Peter Kent - Bitcoin For Dummies

Chapter 2

IN THIS CHAPTER

Understanding the Bitcoin network

Finding out about public-key cryptography

Sending messages to the Bitcoin ledger

Understanding how cryptography proves you own your Bitcoin

How Bitcoin works is a mystery to most of the world. Don’t let it be so to you! If you’re going to get involved with Bitcoin — perhaps invest in it — then you really should know what you’re working with.

Understanding the specifics of how Bitcoin functions as “money” — as well as other aspects of this cryptocurrency — is important. First, it’s always nice to sound intelligent when someone asks you, “ So what is Bitcoin, anyway? ” (It’s so embarrassing to admit that you’ve just invested in something and have no idea what it is!) But more importantly, if you don’t understand how Bitcoin works, it’s hard to keep it safe. Thousands of people have had their Bitcoin stolen from them, or have simply lost access to it, primarily because they really don’t understand how it works. (It’s so sad to know exactly where your Bitcoin is, but never be able to touch it!)

So in this chapter, we explain just that. How Bitcoin really works at a high level. We explain the specifics of securing your Bitcoin in Chapter 5. But for now, let’s start with a high-level, Bitcoin-101 explanation of what’s actually going on when you buy, sell, and store Bitcoin.

Before we get started, though, be prepared. This is complicated stuff that you don’t need to remember in order to buy and sell Bitcoin. We’ve tried to simplify it as much as we can, and we believe that grasping this information is necessary to your understanding of a few important points, which are themselves valuable in helping you keep your Bitcoin safe. We want you to understand, at the very least, the background information that explains these critical issues:

Bitcoin is stored in the blockchain, not in your Bitcoin wallet.

The Bitcoin wallet stores information about your addresses in the blockchain.

The wallet stores the private and public keys that allow you to control your address (and thus control your Bitcoin).

The first thing to understand is that there is no Bitcoin ! Bitcoin as a “physical thing” doesn’t exist, of course. There is no tangible object, no “thing”; no coins, no bills or notes. But more than that, if you were to dig into the programming source code that makes Bitcoin work, you wouldn’t even see a “digital representation” of Bitcoins. That’s because Bitcoin is, plain and simple, information about transactions.

That’s okay, though. There is no physical or digital representation of most of your everyday money, either, whether you use dollars, pounds, euros, yen, or whatever. As historian Yuval Harari has said, “90 percent of all money is nothing more than entries in a computer server.” You can confirm this for yourself; do an Internet search for information about different money supply numbers — M0, M1, M2, and so on — and you’ll find that only around 10 percent of a major currency’s value is represented by actual, physical money (M0) by bills and coins. Instead, the great majority of money is nothing more than entries in a computer server — entries in what we may term a ledger .

Spend some time around Bitcoin folk, and you’ll start to hear talk of the Bitcoin ledger . So let’s back up a moment. What is a ledger? The Merriam-Webster online dictionary defines a ledger as “a book containing accounts to which debits and credits are posted from books of original entry.” Wikipedia defines a ledger as “a book or collection of accounts in which account transactions are recorded.”

So a ledger is a record of transactions. You’ve seen ledgers. Your bank statement, on paper or on your computer screen, is a form of ledger. Your checkbook register is a form of ledger (does anyone still use a checkbook register?). If you use Quicken or Mint or some other form of accounting program, you’ve seen ledgers.

Well, there’s also a Bitcoin ledger, and inside that ledger is a record of Bitcoin transactions. There is no actual Bitcoin, but there is a record of Bitcoin coming into your account and leaving the account. Which is pretty much what you see when you look at your bank statement, which is a record of currency transactions, too, payments to and from your account. It’s generally not, however, a record of actual, physical money transactions. In fact, in the U.S., only one-quarter of transactions are cash (mostly under $25), and more than one-half of transactions are plastic (credit and debit cards). The rest are various electronic payment methods (and a few checks).

Here’s a quick question for you: What’s the difference between U.S. dollars and Bitcoin? With U.S. dollars, 90 percent of all the money is nothing more than entries in a computer server. With Bitcoin, it’s 100 percent!

Now, the Bitcoin ledger is often described as being immutable . The word immutable means “not capable of or susceptible to change,” and of course the Bitcoin ledger can change; hundreds of thousands of transactions are added to the ledger every day. But what immutable means in this context is that once a transaction has been committed to the ledger, that’s it; it can’t be changed. The ledger can’t be “hacked” and modified, for instance. (You’ll find out why in a few moments.)

So, because the ledger is immutable, it means that whatever is recorded in the ledger is the truth. If the ledger says that you own, say, half a Bitcoin, then the fact is you own half a Bitcoin!

Well, there is another very important difference between everyday money and Bitcoin. The transactions are not mere entries in a computer server. Rather, they are entries in a duplicated, distributed ledger spread across a network of thousands of servers.

Bitcoin is sometimes known as a “trustless” system; not because it can’t be trusted, but because trust in a single person or company isn’t required. In a sense, trust is already baked into the system. It’s “trustless” because you don’t have to trust any particular individual, or any particular organization. This is because of the way the mathematics behind Bitcoin functions (keeping participants honest, in effect): It ensures that many servers are involved, and that the system itself can be trusted.

So we have Bitcoin transactions stored in the Bitcoin ledger. Where and how is that ledger stored? To understand that, we have to take another step back, and understand a little about blockchains.

The Bitcoin ledger — the record of Bitcoin transactions — is saved in the Bitcoin blockchain. What’s a blockchain, you ask? A blockchain is a very special type of database. So once again, we need to step back — very quickly this time — to ask, what’s a database?