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How Does Bitcoin Work?

Bitcoin is nothing more than a mobile app or a computer program that provides a digital Bitcoin wallet and allows users to send and receive bitcoins over the internet.  From a user perspective, this is how Bitcoin works in its most simplistic form.

Behind the scenes, the Bitcoin network is comprised of a public ledger often referred to as the bitcoin “block chain”. This block chain ledger contains every transaction ever processed — allowing a user’s computer to verify the security and validity of each transaction. Digital signatures corresponding to the sending addresses proctect the authenticity of each transaction — ultimately allowing all users to have full control over sending bitcoins from their very own Bitcoin addresses.

Additionally, anyone can process transactions using the computing power of specialized hardware and earn a reward in bitcoins for this service.  This is often called “bitcoin mining”.

Who Controls the Bitcoin Network?

Nobody owns the Bitcoin Network — much like no one owns the technology behind email. Bitcoin is controlled by all Bitcoin users around the world.

Developers are continually improving the bitcoin software, but they are completely and utterly unable to change the Bitcoin protocal because all users are free to choose what software revision and version they use.  In order to stay current and compatible with each other, ALL USERS need to use software that complies with the same set of rules.

Bitcoin can only work correctly with a complete consensus among all users — all users and developers inherently have a strong desire to protect this total consensus.


Who Created Bitcoin?

Bitcoin is the first implementation of a concept called “crypto-currency”, which was first described in 1998 by Wei Dai on the cypherpunks mailing list — suggesting the idea of a new form of money that uses cryptography to control its creation and transactions, rather than a central authority.

The first Bitcoin specification and proof of concept was published in 2009 in a cryptography mailing list by Satoshi Nakamoto. Satoshi left the project in late 2010 without revealing much about himself. The community has since grown exponentially with many developers working on Bitcoin.

Satoshi’s anonymity often raised unjustified concerns, many of which are linked to misunderstanding of the open-source nature of Bitcoin. The Bitcoin protocol and software are published openly and any developer around the world can review the code or make their own modified version of the Bitcoin software. Just like current developers, Satoshi’s influence was limited to the changes he made being adopted by others and therefore he did not control Bitcoin. As such, the identity of Bitcoin’s inventor is probably as relevant today as the identity of the person who invented paper.

What is Bitcoin?

Bitcoin is a new form of digital currency created in 2009 by an unknown person using the alias Satoshi Nakamoto. It is the first decentralized peer-to-peer digital currency payment network and is powered by its users with no central authority or middlemen — thus transactions are made with no middle men — meaning, no banks! There are ZERO transaction fees.

Should I leave my Bitcoin Client Open?

Bitcoin is a peer-to-peer network, which means that the clients not only receive the blocks from other clients, but send out the blocks to other clients. (You may notice the “connections” number in the bottom right of the original client. You can think of this as “peers” in a torrent client). So yes, by having your client open you are technically helping relay the recent blocks out across the network faster than they would get their otherwise, but there is really no reason to keep a client running all the time.

At one point, the client also doubled as a CPU miner, but we are far past the point where that is useful from a security point of view.

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Can I Buy Bitcoin with Credit Card or Paypal?

I did some more digging on and answered my own question. According to the FAQ and the list of payment methods, the reason that Paypal and Credit Cards are not accepted is to prevent fraud (by doing a fraudulent charge-back). For this reason, none of the exchanges accept these as forms of payment.

In short, you cannot (directly) use these to buy bitcoins at exchanges.

Edit: I did have some luck buying some Bitcoins using Paypal using #bitcoin-otc. It takes a bit of setup and it’s a bit more expensive, and you can’t buy in significant quantities but it’s possible you can find someone willing to sell to unrated users (liked I did).

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What is a Satoshi?

Satoshi is the smallest fraction of a Bitcoin that can currently be sent: 0.00000001 BTC. In the future, however, the protocol may be updated to allow further subdivisions should they be needed.

