What are bitcoins? What is crypto currency? How does it work

What are bitcoins

Since 2017 at the latest, cryptocurrencies have become a new hype topic in the media and also on the stock exchange as a new, independent type of deposit money. Although different cryptocurrencies exist, the Bitcoins with their blockchain method are the pioneers in the focus of the reporting.

The reason for the current bitcoin hype on the global stock exchanges is not primarily due to their technical finesse, but in particular to the massive increase in the exchange rate between bitcoins and the US dollar in 2017 of around $ 1,000 up to approximately $ 20,000 per Bitcoin. Directly after his crash in December 2017, comparisons were already made with the first well-documented speculative bubble, the Dutch tulip mania from 1632 [1], The value of Bitcoin had halved again to below $ 10,000 in a very short time. Like euros or dollars with their cents, a bitcoin can also be broken down further, namely into 100 million so-called satoshis – named after the pseudonym of the inventor, so that the smallest possible unit is 0.00000001 bitcoins, which is about 1/100 cents today corresponds. Incidentally, all Bitcoin transfers are carried out directly in Satoshis in order to be able to work as an integer.

In the following, we will not be able to answer economic questions about the future course development of bitcoins for understandable reasons – it is usually difficult to make predictions. We will, therefore, focus primarily on the technical and practical background to cryptocurrencies, which unfortunately have been addressed only superficially in many articles up to now. For example, we would like to explain in more detail what kind of lottery is played when generating bitcoins – mining, whether bitcoins could have what it takes to revolutionize banking and trading, how to trade bitcoins and what opportunities and risks there are.

Trade, currencies, and trust

Trade is an important driver of human progress. He started with the direct exchange of goods between people. But gold, silver, and bronze were used as materials for the first coins over 2000 years ago [2]. Due to their exclusivity, these precious metals are still valuable in all societies to this day, only available in limited quantities and not perishable. Paper money was introduced in China as early as the 12th century [3]. In contrast to the direct exchange of goods and precious metals, this piece of paper does not have the value it represents.

In Italy, intangible money was created in the 14th century. Money was deposited at a bank, a customer’s payment claims against the bank were logged and paid out on request. These claims have already been passed on to third parties [4]. They were the forerunners of today’s checks, stocks, or bonds. Through abstract transfers of money from one account to another account, the book money was created in addition to the cash, which is also known as checking money. But why do you trust paper money, intangible money or bank money?

In essence, these types of money are promises of some value. Once trust in them is lost, they become worthless. Central banks today see it as a central task to ensure price level stability in order to maintain this trust [5]. The counter value of money should not fluctuate too much within a time interval: inflation and deflation of the currency should be balanced. Since the global financial crisis and the crisis in Greece within the euro area, it has become evident that the central banks are also willing to use unconventional methods such as negative interest rates for this purpose [6].

The Liberty Reserve SA case

The idea of ​​”virtual” currencies that are not dependent on a state central bank is not new. The so-called Liberty Reserve, an online bank founded in Costa Rica with its own currencies linked to euros and dollars, had over a million customers before it was closed in 2013 at the instigation of the US authorities on allegations of money laundering.

In contrast to today’s cryptocurrencies, the Liberty Reserve offered a centralized solution for money transactions: all transactions were carried out exclusively via the bank’s servers. As a result, the system was naturally extremely susceptible to a blockage or the eventual shut down by the authorities. Since cryptocurrencies like Bitcoin are organized decentrally, similar considerations of a ban – as recently expressed in China and South Korea – are likely to be much more difficult to implement.

What are bitcoins?

Bitcoins are managed by a Peer2Peer network – similar to Napster at the time – the participants of which often don’t even know their true identity, much less that they would have ever met in person. So there is no way to control or even reverse transactions, nor guarantees of currency stability.

However, as we will discuss later, the number of bitcoins and thus the currency inflation is technically limited. To create a basic trust, however, all Bitcoin transactions are publicly viewable. In the worst case, of course, this also comes into the hands of investigative authorities: if you get to the holder of a Bitcoin number account, the so-called Bitcoin address or BTC address, you can track all of his transactions without gaps and, if necessary, even his Identify business partners. We explain in detail how this exchange of bitcoins works in the next section.

A technical view of the bitcoins

At first glance, it seems paradoxical to first discuss the exchange of bitcoins without knowing how bitcoins can get into the trading system, i.e. the Peer2Peer network. Since new bitcoins are only created when existing bitcoins are exchanged (how exactly, we will explain later), we would first like to go into how this can work in a decentralized network without a higher-level supervisory authority and without a secure identity of the participants.

The exchange of bitcoins

Bitcoin transactions work on the basis of the so-called blockchain, which has almost become part of basic IT knowledge. The blockchain is initially nothing more than a gigantic cash ledger) in which all Bitcoin transfers have been recorded from the start. Accordingly, the Bitcoin blockchain had a size of around 175 gigabytes by the end of 2017. Bitcoin transfers are made from one Bitcoin address to another and are always stored in blocks in the blockchain. Hence the first part of the name. You could compare these blocks with the individual pages of a real cash book. To make subsequent manipulation of the cash book impossible, each block is signed with a hash value and linked to the previous block in such a way that any manipulation of the content of all blocks would be noticed immediately. This chaining of blocks explains the second part of the term blockchain. We’ll explain how it works in detail.

But how can you guarantee in a decentralized network that there are no duplicate account numbers? Interestingly, this is by no means guaranteed, but only very, very unlikely. Bitcoin addresses are nothing more than very large random numbers. More specifically, they consist of the public key of a public key account, which is mapped into a very large space of 2 to 160 possibilities using a hash function. This makes it extremely unlikely (if not completely excluded) that two participants will ever choose the same account number for themselves.

If a participant wants to authorize a transfer from his account, he signs this order with the private key of his account and sends the transfer order to the Bitcoin network. There, the known public key is first used to check whether the transfer was actually commissioned by the account holder (i.e. the owner of the private key). Furthermore, the sender must reference one or more previous transactions, which together comprise at least the desired transfer volume. Only if this is the case and the referenced transfers have not already been issued in the blockchain, can the desired transfer be carried out and included in the blockchain?

To emphasize again at this point: Bitcoins only exist as transfers in the blockchain, sufficient “account funds” for a new transfer must be demonstrated by referencing one or more previous transfers. Bitcoins can therefore not be placed in the safe or under the pillow at home, they exist virtually purely in the blockchain.

The account balance of a user results from the sum of all incoming transfers minus the total of all outgoing transfers. Accordingly, wallet software for managing Bitcoin accounts does not store any bitcoins, but only the public and private keys of an account. The person who has access to the private key also has access to the corresponding account, or vice versa, if a private key is lost, the access to the account is also completely lost. There is no “reset password” function and there is no call center that could restore access to an account. As long as public key procedures remain cryptographically secure, the keys of the Bitcoin accounts cannot be overcome.

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