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HTG Explains: What Is Bitcoin, the Virtual Digital Currency?

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Bitcoin is a virtual currency that employs some very interesting principles. Here’s the skinny on what exactly it is and how the fascinating technology behind it works.

Disclaimer: This is NOT financial or legal advice. This. Is. NOT. Financial. Or. Legal. Advice. This is not, in any way, shape, or form, financial or legal advice. We’re covering this topic because of the technological implementations it uses and the innovations it attempts to make. If you do anything because of this post, we are not responsible because this is NOT financial or legal advice. ^_^

Virtual Currency

error notes

(Image by david_shankbone)

Bitcoin is an open-source project created in 2009 by Satoshi Nakamoto that acts as a virtual currency. You can trade real cash for these units and spend them in places online in exchange for actual goods and services. It is actually already anchored to real currency, so people are already trading for Bitcoins and accepting them as payment. The Electronic Frontier Foundation accepts Bitcoin donations, and there are even escrow services related to Bitcoin transactions.

What really makes it different is that it’s based on a really smart form of cryptography to make it secure and it’s not based on a central authority or state treasury. These two dominating characteristics are very important when considering a currency whose basis is the internet.

Crypto-currency

Crypto

(Image from Wikipedia)

Any currency is useless unless it has security. Hard currencies usually have specific characteristics that make it difficult to counterfeit, such as the quality of the paper, special inks, watermarks, and so on. Virtual currencies have a somewhat more difficult time with this because everything is digital. As computers increase in power and get optimized for new functions, so, too, do they become more suitable for breaking encryption algorithms. The Bitcoin system has developed a very robust implementation of Dr. Adam Back’s hashcash to stay ahead of this issue.

Bitcoin transactions work by means of a block-chain. When you make a transaction, you use public and private key authentication (similar to SSH) to transfer funds. These transactions are then broadcast on the network among the nodes, and each node verifies the signatures prior to accepting it as valid. Nodes work to collect these transactions and perform a hash via an encryption algorithm. This process is done repetitively until a particular node creates a hash that meets certain agreed-upon requirements. Each node is competing to complete that block. Then, that group of transactions is bundled in what is called a “block.”

Blockchain

(Image from Wikipedia)

These blocks are chained together by requiring each block to include the previous block in its hash. Thus, there’s a “forward-moving” chain of blocks that starts off difficult to crack, but over time increases in difficulty with each new block that’s created. Blocks eventually are archived and compressed. This process is a very extensive one, but it prevents people from counterfeiting Bitcoins or using the same Bitcoins for multiple simultaneous transactions. You can even check the status of Bitcoin block creation online.

Peer-to-peer

screen3

(Image from bitcoin.org)

How do these blocks work with you? Well in order to use Bitcoins, you need to be running the cross-platform client (of course, with something like this, you can expect Linux support, too). The client functions as a node for transactions, acts as your wallet, and works to make your own transactions. The client joins a private IRC chat (that’s programmed into the client itself – you can’t change the base servers) to download the block information needed to make new transactions and communicate with other nodes. Nodes interact over port 8333, and as of right now port forwarding is required for proper use of the client (creating blocks).

To account for inflation, there’s something built into the client called “mining.” In the old days of gold-backed US dollars, miners would find gold and get money for it, and that was what allowed for inflation of the currency. Here, the client generates 50 Bitcoins for nodes that complete blocks first. There is a fixed number of Bitcoins that will ever be produced: 21 million. Every 4 years, half of the remaining value of Bitcoins will be introduced into the system. Of course, like gold mining, creating Bitcoins isn’t a real long-term way to get rich. It’s more of a reward during the early stages to do the work required to make the system go.

No Central Issuer

outdated us currency

(Image by Maggie Mbroh, joeyjorie)

One of the largest points of Bitcoin is that it doesn’t rely on a central issuer. It is not a fiat currency. This mitigates the problem of a central bank causing instability in the currency. Perhaps more importantly, because Bitcoin is a virtual, internet-based currency, there are no political ties to the currency. Consider the problems that Paypal users in India have. Then there’s the problem of legality. Many online gambling sites would trade money for in-game points that could be cashed out, similar to casino chips. Bitcoin (arguably) circumvents legal issues because there’s no single entity that runs it. Everything is handled by the peer-to-peer network, and the important points are all set in stone already.


The Bitcoin system is really robust in terms of security, but it also provides a very interesting take on digital currency. Most problems, both economic- and fraud-related, have counter-measures built into the system. What do you think about this? Are we finally getting close to a Star Trek Credit-system, or is this thing gonna just blow over in a few years? Make your opinions known in the comments.

