Bitcoin is the best known. All of the “cryptos” work in basically the same way and here is an overview.
How Bitcoin Works
- Each bitcoin is a string of numbers and letters called a hash. To verify that every transaction is legitimate, a worldwide peer-to-peer network of computers constantly checks the cryptographic signatures that represent the parties involved in every transaction. This check is a series of very complex mathematical puzzles.
- The computers in the network are locked in a contest to solve these puzzles. This is called mining. Groups of computers join into groups called pools for faster solving.
- The winner of the contest gets a reward of newly minted coins. The reward shrinks over time. The reward is currently 25 coins for bitcoin. As more computers join the network, the puzzles get harder.
- The miners add transactions to a public ledger called a block chain. This database allows anyone to follow every bitcoin from transaction to transaction.
- Once mined, the bitcoins go into circulation and are used for transactions like any other currency. People can buy them through exchanges like Coinbase or directly from each another. A few cities in North America even have bitcoin ATMs.
- Once acquired, they must be stored. There are apps called digital wallets (Bitcoin-QT and Multibit are examples) for computers and smart phones. They can be stored in offline storage (air gapped) or in the cloud (another service offered by Coinbase).
- The number of individuals and businesses accepting bitcoin is exploding. Everyone from restaurants to Overstock.com accept payment in bitcoin.
- Once a transaction has occurred, computers in the network record it on the block chain. The network groups several transactions together and assembles it into the next puzzle. Each puzzle block is designed to be solved in roughly 10 minutes.
Fun fact: 0.00000001 bitcoin is called a Satoshi after the person that designed the whole bitcoin system in the first place. As I write this, a bitcoin is worth $451.13 and 2000 Satoshi are worth almost one cent.
There are several things that you should consider as you dive into bitcoins or other forms of cryptocurrency:
- The price is driven by supply and demand. Here is a price chart.
- There have been dramatic price swings since bitcoin was created at the end of 2008.
- Bitcoin itself is secure. The systems and platforms built around bitcoin may not be secure. Personal responsibility is a central idea of the bitcoin ecosystem. You as a participant are responsible for your own security measures. The largest bitcoin exchange, a Japanese company named Mt GoX went out of business and 650,000 bitcoins are still missing from that collapse.
- There is no central authority like Visa or MasterCard to arbitrate errors and omissions.
- The relationship between bitcoin and local currencies rely on exchanges which charge fees.
- A transaction is not considered valid until it has been confirmed by 6 computers in the block chain network. 6 confirmations takes about an hour. Most bitcoin users will accept a single confirmation as proof for smaller transactions.
- Cryptocurrencies are open but mostly anonymous. Transactions are recorded by address. Address ownership is not visible but it can be discovered with a moderate amount of effort. You cannot assume anonymity.