Bitcoin: How Cryptocurrencies Work

Say there’s a coin that’s currently worth
hundreds of U.S. dollars, but it’s not made

of gold, or platinum, or any precious metal.

In fact, it’s not the kind of coin you can
hold in your hand or stick in a piggy bank.

It’s a digital currency, which means it
only exists electronically.

I’m talking about bitcoin.

Bitcoin doesn’t work like most money.

It isn’t attached to a state or government,
so it doesn’t have a central issuing authority

or regulatory body.

Basically, that means there’s no organization
deciding when to make more bitcoins, figuring

out how many to produce, keeping track of
where they are, or investigating fraud.

So how does bitcoin work as a currency, or
have any value at all?

Well, bitcoin wouldn’t exist without a whole
network of people and a little thing called

cryptography.

In fact, it’s sometimes described as the
world’s first cryptocurrency.

And here’s how it works.

Bitcoin is a fully digital currency, and you
can exchange bitcoins between computers in

a worldwide peer-to-peer network.

The whole point of most peer-to-peer networks
is sharing stuff, like letting people make

copies of super legal music or movies to download.

If bitcoin is a digital currency, what’s
stopping you from making a bunch of counterfeit

copies and becoming fabulously wealthy?

Well, unlike a mp3 or a video file, a bitcoin
isn’t a string of data that can be duplicated.

A bitcoin is actually an entry on a huge,
global ledger called the blockchain, for reasons

we’ll get to in a minute.

The blockchain records every bitcoin transaction
that has ever happened.

And, as of late 2016, the complete ledger
is about 107 gigabytes of data.

So when you send someone bitcoins, it’s
not like you’re sending them a bunch of

files.

Instead, you’re basically writing the exchange
down on that big ledger – something like,

“Michael sends Hank 5 bitcoins.”

Now, maybe you’re thinking, “But, wait.

You said bitcoin doesn’t have a central
authority to keep track of everything!”

Even though the blockchain is a central record,
there’s no official group of people who

update the ledger and keep track of everybody’s
money like a bank does – it’s decentralized.

In fact, anybody can volunteer to keep the
blockchain up to date with all the new transactions.

And a ton of people do.

It all works because there are lots of people
keeping track of the same thing, to make sure

all transactions are accurate.

Like, imagine you’re playing a game of poker
with some pals, but none of you have poker

chips, and you left your cash at home.

There’s no money on the table, so a few
of you get out some notebooks, and start writing

down who bets how much, who wins, and who
loses.

You don’t completely trust anyone else,
so everyone keeps their ledgers separately.

And at the end of every hand, you all compare
what you’ve written down.

That way, if someone makes a mistake, or tries
to cheat and snag some extra money for themselves,

that discrepancy is caught.

After a couple hands, you might fill up a
page of your notebook with notes about the

money movement.

You can think of each page as a “block of
transactions.”

Eventually, your notebook will have pages
and pages of information – a chain of those

blocks.

Hence: blockchain.

Now, if thousands of people are separately
maintaining the bitcoin blockchain, how are

all the ledgers kept in sync?

To stick with our poker analogy: think of
the entire bitcoin peer-to-peer network as

a really huge poker table with millions of
people.

Some are just exchanging money, but lots of
volunteers are keeping ledgers.

So when you want to send or receive money,
you have to announce it to everyone at the

table, so the people keeping track can update
their ledgers.

So for every transaction, you’re announcing
a couple of things to the bitcoin network:

your account number, the account number of
the person you’re sending bitcoins to, and

how many bitcoins you want to send.

And all of the users who are keeping copies
of the blockchain will add your transaction

to the current block.

Having a bunch of people keep track of transactions
seems like a pretty good security measure.

But if all it takes to send bitcoins is a
couple of account numbers, that seems like

it might be a security problem.

It’s a huge problem with regular money – just
think about all the ways criminals try to

steal other people’s credit card information.

And with bitcoin, there’s no central bank
to notice anything weird going on to shut

down fraud, like if it looked like suddenly
you spent your entire life savings on beef

jerky.

So what’s stopping Hank from pretending
he’s me and just sending himself all of

my bitcoins?

Bitcoins are kept pretty safe thanks to cryptography,
which is why it’s considered a cryptocurrency.

Specifically, bitcoin stays secure because
of keys, which are basically chunks of information

that can be used to make mathematical guarantees
about messages, like “hey, this is really

from me!”

When you create an account on the bitcoin
network, which you might have heard called

a “wallet,” that account is linked to
two unique keys: a private key, and a public

key.

In this case, the private key can take some
data and basically mark it, also known as

signing it, so that other people can verify
those signatures later if they want.

So let’s say I want to send a message to
the network that says, “Michael sends 3

bitcoins to Olivia.”

I sign that message using my private key,
which only I have access to, and nobody else

can replicate.