Yatri Trivedi is a monk-like geek. When he's not overdosing on meditation and geek news of all kinds, he's hacking and tweaking something, often while mumbling in 4 or 5 other languages.

  • Published 03/1/11

Comments (36)

  1. Dave

    Thanks for the free legal and financial advice……..

  2. Seasider

    Well done Dave, you beat us all to it. lol

  3. CodeHxr

    Well played, Dave. :)

  4. Carlos

    Very interisting info, thx

  5. cncgeorge

    This is very timely and interesting. As the US dollar looses value, I wonder if changing from the dollar to bitcoin as the value drops and switching back when the dollar is high has any advantages or disadvantages to me?

  6. BP

    Dave you took the words right off my keyboard!

  7. DavidB

    What should I do with all the bitbucks in my bitwallet?

  8. Snert

    Very Interesting!
    Sounds good to me, but I think I’ll hide and watch.

  9. Derek Shields

    Good stuff, even if it isn’t financial or legal advice. I’ll probably use it to design some completely bogus advice of my own,

  10. Paul Leger

    This looks like it has good possibilities, however I’ll stick with Snert and watch for a bit.

  11. myztic

    Well I think that will blow off

  12. Dan

    Thumbs up.

  13. Thomas Clover

    I’m looking forward to see how well it performs. I will watch from the sidelines though.

  14. roystreet

    Who controls the value of this currency? It won’t work if the international (central) bankers aren’t on board with it. They want to control the worlds money. Just a thought

  15. Ksink

    Sounds a lot like Neal Stephenson’s “Cryptonomicon”.

  16. Kelly

    Also see (listen to ) the Security Now podcast on the subject. : http://twit.tv/sn287

  17. bill

    What a great idea to trade between people as a credit type of thing.

  18. bob

    many thanks for info regarding internet loot

    i ask and hope you answer, “how much, total, loot would you put at risk in
    this incubator of bypassing govt banks etc?”

    i ask because no matter how
    good the safeguards there is always a thousand hackers who are already ahead
    of the game and can come in an scoop up your loot etc,

    of course this is not
    to badmouth govt, nor praise hackers, but to show that this internet creation and or use of money
    pc to pc is nice but how long will it last in a safe mode?

  19. BK

    OK so how do I take my real dollars and convert them into bitcoins…say I wanted to donate 20 bucks to the EFF….how do I get my 20 bucks in?

  20. enigmAZ

    nice artical,thank u

  21. Gavin Andresen

    Nice summary! Minor quibbling corrections:

    + The IRC connection is only used for ‘bootstrapping’ — finding other nodes to communicate with. Blocks and transactions are not transmitted via IRC.

    + You don’t HAVE to open up port 8333 for incoming connections to use Bitcoin, although like all peer-to-peer networks, the more people who accept incoming connections the better. If you don’t open up your firewall, then you’ll connect to 8 randomly chosen nodes that ARE accepting new connections.

  22. G D SILVERMAN

    The value of this currency relies on a steady constant reliable flow of electricity.
    I think we should now be looking for ways to demonetize people and ease our way out of the merchant based policies that reduce societies to factories and parliaments to salesmen.
    Bitcoin is an agreement between parties that it has a certain value.That is what makes anything a currency.
    The instability of current values does afford government opportunities to manipulate events and keep everyone’s nose stuck firmly to the grindstone. This restricts the possibility of wider vision. As such bitcoin will probably be undermined if it looks like getting too popular.
    There is a central bank-it is the power station.
    Regards-silverman

  23. Zedd

    One can only hope that this IS the beginning of something bigger and better than the Federal Reserve BANK. Beam me up Scotty, anyone?

  24. Charlie, CQ

    OK, what if the bitcoin adopted by Facebook as the face-dollar? With current social-network connections of FB, the creditability and value of bitcoin can be further supported by FB’s layers of network connections.

  25. Charles

    To all the naysayers: Even if the program fails in some way, the fact that this idea is out there in a real and functioning way is monumental on its own. If nothing else, Bitcoin has laid the foundation for a fantastic new concept which can be shaped and built upon as our thinking progresses.

  26. TJ

    boy really Hitec stuff I don’t think it will fly but maybe it will or something like it thanks for the info very interesting!

