When I first started learning about bitcoin, I found a lot of information, but nothing that directly answered the most burning question:
When you buy bitcoins… what exactly do you own?
Reading: Is bitcoin a physical object
That is the question I will answer in this post. Along the way, I’ll introduce several key bitcoin concepts. You will see for yourself how bitcoins are protected and how they are transferred.
First of all, a bitcoin is a unit of account, in the same sense that a gallon is a unit of volume or a gram is a unit of mass. you can’t take a bitcoin and hold it in your hand like you would a dollar bill. but that’s okay, because that’s not what’s important. the important thing is that:
- Bitcoins can be owned.
- Bitcoins can be transferred.
- Bitcoins are impossible to copy.
These three properties, combined, allow bitcoins to function effectively as a wealth distribution system. and fundamentally, that’s what makes bitcoins useful.
When you think about it, what makes dollar bills good for distributing wealth? are the same three properties. you can own a dollar bill by putting it in your pocket. you can transfer it to someone else by giving it to them. and dollar bills are pretty hard to copy. therefore, cash is one good way to distribute wealth, and bitcoins are another.
since bitcoins are not physical objects, but simply units of account, there must be some other way to keep track of them. bitcoin’s solution to this problem is particularly clever.
how bitcoins are distributed
As you may have heard, there is no central server to keep track of everyone’s bitcoins. but that does not mean that there are no servers that keep track of bitcoins. just the opposite. there are, in fact, thousands of servers that keep track of bitcoins. each of these servers on the bitcoin network is called a full node.
A full node is basically an e-bookkeeper, and anyone in the world can set up and run one. each node has a complete copy of the public ledger, which is a record of every bitcoin transaction that has ever occurred, in history, since the very beginning of bitcoin. As of today, the public ledger contains over 30 million transactions and requires 13GB of disk space.
To actually use bitcoins, you need some kind of device that works like a wallet. it can be an app running on your computer, a mobile app, a service offered by a website, or something else entirely. Your wallet can add a transaction to the public ledger by reporting to a single node on the bitcoin network. that node will broadcast the transaction to other nodes, which will broadcast it to others, and so on, similar to how bittorrent works. It only takes about 7 seconds for a transaction to propagate throughout the bitcoin network.
what’s in a transaction?
By now, it should be apparent that when you “send” bitcoins to someone else, you’re not actually sending anything directly to that person. instead, your wallet reallocates those bitcoins, from one owner to another, adding a transaction to the public ledger. For example, here is a set of three transactions that took place in December of last year:
As you can see, each transaction has a set of inputs and a set of outputs. the inputs identify which bitcoins are being spent and the outputs allocate those bitcoins to their new owners. each input is just a digitally signed reference to some output of a previous transaction. once a subsequent input spends an output, no other transaction can spend that output again. that’s what makes bitcoins impossible to copy.
Each unspent output represents an amount of bitcoin that is currently in someone’s possession. if you add up all the unspent outputs in the public ledger, you will get the same total amount as there is in bitcoins. I could even go so far as to say that the unspent outputs are bitcoins.
See also: Bitcoin&039s Price Drops Closer to 23,000 With No Clear Direction. Heres How Investors Should React
Note that no one’s real name appears anywhere within a transaction. this is why bitcoin is often referred to as a pseudonym. Instead of real names, bitcoins are assigned to addresses like 1preshx6qrhmswbss8phpz6klrcj9kdpy6. a bitcoin address is like a numbered bank account, only much easier to create, and each person can have an unlimited number of them.
where do addresses come from?
Obviously, if you want to receive bitcoins, you must have a bitcoin address. your wallet can generate addresses for you.
To generate an address, your wallet first generates a private key. A private key is nothing more than a large number, roughly between 1 and 2256. To shorten the writing of these numbers, it is customary to encode them as a sequence of numbers and letters.
Your wallet then converts that private key into a bitcoin address using a well-known function. this function is very simple to perform for a computer. if someone knows your private key, they could just as easily convert it to a bitcoin address. in fact, many bitcoin wallets have a feature that allows you to import private keys.
