Cryptocurrency
How Bitcoin Works

Topics Covered: How Bitcoin Works? Altcoins and Other Cryptocurrency Options | Pricing, Security

How Bitcoin Works?

It’s a lot of math and complex algorithms which involves a distributed (spread across various geographical locations) set of nodes (servers) agreeing on the order of transactions performed which shows who currently owns it and who owned it before.
The biggest duty of a central authority is to keep a ledger (list) of all transactions ever happened so that they make sure there’s no double spending and there’s no fraud.

For Bitcoins to be completely decentralized and anonymous, there can’t be a trusted third party. This makes it more challenging because who will settle the transactions now?

The answer is cryptography and proof of work. Here’s a simple analogy of a Bitcoin transaction between Joey and Chandler.

Joey needs money, he asks Chandler. Chandler asks Joey to send his public key address. Chandler then uses his public and private to get access to his Bitcoin and transfers a couple of them to Joey’s address.

When this happens, the Bitcoin network will note this transaction that 2 Bitcoins are transferred to Joey and he is the new owner. All the servers on the Bitcoin network agree on this and you can’t undo this unless you want to undo the chain of all transactions, which is not possible.

This way there’s no transaction fee, there’s no currency conversion fee, the transaction happens almost instantly and there’s no central authority to stop you from doing this. Since the records are stored in a million of servers spread across the world and every server has all the transaction details, there’s no way a Government can stop or regulate it.

Why should you care about Bitcoin?

If you are reading this for the first time, chances are that you are hearing about Bitcoin a lot in the media and friends and how it’s price is increasing.

While Bitcoins started as a way of moving away from the current financial system, the adoption rate quickly grew. There are currently more than 10 million Bitcoins wallets now.

The underlying concept of the distributed ledger is called Blockchain. The technology and finance companies are trying to use this concept to improve their existing infrastructure and decrease costs. Tons of venture capital investment happened in the space. It’s considered the future of currency, so yeah, you should care.
Bitcoins Mining and How to mine Bitcoins?

There are around 21 million Bitcoins in the world and that’s the maximum number there can be in the system. It’s by design. Anyone can acquire a Bitcoin in two ways,

By mining for Bitcoin using sophisticated hardware and algorithms
By buying from an exchange or other individuals.

Bitcoin system allows people to receive Bitcoins in exchange for solving difficult math problems. The complexity of the problems increases, as there are more people in the system. This way there is more number of servers in the Bitcoin network and the overall network can process more number of transactions.

In the earlier days, the miners used to use their personal computers to mine Bitcoin, but the complexity of the problems increased and they moved to GPU’s which allows more calculations per second. Now the miners use ASIC’s which are best suited for calculations.

Bitcoin Pricing

If you are a non-technical user who is not excited about the underlying technology then you are here because of the gigantic increase in the price.

In the last year alone the price of the Bitcoin increased by 100’s of percentage and the reason is the demand. Through media, evangelists, people started hearing about Bitcoin more and more and started investing.

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In a barter system, your goods as valuable as the highest buyer are willing to pay. Bitcoin price is increasing precisely because of this reason. There are thousands of people who believe Bitcoin is the future and is willing to pay more money for it. This pumped the value of bitcoin to the moon.

As discussed earlier, either you can mine Bitcoins or you can buy it. With increasing power costs, you are better off buying it unless you are a gigantic miner with specialist hardware.

Depending on where you live there are tons of exchanges which allow you to buy, sell and store Bitcoins.

Coinbase.com, Kraken.com, Gemini.com are few examples of bigger Bitcoin exchanges.

You can either store Bitcoins on the exchanges or transfer them to your wallets. There are tons of wallets now on the market both offering an app or hardware to store your Bitcoins.

Bitcoin Investing vs Short-Term Trading

As you know the price of Bitcoins has increased multiple folds in the last year alone. Everyone new to the crypto world has this standard question, whether to invest and wait a long-term or do day trading (buy low, sell high and repeat).

The answer apparently is, it depends. If you are a casual investor who is looking to get more returns to your money than a typical savings account, then you should do long-term investing. The fundamentals of Bitcoin is very strong, there’s a ton of market adoption, but still accounts for 1% of the whole monetary system, so there is a ton of room for growth.

If you are interested in day trading, just know that the volatility in Bitcoins is crazier than any stock on the stock market. So don’t sell off when the price is going down which is typically the natural action any day trader would take. To minimize the risk, you should have a standard risk tolerance predefined, so any loss is minimal and you won’t hate cryptocurrency forever.

Security

Just like your online bank account, you should very careful with your Bitcoin wallet. There are hundreds of incidents where the non-technology savvy users fall for phishing website links and offer passwords to their Bitcoin wallets. If you are a paranoid person, you are better off using a paper wallet (a device like USB) to store your Bitcoin or you can use the exchanges to store your Bitcoins.

Two-factor authentication(involving a text message to login) is a must if you decide to store the Bitcoins on an exchange since any access to your account means you lose your Bitcoins forever.

Altcoins and other Cryptocurrency options

While Bitcoin is the first and most popular cryptocurrency, there are now hundreds of cryptocurrencies in existence. Ethereum, Bitcoin Cash, Litecoin are the three most popular alternate coins (Altcoins) available in the market.

Ethereum differs in the sense that it’s a whole platform that offers more functionality like smart contracts than a traditional Bitcoin.

Venkatesh Thallam

NYU Grad, Engineer at Merrill Lynch, Product Nerd, Crypto Enthusiast. Occasionally Blogs at http://vthallam.com

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