What does it all mean?! Mining. Cryptography. Distributed public ledger. Keys and wallets. HODL, FOMO, and FUD. Cryptocurrency supporters are predicting that their digital currencies will soon take over the material world. But first, wouldn’t it be nice to know how Bitcoin actually works? Read on for an all-inclusive guide explaining Bitcoin in simple terms.
Disclaimer~2% of my portfolio is in $GBTC and $OBTC–two mutual funds that exclusively own Bitcoin.
And huge thanks to friend-of-the-blog Bryan, who played a vital role in fact-checking this article. If you end up purchasing Bitcoin, consider using his Coinbase referral link to repay the knowledge he shared. You’ll both receive $10 in BTC (not bad, right?)
Highlights
First—here’s a high-level review explaining Bitcoin in simple terms. Each of these details is further explained in the rest of the article.
Bitcoin is software. That software tracks a digital-only currency. There’s no physical currency, no coin you can hold in your hand.
Individuals use digital wallets to “store” their Bitcoin. These wallets have a unique bitcoin address and are secure. They can only be accessed via unique passwords, called keys. Using their private key, an individual can authorize a transfer of Bitcoin from their wallet to another wallet.
Every Bitcoin transaction that’s ever occurred is recorded on the blockchain. The blockchain is a distributed ledger, similar to a spreadsheet. It is maintained and monitored by multiple people all over the globe. These monitors are called nodes. Nodes record the blockchain and validate new blocks that are added to the chain.
New transactions are bundled into blocks and added to the blockchain. In order to provide validity to new blocks, proof of work must be submitted that solves a difficult cryptographic puzzle. This puzzle-solving is called mining. The first miner to solve to puzzle is rewarded with Bitcoin as a prize.
The puzzle involves an input-output code, or hash, that only works in one direction. One can easily verify that a specific input leads to a specific output. But it’s near-impossible to start with an output and find its input. The challenge in the puzzle is that miners are given an output, and asked to guess-and-check their way to a correct input.
The puzzle itself is based on previous blocks. The next puzzle is only created once the previous block has been added to the blockchain. Therefore, one cannot predict or solve a puzzle ahead of time.
All miners compete to solve the puzzle, but only one miner can win. That miner provides their solution, or proof of work, to the puzzle. The nodes on the network verify that the solution is mathematically correct and add that block onto the blockchain, verifying the transactions therein. The winning miner gets a prize.
And then the process starts all over again for the next block. That’s it. That’s explaining bitcoin in simple terms.
Let’s Talk About How Money Works
Trust me on this. In order to understand how Bitcoin works, we first need to understand how traditional money works. Once we agree on the basics of traditional money, then explaining Bitcoin in simple terms becomes much easier.
Other “Explained in Simple Terms” Articles
Money is Trust
Money is based entirely on a network of trust. There is no intrinsic reason why a little green sheet of paper is tradable for a week’s worth of food. Or for shoes. Or a car. The grocer accepts that little green paper because he trusts that he can use it to pay his store’s expenses. The store employees accept payment in green papers because they trust the papers will pay for their lifestyle.
But Doesn’t the Government Back Money with Gold?
Yes, the U.S. monetary system once was backed by gold. That ended in 1933 when Franklin Roosevelt allowed the U.S. Treasury to print money without an equivalent gold backing. This fiscal stimulus got us out of the Great Depression. And in 1971, Richard Nixon completely severed ties with gold by no longer permitting foreign countries to exchange U.S. dollars for gold.
Since 1971, only trust has supported the system. Let’s dig into that trust network a little deeper.
Why Do We Need Money?
Imagine a world without money.
A carpenter goes to the grocery store to buy food. Without money, how does the carpenter pay? He can trade his skills! But the grocer doesn’t need any woodwork done. Instead, the carpenter will leave behind some sort of IOU—a favor to be repaid later.
The shoemaker has a leaky roof. He hires the carpenter to come by, and they agree that the carpenter’s fix-up work is worth 20 pairs of shoes. But the carpenter doesn’t need 20 pairs of shoes. The shoemaker agrees that he’ll owe the carpenter in the future. Another IOU.
The grocer is on his feet all day and has worn through his shoes. He goes to the shoemaker to buy new ones. But the shoemaker’s garden is in full bloom, and he doesn’t want to trade shoes for food right now. How will the grocer pay? An IOU.
This is a simple example: the carpenter owes the grocer, the grocer owes the shoemaker, and the shoemaker owes the carpenter.
Expand The Economic Network
We could expand this example further to represent the whole economy, where the businessman owes the airline, and the airline owes the fuel company, and the fuel company owes the oil drillers, etc, etc. A complicated web of IOUs ensues.
How could we ever reconcile all these IOUs? It’s an accounting nightmare, with each individual tracking their credits and debts.
“I’m in debt for 10 pounds of berries and three salmon, but I’m owed a shirt, some lightbulbs, and a set of winter tires.”
-Jesse, in the world of IOUs
Universal trust in money completely solves this problem. We convert each IOU to a dollar amount. Each person measures debts and credits in dollars, rather than in unique products (e.g. berries and fish). The market’s supply and demand determine where prices settle. Economic activity flourishes because concerns over payments diminish.
This is why we need money.
But Who is in Charge of Money?
In the United States, the two institutions with greatest monetary responsibility are the U.S. Federal Reserve and the Department of Treasury.
The Federal Reserve is part of the government but operates with some autonomy. It is the country’s largest bank. The “Fed” has three main mechanisms that it can use to manipulate the amount of money circulating in the economy. It can buy or sell Treasury securities (thus adding or subtracting money from the economy). It can adjust interest rates like it did at the beginning of the COVID-19 pandemic. And last, the Fed can change requirements on how much money a bank must keep in reserve (a.k.a. the “reserve requirement.)
Quantitative Easing
One term often associated with the Federal Reserve is quantitative easing. Quantitative easing, or QE, describes the process where the Fed buys securities (Treasury bonds or other assets) using money that the Fed creates “out of thin air.”
