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ArchivesI recently had a fairly successful post in which I attempted to explain Bitcoin mining in plain English. It was so successful, in fact, that I decided to make it a series.
In the previous article I linked to the always-popular weusecoins. com video, which does one of the best jobs I’ve yet seen of getting across the bare basics, but the video is less than 2 minutes long and I feel like we’re still missing an in-depth explanation of what Bitcoin is, how it works and why you should care without using a gigantic pile of unexplained terminology – so I’ll give it a shot. As with my previous article, I’m going to attempt to use as few technical terms as possible, but invariably there will be a few terms that I just can’t wiggle my way around and maybe a few that I thought were more common than they were. To that end, I’ll be keeping an up-to-date glossary of terms right here at the top of the post. Also keep in mind that this isn’t a tutorial on how to use Bitcoin, plenty of those already exist, it’s an attempt to explain in layman’s terms how Bitcoin actually works.
Key / Key PairBitcoin is based on strong encryption, so a lot of the terms I just can’t wiggle around are basic concepts in encryption, like “keys. ” In encryption, we take some information that’s in an easy-to-read format and use a piece of secret information called a “key” to scramble it up. This scrambling is only reversible if you have a copy of the same key that did the scrambling. There are other ways to do the scrambling that make use of two keys, one private and one public. The private key is kept secret and the public key can be given out to anyone. If you want to send me a message you can scramble it with my public key, but only my private key can be used to unscramble the message. The two keys together are referred to as a “key pair. “SigningBitcoin makes heavy use of an encryption technique called “signing. ” It’s sort of like the scrambling techniques I mentioned above, but it doesn’t actually modify the message. Instead it does some math with the message and your private key and comes up with a little chunk of data that you can tack onto the end of the message. Anyone else can use your public key to verify that the message was created using that data and your private key, both verifying that you hold the correct key and that the message hasn’t been modified or damaged in transit. Block / BlockchainI debated including this one, but it’s such a central concept in Bitcoin that it’s hard not to. When you deposit money at a regular bank, they store information about that deposit and your account in a big database. Bitcoin does this, too, but unlike a regular bank we can’t trust one central authority to store and manage that database for us, which causes some problems. Bitcoin solves these problems by breaking down the database into little chunks called “blocks. ” Each block has sort of a label that links it to the block before it so that anyone can assemble the whole database from the individual pieces and everyone using Bitcoin stores a copy of the whole database (called the “blockchain”) and sends these tiny chunks back and forth to each other. Now that we’ve got the definitions out of the way, let’s get down to business.
Bitcoin is an attempt to create a new currency for the digital age. If we’re being completely honest, the way we perform transactions online is pretty outdated and scarily insecure. Beyond the transactions there are also issues with the kinds of money we use – there’s almost always some authority that can cause all kinds of severe economic problems since they control the currency and the actions of that authority can’t always be predicted. In short, there are some serious problems with our money and the methods we use to spend it, and Bitcoin is perhaps the most successful attempt yet at solving those problems.
Bitcoin is based on very strong encryption, the kind of stuff governments use to keep state secrets out of the hands of other governments, so instead of trying to add security to an inherently insecure currency, we’re starting out strong. Bitcoin is designed to be de-centralized, meaning that no central authority controls Bitcoin – new bitcoins are issued by a mathematical algorithm that is publicly published and incredibly difficult (if not impossible) to change, so everyone knows exactly how many bitcoins there are today and exactly how many there will be tomorrow. New coins are issued to people who donate computer time to help make the transaction database secure. This process is commonly referred to as “mining” and if you’d like to know more about it, I’ve got a “plain English” article on mining here.
This de-centralization aspect of Bitcoin is just as important as the encryption. Everyone has a copy of the transaction database, everyone verifies that transactions are valid and everyone holds a copy of all the rules. This means that we don’t need a bank becauseВ we’re all the bank. We’re not reliant on any company that can fail or become “too big to fail” nor any government or party that can rise or fall. As long as there is a functional internet and two or more people running a copy of the Bitcoin software, Bitcoin will still exist – it’sВ that hard to shut down. Since we’re all the bank, this also means that no central authority gets to decide who can transact business with whom. Remember a while back when Visa and MasterCard cut WikiLeaks’ ability to accept donations, but the KKK got to keep raking in the racism money? That can’t happen with Bitcoin.
