How Bitcoin Really Works

[dualstow]

Mainly for you programmers, and even then you'll want to skim. Saw this link at bogleheads.
Bitcoin as programmable money.
http://www.michaelnielsen.org/ddi/how-t ... lly-works/

Nisiprius and others have some good comments on it. http://www.bogleheads.org/forum/viewtop ... 0&t=127972

[Storm]

Thanks for posting this.  The easiest way I can describe it is that everyone running the full Bitcoin client has a copy of the transaction ledger for every Bitcoin ever transferred, from the beginning of Bitcoin until the end of time.  It would be like an accountant giving everyone a copy of the books.  Then, sending Bitcoins is just a matter of creating a new ledger entry and getting at least 51% of the computing power in the bitcoin network to agree on it.  Because you'd have to get at least 51% of the hashing power of the network to agree on it before it's accepted into a new block (10 minute interval of ledger entries), this solves the double spending problem...  I can't just send someone 1000 bitcoins, then send someone else the same 1000 bitcoins, because nobody would agree with my version of the books, except me and the computers I control.

It does bring up an interesting possibility though:  What if someone like the NSA, with a ton of computing power, made a concerted effort to disrupt the Bitcoin network?  If they could achieve > 51% of the processing power of the entire network, they would stand a chance of taking over and forking the blockchain - essentially creating a new set of books that the network agreed to, because they are the network.  This would be interesting, and might undermine faith in the bitcoin protocol.  As such, it benefits all bitcoin users to have more and more powerful mining be in the hands of individual citizens, to avoid potential 51% attacks.  As far as I know, the 51% attack is really the only legitimate known vulnerability in the bitcoin protocol.

[Storm]

If you understand the transaction ledger concept, the next thing to understand is how mining works.  Essentially, every 10 minutes a new block of ledger entries is added to the blockchain (transaction ledger).  All of the miners in the network participate in a lottery where they perform complex math problems, generating hashes and trying to guess a winning number.  The math problems they are calculating are placing digital signatures on all of the transactions that Bitcoin users are entering into the ledger.  And, one lucky miner that gets closest to guessing that winning number wins the award of 25 BTC that is issued each block.  So, every 10 minutes, 25 BTC appears out of thin air and is awarded to one lucky miner.  It used to be 50 BTC per block, but over time, the amount of BTC awarded per block slowly decreases to keep the money supply constant at ~21 million coins.

This award incentivizes miners to contribute more computing power and strengthen the network to prevent 51% attacks.  You might ask, after 2039, when all Bitcoins are awarded, and there are more no Bitcoins entering the market, why would miners still participate?  The answer is transaction fees.  The fees associated with transferring Bitcoins are very small.  It only costs 0.0001 Bitcoin to transfer >2 Bitcoins, but this small fee is enough to reward the miners that verify your transactions for contributing the computing power to digitally sign and confirm them in the blockchain, so that they become part of the permanent record.

[Gumby]

According to Timothy B. Lee — a Forbes Contributor and avid Bitcoin supporter, he says the Bitcoin network doesn't scale very well:

The Bitcoin protocol requires that every node in the network download a copy of every Bitcoin transaction that has ever occurred. As Bitcoin has grown more popular, running the “full”? Bitcoin client has become more and more resource-intensive. The last time I started up my Bitcoin client, it took several hours to download all the transactions that had occurred in the few weeks since the last time I ran it.

To prevent things from becoming completely unwieldy, the Bitcoin protocol limits the size of each “block,”? the basic unit of Bitcoin’s shared transaction register, to one megabyte. Since one block is created every 10 minutes, on average, this places a hard limit on the number of transactions the network can process each hour.

Right now, the network is operating well below the limit. But it’s not that far below the limit. If the Bitcoin economy continues to grow rapidly, we’re likely to hit it in the next few years.

Reaching the limit wouldn’t be catastrophic; the Bitcoin protocol has an elegant system of transaction fees to process the most urgent transactions first. But it does place some limits on Bitcoin’s long-term future. For example, it’s hard to imagine Bitcoin ever becoming a replacement for conventional credit cards. There are far too many credit card transactions for the Bitcoin network to accomodate.

Source: http://www.forbes.com/sites/timothylee/ ... -bitcoins/

If that's true, it seems a little weird that Bitcoin's ability to scale to a mainstream currency is limited.