QE injects money into our economy, helping “grease the wheels” during hard times. But an increased supply of money without increasing the demand for products will lead to inflation, or the increase in the price of goods and services.
Some credit QE with saving the economy after the 2008 Financial Crisis and COVID-19 pandemic. But many are concerned that QE is leading to out-of-control inflation—that we will reap what we have sown. One of Bitcoin’s ideal use-cases takes inflationary power away from institutions like the Fed.
The Department of Treasury
The Department of Treasury is in charge of printing money that the Federal Reserve requests. They distribute money to the public and to banks. They sent the COVID stimulus checks. The Treasury is also in charge of the IRS—they collect your taxes. Again, Bitcoin’s ideal use-case removes power from the Treasury. You can’t just “print” Bitcoin—we’ll explain later.
Do We Need “Big Brother” In Charge of Our Money?
As we start to transition this article into discussing cryptocurrency, one fundamental question will repeatedly arise: do we need to have the government in control of money? Do we need banks to keep accounts organized—and charge us fees in the process? Can’t the community just take care of these responsibilities?
Since money is based on person-to-person trust, why do we need government involvement? If “free markets” solve all problems, why do we need to government handcuffing monetary freedom?
These are the questions that Bitcoin purists ask. We’ll keep them in mind as we proceed.
What Makes Some Money “Good” and Other Many “Bad?”
There are eight unique attributes that make money “good” (or “bad”).
- General acceptability. This is the “trust” that we’ve discussed. Money needs to be trusted and accepted universally.
- Portability. Money needs to move. Dollar bills are light. Credit cards and bank account transactions and PayPal/Venmo occur electronically. Gold, however, is fairly challenging for an individual to move.
- Indestructibility. Imagine if money was made of tissue paper. You hand over a $50 to the cashier and it rips in half. Who is at fault? Yikes.
- Homogeneity or fungibility. Money needs to be the same, such that your $50 bill is identical to mine. After all, they are worth the same amount. This ability for one unit of money to perfectly replace another is called fungibility. Money is fungible. Stocks and gold are fungible. But baseball cards and pairs of shoes are not fungible—once used, they have a different value than a new copy.
- Divisibility. We need to be able to break large amounts of money into smaller amounts. If I have a $100 bill and need a candy bar, I need a choice other than “buy 100 candy bars.” I need change.
- Malleability. This applies to physical money. You need to be able to work with the material. Paper is easy to print on. Silver and gold are easily melted and stamped. Glass—well, that would be tough to make money with.
- Recognizability. You’ve got to be able to recognize money as money. Unique coins, unique bills, unique credit card designs.
- Stability. This one is huge! We need to rely on the fact that the cost of goods today is relatively stable to the cost of goods next week.
Another Trip to Bestland
There’s an anecdote from Bestland (home of the infamous Bestland Debt Crisis) that illuminates the attributes of currency.
When Bestland fell deep into their debt crisis, they decided to print new Bestland coins using the island’s famous teak wood. Alas, the solution backfired.
Initially, the public generally accepted the money. New money…what could be wrong? The wooden coins were light and portable. The wood was easy to engrave (malleable) and unique in appearance (recognizable). Big coins and small coins made the currency divisible, and the coins were identical to one another—fungible.
But two big problems arose. First, the wooden coins began to rot over time. They were not indestructible. And perhaps more concerning, the Bestland Lumber Company came up with a unique idea. Why should they sell their teak lumber to the public when they could literally turn their lumber into wooden coins?
The Bestland Lumber Company flooded the economy with teak coins, torpedoing the stability of the currency. Inflation ran rampant. Soon enough, nobody believed in the legitimacy or acceptability of the coins anymore.
Bestland will have to find another way.
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Transitioning to Explaining Bitcoin in Simple Terms
Now that we’ve covered some of the basics about money in general, let’s get back to explaining bitcoin in simple terms.
Basic Definitions
Bitcoin is software. That software tracks a digital-only currency. There’s no physical currency, no coin you can hold in your hand.
Bitcoin is decentralized. That means there’s no Federal Reserve or Department of Treasury involved. There’s no “higher power” that signifies trust or stability. Then, you might ask, how can we trust Bitcoin? We’ll get into that.
The Bitcoin network was started in 2008 by a person named Satoshi Nakamoto. Is this a real person? A fake name? A group of people using a fake name? We don’t really know. This mystery surely adds intrigue to the story of Bitcoin.
Nakamoto’s idea was to create a currency that could be trusted independently of government interaction and independently of personal trust. The algorithms and codes are all open-source. There’s full transparency. Anyone can observe how it works.
Why do you believe that the sun will rise tomorrow? Well, because the natural world of math and physics suggests so. Nakamoto wanted to use math to create a similar level of extrinsic trust for Bitcoin.
Wallets, Ledgers, and Blockchains
We’re getting to the point where explaining bitcoin in simple terms becomes not-so-simple. Buckle up. And please comment with your questions. I’d love to make this a “living” article that gets updated with answers to your questions.
If you had Bitcoin, you would keep it using a wallet. But the name “wallet” precipitates ideas of storage. In other words, that Bitcoin is thing, and that the wallet stores the thing. But that’s not true.
Instead, a wallet is nothing more than an identification (or address) and a set of passwords, or keys. It’s similar to how your bank account ID works. Your bank account is not a physical vault. It’s just an ID and passwords, and the bank’s ledger uses that ID to track the account amount. The bank account is intangible storage.
Bitcoin wallets are password protected using one or more private keys that you, the wallet owner, have. Some wallets are accessible online. Since they’re online, they can easily communicate with the rest of the entire Bitcoin network.
Other wallets exist on local hardware—like a personal computer or USB drive—so that they are more secure and harder to access. Hardware wallets require a little extra work (e.g. an internet connection) to connect to the larger Bitcoin network.