Further examples of units

  • 1 BTC = 100,000,000 Satoshis
  • 1 BTC = 1000 mBTC (millibitcoin)
  • 1 mBTC = 100,000 Satoshis
  • 1 μBTC (microbitcoin) = 100 Satoshis


How Can I Accept Bitcoins on My Website?

There are a number of ways one can go about accepting Bitcoin on a web interface. Keep in mind as you review these options that Bitcoin is still a young technology and many of these options aren’t what you’d call “friendly” just yet. That said you do have quite a few options depending on your level of expertise and technical requirements:

  • Use a service like:
  • Use an existing shopping cart interface
    • There are existing plugins for Ubercart, Magento and many other popular e-commerce platforms. If you are looking to modify an existing site that happens to run on one of these platforms, this may be your best bet. If you’ve yet to start a site and don’t want to write code yourself this may still be your best bet since you can choose your platform prior to implementation.
  • Roll your own using existing libraries
    • This is your best bet if you’re using a platform that isn’t currently supported or if you have difficult integration requirements that cannot be satisfied by existing e-commerce platforms like Magento or Ubercart.
    • Languages:
  • Roll your own using the JSON API directly
    • This is only necessary if you are not using one of the half-dozen or so languages that already have pre-written libraries for interfacing with bitcoind. The list of languages may be short, but all of the major industry standards have been covered, so it’s unlikely you will have to go this far.
  • Learn more at
Does Bitcoin Hoarding Hurt the Marketplace?

No. The argument is basically that hoarding will make Bitcoins so valuable that nobody will be willing to offer people enough to part with them. Does that pass the giggle test? Another way of stating the argument is this, “If gold is $2,000/oz today but people think it will be $5,000/oz next year, nobody will trade any gold today.” Again, think about it. Does that pass the giggle test either?

Hoarding increases the value of Bitcoins, increasing the profits from mining. This encourages more people to mine, increasing the total hashing power and thus the security of the system.

It also makes holding Bitcoins more profitable. This helps to encourage people to accept them in trade because they are less worried about them decreasing in value while they are holding them. Using Bitcoins as a currency inevitably means people sometimes have to hold them and having them drop in value while you hold them is a risk. Hoarding reduces this risk. But it also makes it harder to price things in Bitcoins because the value will tend to change more. Merchants don’t like to change their prices twice a day.

Contrary to claims, it should not affect the trading volume or the willingness of people to use Bitcoins to pay for things.

The argument that increasing value means people would prefer to hold Bitcoins rather than spend them is specious. While it will make people want to have Bitcoins more, it will also make people want to convince others to give them Bitcoins more so they can have them.

Think about it, do people prefer to pay for goods in dollars or garbage? By the reasoning of this argument, they should prefer to pay for goods in garbage, since they’d rather hold their dollars and get rid of their garbage. But, of course, people don’t like paying in garbage because nobody wants garbage. If you can pay with the currency others want, you can get a better deal. So you actually prefer to spend the currencies sellers most want.

If Bitcoins are valuable because inflation doesn’t deprive them of value, then a merchant would rather get my Bitcoins than my dollars, so he’ll accept fewer of them. This will cancel out the effect of me preferring to pay in dollars rather than Bitcoins. So it should be a wash.

Or, put another way, whatever the present and future prospects, there should always be some equivalence between dollars and Bitcoins that people roughly agree on. So whether I pay X dollars or Y bitcoins, where X and Y are in this ratio, will purely depend on whether I prefer the characteristics of dollars or Bitcoins for the transaction.

A consequence of this is that hoarding won’t negatively affect the trading volume either because that’s only dependent on people’s use of Bitcoins to buy and sell things. If hoarding makes Bitcoins worth twice as much, only half as many will be used to buy and sell things and the volume (the total value traded) will be the same.

I don’t believe it’s lost opportunity either. It’s not like people who want to trade Bitcoins can’t get them because they’re all being hoarded. (Nor will it ever be likely to be an issue, since that would just raise the price and thus fewer would be needed. Bitcoins have effectively unlimited divisibility.)

