Getting Started with Bitcoin, Part 3: Where do Bitcoins Come From?Submitted by JixMainstream on Thu, 04/04/2013 - 17:27
"Where do bitcoins come from?" It's a very basic question and probably the first thing that people want to know - especially those who are passionate about the principles of sound money. The challenge is that there are other fundamentals which must be understood and internalized before explaining the origin of bitcoins. In the last two parts, What is a Wallet? and Selecting a Wallet, I've given you a few tidbits on the Block Chain, but here's a quick refresher:
The Block Chain is Bitcoin's complete transaction log. It is distributed to every bitcoin user to eliminate the need for trust in a central record-keeper. But how does the Block Chain get updated with new transactions? How can we be sure that those updating the Block chain aren't falsifying the record? How can every single Bitcoin user come to absolute agreement on the Block Chain? The complete answers to these questions will take a few more articles to fully explain, but the process begins with Bitcoin's unique cryptography.
When a user sends bitcoins to another user, he broadcasts his intent publicly, much like a Tweet. Now, with all these "Bit-Tweets" fluttering around, there's a lot of auditing to do! After all, if we're going to eliminate the need for banks, we have to make sure our system of record is legitimate and worthy of trust! That requires some serious work!
I like to describe the audit process as taking apart and re-assembling LEGOs. Imagine that every Bitcoin transaction is pair of LEGOs that are glued together with a secret adhesive. No one knows what the adhesive is, but everyone is using the same substance to lock their LEGOs (transactions) together. The auditors, in the meantime, are trying to build the next Block in the Block Chain. Picture the Block Chain as a giant sky-scraper, and that each block in the Block Chain is a story of that sky-scraper.
Now, I'm an auditor because I _REALLY_ love LEGOs, and I want to help build this skyscraper. Every time I hear of a new Bitcoin transaction floating around, a copy of the unique LEGO pair drops out of a chute onto my workbench. Unfortunately, they're of no use to me glued together! I first have to unlock the pairs, so that I can rebuild the LEGOs into the next floor of the skyscraper. Unfortunately for me, the adhesive is totally inert: no smell, no taste... not even a chemical analysis will give me any hints! All I can do is start trying solvents. So I get to work, guessing which solvent is going to unlock these LEGO transactions, but I can only work so fast! It takes a long time, but eventually, EUREEKA! I discover which solvent unlocks the pairs of LEGOs. Now that I know which solvent to use, I can easily unlock the rest of those LEGOs that are starting to pile up!
The next step is to assemble my newly-freed LEGOs into the next story of the skyscraper. Before I add any LEGOs (transactions) to the next level (block) of the skyscraper (block chain), I have to make sure the bricks are valid. In other words, I need to see whether Bob has the bitcoins he is trying to spend. To determine this, I simply take a look at my own skyscraper! If Bob doesn't have the funds, that transaction is a fake and it gets tossed.
After assembling all the valid LEGOs, I announce to the rest of the network that I have discovered the secret solvent, and have gone through the work of auditing all the transactions that have occurred since that adhesive was first used. The network then adopts my block, switches adhesives and then I'm back to work, trying solvents.
With all the effort required to audit Bitcoin transactions, you might be asking, why bother? The answer is simple: The Bitcoin network incentivizes the audit process! So while I was busy guessing-and-checking solvents, there were thousands of other auditors doing the exact same thing! Some of them have specialized hardware that allows them to check billions of "solvents" every second! These auditors are actually racing to be the first one to discover the "solvent" that will unlock these transactions. Whichever auditor succeeds receives a reward of newly-created bitcoins (as well as any transaction fees which may have been included in that block).
Since the audit process requires difficult work and yields a reward, it is referred to as "Bitcoin Mining" or "Bit-Mining" for short. Bit-Mining can be quite a lucrative business, but it is also very competitive. The most successful miners utilize arrays of high-end graphics cards to increase their odds of finding a "solvent". Others join "mining pools", which divides the work AND the reward amongst the miners.
Now, unlike mining for a precious metal, the supply of bitcoins is time-released to the miners. Adding more mining equipment WILL NOT increase the speed at which bitcoins are created! The Bitcoin Network is self-adjusting: the more powerful the mining community becomes, the harder it is to find the right "solvent". This prevents Bitcoin "production" from accelerating. Instead the Bitcoin Network determines a "difficulty" factor, which keeps "solvent" discovery down to a constant pace of one per roughly every 10 minutes.
But with all the new Bitcoins created, even at a limited pace, what about inflation? Well, that's where the "block reward" comes in. Initially, the reward for finding a "solvent" was 50BTC. Every 210,000 blocks (~4 years), the reward is halved. This halving will occur over 30 times, until the reward is so small, it will stop completely! Even though the reward quickly shrinks, it is believed that the added bonus of the transaction fees will keep the auditors interesting in mining.
A word of caution, however, to those of you who are excited to start mining away at Bitcoins: As I mentioned earlier, Bit-Mining has become incredibly competitive. Unless you have a state-of-the-art graphics card, it is unlikely that you will have much success Bit-Mining. For those who aren't willing to put hundreds (or even thousands) of dollars towards fancy mining equipment, you'll have to find other ways to get a hold of Bitcoins... but that's a topic for next time! (On to Part 4!)
As always, please leave your questions and feedback in the comments section below. I will try to respond to as many of the questions as possible but please understand that I won't be able to get to everyone. There are many knowledgeable Bitcoiners on these forums who probably know more about Bitcoin than I do anyway!
Lastly, I *REALLY* appreciate the positive reaction to these articles, so THANK YOU for all the fantastic feedback so far!