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November 9, 2015
mm Written by:
Ralf Ohlhausen
Business Development Director
Bitcoin: The Incomprehensible Revolution

Do you understand bitcoin? No? Then you’re not alone. One of the biggest problems with this Internet currency is that most people don’t understand it. We answer the key questions and explain how the technology behind bitcoin could change much more than just the financial world.

Bitcoin? That’s the currency drug dealers use online, whose exchange rates fluctuate wildly and whose users are always getting swindled by hackers, right? That would be the general public’s opinion of bitcoin, if there actually was one. But what exactly is this currency, the one we’ve heard of only through scandal stories in the media, whose inventor keeps his identity a secret, and which is so complicated that it requires articles to explain how it works? “Groundbreaking” is probably the best word, and it may well become “revolutionary”, but nothing is certain. At the very least, however, bitcoin has the potential to radically alter the banking world, and the technology behind it – block chains – could cause upheaval in other areas of our lives. Don’t believe it? Some of the world’s biggest banks are planning to develop a joint standard on the basis of this technology [1]. But read for yourself:

1. What is bitcoin?

On the one hand, bitcoin is the name given to the monetary units of the bitcoin system. The sub-unit is known as the satoshi, after bitcoin’s inventor. Bitcoin and satoshi are, therefore comparable to euros and cents. On the other hand, however, bitcoin is also a decentralised payment system. Bitcoin currency can be transferred between users via software. A bitcoin, or BTC for short, is really just a number assigned to a bitcoin address.

2. How does bitcoin work?

Using bitcoin is not entirely simple and explanations of its functions use terminology from the computer world. Until now, this has been one of the system’s greatest weaknesses. The bottom line is that, although you can transfer bitcoin, unlike with cash payments, it’s not money which flows from A to B, but bitcoin. As bitcoin only exist virtually, they are protected by encryption. A user uses a bitcoin programme (wallet) to generate a cryptographic key pair; technology fans call this “asymmetric encryption”. One of these keys is public and can be viewed by anyone, while the other is private and – like a password – must be kept strictly private. In order to transfer a bitcoin to User B, User A uses software to add User B’s public key to the bitcoin. Two different mechanisms are used to prevent this creating easy access for fraudsters. The validity of a bitcoin is verified before each transaction, and each transaction is entered into a public list, known as a block chain. This block chain is the truly revolutionary aspect of bitcoin.

3. Who controls bitcoin?

Nobody, not banks, nor financial service providers, nor governments or companies, controls bitcoin. The currency was created specifically on the basis that it should operate without a central instance. Instead, each participant receives a version of the transaction list (block chain). When a new transaction is performed, the changes are distributed among the local block chains for those participants. In order for this to take place, an online connection is essential, otherwise the block chain cannot be kept up to date.

4. How is bitcoin generated?

Unlike bitcoin, creating banknotes and coins is a tangible process – they are printed or struck and you can hold them in your hand. This, of course, does not work with bitcoin, which is a virtual currency. It must, however, be created somehow. Like bitcoin’s management, the currency creation is also decentralized, using a process known in the industry as “mining”. In doing so, the bitcoin software is used in addition to block chains. Calculations are performed in order to solve mathematical problems and to verify the correctness of the transactions in the bitcoin system. If the software process is successful, a new data block in the block chain is generated, which creates new bitcoin. In practice, this happens approximately every ten minutes

5. What is so “revolutionary” about blockchains?

The block chain is a database in which every bitcoin transaction is recorded. It comprises a long series of data blocks in which one or more transactions are combined and tamper-proofed using checksums. Before you can generate or use bitcoin, you have to download the block chain, which can take a very long time. Currently (mid-October 2015), it is 44 GB in length. Every participant in the system has a version of the block chain, which means that it is not stored centrally and cannot be blocked. Only the two parties involved in each transaction are responsible for it – no bank or payment services provider is required to act as a broker. Transactions are performed relatively quickly, if not in real time, and are cheap.

6. Where else could block chains be used?

The ideas are still being developed, but anywhere transactions must be made, block chains are not far away. One example is in smart contracts. Computers take over the contract processing, verify the conditions in real time, and can automatically execute certain provisions. In a few years’ time, for example, the process of renting a holiday home might look something like this: holidaymakers pay rent for a certain period of time and receive a digital key. This enables them to use the apartment for the predefined period. If they wanted to stay a couple of days longer, they would pay the additional rent and the key would be automatically extended. In the background, the block chain would verify that the payment had actually been made.

There are, however, also a number of other ideas which have nothing to do with financial transactions. Ethereum [2], for example, is a project which aims to build a completely uncensored Internet based on a block chain.

Although not all the ideas out there will be successful, the technology behind bitcoin definitely has the potential to change the world.

[1] http://uk.businessinsider.com/jpmorgan-barclays-and-others-join-r3-on-blockchain-project-2015-9

[2] https://www.ethereum.org/

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