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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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Voiceover: Bitcoin is a new virtual currency system that's been gathering a lot of attention recently, and I thought I would do a series of videos where I really dive into the innards of bitcoin and explain how it works in detail, and my plan for this first video in this series is to describe some of those mechanics at a high level. And then what I'll do in subsequent videos is dive a bit deeper into all of the underlying aspects that I have touched upon within this first video. And my hope is that by the end of this video series, you'll know not only what a bitcoin is, but you'll also understand the mechanics of how transactions are initiated. You'll see how verification occurs for those transactions, and you'll also learn what it means for someone to really engage in a process known as "bitcoin mining", and that may be a term that you've heard if you've had any interest in bitcoin recently. I do want to point out, also, that the bitcoin scheme is fairly involved. It requires some time to really cover all of the relevant details, and to me the best way to really wrap your head around a scheme like bitcoin is to really suspend belief for a bit and get exposed to all of these relevant details. Now, undoubtedly, you'll have a lot of questions along the way, but my hope is that by the end of this video series, all of the relevant stones will have been overturned and your questions will have been appropriately answered, but it might take some time to get there, and in part, that's because I'll try to describe things in a way that's sensible and that might involve leaving some details out until I can explain enough pieces of the scheme and then add in those details in as I go along so that you're not inundated with too many minor points and nuances along the way, but you get a feel for the overall system as I go through things. With that, let me go ahead and just dive right in. First of all, I do want to point out that bitcoin has been described, really, as a decentralized currency because there's no real central bank or entity that's involved in generating or transacting bitcoins, and, in fact, what happens in the content of a bitcoin is all the transactions really require what's known as a peer-to-peer network, a network of just individual hosts that essentially collectively agree on different aspects of how the protocol is implemented and used. Bitcoin itself is also referred to sometimes as a cryptocurrency, and by a cryptocurrency, I mean that we use a lot of cryptographic techniques in order to facilitate or to really enable bitcoin transactions to take place, and I'll do separate videos on some of these techniques, but just take it at face value right now, that it's decentralized and is a type of cryptocurrency. I also want to point out that the term "bitcoin" itself can in fact be a bit confusing, and in many ways, bitcoin transactions don't really resemble traditional coin transactions so much as they represent really entries in some type of a global ledger, and by that, I mean let's say you have a transaction taking place, and let's say the transaction is taking place within, or among two parties, and we'll call them Alice and Bob, which are traditional names that are used in many cryptographic protocols to describe the parties involved, and imagine that Alice wants to transfer, or really wants to assign, a certain number of bitcoins that she possesses over to Bob, and you can think of this transaction, really, as an entry in a ledger of some sort, and I also want to point out before proceeding that even though I've used terms like Alice and Bob, what I really mean in the context of bitcoin is not the actual identities in the physical sense, but really that Alice and Bob are identities in the bitcoin system, and these identities are just, in actual implementation, are just collections of numbers that do not have to be tied with Alice and Bob's real-world identities. In that capacity, you can think of bitcoin at any, it really is effectively being, of being pseudonyms, rather than real names, and the idea is that bitcoin really becomes more of a pseudonymous protocol, where people are addressed by their pseudonyms, and that provides some level of privacy to users that want to transact using the bitcoin system. Now, in a transaction between Alice and Bob, what Alice will basically do is specify a few different numbers. She has to specify how many bitcoins she wants to allocate to Bob. Let's say Alice started off with 50 bitcoins of her own. She might decide that she wants to give, let's say, 30 of these bitcoins over to Bob, and let's say she wants to have some number of bitcoins returned back to her, so you have to specify, or Alice has to specify, rather, how much change she's going to get, so in this case, let's say her change is going to be 18 bitcoins for herself, and then the remaining 2 bitcoins are going to be a transaction fee, and we'll talk about what a transaction fee means a little later, and I think I'll also dive into it in future videos, but it's basically an incentive for other nodes in the bitcoin network to help Alice in essentially validating some of the details of this transaction for Bob. Now, Alice will take these transaction details and apply what's known as a digital signature to these transaction details, and a digital signature is basically the mathematical analog of a traditional signature. It really binds Alice's identity to the details of this transaction. And by Alice's identity, again, I mean her identity within the bitcoin system, and this binding is really done