The Blockchain
But how does another person know how much money is in my Bitcoin Wallet?
This is answered by the blockchain, a.k.a. the distributed ledger (Technically, there are many types of distributed ledgers and the blockchain is just one of them). When you see “blockchain” or “ledger,” you should just think community spreadsheet. That’s it! For simplicity, just imagine that blockchain = a fancy Excel spreadsheet.
The blockchain lists all transactions that have ever occurred on the entire Bitcoin network, just like one would use a spreadsheet to list business payments or to operate a budget. Bob paid Frank two Bitcoins in 2016. Jim paid Sally five Bitcoins in 2018. On and on and on. The blockchain lists every wallet-to-wallet transaction that has ever occurred. It knows where every single Bitcoin is.
By tracking all these transactions, we know exactly which wallets have Bitcoin in them, and exactly how much Bitcoin is in those wallets. However, we don’t which human being owns each wallet. The system is pseudonymous. As long as a transaction is accompanied by the correct wallet private key, the network trusts that the true owner—who knows the private key—approves the transaction.
In the current monetary system, banks and governments control the spreadsheets. Banks give Jim permission to pay Sally. But do we need this central authority intervention? The crypto community says no.
The goal of cryptocurrency is to maintain a globally-shared copy of this spreadsheet. People like you and me would verify the spreadsheet independently (we’ll discuss that next). Each verifier of the spreadsheet is a node.
Verification, “Mining” and The Crypto Prefix
It feels like we might have a complete system. Bitcoin is virtual currency, and a giant shared spreadsheet—the blockchain—tracks all Bitcoin accounts (wallets), quantities and transactions. If all the nodes agree on the spreadsheet, we’re happy.
Our task of explaining bitcoin in simple terms feels complete—what more do we need?
We need trust! We need a way to validate the trustworthiness of the blockchain. How do I really know that Bryan has five Bitcoin? What if someone else’s copy of the blockchain says Bryan only has three Bitcoin? How do we all agree on a consistent, uniform version of the blockchain?
The answer lies in cryptography, mining, and proof of work. A simple spreadsheet might be easy to alter, easy to “hack,” or easy to fake. So Bitcoin uses complicated cryptography, or code solving, to verify new transactions. The act of solving these codes is mining. Bitcoin mining provides proof of work. If you’re confused, don’t worry—we’re going to break it down.
Proof of Work
How do you trust your trainer at the gym?
Is it because he’s fat and unathletic? Or is it because he’s muscular and knowledgeable? It’s not a trick question. You trust your athletic trainer because his body and knowledge act as proof of work. He has put in the effort and he has the results to prove it. That makes him trustworthy.
The same works for Bitcoin. Whenever we append new transactions—a.k.a. a block—to the community spreadsheet, they come with a very difficult puzzle and proof of work that the puzzle has been solved.
All the other nodes in the network can see the solved puzzle and test its proof of work. This is called consensus. The proof of work verifies that the new transactions are in harmony with the current iteration of the blockchain. All nodes can see that the new transactions reconcile with the current state of the spreadsheet.
It’s just like “showing your work” on your math test. It proves your authenticity to the teacher.
You and I can easily determine a physically fit person. It’s obvious. We can also determine that you know what’s on the math test.
But how do all the nodes agree that a new block of transactions has been verified by a sufficiently laborious proof of work? How much proof do we need and what exactly does it look like?
The “Crypto” Bit—Making Proof Difficult
Explaining bitcoin in simple terms requires an explanation of the “crypto” prefix. It refers to cryptography, or the act of breaking codes. And breaking a sufficiently difficult code (which I called a “puzzle” previously) acts as proof of work for the Bitcoin network.
Like many codes, cryptocurrency codes are difficult to decipher upfront yet easy to understand once you have the key. The codes accomplish this via two distinct traits.
First, the code is one-way only. You can always trace an input to an output, but you can never directly trace an output back to an input. Huh?
It’s just like a Play-Doh squeezer (how’s that for explaining bitcoin in simple terms?). It’s easy to start with a random lump and squeeze out a predictable pattern. However, it’s impossible to start with the pattern and accurately recreate the random lump.
Was the starting Play-Doh kinda lumpy or very lumpy? Did it look like a goose or like a cookie? We don’t know. The squeezer—or the crypto hash—creates an end pattern that cannot be traced back to its origin. It is only predictable in one direction.
The end products might all be slightly different from one another. A little more blue Play-Doh, a little more red there. But they are vastly different from their respective input.
The second important trait is that the hash is subject to the “avalanche effect,” which you might know as “chaos theory” or the “butterfly effect.” In short, a tiny change in the input results in a massive change in output. A little extra red Play-Doh in the starting lump completely changes the appearance of the output.
Example of a Hash
Below is a real example of how a single small change (a period at the end of a sentence) completely alters a hash output.
In: ("The quick brown fox jumps over the lazy dog")
Out: 0x 730e109bd7a8a32b1cb9d9a09aa2325d2430587ddbc0c38bad911525
In: ("The quick brown fox jumps over the lazy dog.")
Out: 0x 619cba8e8e05826e9b8c519c0a5c68f4fb653e8a3d8aa04bb2c8cd4c
The “puzzle” in cryptocurrency is to guess what input might have created a specific output.
We start with patterned Play-Doh and have to determine what the input lump looked like. How do we do that? We create a billion lumps of Play-Doh, send them through the squeezer, and compare those output patterns outputs against our target output. A perfect match solves the puzzle.
It’s that simple. It’s a brute force game of guess-and-check.
So, how do we determine the “target pattern of Play-Doh?” And who does the solving?
Mining
Mining is the act of solving these puzzles. It invokes images of physical labor and of hidden discovery, but explaining bitcoin in simple terms requires a true explanation of the bitcoin mining process.