So why do so many people think currency hoarding is bad? Because it usually is, and empiric studies even show that it is. But the logic of why currency hoarding is bad doesn’t apply to Bitcoins, especially when it’s a minority currency.

Bitcoins are different enough from physical fiat currencies that empirical studies don’t apply unless the suspected mechanisms for the observed effects are believed to apply to Bitcoins too. For example, if a penny were enough money to buy a car, how useful would dollars be?

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What are bitcoin days destroyed?

The idea of “bitcoin days destroyed” came about because it was realised that total transaction volume per day might be an inappropriate measure of the level of economic activity in Bitcoin. After all, someone could be sending the same money back and forth between their own addresses repeatedly. If you sent the same 50 btc back and forth 20 times, it would look like 1000 btc worth of activity, while in fact it represents almost nothing in terms of real transaction volume.

With “bitcoin days destroyed”, the idea is instead to give more weight to coins which haven’t been spent in a while. To do this, you multiply the amount of each transaction by the number of days since those coins were last spent. So, 1 bitcoin that hasn’t been spent in 100 days (1 bitcoin * 100 days) counts as much as 100 bitcoins that were just spent yesterday (100 bitcoins * 1 day). Because you can think of these “bitcoin days” as building up over time until a transaction actually occurs, the actual measure is called “bitcoin days destroyed”. This is believed to give a better indication of how much real economic activity is occurring on the bitcoin network.

So how well does it work? Well, it’s still not perfect, because the other day I moved some coins out of a wallet they’ve been in for several months without spending them or giving them away. And some genuine businesses have very rapid turnover in bitcoins, so they’re not being measured well by this method. But it does do a good job of filtering out the “noise” of bitcoins that are just “bouncing around” without really going anywhere. The graph of overall bitcoin days destroyed is believed to show that the genuine level of activity in the Bitcoin economy is continually increasing–it’s not just one person experimenting by rapidly sending the same coins back and forth, flooding the network with meaningless chatter. Looks pretty good, hey?


The above graph is in percentage of bitcoin days destroyed and a little out of date–for a regularly updated version in bitcoin days destroyed check out instead!

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How much will bitcoin transaction fees eventually be?

How much will transaction fees eventually be?
I read that the market will find the equilibrium how much these transaction fees will be.

It will not. This is perhaps the biggest flaw in Bitcoin at the moment: once mining rewards end there is no direct linkage between the amount of hashpower needed to secure the network and the incentive to mine.

True, there is a limit on the blocksize, so if the transaction volume in a block window (approximately 10 minutes) exceeds the block size you can expect a miniature “auction” where transactions fight for space in the block by bidding up the minimum transaction fee needed to get in. However this isn’t really a closed-loop adjustment: the maximum blocksize is an arbitrarily chosen number, and there’s no reason to believe the maximum blocksize is small enough to ensure that transaction fees are high enough to incent enough miners to mine to keep the system secure. Unlike the difficulty and the USD/BTC exchange rate it does not respond to market activity. It also has the negative side effect of capping the worldwide Bitcoin transaction throughput since other parts of the protocol rely on the assumption that blocks are created — in the long run — no more than once every ten minutes.

Compare this to the current situation with mining rewards: the more valuable a bitcoin is the more incentive there is for somebody to try to overwhelm the “good guys” by gaining 50%+1 hashpower. However, the more valuable a bitcoin is the more miners will mine! It isn’t perfect, but the important point is that the demand for security increases the incentive to mine. Note that although the difficulty will go up, that simply ensures that the reward granted every ten minutes is an approximately constant number of BTC — the number of terahashes/sec fighting over that amount of BTC is free to respond to changes in their changing value (as measured in terms of all other goods in the world, including other currencies).

As the mining reward is reduced this “direct coupling” between the network’s need for security and the incentive to mine becomes progressively more diluted.

I worry a lot about what will happen to Bitcoin once we decouple those two forces. I think the developers ought to at least come up with a story on how this will be solved so people can start testing it.

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How does bitcoin mining actually work?

