The soaring price of bitcoin—the virtual currency is now worth more than $250 billion—has gotten a lot of attention in recent weeks. But the real significance of bitcoin isn’t just its rising value. It’s the technological breakthrough that allowed the network to exist in the first place.
Bitcoin’s still anonymous inventor, who went by the pseudonym Satoshi Nakamoto, figured out a completely new way for a decentralized network to reach a consensus about a shared transaction ledger. This innovation made possible the kind of fully decentralized electronic payment systems that cypherpunks had dreamed about for decades.
As part of our recent efforts to shed light on the mechanics of the popular cryptocurrency, today we’ll provide in-depth explanation of how bitcoin works, starting with the basics: how do digital signatures make digital cash possible? How did Nakamoto’s invention of the blockchain solve the double-spending problem that had limited earlier digital cash efforts?
How bitcoin transactions work
The generic digital cash scheme I described in the previous section is very close to how real bitcoin payments work. Here’s a simplified diagram of what real bitcoin transactions look like:
A bitcoin transaction contains a list of inputs and outputs. Each output has a public key associated with it. For a later transaction to spend those coins, it needs an input with a matching digital signature. Bitcoin uses elliptic curve cryptography for digital signatures.
For example, suppose you own the private key corresponding to Public Key D in the diagram above. Someone wants to send you 2.5 bitcoins. The person will create a transaction like Transaction 3, with 2.5 bitcoins going to you—the owner of Public Key D.
When you’re ready to spend those bitcoins, you create a new transaction like Transaction 4. You list Transaction 3, output 1 as a source of the funds (outputs are zero-indexed, so output 1 is the second output). You use your private key to generate Signature D, a signature that can be verified with Public Key D. These 2.5 bitcoins are then split up between two new outputs: 2 bitcoins for Public Key E and 0.5 bitcoins for Public Key F. Now they can only be spent by the owners of the corresponding private keys.
Bitcoin is a network that runs on a protocol known as the blockchain. A 2008 paper by a person or people calling themselves Satoshi Nakamoto first described both the blockchain and bitcoin, and for a while the two terms were all but synonymous. The blockchain has since been conceptually divorced from its first application, and thousands of blockchains have been created using similar cryptographic techniques. This history can make the nomenclature confusing. “Blockchain” sometimes refers to the original, bitcoin blockchain; other times it refers to blockchain technology in general, or to any other specific blockchain, such as the one that powers Ethereum.
The process that maintains this trustless, public ledger is known as mining. Undergirding the network of bitcoin users, who trade the cryptocurrency among themselves, is a network of miners, who record these transactions on the blockchain.
Recording a string of transactions is trivial for a modern computer, but mining is difficult, because bitcoin’s software makes the process artificially time consuming. Without the added difficulty, someone could spoof a transaction to enrich themselves or bankrupt someone else. They could log it in the blockchain and pile so many trivial transactions on top of it that untangling the fraud would become impossible. By the same token, it would be easy to insert fraudulent transactions into past blocks. The network would become a sprawling, spammy mess of competing ledgers, and bitcoin would be worthless.
Here is a slightly more technical description of how mining works. The network of miners, who are scattered across the globe and not bound to each other by personal or professional ties, receives the latest batch of transaction data. They run the data through a cryptographic algorithm that generates a “hash,” a string of numbers and letters that serves to verify the information’s validity, but does not reveal the information itself.
hash 000000000000000000c2c4d562265f272bd55d64f1a7c22ffeb66e15e826ca30, you cannot know what transactions the relevant block (#480504) contains. You can, however, take a bunch of data purporting to be block #480504 and make sure that it has not been tampered with. If one number were out of place, no matter how insignificant, the data would generate a totally different hash. If you run the declaration of independence through a hash calculator, you get 839f561caa4b466c84e2b4809afe116c76a465ce5da68c3370f5c36bd3f67350. Delete the period after “submitted to a candid world,” and you get 800790e4fd445ca4c5e3092f9884cdcd4cf536f735ca958b93f60f82f23f97c4. Which is more than a little different.
Keys and Wallets
Bitcoin ownership boils down to two numbers, a public key and a private key. A rough analogy is a username (public key) and password (private key). A hash of the public key, called an address, is the one displayed on the blockchain (using the hash provides an extra layer of security). To receive bitcoin, it’s enough for the sender to know your address. The public key is derived from the private key, which you need to send bitcoin to another address. In other words, the public key corresponds to inputs, the private key to outputs; the system makes it easy for you to receive money, but requires you to verify your identity to send it.
Who uses it and who accepts it?
Bitcoins are used by everyday people — online shoppers, traders, businesses, etc.
You can use Bitcoin to buy a Subway sandwich or holiday gifts at Overstock.com, as well as at dozens of other online retailers, but don’t expect to use Bitcoin to pay for your milk or beer at the local store just yet.
Even as Bitcoin becomes more widely accepted, the digital currency just might take some time to become as commonplace as dollar bills, y’all.
What is it used for?
Bitcoin can be used to purchase just about anything online, but its reputation has been injured by some cyber criminals who transact their business in Bitcoin.
Most recently, hackers obtained the data of more than 19 million California voters and held it ransom for 0.2 Bitcoin, which was valuated Friday at roughly $3,500.
Is it really worth a lot of money?
Bitcoins are in short supply — as of Friday there were just over 16 million in circulation — for now. And there are a number of factors that are believed to be driving up its value, including speculation and the fact that governments and banks can’t trace or tax them.
And while Bitcoin is really worth that much money in terms of dollars, some people are beginning to think that it may be the biggest financial bubble of all time. People like U-T political cartoonist Steve Breen, for example.