NEWS: the price of bitcoin is up to $905 as of this morning.

I am continuing to be astounded.

So in yesterday’s post (Bitcoin: Triple Entry Accounting), I gave a quick overview of Bitcoin’s mysterious origins and its somewhat questionable connection to the world of underground crime.

Today, my plan is to explain how it works: and I’m going to do so by relying on this video.

The Not-so-Basic Summary*
*the basic summary is in the video.

  1. There are only 21 million possible bitcoins, not all of which have been released into circulation (until then, the bitcoins are “locked into the network code” ie. they’re only released into circulation in accordance with a formula put in place by the mysterious Satoshi).
  2. The unreleased coins can be “mined” if you’re prepared to install some bitcoin software onto your computer (you may need a specialised computer – especially today, when the price of bitcoins is making investment in bitcoin-mining-specific hardware really really attractive).
  3. Now we get to the fun part. And I need to start with some background:
    1. The real problem that Satoshi Nakamoto was trying to overcome with bitcoin is the concept of “double-spend” (bear with me).
    2. Let’s say that I have a $100 note. Obviously, I can’t spend it more than once – because I have to hand over the note before I get the good/service in return.
    3. But let’s say that I have $100 in digital currency. “Digital currency” is really just a piece of code.
    4. What if I just duplicated it and sent it to you? How would you know if you had the original and only piece of code?
    5. A real world example: if I sell you a book, then I’ve handed over the book and you have it; but if I sell you an ebook, how do you know that I no longer have the ebook, or that I haven’t sold that same ebook to numerous other people?
    6. So there needs to be some way of making the digital currency unique and impossible to duplicate.
    7. Solution: the timestamp server.
    8. Every ten minutes, a block of transactions gets processed through the timestamp server, embedding each bitcoin with another timestamp and making that transaction widely-known to the rest of the network.
  4. And how that works (roughly):
    1. Each transaction block requires all the computers (or nodes) in the network to solve a complex mathematical proof in order to get the new timestamp (the solution forms part of the timestamp itself).
    2. When a network node finds the solution, it broadcasts it to the rest of the network.
    3. The rest of the network nodes will only accept the timestamp if all the transactions are unique.
    4. And the nodes express their acceptance by starting to solve the next proof-of-work.
    5. Importantly: the new proof-of-work builds on the previous proof-of-work, meaning that duplication requires all the work to be repeated from the beginning.
    6. So we only need to worry about duplication once someone invents a quantum computer that can work faster than the combined computing power of every bitcoin mining computer in existence.
  5. The real point is that it’s mathematically improbable that a bitcoin will be counterfeited, short of rapid advance in the world of computing.
  6. So if the bitcoin bubble bursts because of duplication, you can be consoled by the fact that you’re no longer going to be annoyed by waiting for Windows to start up.

So that’s the mechanics. In the real world, bitcoin still feels like a bit of a fad.

However: as people become more invested in it (by doing more mining), there will be a strong and deeply vested interest in the use of bitcoin becoming more widespread.

Which I’ll get to tomorrow.