The puzzle might be:
Find an input that creates an output of this (or less): 619cba8e8e05826e9b8c519c0a5c68f4fb653e8a3d8aa04bb2c8cd4c which might have a binary value of 000000000001298274598275092834
And the challenge is to run through potential inputs as fast as possible, finally arriving at a specific input that creates a target output whose binary value is less than
000000000001298274598275092834
Mining is guess-and-check to solve that puzzle. That’s it.
What Does Mining Accomplish?
Mining simultaneously completes two tasks.
First, the complexity of the puzzle provides sufficient proof of work to the Bitcoin nodes, thus verifying recent transactions. New blocks are assumed “guilty until proven innocent,” as if a random bad actor is attempting to add fraudulent transactions to the blockchain. Mining’s proof of work provides evidence of authenticity.
Second, the miner who solves the puzzle earns Bitcoin as a reward (note: the “rewards” have been decreasing over time, by design).
Approximately every ten minutes, a puzzle is solved and a new block of transactions is added to the blockchain. Importantly, the details of the current puzzle and details of the current transactions help create the next puzzle. In this way, the new puzzles are unpredictable. The next puzzle is based on transactions that we will not know about until the current block is solved.
Miners repeat guesses and checks a million, billion, trillion, or more times until the puzzle is solved. The difficulty of the puzzles is automatically adjusted based on the total number of miners trying to solve them.
This is a terrific example of harmonized economic incentives. Miners are incentivized to compete to find puzzle solutions. The winning miner gets a prize (their incentive). The Bitcoin network gets verification that transactions are valid. The more competitors, the greater the integrity of the system.
Eureka!
Let’s walk through a block/puzzle cycle again, tying ideas together and explaining bitcoin in simple terms. There’s a bit of chicken/egg syndrome here—where exactly do we start?
We’re at the beginning of a new block. All over the world, each node is updating. The nodes are aware of the solution to the previous block’s puzzle. The nodes are aware of the specific wallet-to-wallet Bitcoin transactions that the previous block verified. The ledger is now up to date—we know the current status of every Bitcoin wallet in the world.
Time to start the next block.
A new puzzle forms based upon the previous block’s puzzle, solution, and transactions. The miners now know the next target output that they are guess-and-checking to solve. Think back to Play-Doh. The target output pattern is now apparent, but who knows what the random lump input looked like? The miners get to work guess-and-checking.
Note: while many nodes are also miners, the two terms are not necessarily synonymous.
A node is a complete record of the blockchain. A miner wants to solve the next block.
A node can act as a miner, or not. A miner can be a node, or not.
Every miner on the network starts racing to find the solution. Play-Doh everywhere. After a few minutes, someone solves the problem. Eureka!
The correct input that solves the puzzle—the proof of work—is sent to every node on the network for them to individually verify. They try the solution for themselves. Did this shape of Play-Doh actually create the desired output pattern? Did this random number input actually create the desired hash output?
The math doesn’t lie. Verifying these proofs of work is an objective process. The block of transactions is appended to the blockchain when the nodes reach consensus that the proof of work is valid.
Winning, Updating, Verifying
The “winning” miner gets to do two things. First, they pack the block with their choice of transactions. Some transactions come with fees in order to entice miners to include those transactions in the next block. Fees go to the winning miner. Second, the winning miner claims a bounty of Bitcoin by appending one extra transaction onto the end of the block—P.S. Jesse mined this block, his wallet gets two Bitcoin. Woohoo!
All parties win. The winning miner gets bitcoin as a reward. Sweet! And the network as a whole receives concurrence that the ledger is accurate and up to date. This is vital to maintain trust in the network.
Importantly, since miners are racing for the reward, the block gets verified in a timely manner. The individual wallet owners don’t need to fear that their transactions might get “stuck in limbo.”
When one door closes, another door opens. Now that the block has been mined, the competition for the next block has been started.
All over the world, each node updates its version of the blockchain to include this most recent block. The nodes are aware of the solution to that block’s puzzle, and the nodes are aware of the Bitcoin transactions that the block verified. The ledger is now up to date—we know the status of every Bitcoin wallet address in the world.
Onto the next block. We have a new puzzle to solve.
Highlights and Quick Review
Let’s review again, explaining bitcoin in simple terms.
Bitcoin is a digital currency and software system.
Individuals use digital wallets to “store” their Bitcoin. These wallets have a unique bitcoin address and are secure. They can only be accessed via unique passwords, called keys. Using their private key, an individual can authorize a transfer of Bitcoin from their wallet to another wallet.
Every Bitcoin transaction that’s ever occurred is recorded on the blockchain. The blockchain is a distributed ledger, similar to a spreadsheet that is maintained and monitored by multiple people all over the globe. These monitors are called nodes. Nodes record the blockchain and validate new blocks that are added to the chain.
New transactions are bundled into blocks and added to the blockchain. In order to provide validity to new blocks, proof of work must be submitted that solves a difficult cryptographic puzzle. This puzzle-solving is called mining. The first miner to solve to puzzle is rewarded with Bitcoin as a prize.
The puzzle involves an input-output code, or hash, that only works in one direction. One can easily verify that a specific input leads to a specific output. But it’s near-impossible to start with an output and find its input. The challenge in the puzzle is that miners are given an output, and asked to guess-and-check their way to a correct input.
The puzzle itself is based on previous blocks. The next puzzle is only created once the previous block has been added to the blockchain. Therefore, one cannot predict or solve a puzzle ahead of time.
All miners compete to solve the puzzle, but only one miner can win. That miner provides their solution, or proof of work, to the puzzle. The nodes on the network verify that the solution is mathematically correct and add that block onto the blockchain, verifying the transactions therein. The winning miner gets a prize.
And then the process starts all over again for the next block. That’s it. That’s explaining bitcoin in simple terms.
Questions and Answers
This next section is going to take a second look at some of the intricate questions you might have, still explaining Bitcoin in simple terms.
Can Bitcoin Really Last? Will People Really Use It?
I’ve tried to stay unbiased, but let me put my bear’s hat on. Why might Bitcoin fail?
