What Is Bitcoin, the Virtual Digital Currency?

By YatriTrivedi on March 1st, 2011

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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

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(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

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(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
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