[Storm]

Gumby, very insightful, and as usual, you get right to the heart of the issue.  There have been a few blocks that have already been close to the 1MB limit; one was 897K just a week or so ago.  The real limitation is that 1MB blocksize only allows 7 transactions per second.  This is serious, because Visa/MC/Amex/Discover process many more transactions than that in a second.  Gavin Andreesen, the lead developer on Bitcoin, has stated his intention to increase the blocksize, but it's not that easy.  He must get at least 51% of the miners and users of bitcoin to agree and convert to the new version of the software all at once.  Meanwhile, some people are publicly fighting against increasing the 1MB blocksize.  These people seem like idiots to me, but you might check out their website and decide for yourself.  IMHO, Bitcoin needs to be able to process hundreds or thousand of transactions a second (millions maybe?) to be considered a legitimate currency that could be used for commerce by the entire universe.

http://keepbitcoinfree.org/ for an alternative view...

Btw, there are other altcoins that have much higher transactions per second, based solely on their block interval.  For example, Zetacoin has a 30 second block interval (20x bitcoin) and should theoretically be able to process 140 transactions per second.  https://cryptocointalk.com/topic/953-ze ... formation/

This is just one example of an alternative - perhaps people could use alternative digital currencies like Litecoin (4x Bitcoin) or Zetacoin (20x Bitcoin) for small transactions, while Bitcoin could remain the "gold" in the digital currency market for large transfers of wealth.

[MediumTex]

Nice to see you Storm.

[Reub]

Could it be that there's a causal relationship between bitcoin's recent plummet and a rise in the price of gold? Are they both going after the same dollars?

[Peak2Trough]

I think it's more likely that the bitcoin market is so small, the price is very easily manipulated.  With only 21M bitcoins ever possible, this plus the transaction limitations may be the most significant drawbacks this currency faces.

[Kshartle]

Could it be that there's a causal relationship between bitcoin's recent plummet and a rise in the price of gold? Are they both going after the same dollars?

I think without a doubt. There are a lot of participants in one or the other or both who are buying to protect themselves from dollar, fiat fears.

Obviously there are a lot of people buying for a lot of reasons but you hit the nail on the head. You can read in Marc's posts and other's that they look at bitcoin as another currency/money alternative.

Now I think bitcoin will eventually go to zero, time will tell. Those bitcoin billions will flow into the metals I think rather than the paper. That's all opinion though but it's based on reasonable premesis.

[Libertarian666]

It seems that there is no real scarcity of competing "bitcoin-like" digital currencies, so the long-term value of any of them will asymptotically approach zero.

[Storm]

What makes you believe Bitcoin will be zero?  I could see that if some entity like the US government put on a concerted effort to shut it down, but otherwise, it's a very convenient way to send value across international borders without sticking gold coins up your *$$...  Please don't underestimate the convenience of sending anyone in the world money, without worrying about whether they will get it or not.  Whether or not Bitcoin is THE digital money supply of the future, some type of digital coin will replace fiat money.  It's like the Internet replacing snail mail.  Unthinkable in 1992, but passe today.  You all will look back on this as the 1992 moment for Bitcoin as well.

[Storm]

Nice to see you Storm.

Thanks.  Work has me so busy that I don't have much time for forums or Facebook any more.  That's ok, though, because for the most part my life is better if I focus on what matters; family, friends, and work.

Cheers.

[Peak2Trough]

What makes you believe Bitcoin will be zero?  I could see that if some entity like the US government put on a concerted effort to shut it down, but otherwise, it's a very convenient way to send value across international borders without sticking gold coins up your *$$...  Please don't underestimate the convenience of sending anyone in the world money, without worrying about whether they will get it or not.  Whether or not Bitcoin is THE digital money supply of the future, some type of digital coin will replace fiat money.  It's like the Internet replacing snail mail.  Unthinkable in 1992, but passe today.  You all will look back on this as the 1992 moment for Bitcoin as well.

You make good points Storm.  I think Libertarian666 also makes a good point though… there's nothing but math between bitcoin and a virtually infinite number of new, competing digital currencies. 

Honest questions:

1.  Why would one digital currency retain any more value than another?  (assuming equal security, etc)

2.  More to the point, why wouldn't the aggregate value of all digital currencies be inversely proportional to the total number of possible cryptographic currencies?

[Reub]

"What makes you believe Bitcoin will be zero?  I could see that if some entity like the US government put on a concerted effort to shut it down"

I could definitely see govt's looking to shut it down. When you're running the biggest Ponzi scheme in town why would you want any competition?

