How Bitcoin Works

There's some misinformation going around about Bitcoin, about how it's anonymous and good for money laundering, but it's not. This article is a basic explanation of how Bitcon works.

The basis of Bitcoin is the Block Chain. The block chain is basically like a ledger book, where transactions between parties is recorded. The bitcoin system is based on all (or most) participants in the system running a piece of software that replicates the block chain onto the user's computer. (If you've used Bittorrent, you'll understand how the chain is copied from multiple peers, and spread to multiple peers.)

The integrity of the system is based on replicating the entire block chain for every user. It's not “anonymous” - every single bitcoin transaction is logged in the block chain.

What is a block?

If the block chain is like a ledger, then a block is like a page in the ledger. Numerous transactions are recorded within a block.

How do you prevent forging the chain? Like how people do with ledgers.

Well, that's complex, but the basic idea is to use cryptography math to guarantee the sequence of blocks, and the integrity of any single block. All transactions recorded into a block are via unique strings that look like this: 16Xjne85i97UK9zMfhk5qpZfSYABZ2P2W6.

Feel free to send money to that address. It's mine.

To get your transaction recorded into a block, you may have to pay a transaction fee. That fee goes to the person who discovered the block.

What do you mean “discovered”? Isn't a block created by some central authority wh owns the ledger?

No, blocks are not created centrally. This gets into a different feature of Bitcoin, which is “proof of work”. One of the goals of Bitcoin is to make a virtual “gold standard” of currency that has a limited quantity, that cannot be created “by fiat” or at will based on political or economic justifications.

Instead, to create a bitcoin, it must be “mined,” or discovered. A bitcoin is not actually what's found. What is found is a special kind of number, and that number confers to the finder the right to create a block and have it accepted by the network for addition onto the block chain... and within that block there are some bitcoins, a reward to the finder.

In fact, “mining” is a bad analogy. It's more like finding four-leaf clovers in a field full of three-leaf clovers. The four-leaf clover is a common genetic variation that is rare.

Likewise, what you're looking for is a number that is less than a number called the difficulty level. The number must be discovered using what's called a “hash function”, which is a kind of formula that takes a number and calculates, from that, another number which is almost unique. Small changes in the input lead to wildly different changes in the result.

To generate a new block, you start with the last block, and then add to it a value called a “nonce”, then hash it. If the result is below the difficulty level, you have found the next block. Typically, it won't be a low number, so you try another nonce then hash it. Repeat billions of times until you find the next block. You get to choose the nonce (really, it's just a random number), so that's where the competition sets in.

It's easily verifiable. Hash( hash(Old Block) + Nonce ) = a number that's lower than difficulty.

Money Laundering?

So, can bitcoin be used for money laundering? Sure. Bitcoin allows you to create many identities. You need an external service that will accept your bitcoins, and then send them back to you via different addresses.

Drugs?

Drug purchases are not anonymous, if your dealer fails to launder their money, or you fail to run your money through a laundering service, you can be traced. Imagine if you and your drug dealer both have Mt.Gox accounts, and then transact drugs using your regular bitcoin addresses. The transaction might be recorded for posterity.

So be careful out there, or be like me and don't transact anything illegal online.