Updated: Jul 5, 2022
Bitcoin purists may disagree, but I feel this explanation reasonably, accurately, and fairly explains how cryptocurrency works to a non-tech-savvy investor.
In 2008, Satoshi Nakamoto (not his real name) wrote a paper, “Bitcoin: A Peer-To-Peer Cash System” about peer-to-peer financial asset transfers. Nakamoto explained how a decentralized (stored on the entire computer network rather than in a single location) digital currency could be created and transferred between private parties. Naturally, people immediately began creating and using this technology and the first cryptocurrency, Bitcoin, was born.
The goal was to cut out banks, governments, regulators, and money-sucking middlemen. Peer-to-peer transfers of money without any intermediary (like a bank or PayPal) is the stated goal of Bitcoin’s creator. Nakamoto felt this product helped restore equity in the financial system since Bitcoin cannot be controlled by the current establishment. This initiative was inspired by the 2008 recession, which damaged society’s trust in financial institutions.
A Bitcoin is not a coin or physical currency. It is an encoded data packet (identified by a unique hash code/serial number) that contains a transaction record. Every packet also contains a unique link (hash code) to the previous transaction involving this individual Bitcoin. The history of a single Bitcoin can be viewed by the entire network but not altered. To create a better understanding of a Bitcoin’s inner workings, let’s consider the journey of a one-dollar bill.
The Hypothetical Journey of One Dollar:
1. A dollar is printed by the U.S. Treasury.
2. The dollar is sent to the bank for distribution.
3. The bank hands the dollar out to a customer who cashed a paycheck.
4. The customer later spends the dollar at a convenience store on a soft drink.
5. The convenience store pays a bread wholesaler with this same dollar.
6. The bread wholesaler deposits the dollar into the company’s bank.
7. The dollar is currently being held in the bread company’s bank.
Now, let’s move a Bitcoin through the same journey above, assuming everyone accepted Bitcoin as a valid payment (which currently is not the case). We will also pretend a Bitcoin only has a one-dollar value just to explain this process.
The Hypothetical Journey of a Bitcoin:
1. A Bitcoin is created by a person’s advanced computer on the Bitcoin network by solving a puzzle or equation. Solving the equation creates a unique hash (a 256 bit code identifying one Bitcoin from every other Bitcoin).
2. The person trades the newly created Bitcoin to a local convenience store in exchange for a soft drink. This transfer of the Bitcoin is recorded on a data packet called a block (an encoded, detailed record of this transaction). Before this transaction can be considered valid, however, it must first be sent throughout the entire Bitcoin network and wait for someone else’s computer to validate the transaction as legitimate and not a forgery. This is done by solving the unique hash generated by the electronic exchange of a Bitcoin for the convenience store’s soda. Someone’s computer on the network solves the newest hash equation sent out for verification. Once solved, the transfer is “validated.”
3. When the convenience store uses the Bitcoin to pay the bread supplier, the entire hash, block, and verification process is repeated again. This ongoing record of the Bitcoin’s journey creates the “blockchain.” A blockchain is simply a group of linked transaction records—like a database.
4. The latest block in the chain would now show that the coin is being temporarily held at a bank (of course, banks will have nothing to do with Bitcoins currently).
A Few Important Details That Will Help You Better Understand This Process:
1. A hash is both an equation and a unique identifier like a serial number (my explanation[DS1] and not a term Bitcoin true believers will embrace). Once the hash[DS2] /equation is solved, it will reproduce all the data needed for the transactional block. Every block has a unique identifier because every block holds its own unique transaction.
2. The technical term for solving the hash equation in the crypto world is called “proof of work.”
3. A clarification on the “mining” concept: In exchange for verifying transactions, computers in the networks are awarded Bitcoins or partial pieces of Bitcoins. Bitcoins can only be created at a certain speed. Each year, the number of Bitcoins being made available is cut in half by the crypto’s code.
4. Every single block in a block chain contains the following data:
A.Hash: A unique blockchain identifier generated by the transaction that created it
B. Data: The details describing the Bitcoin transactions including dates, times, amount, etc.
C. The hash of the previous block is always included within the data block. The link to the previous block creates a continuous chain that can be followed back to a Bitcoin’s creation. If any tampering occurs, it breaks the chain, making forgeries or fake cryptocurrency easily detectable.
How Do You Obtain A Bitcoin?
1. Join a Bitcoin Exchange (much like joining a social media site) such as https://bitcoin.org/en/.
2. Obtain a digital Bitcoin wallet to store your Bitcoin. Never store your Bitcoins on the network as they can be stolen.
3. Connect your wallet to a bank account to transfer out real money to purchase Bitcoins or to transfer in real money if you sell your Bitcoins to someone else. A wallet is an encrypted number. The wallet has a public address (numbered location on the network) and a private number that only you know. The private number provides you access to your Bitcoins. If you lose the wallet (your private number) it cannot be regenerated or recovered. It is simply gone forever. Many, many people lose their Bitcoins from this blunder.
4. Place your Bitcoin order and pay with real dollars.
5. Store your Bitcoins in your wallet.
~ Larry Faulkner