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Bitcoin trading how it works
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How do bitcoin exchanges work?
I'm relatively new to the world of Bitcoins and understand the basic principles of wallets and addresses etc, but was wondering how exchanges (like Coinbase) work exactly.
Is the entire exchange basically one large wallet with each user having their own address? That would mean that an exchange would hold a wallet containing all their users Bitcoins, no?
When you buy Bitcoins from an exchange using a bank transfer or credit card, where are the Bitcoins you're buying sourced from? It was my understanding that you have to buy Bitcoins from an individual who's actively selling their Bitcoins. Do they just buy a massive amount of coins all at once and slowly sell them off?
First of all, Coinbase is a little different from the main concept of an "exchange".
Real exchanges, like MtGox or Bitstamp, are really just a medium between traders. People can set limit orders to buy / sell bitcoins for a certain price. The exchange will match buyers and sellers when conditions of both the buyer and the seller are met.
More concrete, there are two types of orders: limit orders and market orders. Limit orders allow a trader to buy bitcoins at a price lower than the current price or sell bitcoins higher than the current price. However, these orders will only be executed once another user accepts them. Market orders will just find the best matching limit order.
So, let's say the last trading price is 100 EUR/BTC. Two people want to sell bitcoins but not for 100 EUR. One sets a limit order for 105 and the other for 110. So the best price to buy bitcoins for is then 105. When a person places a buying market order, it will look for the best price and it will buy from the one trader for 105 EUR. If the buyer wants to buy more than just one bitcoin, he will continually take the lowest price available. Doing this, the "price" of bitcoin will increase as the lower-price sell orders are no longer available.
Coinbase is different because it, as far as I know, does not allow for limit orders. I'm not sure how they implement trading, but it's possible that they charge a little higher price and take the risk for themselves or they may just make your order at another real exchange they partner with. But in any case, if no limit orders are supported, it is not a real person-to-person exchange like most others are.
An exchange is where buyers and sellers conduct their business. A seller of BTC deposits BTC with the exchange's address. He can then use his positive BTC balance in the exchange to sell his BTC for Dollars (or other coins). Similarly, a buyer of BTC deposits USD with the exchange and then uses the balance to buy BTC from sellers.
How does Bitcoin work?
This is a question that often causes confusion. Here's a quick explanation!
The basics for a new user.
As a new user, you can get started with Bitcoin without understanding the technical details. Once you have installed a Bitcoin wallet on your computer or mobile phone, it will generate your first Bitcoin address and you can create more whenever you need one. You can disclose your addresses to your friends so that they can pay you or vice versa. In fact, this is pretty similar to how email works, except that Bitcoin addresses should only be used once.
Balances - block chain.
The block chain is a shared public ledger on which the entire Bitcoin network relies. All confirmed transactions are included in the block chain. This way, Bitcoin wallets can calculate their spendable balance and new transactions can be verified to be spending bitcoins that are actually owned by the spender. The integrity and the chronological order of the block chain are enforced with cryptography.
Transactions - private keys.
A transaction is a transfer of value between Bitcoin wallets that gets included in the block chain. Bitcoin wallets keep a secret piece of data called a private key or seed, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet. The signature also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and usually begin to be confirmed by the network in the following 10 minutes, through a process called mining .
Processing - mining.
Mining is a distributed consensus system that is used to confirm waiting transactions by including them in the block chain. It enforces a chronological order in the block chain, protects the neutrality of the network, and allows different computers to agree on the state of the system. To be confirmed, transactions must be packed in a block that fits very strict cryptographic rules that will be verified by the network. These rules prevent previous blocks from being modified because doing so would invalidate all following blocks. Mining also creates the equivalent of a competitive lottery that prevents any individual from easily adding new blocks consecutively in the block chain. This way, no individuals can control what is included in the block chain or replace parts of the block chain to roll back their own spends.
Going down the rabbit hole.
This is only a very short and concise summary of the system. If you want to get into the details, you can read the original paper that describes the system's design, read the developer documentation, and explore the Bitcoin wiki.
The Economist explains.
How does Bitcoin work?
