Bitcoin in Technical Terms

Bitcoin

Bitcoin is a digital currency that was introduced in 2009. There is no physical version of the currency, so all Bitcoin transactions take place over the Internet. Unlike traditional currencies, Bitcoin is decentralized, meaning it is not controlled by a single bank or government. Instead, Bitcoin uses a peer-to-peer (P2P) payment network made up of users with Bitcoin accounts.

Bitcoins can be acquired using two different methods: 1) exchanging other currencies for bitcoins, and 2) bitcoin mining. The first method is by far the most common and can be done using a Bitcoin exchange like Mt. Gox or CampBX. These exchanges allow users to trade dollars, euros, or other currencies for bitcoins.

The other method, bitcoin mining, involves setting up a computer system to solve math problems generated by the Bitcoin network. As a bitcoin miner solves these complex problems, bitcoins are credited to the miner. While this seems like an easy way to earn bitcoins, the Bitcoin network is designed to generate increasingly more difficult math problems, which ensures new bitcoins will be generated at a consistent rate. Additionally, the Bitcoin protocol and software are open source to make sure the network isn't controlled by a single person or entity.

When you obtain bitcoins, your balance is stored in a secure “wallet” that is encryptedusing password protection. When you perform a bitcoin transaction, the ownership of the bitcoins is updated in the network and the balance in your wallet is updated accordingly. Bitcoin transactions are verified by the bitcoin mining systems connected to the network, so there is no need for a central bank to authorize transactions.

Since bitcoins are transferred directly from person to person, the transaction fees are small (around $0.01 per transaction). Additionally, there are no prerequisites for creating a Bitcoin account and no transaction limits. Bitcoins can be used around the world, but the currency is only good for purchasing items from vendors that accept Bitcoin.

The Network and the Blockchain

• The Bitcoin network is the network of computers through which Bitcoin transactions are broadcasted and which maintains the public blockchain. Sometimes, the term is used to refer to just miners (see below).
• The blockchain is a public list of all transactions that have ever been sent, ensuring that everyone knows which bitcoins belong to whom. All fully fledged nodes on the network keep a copy of the blockchain.
• A block is an individual unit of a blockchain. Each block contains the hash of the previous block (so someone passing along the blockchain can’t take out or change any block without making some hash along the way not match), as many unconfirmed transactions as can be found in the network, and a number called a nonce. Someone creating a block must find a nonce such that the hash of the block is below a certain threshold (the target), which can only be done by trying out all the nonces one after the other until one that produces a desirable hash is found, and is harder the lower the target is. The reason why block creation is made deliberately difficult is to prevent someone from spending bitcoins and then creating and pushing his own blockchain that doesn’t contain the transaction that shows that the bitcoins are spent, effectively erasing that record and allowing him to spend them twice. When a valid block is created, it is distributed through the network and work on the next block starts.
• The genesis block is the first block of the blockchain released on Jan 4, 2009.
• An unconfirmed transaction is a transaction which is not yet part of a block. A confirmation is when a transaction is put into a block to permanently become part of the blockchain. “6 confirmations” means that the transaction is in a block and there are 5 blocks after it in the chain, which provides added assurance that the transaction is legitimate.
• A miner is someone who tries to create blocks to add to the blockchain (the term also refers to a piece of software that does this). Miners are rewarded for their work by the Bitcoin protocol, which automatically assigns 50 new bitcoins to the miner who creates a valid block. This is how all bitcoins come into existence.
• The difficulty is how difficult it it to create a new block (ie. the inverse of the target), and it is automatically adjusted to ensure that the network takes an average of 10 minutes to find a valid block.
• A mining pool is a service that allows miners to work together on creating blocks and split the profits evenly, providing miners with a reliable income rather than a small chance of 50 BTC profits.
• A 51% attack is an attempt to gain the power to block and reverse Bitcoin transactions by obtaining and using a sufficiently strong pool of computing power to overpower the rest of the Bitcoin network combined (ie. controlling at least 51% of the network).
• A double spend is an attempt to send the same bitcoins twice. Miners generally prevent this, but such an attack is possible against users who accept unconfirmed transactions and in conjunction with a 51% attack.

The Market

• An exchange is a service which allows people to buy and sell bitcoins to each other. The most popular at the time of this writing are MtGox,  CryptoXChange, Cavirtex (Bitcoin to Canadian dollars) and Intersango (Bitcoin to UK pounds).
• The “ask” price is the lowest price people on a certain exchange are willing to sell bitcoins for, and the “bid” price is the highest price people are willing to buy for. The ask-bid spread is the difference between the two.
• The volume of an exchange is the number of bitcoins traded during a given time period.
• The market depth is the number of bitcoins that people have put up for sale on an exchange and haven’t been sold yet (since no one is yet willing to accept their price) at a given time.
• A speculator is someone who tries to make money by buying bitcoins at a low price and selling them at a high price. Arbitrage is the activity of trying to make money by taking advantage of price differences across multiple exchanges, and high-frequency trading is the activity of trying to make money by predicting very short term price movements and buying low and selling high on those.
• A bubble is when people are optimistic about the Bitcoin price going up in the future, and buy bitcoins to speculate on this, causing the Bitcoin price to go up, and continuing the cycle until the bubble “pops” and the price crashes back down (a correction). The largest bubble to date has been the April-June 2011 bubble, pushing the price up from $0.75 to over $30 before it crashed back down to $2 (from which level it is, as of the time of this writing, picking up again).
• Margin trading is a risky form of speculation where you trade bitcoins using borrowed money in addition to your own (the ratio of total money to your own money being the leverage), allowing much higher profits but risking liquidation (losing all your money) if the price falls by, for example, 20% at a 5-to-1 leverage. It’s also possible to use margin trading to bet against bitcoins (shorting), in which case you’re buying dollars with borrowed bitcoins, so you earn a profit if the bitcoin price goes down and you get liquidated if the bitcoin price goes up too much. The first margin trading service available was Bitcoinica, which is now no longer operational, and Kronos.io will likely be the first competitor to replace it.

Miscellaneous

• A satoshi, named after Bitcoin creator Satoshi Nakamoto, is one hundred-millionth of a bitcoin, or the smallest unit of the currency that can possibly be sent.
• A tumbler, or Bitcoin laundry, is a service that allows people to put their bitcoins in and then randomly hands them back and equal (perhaps minus a small fee) amount of bitcoins from someone else. These new bitcoins cannot be traced back to the old ones through the blockchain except by the tumbler operator themselves.
• An escrow service is one that holds payments made for a service and releases them to the intended recipient only after it has been verified that the recipient has kept his end of the deal.
• A script is an advanced Bitcoin feature that allows for unconventional transactions like transactions that can be spent by anyone and, in the future, transactions that require two or more (or even two out of three) people to sign. Technically, all Bitcoin transactions use scripts but the term is typically used only in discussions surrounding unconventional transactions.
• A fiat currency is a traditional currency like the US dollar and the euro, which ultimately derives its value from its use being mandated by a government for payment of taxes and as legal tender.