Bitcoin is decentralized and free from control by governments, banks and corporations. It is therefore being touted by free thinkers and hackers as the currency of the future. Assets are secured through the rigorous use of cryptography.
The Bitcoin virtual currency works like a collective accounting system. A kind of global ledger records every transaction and the location of each virtual coin. While a Bitcoin (BTC) exists only in a computer, the system ensures that the total number of coins is limited, and that no one can counterfeit or even spend them twice. This protects the community of users from single, malicious individuals: as long as the majority of participants are interested in the currency’s reliability, no one can manipulate the accounting.
Bitcoins only appear in this global accounting system in the context of transactions. A transaction, in the context of the peer-to-peer currency, is a message addressed to all other clients on the network expressing the intention to send money from one Bitcoin address to another. Any user can create an unlimited number of such addresses and send and receive money between them. The public transaction history, which every network participant can check, shows which address has how many Bitcoins. This shows exactly which bitcoins have circulated where since its inception, and from this it is possible to determine how many bitcoins each address may have at its disposal.
Paying with bitcoins
Suppose Stefan wants to rent a web server from Mary. Since Mary runs her hosting company in the USA and Stefan lives in Germany, Bitcoin is an interesting alternative to a credit card or online payment service. Stefan can transfer bitcoins relatively quickly and easily – although at present, bitcoin transaction fees can be higher.
Firstly, Stefan and Mary each need a Bitcoin address. To create an address, Stefan generates a public and private key pair. He needs the private key to cryptographically sign his transactions using the Elliptic Curve Digital Signature Algorithm (ECDSA) and confirm to all other network participants that he really wants to use his address to carry out this transaction. A hash of the public key yields the Bitcoin address.
The whole thing is effectively a public account: all Bitcoin users know how much money is associated with the address, but nobody knows that it belongs to Stefan. And nobody but Stefan can access the money – at least not until Stefan gives up the secret key. However, anyone can transfer money to this address – they just need to know it.
To carry out his first transaction, Stefan first needs bitcoins. For example, he could exchange euros for bitcoins at an Internet supplier: he transfers the money in euros to the merchant, who sends the corresponding equivalent in bitcoins to the address provided by Stefan. Or Stefan could go among the gold miners and extract his bitcoins himself.
Digital signature
Stefan signs this transaction with his secret key. Then his client sends it to the peer-to-peer network. Marie’s client learns of it this way and sees that 0.02 BTC has been sent to one of her addresses. Mary can then use Stefan’s public key to verify the transaction signature. Mary can now use her 0.02 BTC in another transaction.
Digital signatures guarantee that only the recipient of a bitcoin amount can spend it again. The only thing left to do is to make sure he doesn’t do it more than once. There’s a simple rule for this: if several transactions with the same entry appear, only the first one is valid. To enforce this rule, all transactions must be time-stamped.
This would be easy if there were a central authority that authenticated all transactions in order of receipt. In a peer-to-peer network, where everyone is equal and you don’t know who to trust, it’s a little trickier. In the Bitcoin system, any participant who wants to can act as a miner and help authenticate transactions.