Then, I send that signed message out to the
bitcoin network, and everyone can use my public

key to make sure my signature checks out.

That way, everyone keeping track of all the
bitcoin trading knows to add my transaction

to their copy of the blockchain.

In other words, if the public key works, that’s
proof that the message was signed by my private

key and is something I wanted to send.

Unlike a handwritten signature, or a credit
card number, this proof of identity isn’t

something that can be faked by a scam artist.

The “who” part of each transaction is
obviously important, to make sure the right

people are swapping bitcoins.

But the “when” matters, as well.

If you had a thousand dollars in your bank
account, for example, and tried to buy two

things for a thousand dollars each, the bank
would honor the first purchase and deny the

second one.

If the bank didn’t do that, you’d be able
to spend the same money multiple times.

Which … might sound awesome, but it’s
also terrible.

A financial system can’t work like that,
because no one would get paid.

So if I only have enough money to pay Olivia
or Hank, but I try to pay them both, there’s

a check built into the bitcoin system.

Both the bitcoin network and your wallet automatically
check your previous transactions to make sure

you have enough bitcoins to send in the first
place.

But there’s another problem that might happen
with timing:

Because lots of people are keeping copies
of the blockchain all over the world, network

delays mean that you won’t always receive
the transaction requests in the same order.

So now you’ve got a bunch of people with
a bunch of slightly different blocks to pick

from, but none of them are necessarily wrong.

Okay, bitcoin.

How do you solve that problem?

Turns out, it’s by actually solving problems.

Math problems.

To add a block of transactions to the chain,
each person maintaining a ledger has to solve

a special kind of math problem created by
a cryptographic hash function.

A hash function is an algorithm that takes
an input of any size, and turns it into an

output with a fixed size.

For example, let’s say you had this string
of numbers as your input

And our example hash function says to add
all of the numbers together.

So, in this case, the output would be 10.

What makes hash functions really good for
cryptography is that when you’re given an

input, it’s really easy to find the output.

But it’s really hard to take an output and
figure out the original input.

Even in this super simple example, there are
lots of strings of numbers that add up to

The only way to figure out that the input
was ‘1-2-3-4’ is to just guess until you

get it right.

Now, the hash function that bitcoin uses is
called SHA256, which stands for Secure Hash

Algorithm 256-bit.

And it was originally developed by the United
States National Security Agency.

Computers that were specifically designed
to solve SHA256 hash problems take, on average,

about ten minutes to guess the solution to
each one.

That means they’re churning through billions
and billions of guesses before they get it

right.

Whoever solves the hash first gets to add
the next block of transactions to the blockchain,

which then generates a new math problem that
needs to be solved.

If multiple people make blocks at roughly
the same time, then the network picks one

to keep building upon, which becomes the longest,
and most trusted chain.

And any transactions in those alternate branches
of the chain get put back into a pool to be

added onto later blocks.

These volunteers spend thousands of dollars
on special computers built to solve SHA256

problems, and run their electricity bills
up sky high to keep those machines running.

But why?

What do they get out of maintaining the blockchain?

Is it just community service?

Well, bitcoin actually has a built-in system
to reward them.

Today, every time you win the race to add
a block to the blockchain, 12 and a half new

bitcoins are created out of thin air, and
awarded to your account.

In fact, you might know the bitcoin ledger-keepers
by another name: miners.

That’s because keeping the blockchain updated
is like swinging a proverbial pickaxe at those

hash problems, hoping to strike it rich.

When bitcoins were first created in 2009,
they didn’t really have any perceived value.

Tens of bitcoins would have been worth the
same as a bunch of pennies.

As of November 10th, 2016, though, one bitcoin
is worth 708 US dollars.

So 12 and a half bitcoins are worth 8,850
dollars.

That’s a nice chunk of change!

Every single bitcoin that exists was created
to reward a bitcoin miner.

Besides the big payout when they add a new
block of transactions, miners are also essentially

tipped a very small amount for each transaction
they add to the ledger.

It’s also worth noting that every 210,000
blocks, the number of coins generated when

a new block is added goes down by half.

So what started as a reward of 50 bitcoins
decreased to 25, then 12 and a half.

It’ll only be around 6 bitcoins in a couple
more years, and keep decreasing.

Eventually, there will be so many transactions
in a block, that it’ll still be worthwhile

for miners to mostly be paid in tips.

According to current projections, the last
bitcoin – probably around the 21 millionth

coin – will be mined in the year 2140.

This decreasing number of bitcoins is actually
modelled off the rate at which things like

gold are dug out of the earth.

And the idea is that keeping the supply of
bitcoins limited will raise their value over

time.

So, is investing in bitcoin a good idea?

Now that’s... not really a SciShow kind
of question.

Bitcoin is still volatile, and experimental.

A lot of people love it, and a lot of people
think it’s doomed to fail.