On the other hand, it is extremely difficult to go the other way. if someone only knows your bitcoin address, it’s virtually impossible to figure out what the private key was.
It is perfectly safe to give your bitcoin addresses to other people, but it is extremely important to keep your private keys secret. Most of the time, as a bitcoin user, you won’t even see your own private keys. Your wallet typically keeps track of your private keys, usually by storing them in an encrypted wallet file, either on your hard drive, on a server over the internet, or elsewhere.
how are transactions authorized?
That brings us to why it’s important to keep your private keys secret: Your private keys allow you to spend the bitcoins you’ve received.
To see how, take a closer look at the second transaction in the list above, b6f4ec453a021ac561…. this transaction spends the bitcoins from the previous output e14768c1d648b98a52…:0. When we examine that earlier output, we see that those bitcoins were previously sent to the address 1nquajrfestshjad1bhreffzwsqw6jhbqv. it stands to reason that this transaction should be authorized by whoever generated that address in the first place.
That’s where the digital signature comes into play. In bitcoin, a valid digital signature serves as proof that the transaction was authorized by the owner of the address. this is what makes it secure: just as a private key was required to generate that address, the same private key is required, once again, to generate a valid digital signature.
A digital signature is only valid if the address, previous output, and signature satisfy a specific equation. Unsurprisingly, every time a bitcoin node receives a new transaction, it checks to make sure each digital signature is valid. node has no idea what private key was used to generate each signature, but that’s fine, because it doesn’t need to know. you just need to verify that the equation holds.
The concept of digital signatures is based on an old idea known as public key cryptography. bitcoin is not the first digital currency to secure transactions using such cryptography, but it is the first to do so without relying on a single centralized server. that’s the breakthrough at the heart of bitcoin.
some types of wallet
There is already a wide range of bitcoin wallets to choose from, but in most cases, the purposes of the wallet are the same:
- to store your private keys.
- to send bitcoins to other people.
- to generate addresses, so you can receive bitcoins from other people.
- to view your transaction history and current balance.
A desktop wallet is an application that you install on windows, macos, or linux. examples include electrum, multibit, and bitcoin qt. Your private keys are stored locally, in a file somewhere on your hard drive, like wallet.dat, and the security of your bitcoins is only as good as your ability to protect that file against data loss and theft. Unusually, bitcoin qt also turns your computer into a bitcoin node and thus requires much more disk space and bandwidth than the other applications.
There are also web wallets such as coinbase or blockchain.info’s my wallet service. When you use a web wallet, your private keys are stored, usually encrypted, on the website’s servers instead of on your own hard drive. some web wallets are also bitcoin exchanges, such as bitstamp or virtex, where bitcoins can be exchanged for US dollars and other currencies.
See also: Top 20+ zoom investors hottest
A mobile wallet is an application that you install on a smartphone or tablet. Many mobile wallets, like the Coinbase app, are simply interfaces to a web wallet, meaning your private keys are once again stored online. one notable exception is the android bitcoin wallet, which stores private keys directly on your mobile device.
Since virtually all smartphones have a built-in camera, qr codes have become a popular way to communicate bitcoin addresses. you can send bitcoins to someone by scanning their qr code with your mobile wallet.
qr codes can also be dynamically generated and can include additional information such as the exact amount of bitcoin the recipient expects to receive. this allows some mobile wallets to function as point of sale devices.
There is even a paper wallet. A paper wallet has only one purpose: to store your private keys. Some of the above wallets can print your private keys for you, but you can also generate a new private key and address pair without an existing wallet. bitaddress.org offers one such service. Once your private keys are printed, you can lock them in a safe place, such as a safe deposit box, and delete them from your computer. this is known as cold storage.