in a cryptographically strong way. Now, the details of this transaction once it takes place, are going to be broadcast out, so Alice is going to take these transaction details and effectively just broadcast them out to all the nodes in the peer-to-peer network that represent bitcoin nodes. Now, Bob, when he receives information about this transaction, he receives it over the peer-to-peer network. He'll probably sandy check some part of the transaction. For example, he might check that the numbers work out correctly, that Alice, let's say, started off with 50 bitcoins and is not trying to transfer more than 50 bitcoins to him, and so on and so forth. He's going to have some mathematical assurance because of some of the cryptography involved that some of these claims are accurate, that Alice, let's say, has the bitcoins that she's claimed to possess, and that she's expressed an interest to assign those bitcoins to him, but what he won't know yet is whether Alice has really tried to transfer those same bitcoins to anyone else over the course of time or maybe just prior to that point. the way that we handle that situation, and by the way, I should point out that this concept of Alice trying to, let's say, spend coins twice, in the context of digital cash and electronic currency systems, this concept is known as double spending, and it's something you have to worry about when you have virtual currencies because it's very easy for someone to just copy the numbers that represent this transaction and try to use them elsewhere. The way we basically handle and reduce the risk of double spending is through a specific set of nodes in this peer-to-peer network who are known as bitcoin miners. You might have heard this term bitcoin miners, and the bitcoin miners are basically specific individuals, specific nodes within this peer-to-peer network, and what they basically do is they take all of the transactions that they see, and remember, they're listening to all of these transactions, and not just Alice and Bob's, but other transactions that are taking place, and they'll take those transactions, and ultimately, they will take those transactions and will compile them into what's known as a transaction block. So it's basically a recording of all the previously unrecorded transactions. If you think of a single transaction let's say, as a ledger item, you could think of a transaction block as representing, let's say, an entire page in a ledger book. These bitcoin miners will also include in this block, in addition to all these unrecorded transactions, they will also include in this block a special transaction that's meant just for themselves to basically reward themselves for the effort of doing this mining. Now, a transaction block will also contain an encoding of the previous transaction block, so there's going to be some level of continuity, and then bitcoin miners will also include a specially-crafted sequence of numbers associated with these transactions, and this sequence of numbers is known as a proof of work, and it's called a proof of work because it's sometihng that's really hard to generate, something that requires a lot of effort to do, and that kind of makes it hard for just anybody to get involved with bitcoin mining willy-nilly, but it requires that they really exhibit or exert some computational effort, basically in exchange for getting this extra reward of a payment, and also in exchange for getting this transaction fee that they're going to be promised by Alice to engage in this sort of work. I'll talk about what proof-of-work protocols are in a separate video in more detail. Now, because each transaction block contains information about previous transactions, really what you end up having is not just a single block. You ultimately have what you can think of as a chain of transactions, and you can call this a transaction block chain. The idea is as soon as a bitcoin miner is able to construct a transaction block chain containing all these unrecorded transactions, and this proof of work, it'll broadcast the details of that chain out to all of the nodes, all of the peers on that peer-to-peer network for bitcoin. And then once the newly-broadcast chain gets kind of verified and meets the right properties, the nodes on the network are just going to go ahead and start using it, and they're going to start appending new transaction blocks to that chain. They're going to take anything that hasn't yet been processed and start incorporating it into the transaction chain that was broadcast out by the node who came up with the proof of work correctly. Now, this transaction block chain, really what we're going to be doing in the context of bitcoin is the nodes are only going to consider the transaction block chain that reflects the greatest amount of work to generate its contents, and again, there's this proof of work that I mentioned that is used to kind of determine or identify what the, what work was involved in coming up with the transaction block chain. The one that's the longest is going to be considered sacrosanct within the bitcoin system. Future miners are supposed to only work off the chain that has the most work put into it. Now, what's remarkable here is that the whole process is decentralized. There is no bank or no centrally-trusted entity that was actually involved in the transaction. Hopefully this first video gave you a bit of description, a flavor, if you will, for the high-level mechanics of the bitcoin system. There are a lot of stones I have left unturned, and what I'll do in subsequent videos is start covering those details, and I'm sure you have a lot of questions, and hopefully the future videos will help answer some of those questions for you.