In this blog post we will build on top of the knowledge acquired in the last blog post. We will explore differences between fiat and digital currencies, bitcoin as digital currency and how it can be kept safe in digital wallets.
Fiat currency refers to money used in a particular country that lets consumers purchase goods. Every country has its currency, and each currency differs in value. Generally, the value is controlled by the respective governments.
For instance, if someone has a $100 bill, it is necessarily just a piece of paper. However, the issuing country has attached a specific value to this bill, granting the owner purchasing power. Therefore, we can think of this kind of currency as part of a centralized system.
Banks are institutions that were designed to keep money safe. Additionally, when backed by the FDIC, this money is insured with the full faith and credit of the United States government.
To ensure its security, users must prove their identity and sign various agreements to open a bank account. When someone deposits money in their account, the Bank keeps a ledger for that user on file, which they continue to update each time there is activity.
If someone needs to send money to another user via their Bank, the Bank acts as an intermediary and will transfer the capital straight to the recipient’s Bank, which will then update their account. Banks operate as centralized systems, have complete control of users’ accounts, have the power to seize users’ accounts, and can dictate certain restrictions, preventing users from using their own money.
We are currently in the digital age where computers surround us and have access to information at the touch of our fingertips. Like most other companies in today’s financial market, banks use computers to keep track of ledgers with all transactional details recorded.
A new payment system, Bitcoin, showed up in 2009 and has since revolutionized how we think about money. After the internet, many described Bitcoin as the most disruptive technology of the century. But what exactly is Bitcoin, and how does it work?
Bitcoin is a virtual and digital currency built on a blockchain infrastructure. Imagine a hypothetical system in which pictures of dollar bills represent one’s ownership of money. In this case, if you have an image of $100, then it is possible to email that image to a friend of yours. After your friend receives the email and stores that image on their computer, they own $100, and they can utilize it by sending it to someone else in exchange for goods.
Similarly, Bitcoin is a currency that lives entirely in a computer system. You can send and receive Bitcoin currency to and from anyone. Additionally, since Bitcoin’s network is decentralized, no single entity controls the system. Therefore, the value of Bitcoin is determined by users based on the supply/demand premises.
Identity on Blockchain:
Banks require proof of identity to open an account so that it can be associated with someone. So, who holds the identity on Blockchain? Who opens the accounts on Blockchain? How does someone prove their identity?
The answer to all these questions is simple: no one does. No one can figure out how many Bitcoins a person owns, but there has to be a way to associate Bitcoins with their owners.
Recall public/private keys from the previous post. That public key, also referred to as the Bitcoin address, acts as the identity for that individual. Therefore, if someone wishes to send Bitcoin to a particular person, they need to send it to that individual’s public key.
Private keys are used to access and manage the Bitcoins a person owns. So, the only way to send Bitcoins to someone’s public key is to sign the transaction using the private key digitally. It is crucial to keep the private key safe. If the private key is lost, then there is no way to access the Bitcoins controlled by that private key which can cause them to be lost forever.
We keep Fiat cash in our wallets or purses. Just like physical wallets, digital wallets are used to store cryptocurrencies. There is, however, a misconception that wallets store Bitcoins, but in reality, Bitcoins are tracked in the Bitcoin Network, whereas wallets keep track of private keys used to access those funds.
What happens when the wallet is lost? Well, in the “real” world, we lose all the money in it. Similarly, if the digital wallet is lost or corrupted and the private keys are not stored elsewhere, the Bitcoins associated with those private keys are also lost forever.
There are different types of wallets, each with pros and cons.
These wallets can be installed on desktops or laptops, but they are not very secure.
These wallets can be installed on cell phones, and they are more secure than desktop wallets.
These wallets are developed by 3rd party companies and are primarily managed in the cloud.
These are special-purpose hardware wallets designed to store keys safely. Because of their design, they are very secure.
Keys can be engraved on paper, metal, or other materials and kept safe.
How do we track changes in Bitcoin ownership? We do it through Transactions that are recorded on the ledger permanently and contain information about the evolution of ownership from the sender to the receiver.
For the transaction to be accepted by the network, it should be digitally signed by the sender using their private key. The sender should have enough funds to transfer, network fees should be covered, and the receiver’s public key should be valid.
Accepted Transactions then become part of the Blockchain and can be verified by anyone who has access to it.
Once the transaction is sent to the Bitcoin Network, it takes 10 minutes to become part of the ledger.
What exactly is Double Spending? Imagine you have a $100 bill and give it to someone. At this moment, a change of ownership has taken place, meaning you no longer have access to that $100 bill. After you transfer ownership, you cannot use it multiple times. You can have a different $100 bill that you are free to spend, but you cannot use the one already spent.
When using a credit card, your Bank keeps track of your spending. Every time a purchase takes place, it is recorded on the Bank’s internal ledger, and the balance is decremented, preventing you from spending more than you have.
So, how do we prevent someone from using the same Bitcoin multiple times (i.e., double spending)? To understand the solution, we first have to understand mining.