What is bitcoin and how does it work?

Bitcoin, the digital currency, has whipped up a frenzy of excitement among speculators. Ken Tindell explains how it works.

In this week's magazine, Ken Tindell takes a look at how the network that underpins the digital currency bitcoin could end up being as transformational as the internet. But how exactly does bitcoin itself work? Ken explains.

Bitcoin has been hitting the news again. The price of a bitcoin has exceeded the price of an ounce of gold; there's been a $96m bitcoin heist; £4m of bitcoins were lost in a landfill in Wales; China bans banks from transacting bitcoins; Bank of America Merrill Lynch puts a fair value' on bitcoins of $1,300 it's all over the place.

These stories are like the gee-whiz' stories about the internet in the 1990s. And just as the true impact of the internet was mostly missed then, the true importance of bitcoin is being overlooked now.

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The underlying bitcoin system can do a lot more than provide a virtual currency: it can be used to manage the ownership of a range of assets in the real world. Subscribers can read about this inmore detailhere.

But if you're still confused as to what bitcoin the digital currency actually is, here's a backgrounder, which should hopefully clarify things.

Bitcoin is just a massive public ledger

At heart, bitcoin is simply a huge public ledger, recording who gave what to whom and when: a long list of transactions (27 million at last count), replicated across a network of thousands of computers.

To work out how much bitcoin money you have, you just look down the list of your transactions and add them up.

To give someone bitcoin money, you send a transfer please' message to the network, which copies the request around the computers and checks all is in order. It is put in a block of transactions, which are added to the ledger (the block chain'). That, in essence, is bitcoin.

This of course raises some questions. What's to stop a computer in the network just adding whatever it likes to the block chain? The answer is that the block of transactions has to be agreed among the majority of the computers in the network. So any rogue computer is just ignored by the rest.

This in turn begs the question of how bitcoins are created in the first place if the block chain records the spending, where do they originally come from? Well, bitcoins come from the operation of the network itself: before you gain the right to add a block, you need to solve a time-consuming complex mathematical puzzle. The puzzle is designed to be hard to solve, but easy to check like a really fiendish sudoku.

The first computer to solve the puzzle tells the network and wins the ownership of 25 new bitcoins - and also takes ownership of the fees (if any) attached to the transactions in the block.

How bitcoin mining works

This process of solving the puzzle and adding new bitcoins to the ledger is called mining'. The miners are competing with each other to be the first to find the solution to each puzzle. The puzzle is also designed to get ever more fiendish as the network gets faster, so that it always takes about ten minutes for the network to solve.

Unsurprisingly, an arms race has developed between miners, who have to use ever-faster computers just to stay in the game (the total computing power of the bitcoin network doubled in just the last month). The race has gone so far that mining now requires computers built from specially-designed bitcoin chips.

Mining is a zero-sum game, and will eventually become an activity finely balanced between the costs of electricity used for mining and the value of bitcoins produced (very similar to gold mining, where the costs are largely dictated by the price of fuel for the equipment used).

This is already happening: it's now just a myth that an ordinary PC can be used for mining, because it runs so slowly that it costs a hundred times more in electricity than it could be expected to yield in bitcoins. As a result, the solo PC miners are dropping out.

The key point about the mining process is that it's the miners competing to get new bitcoins and transaction fees that actually operate the bitcoin network. In effect, the self-interest of the miners in prospecting for bitcoins is being exploited to provide the underlying public service. Adam Smith would be proud.

Despite the myths, bitcoin is not anonymous

The way you identify yourself to the bitcoin network is to use a bit of software to create two big random numbers that have a particular mathematical relationship to each other. One is called the address' and is used to identify the bitcoin account (a bit like using an email address to log into a web account).

The other number is called the private key' and is a little like a password (if you lose the password, that's it for good: there's no chance to recover the bitcoins in the wallet).

Bitcoins are spent by specifying sending and receiving addresses in a transaction message, with the message signed using the private key corresponding to sender's address. This is done in a way that doesn't reveal the private key, but that still enables the network to verify that the private key was used.

The myth that bitcoin is anonymous comes from the idea that a bitcoin address has no personal identity information in it. But it's not really anonymous: every single bitcoin transaction is laid out in detail in the block chain for anyone to inspect, and patterns of spending can reveal information about who is behind a bitcoin address (just as the NSA accessing email and phone metadata can reveal a lot about a suspect).

When bitcoins are bought and sold for US dollars through an exchange like Mt. Gox, an address will get tied to a real person through the anti-money laundering checks that a regulated financial institution must perform.

And so anyone with access to the exchange's records (such as law enforcement agencies) can use the contents of the block chain to trace bitcoin money around the world.

Bitcoin heists are not due to flaws in the system

But what about security? The bitcoin system is very simple, yet very secure. The high-profile heists where bitcoins have been stolen have happened not from a weakness in the bitcoin system, but as a result of carelessness with private keys (once a thief steals the private key, they can sign a transaction that empties the account). Private keys stored on a PC can be stolen if that PC is hacked.

The biggest losses have come from bitcoin wallet services: these are websites that promise to look after your bitcoins for you. If that whole approach sounds a bit nave, that's because it is.

For very valuable private keys, a level of physical security is needed: computer security researchers joke about rubber hose cryptanalysis' where a target is beaten with rubber hoses until they disclose their keys (academics have an odd sense of humour).

Beyond bitcoins

The basic bitcoin system described above is pretty simple. Yet it has lead to a wild ride where crazy amounts of hard cash are exchanged for numbers in an abstract ledger.

In May 2010, a pizza was bought for 10,000 bitcoins. By January 2013, bitcoins were trading at $10 each. In December 2013, the price of a single bitcoin exceeded the price of an ounce of gold.

And if bitcoin were a usable currency, this would represent a revolution in the finance industry, eliminating a whole class of payment intermediaries no banks, no payment processors.

However, right now it can't happen: the volatility in the price of bitcoin means that no merchant can credibly set prices in bitcoins, and so they can't really be spent directly.

Even as a money transfer system (where real currency is converted to bitcoins, which are then converted into another real currency), bitcoin is pretty poor there is still the need for intermediaries (that famous 10,000 bitcoin pizza was actually bought by sending the bitcoin to someone, who then ordered the pizza online using a credit card).

Bitcoin transactions are also very slow when compared to payments using credit cards, and so aren't really suitable for point-of-sale transactions.

But with all these crazy numbers it's easy to focus on just the bitcoin price speculation and ignore the wider ramifications. You see, the system that underpins bitcoin can be used for far more than just the bitcoin currency itself.

One way to look at bitcoin is to separate the currency from the underlying system and to realise that the currency is just the first app' to run on the bitcoin system.

Just as with the launch of the iPhone, the built-in apps are eclipsed by the innovation the system unleashes. This is what I look at in more detail in the latest issue of MoneyWeek.

Ken Tindell is an entrepreneur with experience in various industries, including automotive, embedded internet, and web TV. He currently runs a software development company.