MANILA, Philippines – Whether it’s buying physical and digital goods through an online retailer like Overstock.com or paying for a postgraduate course on Sustainable Leadership at the University of Cumbria in the UK, bitcoin has become a big technology trend worth watching because it’s a mix of the physical and the digital.

Bitcoin is a digital currency, commonly called BTC, designed with protections in place to allow it to have value like physical money. At the same time, some may also see bitcoin as the decentralized system that enables the trading of the currency through a “block chain” – an up-to-date accounting of every transaction ever made using the currency.

How does bitcoin work? How is the block chain maintained? How can we be sure all transactions using bitcoin are valid?

Below are some insights that attempt to answer these questions. Beginning with a short history of bitcoin, we’ll discuss the mental leap needed to take bitcoin for what it is, followed by how new bitcoins are introduced into the system and how that system sustains itself. We’ll then discuss the challenges and reception the new currency has had.

Bitcoin begins with Satoshi

Bitcoin began as a paper published online in November 2008. The paper, titled Bitcoin: A Peer-to-Peer Electronic Cash System, was written by someone who called himself Satoshi Nakamoto, though the identity of the author remains secret.

In the paper, bitcoin was described as a “system for economic transactions without relying on trust.” Rather than rely on a “trusted third party,” such as a bank, to facilitate or mediate a transaction, the paper devises an electronic payment system that uses cryptographic proof to do the job. By January of 2009, the first open-source bitcoin client was released to the public.

Perceiving Bitcoin

The mental hurdle of how a person treats bitcoin is an important step in coming to terms with how it works. To better explain it, let’s discuss how one should perceive a bitcoin, as well as how bitcoins are acquired and placed in the market.

This post on Medium cuts through the mental paradigms quite well. The idea behind the post shows that bitcoin is a digital currency that treats itself to some of the advantages and features of physical currency, but without the same system pushing the vaue of the currency up or down.

In this case, imagine that bitcoins are like gold coins, and imagine that I’m giving you one gold coin.

Like physical coins, when I give you a bitcoin I have, I lose that bitcoin. Despite being a digital construct, there are safeguards in place that ensure that bitcoin is treated like a unique physical item – traded by one person or entity to another person or entity only – and people can’t fake the creation of a bitcoin under normal circumstances.

Block chains and cut-up currency

How do you ensure that no fake bitcoins or copied bitcoins ever come into circulation? The answer comes from another physical construct: an accounting ledger. Whenever someone gives a bitcoin to someone else, that transaction is placed in that ledger.

Unlike the physical world where specific people or entities, like banks, hold the accounting ledger, the bitcoin accounting ledger – or block chain – is shared by everyone who wants to help maintain the ledger.

A Quartz article on bitcoins explains each part of the block chain is a transactions log made up of a 10-minute block of activity, referencing the block that came before it.

The block chain’s records show that when I, for example, give a bitcoin to someone, that transaction is recorded and open to anyone who wants to view it.

It ensures that I no longer have that particular bitcoin in my possession. More importantly, if anyone tried to fake that bitcoin and put it into the system, it wouldn’t match up with every other copy of the ledger.

Now for one additional twist that’s decidedly digital. Unlike most physical coins, which tend to lose their value if you cut them up into smaller portions, you can send increments of a full bitcoin to other people.

In other words, despite one bitcoin having an inherent value, you can also transfer 0.1 or 0.001 bitcoin if you wanted to, and these will also have their own equivalent value.

Watch this promotional explanation on Bitcoin:

Earning BTC

Bitcoins are a finite currency. Despite being a digital currency, there is actually a cap on how many total bitcoins can ever be made. The current estimated number of bitcoins in circulation is 12 million, and the release of bitcoins is capped at 21 million by the year 2140.

The introduction of new bitcoin is done through a process called mining, though there’s no actual ore mining involved.

Instead, bitcoin miners maintain the block chain mentioned above using a computer or system of computers to do cryptographic work. They check the records to ensure that transactions are legitimate and then keep the ledgers protected to avoid tampering.

Not all bitcoin miners get paid for their services, however. Instead, bitcoin mining is more of a race to complete a transaction set. The first to complete the set earns new bitcoin for their work. 

Users who don’t want to get into bitcoin mining but want to use the new currency can also go to a Bitcoin Exchange to buy at the given exchange rate. Some online marketing firms and other initiatives also offer payment using bitcoins for being a part of a marketing survey.

Challenges

Bitcoin has had a number of incidents that have caused a rolling back of one’s earnings of bitcoin to a certain version of the bitcoin system. In one major incident in 2010, users temporarily exploited a vulnerability in the bitcoin protocol to replicate and create 184 million bitcoins. 

This was eventually resolved after the vulnerability was stamped out and the bitcoin system reverted to a pre-exploit state.

In one other notable case, a bitcoin miner using version 0.8.0 created a block of data that wasn’t compatible with earlier bitcoin software versions due to its size. As a result, the system split in two, with one fork in the block chain accepting that block of data and the other fork rejecting it, leading to the creation of two separate transaction logs. This let the same funds be spent twice depending on the chain being referenced. 

This “forking” of the transaction logs eventually reached a concensus after some users reverted to an earlier version of the bitcoin software.

The world reacts

If you can imagine those two scenarios as being indicative of how scary the virtual currency can be, you can expect governments to also take notice and pause to examine what this new currency can do. As such, bitcoin has acquired varying levels of acceptance depending on where you live. 

The Canada Revenue Agency said bitcoin users have to pay taxes on transactions using bitcoin or other digital currency.

In Europe, the European Banking Authority has issued a warning on transactions made with bitcoin or other alternative currencies, saying that these do not have the same protections or regulations as regular currency. It has also warned that “there is no guarantee that currency values remain stable.”  

China has played a strange role in charting the course of bitcoin, restricting the trade in the country.

Meanwhile, the US Internal Revenue Service (IRS) has remained quiet on bitcoin. In a report on Forbes, the IRS was quoted as saying it “continues to study virtual currencies and intends to provide some guidance on the tax consequences of transactions involving them. The agency is also aware of the potential tax compliance risk posed by virtual currencies.”

A complex system

The bitcoin currency is actually a very complex system, and while this article serves as a simplified primer, there’s a lot more to it if you actually want to start investing your money into a bitcoin mine or using bitcoin for remittances.

For a more detailed overview explaining how bitcoin works and the math and coding behind bitcoin transactions, there are two resources that would be helpful for newcomers to watch.

The first resource is the Bitcoin 101 Blackboard series on YouTube, specifically the 3-part series called “Understanding Bitcoin.”

Watch the first episode of Understanding Bitcoin below:

There are quite a number of videos that attempt to explain bitcoin, but if you tried to learn more about it by going to Wikipedia, this video series actually tries to explain the very first paragraph on the Wikipedia page by discussing the technical terms.

Some of the terms relayed in these videos have been updated or altered slightly on Wikipedia, but the definitions for particular ideas in the video remain valuable for those trying to grasp the nature of bitcoin.

The second resource, which is more technical, is Khan Academy’s educational series.

Khan Academy’s course goes into detail on what bitcoin is, how the block chain works, and discussions on the technology used for block chain management.

It’s recommended for people who have some understanding of how bitcoin works, but want to dig into the systems rather than using bitcoin as a money-making or currency venture. – Rappler.com

Golden Bitcoins image from Shutterstock