First, I have doubts about how people will deal with non-physical money. Yes, I know we live in the world of electronic banking, credit cards, PayPal, etc. Non-physical transactions occur all the time. I get it. But at the end of the day, we always know we can withdraw physical money if we need to. And with Bitcoin? No such luck. We’re material girls living in a material world. Will fully digital Bitcoin satisfy us?
I touched on this earlier, but the lack of a safety net in Bitcoin is concerning. I’m already thinking about the unlucky schmucks who lose their life savings because their dog ate their wallet key.
Another reason Bitcoin might never catch up: its volatility needs to settle down! Stability is a key for a working currency. “But,” the detractors would say, “Bitcoin will stabilize once it becomes the ‘standard.’” That might be true.
But there’s a chicken-and-egg issue. Do we make Bitcoin the ‘standard’ in order for it to stabilize? Or do expect it to be stable before it becomes the standard?
Two more reasons:
1) Google “Mt Gox” and read a couple articles. The most-used Bitcoin exchange in the world collapsed in 2014, along with 850,000 Bitcoins it was holding for its customers.
2) Bitcoin’s anonymity makes it a preferred payment method for nefarious actors. Drugs, ransom, hacking—all have connections to Bitcoin. And while it’s not necessarily Bitcoin’s fault, people vote with their morality all the time. Will they ‘vote’ for Bitcoin?
I think technologists must (and will) develop ways to overcome these hurdles in order for Bitcoin adoption to take hold.
But Why Are Puzzles Needed Again?
It seems like Bitcoin would do fine without the puzzles. Just update the blockchain, verify every single transaction, etc. Right?
Well, as we’ve discussed here, the blockchain is “append-only.” You can only add blocks to the end of the chain, and can never edit previous blocks once they’ve been verified.
Cryptography ensures this since any small change in a previous block would alter subsequent cryptographic proofs of work. Without cryptography, we could not trust that previous blocks have been unedited.
Difficult cryptography provides trust that the system is whole and immutable.
What If A Node Chooses to Stall?
You might wonder, “What if a node ‘disagrees’ with a puzzle solution? Can’t it argue?”
First, keep in mind that the math doesn’t lie. If one miner claims it has found a solution, it can be easily verified due to the one-way nature of the hash/code. It either works, or it doesn’t.
Second, a copy of the blockchain that is missing a block is no longer valid. Remember the “avalanche effect?” If a node “chooses” to neglect a block, then any subsequent solutions based on that chain will look vastly different than the rest of the network’s solutions. That invalid node will be ignored until it comes back in sync with the current state of the blockchain.
Can’t Someone Change an Old Transaction?
Couldn’t a winning miner slip in an extra zero into a previous transaction? Bryan doesn’t have 10 Bitcoin…he has 100 Bitcoin!
No, winning miners can’t do that. Recall the “avalanche effect.” That small change in a previous block would create an unpredictable and enormous ripple through the rest of the blockchain. The other nodes in the network would easily determine that the winning miner changed something in the previous blocks, and thus the previous blocks’ proof of work would no longer be valid.
The miner’s proposed change would be rejected.
Is It Really Un-hackable?
There is one exception to Bitcoin’s safety, commonly referred to as a 51% percent attack.
If an evildoer—let’s call him BOB—set up enough computers, he could theoretically control more than half of the mining power and more than half of the nodes on the Bitcoin network. 51% = more than half.
With this computing power, BOB could simultaneously mine blocks containing fraudulent transactions and then approve those fraudulent blocks using his majority of the nodes.
The cryptographic math in BOB’s blockchain would be valid. But it would be different than the cryptographic math in the “49%’s” blockchain. BOB’s fraudulent transactions create different puzzles to solve, but his solutions to those puzzles would still be mathematically correct.
So BOB goes rogue. Since BOB controls more than half the computing power, he adds new blocks to the blockchain faster than the rest of the network combined (51% is greater than 49%). BOB’s blockchain grows long.
Wait! The blockchain is out of sync!
- 51% are listing these transactions and showing proper proof of work based on these transactions.
- The other 49% are listing those transactions and showing proper proof of work for those transactions.
How do we push through this impasse?
There’s a rule in Bitcoin protocol: if there’s ever a dispute between multiple versions of the blockchain, the one with more proof of work is considered more valid. The longer chain wins.
BOB has more computing power. He can mine blocks faster than the rest of the network. His chain is longer. And eventually, the rest of the network abides by the protocol—BOB’s longer chain is considered the “new truth.”
Thankfully, the likelihood of a 51% attack is grows smaller by the day. As the network itself grows larger, the possibility of building a 51% majority grows smaller.
How Do the Eight Attributes of Money Apply to Bitcoin?
Part of explaining Bitcoin in simple terms requires that we revisit its applicability as money. Let’s check out the eight attributes of Bitcoin.
- General acceptability. This is the “trust” that we’ve discussed. While Bitcoin is not generally accepted by the public yet, Bitcoin proponents are betting big that it will be generally accepted eventually. And why? Because blockchain technology provides a high level of security and validity.
- Portability. Money needs to move. And a digital currency group is extremely portable.
- Indestructibility. As long as our electrical infrastructure remains intact, Bitcoin is indestructible.
- Homogeneity or fungibility. All Bitcoin are created equal. It’s fungible.
- Divisibility. We need to be able to break large amounts of money into smaller amounts. Bitcoin is tracked down to fractions equal to 1-in-100 million. At present values (April 2021, 1 BTC = $60000), that’s about 1/20 of a penny.
- Malleability. This applies to physical money. Bitcoin is fine here.
- Recognizability. You’ve got to be able to recognize money as money. I have some concerns about this one. We’ll discuss this later.
- Stability. This one is huge! We need to rely on the fact that the cost of goods today is stable compared to the cost of goods next week. This is another sore spot for Bitcoin in its present level of adoption.
In What Ways is Bitcoin “Better” Than Normal Money?
