How Bitcoin Works- Part 2

1. How Bitcoin Works- Part 2

2. Bitcoin transactions have limitations: A Bitcoin transaction can take as long as 10 minutes to confirm. Transactions are also irreversible and can only be refunded by the Bitcoin recipient. These limitations do not exist with conventional currencies, where debit and credit transactions are confirmed within seconds; certain transactions can also be reversed for valid reasons by the originator, without having to rely on the recipient’s largesse. • Bitcoin balances are not insured: This means that if you lose your Bitcoins for any reason – for example, your hard drive crashes, or a hacker steals the digital wallet in which your Bitcoins are stored, or the Bitcoin exchange where you held a balance went out of business – you have little recourse. Currency balances held at banks, on the other hand, are insured against certain events such as bank failure by agencies like the Federal Deposit Insurance Corporation in the U.S.

3. Let’s say you want to test the Bitcoin waters. The first thing you need to do as a new user is install a digital wallet on your computer or mobile device. This wallet is simply a free, open-source software program that will generate your first and subsequent Bitcoin addresses. There are three types of wallets – a software wallet (installed on your computer), a mobile wallet (which resides on your mobile device) or a Web wallet (located on the website of a service provider that hosts bitcoins). Bitcoin uses public key encryption4 techniques for security. This means that when a new Bitcoin address is created, a cryptographic key pair consisting of a public key and private key – which are essentially unique, long strings of letters and numbers – is generated.

4. Each address has its own Bitcoins balance, so all you need to do is acquire a number of Bitcoins that will be held at one of the addresses in your wallet. You can acquire Bitcoins through a number of ways – by buying them from a Bitcoin currency exchange such as Mt. Gox or Bitstamp, or through a service like BitInstant that enables fund transfers between Bitcoin exchanges and supports various payment mechanisms. Note that all Bitcoin transactions are stored publicly and permanently on the Bitcoin network, which means that the balance and transactions of any Bitcoin address are visible to anyone. Experts therefore recommend that Bitcoin owners create a new address for each transaction as a means of ensuring privacy and enhancing security.

5. Once you have created a Bitcoin address and have acquired Bitcoins, you can use them for an online transaction with a company that accepts Bitcoins as a payment mode. The company will send you the Bitcoin address to which you can send your Bitcoin payment. You direct the payment to that address; while the transaction takes place within seconds, verification can take 10 minutes or longer. All Bitcoin transactions, without exception, are included in a shared public transaction log known as a “block chain”. This is to confirm that the party spending the Bitcoins really owns them, and also to prevent fraud and double-spending.

6. Why does transaction verification or confirmation take so long? Because the complex algorithms involved in Bitcoin mining (see description below) take time to solve, even with immense computing power at one’s disposal. Lets see some examples.

7. An Example of a Bitcoin Transaction Let’s assume you want to make an online payment to a company – call it BitChamp – using 5 Bitcoins that you have in an address in your digital wallet. Here are the steps in the transaction: • BitChamp creates a new Bitcoin address and directs you to send your payment to it. This creates a private key (known only to BitChamp) and a public key (available to you and anyone else). Note that just as a seller does not need to know your physical identity if you pay cash, you do not need to disclose your real identity to BitChamp and can remain anonymous. • You instruct your Bitcoin client (the free Bitcoin software you first installed on your computer) to transfer 5 Bitcoins from your wallet to the BitChamp address. This is the transaction message.

8. Your Bitcoin client will electronically “sign” the transaction request with the private key of the address from where you are transferring the Bitcoins. Recall that your public key is available to anyone for signature verification. • Your transaction is broadcast to the Bitcoin network and will be verified in a few minutes. The 5 Bitcoins have been successfully transferred from your address to the BitChamp address. • Note that only the first two steps involve action by the seller and you respectively. The latter two steps are automatically executed by the Bitcoin client software and Bitcoin network. As well, storing the private key attached to an address safely and securely is of the utmost importance; otherwise, anyone who obtains the private key can control the Bitcoins at that address and use them fraudulently.

9. My sources: http://www.coinsetter.com http://www.forbes.com/sites/investopedia/2013/08/01/how-bitcoin-works/