The way Bitcoin works is that instead of having one central authority who secures and controls the money supply (like most governments do for their national currencies), this work is spread out all across the network. Most of the heavy lifting for Bitcoin is done by “miners”.

Miners collect the transactions on the network (like “Alice pays Karim 10 bitcoins” and “Liam pays Sofia 8.3 bitcoins”) into large bundles called blocks. These blocks are strung together into one continuous, authoritative record called the block chain, which doesn’t permit any conflicting transactions. This is necessary because without it people would be able to sign the same bitcoins over to two different recipients, like writing cheques for more money than you have in your account. The block chain lets you know for sure exactly which transactions count and can be trusted (so no bad cheques!).

The way Bitcoin makes sure there is only one block chain is by making blocks really hard to produce. So instead of just being able to make blocks at will, miners have to compute a cryptographic hash of the block that meets certain criteria. Bitcoiners refer to this process as “hashing”. The only way to find a cryptographic hash that’s “good enough to count” is to try computing a whole bunch of them until you get lucky and find one that works. This is the “lottery” that David Schwartz refers to, because miners who successfully create a block are rewarded some bitcoins according to a preset schedule. The difficulty of the criteria for the hash is continually adjusted based on how frequently blocks are appearing, so more competition equals more work needed to find a block. A modern GPU can try hundreds of millions of hashes per second, so to be competitive in this race to find hashes miners need specialised hardware, otherwise they will tend to spend more on electricity than they make in the “lottery”.

In addition to the hash criteria, a block needs to contain only valid, non-conflicting transactions. So the other main task for miners is to carefully validate all the transactions that go into their blocks, otherwise they won’t get any reward for their work!

Because of all this work, when a Bitcoin client signs on to the network it can trust the block chain that was most difficult to produce (since this is evidently the one that was being worked on by the most miners). If there was a “fake” blockchain competing with the real ones (say, where someone pretends that they didn’t actually give Sofia those 8.4 bitcoins and they still have them), the fraudster would have to do as much work as the whole rest of the network to make their block chain look as trustworthy. So essentially, the intense work that goes into finding blocks through hashing secures the network against fraud. There is also, of course, some nifty code that figures out how to choose between conflicting transactions; and what to do if two people find valid blocks at the same time.

One last thing: why is it called mining? In the original analogy, people who performed this essential work were compared to gold miners digging the gold out of the ground so that everyone could use it. But in reality, Bitcoin “miners” are just running computer programs on very specialised hardware that automates the process of securing the network. To sum up, this software

Collects transactions from the network
Validates them, and doesn’t allow conflicting ones
Puts them into large bundles called blocks
Computes cryptographic hashes over and over until if finds one “good enough to count”
Then submits the block to the network, adding it to the block chain and earning a reward in return.
That’s mining in a nutshell!


How to Explain Bitcoin in Easy Terms?

Bitcoin is a new kind of money. It’s the first decentralized electronic currency not controlled by a single organization or government. It’s an open source project, and it is used by more than 100,000 people. All over the world people are trading hundreds of thousands of dollars worth of bitcoin every day with no middle man and no credit card companies. It’s a startup currency which has never happened before.

Bitcoin is the first digital currency that is completely distributed. The network is made up of users like yourself so no bank or payment processor is required between you and whoever you’re trading with. This decentralization is the basis for Bitcoin’s security and freedom.

Email let us send letters for free, anywhere in the world. Skype lets us make phone and video calls for free, anywhere in the world. Now there’s bitcoin. Bitcoin lets you send money to anyone online, anywhere in the world for less than a cent per transaction! Bitcoin is a community run system not controlled by any bank or government. There’s no wallstreet banker getting rich by standing between you and the people you want to send and receive money from.

Bitcoin is more efficient than all competing currencies. This will drive its adoption in the same way computers were adopted, in that computers made people more efficient in competing in the marketplace. A currency has value by it being widely used. Bitcoin is a startup currency with a deflationary bootstrapping economy. Its use spreads by providing the speculator incentive.

Bitcoin is going to be the biggest opportunity for innovation that the world has seen since the industrial revolution. An idea whose time has come.

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