Just like Dollars, Euros, Pounds, or other government-backed currencies, Bitcoin and other cryptocurrencies are a way to exchange a store of value for goods and services.  The main difference though is that instead of being backed by a government, cryptocurrency legitimacy is backed by the collective community, spanning many countries across the world. 

Not a Physical Coin

Typically when writing about Bitcoin, news articles will accompany the story with the ubiquitous graphic of an actual gold-colored coin with the Bitcoin symbol embossed on it.  Combined with the fact that many cryptocurrencies are referred to as “coins”, this can be confusing for the general public in that it seems like people are talking about physical coins one could carry in their pocket when discussing Bitcoin.  This couldn’t be further from the truth, as one’s ownership of a Bitcoin is actually an entry in a digital ledger, and has nothing to do with any type of actual coins.

If you think about it, this isn’t all that different from the way our current mainstream banking system works today.  For example, let’s say you have $1220.26 in your checking account at a bank in your town such as Bank of America or Wells Fargo.  The local bank branch where you opened the account doesn’t actually have a pile of hundreds and twenties and a quarter and penny sitting in their vault with a label with your name on it.  The fact that you have this amount of funds in your account is simply the result of multiple entries in their master database of transactions you’ve made with the bank.  Maybe your paycheck of $2200 was deposited last week which was a transaction between your employer’s bank and your bank.  Then you used about $900 or so to pay some bills, which resulted in multiple transactions between your bank and the banks your creditors use.  And then yesterday, you took your family out to dinner and paid via debit card, spending about $80 in a transaction between your bank and the restaurant’s bank.  In each case, funds were transferred via entries in databases on both sides, facilitated by either the banks themselves if you made any of these payments by writing out paper checks, or more typically these days, transaction processing companies if you used your debit card or made a direct debit payment by entering your bank account and routing numbers.  Your ownership of the current number of dollars in your account is based on the sum of those transactions, as well as the other transactions you’ve made with the bank since you opened the account.

The Blockchain

Cryptocurrency operates in much the same manner, storing each transaction you make as an entry in a ledger (called a blockchain), which is stored on thousands of servers across the world, all set up to synchronize with each other.  The main difference being that a banking system’s database is controlled by a central authority, the bank.  This organization stands behind the entries in their databases, in this case, your transactions and account balance, and has the sole responsibility to ensure these numbers are correct.  A cryptocurrency blockchain, however, is a decentralized system, and therefore maintained by the community.   You may ask, how can one be sure that someone doesn’t just go in and alter the blockchain, and add or alter some transactions that allows them to redirect your bitcoins into their digital wallet?  The answer is that the participants all work together to come to a consensus that any changes to the blockchain are legitimate.

Consensus Mechanism

There are several different types of consensus mechanism the community can use to determine the legitimacy of transactions, however the one used by Bitcoin in particular is referred to as “proof of work”.  To describe this methodology, it’s necessary to take a step back and examine the makeup of the blockchain itself.  This digital ledger contains a record of all transactions made with bitcoin, in a series of groups of transactions called “blocks”.  To prevent tampering, each block also contains a numeric value called a “hash” that represents all the data from the previous block after it’s been run through an algorithm that is virtually impossible to reverse engineer.  So, from the block of data itself you can arrive at the hash, but given only the hash, it’s not possible to determine the original block of data. 

By itself, a block with a hash of the prior block doesn’t make a secure system, since you also have the data in the prior block as well.  But all blocks chained together into one blockchain creates what’s called an “avalanche effect” .  Change one piece of information in a block such as the amount of one of the contained transactions, and it renders the hash in the subsequent block invalid.  If you change that hash to incorporate the new value in the prior block, then the hash in the block following it becomes invalid because it contains the data from the existing block’s hash.  And so on and so forth.  So essentially, if you change any piece of data in any block, it renders the data in the entire rest of the blockchain invalid due to the daisy-chaining of hashes in each block.

Bitcoin Mining

This is where the actual Proof of Work enters the picture.  In the case of the Bitcoin blockchain, it’s not just any hash value that will be accepted as part of a block, but only hashes that are below a certain number, or a “target hash”.  While every hash is computed by the same algorithm, different hashes are produced for a block by adding an arbitrary number, called a “nonce”, to the data to arrive at a different hash.  Through trial and error, bitcoin miners add various nonces to the block data until they determine the correct number that will produce a hash value that is low enough to be accepted.

This may sound somewhat trivial, but a Bitcoin hash is 256 digits long, and the target hash is considerably smaller than that number – at the time of this writing, there are 201 zeros in front of the target hash.  This provides roughly a

0.0000000000000000000000000000000000000000000000000

000000000000000000000000000000000000000000000000000

000000000000000000000000000000000000000000000000000

00000000000000000000000000000000000000000000000001

chance of finding an acceptable number.  When you hear about mining “difficulty”, it’s that maximum hash value that makes it so difficult, and it’s easy to see why extremely powerful machines are required to perform this feat.  But the reason people spend so much time and money at mining for Bitcoin is the block reward, which is a payment for finding an acceptable hash used to add a new block to the blockchain, and used to encourage people to validate these transactions in the first place.  The current block reward is 6.25 bitcoins per reward, worth about $293,750 at today’s exchange rate.