The bitcoin protocol is completely open, allowing anyone to implement an application or device that supports bitcoin. in effect, the entire bitcoin ecosystem has been collaborative. this has sparked all kinds of innovation: there are many more bitcoin wallets and point of sale devices than I have mentioned here, and there will certainly be more to come. the landscape is constantly changing.
Unfortunately, this opening also creates an opportunity for scammers. That’s why you should choose your wallet carefully. Do some research before deciding that your wallet provider is trustworthy. In the case of a web wallet, you must trust that website with your bitcoins exactly as you would trust a bank with your cash. a desktop wallet allows you to be your own bank, but you still have to trust that the desktop wallet actually works as advertised. It’s helpful to choose a wallet that is open source, actually built from that source, and has a good reputation on discussion forums such as the bitcoin subreddit and bitcointalk.org.
Are bitcoins backed by something valuable?
If you’re looking for something of value behind bitcoin, I’d say it’s the private keys. certainly every fraction of a bitcoin is backed by one. and once bitcoins are sent to an address, the corresponding private key becomes extremely valuable.
Consider the bitcoin address 1933phfhk3zgfqnlgsdxvqcn32k2buxy8a. currently contains 111114 bitcoins. at the time of this writing, that’s worth about $90 million to us. if only he knew the private key for that address, he could spend that $90 million as his own.
but you don’t know. Nobody knows that private key except the owner of 1933phfhk3zgfqnlgsdxvqcn32k2buxy8a, whoever that is.
suffice it to say that thieves all over the world are eager to discover people’s private keys. A new generation of wallet-stealing malware has already emerged. Safeguarding your wallet is an important topic that I won’t cover here, except to say that you should never, ever forget the password to an encrypted wallet, and you should practice impeccable computer hygiene to ensure that no spyware or malware infects any computer you’re using. to access a bitcoin wallet.
summary
so when you buy bitcoins…what exactly do you own?
When you own bitcoin, what you have is the unique ability to add specific transactions to the public ledger. Your bitcoins exist as unspent output from previous transactions on the ledger, sent to an address your wallet created out of thin air, waiting for you to use them as input in a future transaction. your wallet is the only wallet that can digitally sign those entries, because it contains a private key that no one else has.
The entire public ledger is redundantly stored on thousands of nodes spread across the globe. closing bitcoin at this point would be really very difficult.
Don’t be fooled by the overly simplified explanations you’ll find on the web. For example, in the introductory video for bitcoin, there is an animation of one user throwing a stack of coins directly at another. In major bitcoin news articles, there is usually a stock photo of a physical coin with the bitcoin logo on it. By now, you must recognize that such illustrations are largely symbolic. they do not represent how bitcoins are stored and transferred in practice. (Some physical bitcoins exist and are similar in concept to paper wallets, but they are new.)
more information
Now that you know exactly what a bitcoin is, how it is secured, and how it is transferred, you have a foundation for understanding more about bitcoin.
See also: Top 29 costco profit from membership fees best
- the bitcoin public ledger is also known as the blockchain. Since the blockchain is entirely public, people have created websites to interactively browse its content, such as blockchain.info and blockexplorer.
- I have intentionally left out any details about the process of mining and its role in the extension of the blockchain. it is simply no longer profitable to mine bitcoins using ordinary computer hardware. therefore, mining is not the first concern for novice bitcoin users. if you’re interested in the state of the art, check out asic miners and how to join a mining pool.
- the khan academy has a pretty comprehensive series of videos that delve into the guts of bitcoin.
- there is an insightful and entertaining talk, dated September. 25, 2013, with andreas antonopoulos, a renowned bitcoin expert. highly recommended.
- satoshi nakamoto’s original white paper is what started it all. it’s an accessible read for those with a computer background.
- almost all other cryptocurrencies in existence, including litecoin, peercoin, namecoin, dogecoin, and all those listed on coinwarz, are cloned and derived from the reference bitcoin implementation. on github.
- This post presented a simplified description of a bitcoin transaction. actual bitcoin transactions are based on scripts, which allow other types of financial instruments to exist on the bitcoin platform.
