Sunday, July 14, 2013

How Bitcoin Works Under the Hood

new 3.5 in-depth course: Introduction to Bitcoin, Blockchain and Decentralized projects (Ethereum).

The goal of this video is to explain how Bitcoin works under the hood, to give a clearer idea of what it really means to own, send or “mine” Bitcoins.

New: Turkish translation by now available.

If, instead of how it works, you're looking for where to buy Bitcoin, I use coinbase. And for trading, check out bitcoin wealth alliance (both affiliate links).

What is Bitcoin at a high level?

First, a brief high-level overview of what Bitcoin is.

At its core, Bitcoin is just a digital file that lists accounts and money like a ledger. A copy of this file is maintained on every computer in the Bitcoin network. (update: you don't have to maintain a ledger just to use Bitcoin to send and receive money, this is for people who want to help maintain the system).

These numbers don’t represent anything in the physical world, they only have value because people are willing to trade real goods and services for a higher number next to their account, and believe that others will do the same. The numbers only have value because we believe they have value, just like any other fiat currency.

To send money, you broadcast to the network that the amount on your account should go down, and the amount on a receiver’s account up. Nodes, or computers, in the Bitcoin network apply that transaction to their copy of the ledger, and then pass on the transaction to other nodes. This, with some math-based security, is really all there is--a system that lets a group of computers maintain a ledger.

While this may sound similar to the way a bank maintains a ledger, the fact that the ledger is maintained by a group rather than a single entity introduces a number of important differences. For one, unlike at a bank where you only know about your own transactions, in Bitcoin, everyone knows about everyone else’s transactions.

Also, while you can trust your bank, or can at least sue it if something goes wrong, in Bitcoin, you’re dealing with anonymous strangers, so you shouldn’t trust anyone. The Bitcoin system is amazingly designed so that no trust is needed--special mathematical functions protect every aspect of the system.

The rest of this entry will explain in detail how Bitcoin allows such a group of strangers to manage each other’s financial transactions.