Bitcoin proponents would list the following virtues of Bitcoin that make it superior to normal currency.
- It’s decentralized. We don’t have to worry about central banks or manipulative governments. We don’t have to worry about wild inflation due to printing new money. The Bitcoin supply is verified by a distributed network and the supply is limited, described in the image below.
- The information on the blockchain is perfect. Normal currencies cannot accurately track their own supply. With Bitcoin, we know exactly where it exists.
- Bitcoin is secure and frictionless. It cannot be hacked (unlike a bank) and we don’t have to wait for 9AM tomorrow morning for our money (unlike a bank).
- Bitcoin is universal and transnational. No exchange rate needed.
- Bitcoin cannot be counterfeited or duplicated, unlike normal currency.
How Would I Spend Bitcoin?
Without getting into technical details, a merchant that accepts bitcoin will give you their address, likely through an easy means such as a QR code. You could scan it with your mobile phone. Your wallet would send bitcoins to their wallet, plus very small transaction fees.
What If I Need Help With My Bitcoin?
What if I lose my wallet key? How do I contest a transaction? I need help—who do I consult?
The double-edged sword of a decentralized monetary system is that there’s nobody to help you. Personally, this is where I believe many individuals will get stuck. They might be willing to ignore the technical details of Bitcoin, but how will they deal with the fact that their “screw-ups” are impossible to reverse?
If you lose your wallet key, you are screwed. One man threw away a hard drive that held the key to 7500 Bitcoin. Those Bitcoin are still in his wallet, but he can’t access them. They will sit in that wallet forever, unused. No key, no access.
Aside: Guessing A Wallet Key
The key has 64 characters (0-9, A-Z…that’s 36 options for each character.
That’s 4.01*(10^99) possible combinations.
For reference, the universe is estimated to be 4.10*(10^17) seconds old.
Guess-and-checking your lost wallet key is a statistical impossibility. It is more difficult than guessing the exact coordinates of an atom that is hiding in a random location inside the Milky Way galaxy.
Size of atom = 10^-31 cubic meters.
Size of Milky Way = 10^62 cubic meters
Finding an atom hiding in the Milky Way = 1 in 10^93…easier than guessing a wallet key.
…Back to “I Need Help!”
If you make a transaction and accidentally add an extra zero to the end, you can’t contest the charge like you would with credit card companies. Your only hope is to convince the recipient to send your extra funds back to you.
If $1000 burns up in a house fire, the U.S. Bureau of Engraving and Printing will verify the details of the situation and replace that cash. The “victim” is made whole. But if your wallet key burns up in a house fire, nobody can help.
There’s no higher power that can take advantage of you, but there’s also no higher power to consult or bail you out. This is the selling point behind Bitcoin, but it’s also the massive downside. It does not forgive human error. And that, in my opinion, makes Bitcoin difficult for many humans to accept.
Many people use an “exchange” to obtain their Bitcoin. These exchanges operate like stock exchanges, acting as middlemen and safety nets (but removing aspects of decentralization in the process). In some cases, this exchanges will hold Bitcoin in intermediate accounts, just like a bank might hold a payment for 24 hours. This provides some level of a safety net some of the time.
Can I Become a Node? Can I Mine?
Yes, you can become a node. The blockchain is currently about 320 GB in size (as of early January 2021), and is growing ~1.5 GB per week. The benefit of using your computer as a node is that it adds security to the overall network. If you have money in the system, you’d want to do your part to ensure its security.
And yes, you can mine Bitcoin, even using your computer at home. But keep in mind—bitcoin mining is energy-intensive, and that energy costs money (e.g. electricity bill). You’d be competing with miners all over the world, most of whom are using specialized computer hardware to make mining as efficient as possible. Your PC likely cannot compete with them, and you’ll pay more in electricity than you’ll ever mine in Bitcoin.
Is Bitcoin A Good Investment?
Traditional investments do one of two things. They create a cashflow or they increase in intrinsic value. A stock, for example, usually does both. The stock pays a regular dividend (cashflow). And the underlying company grows (ideally), thus increasing the intrinsic value of the stock.
Bitcoin does not create cashflow. It is cash.
So, will it increase in intrinsic value?
Proponents scream yes! They believe Bitcoin is a superior currency that will vastly increase in value as compared to inferior currencies (e.g. the U.S. dollar, all traditional national-state currencies). The more it is used (general acceptability), the more in demand it will be. High demand = high price.
And this ties back to where we started: what makes money good?
Bitcoin proponents will be proven correct if enough of the general public believes in it. It needs to be generally accepted. And users need to have faith that it will be stable. To date, it hasn’t been (at least, relative to the U.S. dollar). But if we believe Bitcoin is still in its nascent days, then perhaps volatility is to be expected.
Detractors believe that Bitcoin is nothing more than a speculative asset. They worry it will never act as a fully adopted currency, and therefore will never have intrinsic value. It will only be valued as compared to the U.S. dollar.
Getting started is fairly easy. You can buy bitcoins via one of many popular exchanges. They will create a bitcoin wallet address for you, handle the transactions fees, etc.
Friend-of-the-blog Bryan played a huge role in helping create this article. If you want to buy Bitcoin, use his Coinbase referral link to repay the knowledge he shared. Both you and he received $10 USD worth of free Bitcoin—a win-win proposition.
HODL? FOMO? FUD? What Do These Words Mean?
Like many movements, niches, communities, etc, cryptocurrency has its own lingo. For example, Bitcoin bulls advice others to HODL, or hold on for dear life. As in, “Don’t sell now…the future is bright. Just HODL.”
The FOMO/FUD cycle is another well-known acronym. It stands for fear of missing out and fear, uncertainty, doubt. In Bitcoin’s short life, there have been multiple rampant bull markets (everyone buys because they fear they are missing out on something big). Those manias end and are replaced by fear, uncertainty, and doubt. Everyone sells, the price tanks.
What does this sound like? It’s Mr. Market.