[Kshartle]

Why would they have any value in the first place?

This has all been covered in another thread so I won't repeat the entire argument but instead state some points for discussion.

If something is worthless.....the ability to transfer it easily and cheaply doesn't make it valueable. I can mail you a jar of poo very easily, leave off my address, etc. and it still doesn't make it valuable.

If something is worthless.....the fact that it's scarce doesn't make it valueable. I can take a bunch of crayons, scribble out a completely unique picture...totally unique and non-replicatable (is that a word) and it won't have any value, trust me.

If something is worthless.....the fact that it costs a lot of money to obtain it doesn't make it valueable. I can spend thousands and thousands traveling to Antarctica, break off tons of ice and come back and sell Antarctica ice cubes. I will probably get a higher price for the novelty.....but since no one is doing this it's because it would be a losing business. The price I can get for the ice is not related to, or even close to the cost incured getting it.

When I say bitcoin is worthless....what I mean is the bitcoin itself does absolutely nothing. You can't use it for anything. Why would anyone ever want one? The claim that it's valuable because it's easily transferable, scarce, or expensive to mine doesn't hold water to me. If you guys disagree maybe explain why.

Ohhh the last one is that it's valueable because people believe it is. I would say that's an argument for the price, which is different from the value. It has a price but it has no value. We know those two things are not the same because everything has a price, and yet some buy and some sell and some just stay away because the subjective value to them is different then the objective price. The value is subjective, but as long as something can be used for anything....it has some value. I don't see what this is for bitcoin. Belief in something doesn't change reality. It has to convey some benefit on it's own to be valueable, belief itself doesn't generate that.

Incidently even though dollars aren't backed by anything other than threats, we are forced to accept them and forced to pay taxes in them so you are forced to use them. Staying out of a cage (jail) has a value.

I'll sit out if you guys want to discuss any of this. I've shared my opinion and the arguments at an exhausting length on this already. If you don't think it's worth commenting on my feelings won't be hurt. 

[Mountaineer]

I know next to nothing about Bitcoins so this may be a really, really stupid view.  It seems to me that Bitcoins are just an exchange medium (like paper money) that has no value.  The difference with Bitcoins are they are virtual and do not really exist like paper money.  Basically, it just makes the bartering process easier.  It seems the issue is how to "protect" the Bitcoins from abuse like we try to do with paper money to stop counterfeiting.  Is this crazy?

... Mountaineer

[Kshartle]

I know I promised....but I can't help myself 

The paper money exists, but only a small fraction of USD or fiat money is paper. Even the portion that is paper.....the price of the USD (what you can buy with it) it totally far and above the value of the paper. So the paper only has the smallest fraction of paper value (make airplanes ith it, roll green cigarettes with it, start a fire with it). The value of the FIAT comes from keeping you out of cage. Bitcoin lacks all of this.

Bartering process? I would say it's not barter because barter implies the exchange of two items with value.

We "try" to stop counterfeiting? Looks to me like the government just tries to prevent competition with it's own counterfeiting.

Crazy? No. Well, I think the entire thing is crazy. As bitcoins rise in price, IF they rise in price......they will be subject to more countereiting and theft.

The Bitcoin is a response to FIAT currency that lacks real value and is subject to extreme counterfitting. Well....bitcoin has no real value (far as I can tell) and there can be an endless supply of so-called virtual currency. I can't think of a way it could possibly work.

That being said....I was really tempted to drop 5k in a few months ago. Instead I bought gold mining stocks so who's the idiot here?

[Storm]

When I say bitcoin is worthless....what I mean is the bitcoin itself does absolutely nothing. You can't use it for anything. Why would anyone ever want one? The claim that it's valuable because it's easily transferable, scarce, or expensive to mine doesn't hold water to me. If you guys disagree maybe explain why.

You could say all of the exact same things about paper US dollars.  Don't worry, I'm not offended.

[Storm]

Crazy? No. Well, I think the entire thing is crazy. As bitcoins rise in price, IF they rise in price......they will be subject to more countereiting and theft.

The Bitcoin is a response to FIAT currency that lacks real value and is subject to extreme counterfitting. Well....bitcoin has no real value (far as I can tell) and there can be an endless supply of so-called virtual currency. I can't think of a way it could possibly work.

