Instead of the ledger above being handled by a third party, we can make sure that each of the 5 of us within our ‘circle’ holds a copy of the ledger on our computers. Doing this would make sure that every single transaction which occurs between any of us gets updated on every single ledger. Should two of us make a secret transaction and not tell the other three; their ledgers wouldn’t match ours and they could therefore point out that our transactions were false or fraudulent. Every exchange of digital bottle caps between you and I would be recorded on our computers and in turn would be approved by and recorded on the ledgers on the other 3 peoples’ computers. No single person controls the ledger and therefore no one is able to add more bottle caps; there are only ever 50 in existence. If someone tried to add new digital bottle caps to the system, the ledgers on the other computers would notice that there are no longer 50 bottle caps and that someone has attempted to cheat our system.

The ledger which exists on all of our computers would be ‘open source’, which means that any person is able to view it and that the smartest people around the world are able to collaborate and work on the code. Additionally, this means that anyone in the world can see how many digital bottle caps there are in existence and which computer holds which bottle caps.

Now, if you take this example described above and replace the 5 of us with millions of people and if you replace the 50 bottle caps with 21 million bitcoin (this is the maximum amount of bitcoin which will ever exist), you have the Bitcoin protocol and you have a basic understanding of how Bitcoin really works.

What about Bitcoin mining? How does that work? Click this link here to find out more: Bitcoin Mining Explained

If you are interested in finding out more information about Bitcoin, feel free to check out the rest of our blog which posts about a number of topics, including cryptocurrencies on a regular basis.

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