For more common crypto sayings, there are any online cryptionaries.
What About All the Other Cryptocurrencies?
Bitcoin is original and most famous cryptocurrency. But there are thousands of alternative cryptos, collectively known as alt-coins.
For most alt-coins, their founders thoughts, “Bitcoin isn’t perfect…let me try to improve on it.” Perhaps they made the cryptography easier or harder. Perhaps they made their alt-coin easier for businesses to use.
One big issue is that Bitcoin blocks are mined (on average) once every ten minutes. So if you just sold someone a car using Bitcoin, you might have to wait ten 10 minutes (or longer sometimes) to verify that the transaction was valid. That’s not great for business.
But for the most part, the differences aren’t enormous. Bitcoin remains the zenith crypto. All alt-coins combined have less than half the value of Bitcoin alone (again, as of January 2021).
What Are YOUR Questions?
I’m happy to append this article over time, adding your questions as they arise. Explaining bitcoin in simple terms wasn’t that simple, was it?
I hope this article helped you think about Bitcoin and other cryptocurrencies in a new light. Yes, the system is quite complex. But the underlying building blocks are reasonable when examined one at a time.
What does the future hold for Bitcoin? I have no idea. But it’s exciting to learn about and follow along!
Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
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Miners are integral to the blockchain continuing; without them all new transactions are condemned to limbo. There are only 3 million bitcoin left to be mined. With gold, when it becomes uneconomic to mine, the site is abandoned and sealed. However, the gold already mined still exists for thousands of years, after the miners have all died.
How will bitcoin transactions occur and bitcoin really exist if the miners stop mining?
Thanks.
Phenomenal question, Gary.
Yes, miners are integral.
Currently, miners are incentivized by a “bounty”—when they “mine” successfully, the Bitcoin protocol awards them with *new* Bitcoin.
But as you point out—that *new* Bitcoin WILL eventually run out. The protocol is programmed that way!
Why will miners continue to mine after the bounties end?
Because individuals will start to include very small transaction fees along with their purchases.
I give a little detail in the “Winning , Updating, Verifying” section
Thanks for reading! Terrific question
What if miners decide to “unionize” and jack up the tx fees to where it no longer makes sense? Even now, I see some people have a very small amount of coins that would cost more to spend than its value. Or, what if miners all die off or v. little of them left thus making tx even longer than 10min and more expensive?
Cool questions, Dan
Re: unionizing, I think there will always be “union busters” who would undercut the market and transact for lower fees. It’ll end up being a supply/demand/price problem, just like everything else in market economics (which is cool to consider, IMO)
Re: miners dying/few left. I suppose the answer is that more people are being born every day, and people will continue to mine so long as it’s profitable.
Both questions are really interesting. What do you think?
Thanks for writing in,
Jesse
if only the first miner that solves the puzzle can get the reward , so the people with the strongest infra gpu will always be the first miner to solve the puzzle and will be dominance in the race ? so others wont get any incentive since only the fastest to solve the puzzle can get the price
Close, but not quite!
The most powerful miners have the best chance of “winning the race.”
But it’s more like a scavenger hunt than a conventional race. Just because someone is the fastest runner doesn’t mean they’ll find the hidden objects first.
Similarly, the fastest miners will make the most guesses at solving a cryptographic puzzle. But a less powerful miner could easily guess the right answer (aka “get lucky”) before the more powerful miner.
Thank you for your rapid answer, and your excellent review article.
The next Bitcoin halving is in 2024. Mining might not be as profitable after that.
Also, central banks are starting to attack the dis-intermediation that Bitcoin represents by closing and on and off ramps to bitcoin exchange vis a vis fiat currencies.
My personal plan is to buy two bitcoin under $22K, hold them for 3 years, and then sell. Sound reasonable?
Thanks again.
Absolutely, Garry (apologies–typo’d your name the first time!). You’re 100% welcome.
As for specific Bitcoin investing plans…man, that’s a million (billion?) dollar question! I am far from an expert. Though, in the Crypto space, how exactly does one become an expert?
I will comment that the crypto “cycle” is very interesting. If you plot Bitcoin’s price using a log scale, it has exhibited a clear three year peak-to-peak cycle…first in 2011, then 2014, then 2017, and then 2020.
But will that pattern continue? And why has that particular pattern occurred in the first place? Is there a signal, or is it pure noise that just happens to have peaked every three years?
I don’t know 🙂 but it’s cool to ponder over
-Jesse
So far, bitcoin has had its best price runs within a year of halving: Nov 28, 2012; July 9, 2015; May 11, 2020; next halving about March 11, 2024. Thus, buying on a pull back this summer and holding to Q4 2024 might work out.
That said, the float of bitcoin is so small relative to USD or gold it’s hard to predict anything.
Garry Rains left the comment at 1519 17JAN21
Thank you for the article. Very instructive!
I wonder if you could expound upon something you glossed over but appears to be rather important. You state:
“The “winning” miner gets to do two things. First, they pack the block with their choice of transactions. Some transactions come with fees in order to entice miners to include those transactions in the next block. Fees go to the winning miner. Second, the winning miner claims a bounty of Bitcoin by appending one extra transaction onto the end of the block—P.S. Jesse mined this block, his wallet gets two Bitcoin. Woohoo!”
According to your explanation, block verification is tied to the fact that a majority of other miners agree that Jesse solved the current puzzle (which was based on past puzzles, solutions, and transactions), and Jesse gets to claim a bounty as a reward. But why does Jesse get to choose which new transactions are included in this block (or is he choosing transactions for the next block — this part of your explanation was unclear)? If Jesse gets to choose the transactions he has just “won” the right to include in his own block, this seems to me to create the opportunity for a range of unhealthy incentives, unless there are guardrails in place that you did not mention. Some related questions:
— Where does the pool of yet-to-be-chosen new transactions live, and is it open for everyone to see?