You don't really understand how bitcoin works, do you?  Bitcoin can't be counterfeited.  If it could be, don't you think people would be counterfeiting it left and right given the value is almost $1,000 per coin?  Unless someone figures out a weakness in SHA256 Bitcoin is fairly secure.  What Satoshi Nakamoto figured out was how to use digital cryptography to solve the double spending problem.  Unless you understand cryptography you probably shouldn't assume Bitcoin can be counterfeited.

[Kshartle]

When I say bitcoin is worthless....what I mean is the bitcoin itself does absolutely nothing. You can't use it for anything. Why would anyone ever want one? The claim that it's valuable because it's easily transferable, scarce, or expensive to mine doesn't hold water to me. If you guys disagree maybe explain why.

You could say all of the exact same things about paper US dollars.  Don't worry, I'm not offended.

Yes I'm definately not a fan of USD. I never hold more than 10% of my net worth in it and rarely more than 5%. USD does have value though in that we are required by law to accept as payment of debts and pay taxes in it. Even if no one owes you anything and you owe no taxes, someone does. Therefore taking and using USD keeps them out of jail. There's a value there. It has value by FIAT in that it prevents people from going into cages.

That being said I'm not a fan of USD or any FIAT money at all.

[Kshartle]

Crazy? No. Well, I think the entire thing is crazy. As bitcoins rise in price, IF they rise in price......they will be subject to more countereiting and theft.

The Bitcoin is a response to FIAT currency that lacks real value and is subject to extreme counterfitting. Well....bitcoin has no real value (far as I can tell) and there can be an endless supply of so-called virtual currency. I can't think of a way it could possibly work.

You don't really understand how bitcoin works, do you?  Bitcoin can't be counterfeited.  If it could be, don't you think people would be counterfeiting it left and right given the value is almost $1,000 per coin?  Unless someone figures out a weakness in SHA256 Bitcoin is fairly secure.  What Satoshi Nakamoto figured out was how to use digital cryptography to solve the double spending problem.  Unless you understand cryptography you probably shouldn't assume Bitcoin can be counterfeited.

No I don't really understand how it works. I should have said they will be subject to counterfeiting attempts. I think it's premature to assume they will be impossible to counterfeit, but again, I don't understand how they work. I think the opposite sentence to yours makes more sense "Unless I understand cryptography I SHOULD assume bitcoin can be counterfited." That way I keep myself from putting too much faith in something I don't understand.

Regarding counterfeiting though.....aren't there many other digital currencies now? Aren't some of them improvements on bitcoin? I guess my point is......what's to stop millions of these things being created, and what makes bitcoin better than the others? People like bitcoin for certain reasons, so why wouldn't they like these others and just jump to one of them? How difficult is it to set up the exchanges and wallets and such? I'll bet it just gets easier and easier. There is no government enforcing them and no......tangible or intrinsic value (far as I can tell).

Listen I don't know a lot about them but I think I'm raising some decent points for an ignoramous and I want to hear from the holders of bitcoin on this stuff because you're more knowlegable.

Maybe bitcoin takes over the entire world, maybe it goes to zero, time will tell. There are a lot of smart guys here who own bitcoins and I'm curious about the answers to my questions. Some have answered that they're just making a small bet that might pay off in a big way so what the heck. Well.....no problem there. I've spun the old roulette wheel more than a few times at the casino and in the stock market. Congrats to anyone who has won so far and wins in the future. I just can't bring myself to buy unless I understand better so help me if you can please.

[Pointedstick]

Regarding counterfeiting though.....aren't there many other digital currencies now? Aren't some of them improvements on bitcoin? I guess my point is......what's to stop millions of these things being created, and what makes bitcoin better than the others? People like bitcoin for certain reasons, so why wouldn't they like these others and just jump to one of them? How difficult is it to set up the exchanges and wallets and such? I'll bet it just gets easier and easier. There is no government enforcing them and no......tangible or intrinsic value (far as I can tell).

I wonder about this too. Because we're talking about purely digital currencies with no "real-world" use value, I think the risk is very real that a competing currency could prove to be more popular than Bitcoin and lure people away, causing Bitcoin to crash. Of course, over the long term this is probably good for the currency user who wants a high-quality medium of exchange, but can be exhausting to early adopters, producers, people who want stability, etc.

It's like the creative destruction of competitive capitalism with physical goods times 1000.