  27. Phylis Sophical

    There is some really good info on BitCoin and it’s use in places like Kenya right now. Just Google ‘Spark CBC Radio’. It’s on the main page right now, or available through itunes. Spark 139, Feb 27. I was very impressed.

  28. Ja5087

    Smells Like Bittorent

  29. dwkarl

    Can I use it to send my money to that guy in Nigeria?

  30. cam2644

    Some of the comments are clearly skeptical but I think it’s a good idea that could be a step towards liberating us from the control of greedy and sometimes dishonest banks.
    Currency speculation is a scourge that prevents the wheels of free trade moving and an international virtual currency has to be the long term answer.

  31. eMansipater

    Been following Bitcoin for a while now. You got to laugh at the people who said “it’ll never work” six months ago since it’s increased nearly 16 times in value since then. Predicting the success of this is not like predicting the flip of a coin–it will succeed if many, many people build successful businesses and services on it, and fail if nobody does. So it’s more about work and less about soothsaying.

    I have to say, the idea of being able to interact with money programmatically is very cool. Kind of like HTML for money. Means there is a very low barrier to entry and some very cool technologies that can be built on top of it. Already people are building smartphone apps to transfer money in person and using QR codes to simplify real world deployment. Not having to pay fees to Paypal is pretty cool too. Microtransactions that cost next to nothing is an exciting possibility as well. Birth of an online tipping economy perhaps? That’s what sites like http://www.youtipit.org/en/home are going for and seems very cool.

    Digital money is definitely coming. If Bitcoin is it, then I’d say we could do a lot worse.

  32. Danny

    This reminds me of Flooz during the first internet bubble era.

  33. weekses

    Let me first say that I love this blog and read it religiously. Normally I’d have very little to contribute, but here I’d like to chime in with a few nits. Caveats: maybe I misunderstood how Bitcoin will be managed, and I haven’t read anything further on Bitcoin (though maybe I will if I can find the time).

    1a) what seems to be a contradiction: If Bitcoin is anchored to real currency, and is fully transferable (e.g. I can exchange Bitcoins for dollars, euros, yen, etc. at some fixed or market rate at any point in time), then its relative value, and therefore its purchasing power, depends entirely on the actions of one or more central banks (depending whether its anchored to a single currency or a basket of currencies). Say it’s anchored to the dollar. To paraphrase (plagiarize from) the IMF, the monetary authority (Satoshi Nakamoto) must stand ready buy/sell dollars at given quoted rates to maintain the exchange rate at its pre-announced level or range; the exchange rate serves as the nominal anchor or intermediate target of Bitcoins in circulation. 1b) the whole system breaks down once you introduce an upper limit on the number of Bitcoins in circulation; hit that limit and break the anchor – then you have deflation of the Bitcoin (assuming it could get that far). conceptually it’s not clear how this would account for inflation, or what is driving inflation, and the rigidity of the inflation rules would inevitably lead to Nakamoto missing his inflation targets, possibly by a substantial margin.

    …One could continue here on the question of monetary stability and the role of central banks, political independence of central banks, etc., but that escapes the main point. Suffice it to say that financial crises pre-dated the concept of the central bank, at least in the U.S.

    2) Bitcoin is a fiat currency in the sense that it holds value only inasmuch as people believe it does, in the very same “let it be so” sense that is attached to all other paper money.

    3) a question on “virtual” currency or digital money vs. what’s in my bank account: is it really that much different from the cash that I transact in right now? Everything is electronic. I see only a small fraction of my income in cash. When the fed sells bonds on the open market, they don’t go to Goldman and hand them a pile of paper bonds in exchange for a few briefcases of cash, it’s all done in a few keyboard strokes. balances change, deal done.

    I might buy into the circumvention of legal issues in the absence of a sovereign. Of course then the Bitcoin could get blacklisted for money laundering and then you wouldn’t be able to buy any with most major currencies.

    …anyhow, I probably missed the whole point of this article, but nonetheless was compelled to chime in.

    Cheers.

  34. nonosh

    Finally, the Buckazoids that I collected in Roger Wilco’s pixelated inventory will have some use in this world!

  35. Greg

    @weekses:
    1a) “If Bitcoin is anchored to real currency…” It’s not anchored to anything, it’s a floating exchange rate.
    1b) “the whole system breaks down once you introduce an upper limit on the number of Bitcoins in circulation; hit that limit and break the anchor”. Again, it’s not anchored, so the ‘whole system’ doesn’t break down on this premise.

  36. oneplusone

    Be it Bitcoin or some other permutation this concept is not going to go away.

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