— How many transactions are included in each block? Does Jesse get to choose that too? Can he exclude transactions that do not promise a “finders fee”? You say that “The individual wallet owners don’t need to fear that their transactions might get “stuck in limbo”.” But it seems to me that this is exactly what could happen once transaction fees dominate the incentive structure.
— Is the Bitcoin “bounty” known a priori, at the time the new puzzle is launched? Is it a publicly stated prize, the same for every miner?
Sorry if I am misunderstanding your explanation or asking questions that are obvious to everyone else, but this is all new to me. Thanks again for the helpful article!
Terrific! Thank you for reading and asking such thoughtful questions.
You can actually see the currently unconfirmed transactions LIVE! (https://www.blockchain.com/btc/unconfirmed-transactions)
Yes, it’s open info. Anyone can see it.
Virtually all transactions include fees these days to properly incentivize miners to include them. There’s a secondary metric called “priority” that includes transaction age. (https://en.bitcoin.it/wiki/Miner_fees#Priority_transactions). But it appears “priority” is rarely actually used by miners anymore. They are “fee only.” 🙂
New blocks are limited at ~1MB of data. This has been identified as a potential issue in the future (https://en.wikipedia.org/wiki/Bitcoin_scalability_problem)
Summary: *you* have independently identified one of the core potential issues in Bitcoin’s future. That’s cool!!!
After a few days, a transaction in limbo will get returned to the sender.
Yes, the “bounty” is known a priori. It’s the same for every miner. It’s current 6.25 BTC (or about $200K…whoa)
Hi Jesse! Great post. So happy I came across this article. Here’s a question – say I buy Bitcoin (which I won’t because my understanding of it is still very limited) from an exchange say Coinbase, does that mean Coinbase serves as my “wallet” that stores my Bitcoin? Also, do I then automatically become a node that verifies the blockchain? Or can I then become a miner because I now have a wallet? Is that how it works? This is one part that confuses me. Thanks!
Hi there! Thanks for the kind words, and thanks for reading! Fantastic questions.
If you have a Coinbase.com account, then YES–Coinbase serves as your wallet. They hold the keys.
Coinbase also offers a service/app called “Coinbase Wallet” where you store the keys on your private hardware (e.g. a phone or PC).
Creating a wallet (e.g. with Coinbase) is NOT the same as becoming a miner and is NOT the same as becoming a node.
If you want to be a NODE, you need to download the full Blockchain—all that data is about 350GB right now—to your PC. And you need to run software on your machine called ‘Bitcoin Core.’
If you want to be a MINER, you do need a wallet (!), but you also need to run specific mining software on your PC.
Ok gotcha! Thanks for clarifying. I read the article again and I have another question. Lol!
My understanding is that in order for a transaction (Sally pays Jim 2 bitcoins) to be added to the blockchain, a puzzle associated with this transaction needs to be solved first (to ensure that Sally does have 2 bitcoins to pay to Jim).
So the process goes: Sally’s transaction comes with a puzzle —> this puzzle needs to be solved —> a miner solves this puzzle —> nodes agree with the solution/proof of work —> Sally’s transaction is added to the blockchain.
I’m having a hard time reconciling this with the fact that the winning miner gets to “pack the block with their choice of transactions.” This tells me a bit of a different story.
So the process goes: Sally’s transaction comes with a puzzle — this puzzle needs to be solved — a miner solves a puzzle — miner chooses transaction(s) to associate to the solved puzzle (could pick Sally’s, could pick someone else’s that offer fees) — nodes verify proof of work — a group of transactions gets added to the blockchain.
This process seems to be distorted because (a) doesn’t each transaction come with it’s own puzzle to be solved, and (b) why does a winning miner have the ability to choose transactions that will go with the solved puzzle if (a) is true?
Which part am I not getting right?
Hey! I’ll have time for a more detailed answer later, but your “A” isn’t right.
Each transactions does *not* come with its own puzzle.
Instead, each new block comes with its own new puzzle. That’s why your “B” is true.
Ohhh okay I see where I got confused there. I thought transactions come with puzzles. Instead, transactions are grouped into blocks and blocks come with puzzles. So when a puzzle is solved, a group of transactions gets verified at the same time and gets added to the ledger. Very interesting! Thanks again for writing this!!
Right! (and thank you again for reading!)
Each new block comes with a cryptographic puzzle.
The parameters of that new block’s puzzle aren’t set until the previous block has been mined. That way, nobody can get a “head start” solving the new puzzle.
Once a miner has solved the new block’s puzzle, they get to pack the block with transactions.
Best article I’ve read to date on Bitcoin! As a retired banker I’ve been trying to understand this and your article helped a lot. But do I have this right? Bitcoin is uninsured currency that is subject to market volatility. A 100k purchase of bitcoin today could be worth 500k or 10k tomorrow or next year-or 0 if you lose your key. If I have this correct then it’s no better than putting all your money into a particular stock or fund? Also, a news commentator said this morning that there is a finite amount of bitcoin making it more valuable as it can run out?? Does the “halving” mentioned in prior questions mean that’s how availability increases?
If I’ve got this wrong then I need a lot more help understanding virtual currency:(
S
Sheryl! First, THANK YOU for the kind words. So glad it was a helpful article.
Uninsured. Yes.
Volatile. Yes. Though proponents say the volatility will decrease as it becomes more established.
Finite amount of Bitcoin – yes.
Over time, the ‘reward’ for miners is decreasing and decreasing. Each time it decreases by half…called a ‘halving’.
Eventually, the reward will go to zero. No more new Bitcoin!
The only incentive for miners at that point will be fees the people submit with their transactions.
The goal, according to proponents, is that Bitcoin will be worth SO MUCH that even tiny fractional BTC fees will make mining worthwhile.
You’re def on the right track!
Thanks again for reading.
-Jesse
Thanks to you for sharing the post in simple terms. You explained very well and I understood all the things. I joined a platform where we all do cryptocurrency talks. Do you want to join that platform?