[Kshartle]

Regarding counterfeiting though.....aren't there many other digital currencies now? Aren't some of them improvements on bitcoin? I guess my point is......what's to stop millions of these things being created, and what makes bitcoin better than the others? People like bitcoin for certain reasons, so why wouldn't they like these others and just jump to one of them? How difficult is it to set up the exchanges and wallets and such? I'll bet it just gets easier and easier. There is no government enforcing them and no......tangible or intrinsic value (far as I can tell).

I wonder about this too. Because we're talking about purely digital currencies with no "real-world" use value, I think the risk is very real that a competing currency could prove to be more popular than Bitcoin and lure people away, causing Bitcoin to crash. Of course, over the long term this is probably good for the currency user who wants a high-quality medium of exchange, but can be exhausting to early adopters, producers, people who want stability, etc.

It's like the creative destruction of competitive capitalism with physical goods times 1000.

You don't think if bitcoin fails and goes to zero for whatever reason it won't demonstrate that the concept of a useless (in a practical sense) currency is not practical? I mean....if a new digital currency crushes bitcoin, why would anyone think this new "currency" will survive? At some point no one would think it makes sense to trade FIAT or items of real value for digital "currency". It's only the belief that someone else will take it that supports the price anyway since it's not based any tangible use of a bitcoin.

[Pointedstick]

You don't think if bitcoin fails and goes to zero for whatever reason it won't demonstrate that the concept of a useless (in a practical sense) is not practical? I mean....if a new digital currency crushes bitcoin, why would anyone think this new "currency" will survive? At some point no one would think it makes sense to trade FIAT or items of real value for digital "currency". It's only the belief that someone else will take it that supports the price anyway since it's not based any tangible use of a bitcoin.

I think people like a relatively stable currency and aren't terribly dogmatic about fiat vs hard backing. Even though the dollar has lost purchasing power at around 1-5% every year, apparently that's enough stability for the average person, and I just can't see Bitcoin or another currency catching on if it has daily swings of 20% or more. A digital currency with a relatively stable value that has all the other advantages of Bitcoin will probably prove to be very popular even if it's not backed by gold or silver or poop in a jar.

[Storm]

You both raise some good points.  There are many new digital currencies competing against Bitcoin.  At this time, though, it's really the ecosystem of business investment around Bitcoin that makes it the most valuable and most stable (relatively speaking, of course) compared to the others.

For example, Bitpay, a service that allows merchants to accept Bitcoin and immediately converts it into USD to eliminate the currency risk, has transacted over $100 million this year:  http://www.coindesk.com/merchants-love- ... ons-prove/

Coinbase, a Silicon Valley startup that allows consumers to buy and sell Bitcoins using their checking account (like Paypal), and merchants to accept Bitcoin, just received another round of $25 million from Andreesen Horowitz:  http://techcrunch.com/2013/12/12/coinba ... -services/

If you're familiar with startup funding, Andreesen Horowitz doesn't just invest in companies that are high risk; they usually pick winners.

BitPay also has some interesting statistics around black friday sales made using Bitcoin:

http://www.washingtonpost.com/blogs/the ... tpay-says/

They were only 6% of the total transactions on the network, indicating that much of the volume is pure Forex type activity; currency trading.  But, look at total FX volume for "legitimate" currencies: approximately $3.98 trillion USD per day in 2010, and compare that as a percentage of retail sales.

You're right, Kshartle, this is all pure speculation, and extremely high risk.  My initial investment in Bitcoin was a $729 graphics card to mine in 2011 and about $1500 in electricity.  That initial investment was roughly 0.25% of my portfolio, and an interesting hobby for someone like me that is into computers.  That initial speculation, if I wouldn't have cashed $12,000 out a while ago, would be 50% of my portfolio now, however, as is, it's still a respectable 20%.  I've taken some additional cash out to do a few repairs around the house and buy a piano for my son.

I wouldn't recommend anyone put more than 1% of their portfolio in Bitcoin, however, if I would have put just 5% I could have retired by now... That's something to think about.  But, I'm too damn conservative to do something like that.

As someone else in a different forum said "I feel more comfortable investing at $850 instead of $10 because it's less risky now."  I think there's something to be said for that.  Big money is investing into Bitcoin now.  When the merchants and general payment processors start using it, watch out.

Regarding volatility:  It's extremely volatile because the markets are not well developed and have low volume and liquidity now.  A big whale can drive the price down by putting fake sell walls up, constantly moving them lower, then scoop up cheap Bitcoins at the bottom and drive it back up with buy walls, netting a 10-20% profit from price movements a day.  When we have more efficient markets with more liquidity, this activity will be self-regulating.