Bitcoin is a phrase we’re hearing more and more often. It has a lot of smart people really excited, but if you’re not in IT the concepts can be difficult to grasp.
So in case someone tries to test your knowledge at the office coffeepot, here are some simple explanations to ease you into the new world of digital currency.
For starters, it helps to compare bitcoin to how money has worked for centuries. The gold standard was the basis for our fiscal system for a long-time, and what it did was give our paper currency an equivalent value to gold, a tangible finite resource of certain value.
Bitcoin is a digital currency and as such does not have a relationship to a resource like gold. So how does bitcoin ensure it’s currency has value? Well, Bitcoins aren’t printed like cash, they are discovered through a process called ‘mining’.
What is mining and how does it work?
When people send bitcoins to each other, the details of transactions are grouped with other transactions made at the same time. This list of transactions is called a ‘block’.
It is the miner’s job to confirm these transactions and add them to the general ledger. This ledger is made up of previous blocks, which when added becomes the ‘blockchain’.
The advantage of this system is this: it can be used to place any transaction made between bitcoin addresses at any point in the network. Each new block creates an increasingly complex list of transactions that happened on the network.
It’s usually at this point that your friend at the coffeepot has lost interest or abandoned you. Or worse still, they have stuck around to ask you trick questions. Like: how do we know that the general ledger – the blockchain – can be trusted? And if this is all digital how do we know someone can’t hacked it?
This is where bitcoin miners come in. The miner’s role is to encrypt the information in a block. They take all this information and through a mathematical process create a shorter series of numbers and letters – called a ‘hash’.
Hashes are vital to blockchain security because while it is easy to create a hash from data, it is nearly impossible to work out what data is contained in a hash. Each hash created is unique to the block, and changing just one character in a bitcoin block can change it completely.
Each block’s hash uses the data from its transactions to make its unique sequence. However, it also uses the previous block’s hash, thus creating a series of encrypted blocks and multiple levels of security.
Each hash can be thought of as a digital seal. Not only does it protect the information in its block, but it ensures that the subsequent block is verified as part of the blockchain.
If someone were to try and tamper with a transaction by changing a block already stored in the chain, it would be immediately identifiable due to its different hash. The snowball effect of hashing means that a small change further up the chain would be noticed all along the chain and traceable back to its source.
Your friend at the coffeepot is starting to look impressed, but he still has some curveballs to throw at you. Like: if miners get bitcoins for mining, how does the system sustain value?
The simple answer is that mining isn’t easy. Bitcoin calls this ‘proof of work’ and suggests that by making the computational tasks more difficult, each miner has to invest real time, power and hardware in order to seal off a block. In this way, there has to be capital investment made by miners that inherently makes the system valuable.
The bitcoin protocol requires that each hash looks a certain way: it must have a specific number of zeroes at the start. By limiting the hash sequence to be both a specific format, but requiring that it is a unique sequence, the process of mining becomes labour-intensive.
Miners are therefore required to change the transaction data in a block without tampering with it. This is done by adding a random piece of data called a ‘nonce’.
A block is made up of the previous block’s hash, the transaction data, and a nonce. If the generated hash doesn’t fit the format, the nonce is changed and the entire process repeated. ‘Proof of work’ is made harder because none of this happens in isolation. Each miner must compete with other miners who are trying to process the same block.
By now your coffeepot companion has run out of questions. But don’t worry, we have more articles to back you up for your next encounter with him.
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