The decentralized nature of Bitcoin also means that it would be very difficult, if not impossible, to intentionally shut Bitcoin down. Other internet currencies have existed before and while many have failed because they were inherently flawed, those that gained any meaningful traction got shut down for another reason: Governments are like jealous brides. Heaven forbid any of their bridesmaids start to look as good as the bride, one of two things happen: ugly sea-foam green dresses or you’re out of the wedding. Every prior internet currency has been operated by some individual and the government likes to go kick down that individual’s door and seize their assets. Bitcoin has the benefit of not having a door to kick down. We’re still vulnerable to the “sea-foam dress” in the form of smear campaigns, but pretty much everyone understands that a sea-foam dress means the bride is insecure and no matter how ugly the dresses, someone always hits on the bridesmaids at the reception… Maybe I’ve taken this analogy too far…
In the beginning, we used to claim that Bitcoin was also anonymous – then people on the internet got all annoying and pedantic and made us start using the word “pseudonymous. ” Anonymous means there’s no tie to any identity whatsoever, which isn’t technically true, while pseudonymous means that information ties back toВ some identity, but not necessarily any identity recognizable asВ your identity. Let me explain. Every Bitcoin “account” is actually a key pair, as explained in the glossary. We apply some funky formatting to the public key and call it an “address. ” Think of the address like a bank account number, you can give that address out to someone and they send money to it. Once you’ve got some funds at that address, you can use the corresponding private key to spend those funds. This all happens behind the scenes, the Bitcoin client software handles the entire process. The important thing, though, is that if I physically hand you a slip of paper with my address on it, you now know that I own and control that address and all the funds in it. If I do business with you anonymously and send you my address in a way that doesn’t reveal my actual identity to you, there’s no way for you to otherwise tie my address to my identity.
This is important because since everyone has a copy of the entire transaction database, it’s trivial to look up every transaction ever performed by a particular address. This might seem to be a privacy concern, but remember that unless you run all over the internet screaming “HEY EVERYBODY, I’M JOE SMITH AND THIS IS MY BITCOIN ADDRESS! ” it’s basically impossible to figure out who owns an address. Combine this with the fact that it’s trivial to create any number of new addresses any time you want and Bitcoin can be as secure as you make it. Imagine a future where non-profits (whose financial records are required to be public) don’t have to do anything special to publish their books in order to make completely transparent real-time monitoring of their financial data a reality – meanwhile millions of people using the exact same system get near-perfect anonymity since people can see Bitcoins moving, but have no way of knowing who is holding which keys.
Another important aspect of Bitcoin is that it was intentionally designed to be cash-like. There are a lot of important ways in which Bitcoin more closely resembles physical money than other forms of electronic payment, but I want to focus on the two biggest: cutting out the middle-man and irreversible transactions.
Have you ever noticed that more places seem to be offering discounts for cash transactions every day? There are two very valid reasons for this and they’re both problems that Bitcoin solves. First, every credit card transaction is being bled dry by a handful of middle-men.
Let’s say you’re buying a candy bar at 7-11 – if you pay cash, you hand the clerk your dollar and that’s it. Business has been transacted between you and the store; you got a candy bar, the store got a dollar and since no one else was involved the merchant gets the whole dollar. Swipe your credit card, though, and the merchant needs help from your bank, his bank, a merchant services company that speaks all the different languages of all the different banks and (indirectly) the company whose logo is on your card (Visa, MasterCard, etc). Every single one of those people makes money by charging fees on those transactions. The fee structures are complicated and vary wildly, but on average you can probably guess that swiping your card costs the merchant a flat fee of around 15 cents plus about 3% of the dollar amount shown on the register. Your $1 candy bar just cost the merchant 18 cents in fees, or about 18% of the actual price of the candy bar… OUCH. While Bitcoin does have fees, they’re only required for really complicated transactions (i. e. pay someone with the combined funds from 30 different accounts) and they’re always flat fees and they’re always very tiny. Almost all transactions go through with no fee at all.
The second important way that Bitcoin is cash-like is that Bitcoin transactions are irreversible. Going back to our “candy bar from 7-11” example, imagine you paid cash. You hand the merchant your $1 bill and walk away with the candy bar but… oh God this candy bar is stale and awful! Whether or not you get your money back is up to the merchant. If you bring back an empty wrapper the merchant could say “well it can’t have been that bad, you at the whole thing” or if something is visibly wrong with the candy bar they might go the other way. This is the way returns have been handled for ages, but credit card processing has invented a new method that really hurts merchants: the charge dispute. If you’d paid for your candy bar with a credit card, first you cost the merchant 18% of its value in fees, then you can call your bank and dispute that charge. A fair amount of the time, your dispute will succeed and the bank will reverse the charge, taking $1 away from the merchant and giving it back to you. В So now the merchant is out the $1 you spent, and the 18 cents in fees, and the 50 cents he spent on the candy bar he’ll never get back and there are often fees the merchant will incur for the reversal. Even without the fees the merchant has now lost $1. 68 on a $1 sale that would only have profited him 32 cents thanks to the fees. Now scale this up and imagine it’s a TV. Is it any wonder merchants prefer cash?
But why should you care about the merchant? Well there are lots of compelling arguments if you want to get into the economics of it all but here’s the simplest: If 7-11 has enough charges reversed that it results in, say, a 3% reduction in overall income then they have to get that 3% back from somewhere and that usually means raising prices across the entire business. You, I and everyone else now pays 3% more В to make up for reversed transactions we had nothing to do with. What’s worse, other companies will look at 7-11’s experiences with reversed transactions and preemptively raise prices 3% in preparation for reversed transactions they haven’t actually experienced.
So that’s Bitcoin in plain English. If there’s anything you’d like to see added to this post, let me know in the comments and if it’s reasonable or possible to explain without jargon, I’ll do the best I can to add it.
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Read moreDavid Perry