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BITCOIN, the world’s “first decentralised digital currency”, was launched in 2009 by a mysterious person known only by the pseudonym Satoshi Nakamoto, whose true identity is still unknown. Since then, the value of a single Bitcoin has fluctuated wildly, reaching a high of around $1,000 in late 2013 before falling to less than half that level, and then rebounding in 2016. What exactly is Bitcoin, and how does it work?
Unlike traditional currencies, which are issued by central banks, Bitcoin has no central monetary authority. Instead it is underpinned by a peer-to-peer computer network made up of its users’ machines, akin to the networks that underpin BitTorrent, a file-sharing system, and Skype, an audio, video and chat service. Bitcoins are mathematically generated as the computers in this network execute difficult number-crunching tasks, a procedure known as Bitcoin “mining”. The mathematics of the Bitcoin system were set up so that it becomes progressively more difficult to “mine” Bitcoins over time, and the total number that can ever be mined is limited to around 21 million. There is therefore no way for a central bank to issue a flood of new Bitcoins and devalue those already in circulation.
The entire network is used to monitor and verify both the creation of new Bitcoins through mining, and the transfer of Bitcoins between users. A log is collectively maintained of all transactions, with every new transaction broadcast across the Bitcoin network. Participating machines communicate to create and agree on updates to the official log. This process, which is computationally intensive, is in fact the process used to mine Bitcoins: roughly every 10 minutes, a user whose updates to the log have been approved by the network is awarded a fixed number of new Bitcoins. This has prompted Bitcoin fans to build ever more powerful computers for use in Bitcoin mining.
Bitcoins (or fractions of Bitcoins known as satoshis) can be bought and sold in return for traditional currency on several exchanges, and can also be directly transferred across the internet from one user to another using appropriate software. This makes Bitcoin a potentially attractive currency in which to settle international transactions, without messing around with bank charges or exchange rates. Some internet services (such as web hosting and online gambling) can be paid for using Bitcoin. The complexity and opacity of the system means it also appeals to those with more nefarious purposes in mind, such as money laundering or paying for illegal drugs. But most people will be reluctant to adopt Bitcoin while the software required to use it remains so complex, and the value of an individual Bitcoin is so volatile. Just as BitTorrent was not the first file-sharing service and Skype was not the first voice-over-internet service, it may be that Bitcoin will be a pioneer in the field of virtual currencies, but will be overshadowed by an easier-to-use rival.
Update: This blog post has been amended to remove the news peg.
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Bitcoin: What The Heck Is It, And How Does It Work?
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Bitcoin: What The Heck Is It, And How Does It Work?
The world of finance and economics is pretty complicated as-is, and now there’s “digital money” in the mix making it even worse. Bitcoin is everywhere in the news lately, from hacks to hearings and everything in between. But there are a lot of questions about Bitcoin — starting with, what the heck is all this, anyway? And so, here is everything you wanted to know about Bitcoin, but didn’t actually want to ask your tech-loving, early-adopter friend.
Bitcoin is the world’s biggest cryptocurrency. It was introduced in 2009, and is the longest-standing, best-known, and most widely-traded cryptocurrency.
Generally, Bitcoin with a capital B means the software and the system; bitcoin with a lowercase b means the actual money.
A cryptocurrency is digital money. It’s a virtual medium of exchange, not issued by, backed by, or tied to any particular nation or government.
Yup. The software that runs Bitcoin is open-source, and there are lots of other folks running with it, too. The Guardian covered nine of the biggest in late November. And of course, the internet being what it is, there are novelty versions, like the actually-popular dogecoin or the defunct Coinye West.
If it’s not issued by a government, where does it come from and who keeps track of it?
The acts of generating new bitcoins and of tracking Bitcoin transactions go hand in hand, and both are accomplished through a process known as “mining.” This is where it starts to get a little complicated.
Basically, mining occurs when a computer or a network of computers runs Bitcoin software. That software creates new entries in Bitcoin’s public record of transactions, called block chains. The math is complicated and hard to forge, so the block chain stays accurate. Because anyone can download and install the Bitcoin software for free, the payment processing and record-keeping for Bitcoin is done in a widely distributed way, rather than on one particular server.
When block chains are created, so are new bitcoins — but there’s a hard limit to how many will ever exist. The system was designed to create more bitcoins at first, then to dwindle exponentially over time. The first set of block chains each created 50 bitcoins. The next set each created 25 bitcoins, and so on. New block chains are created roughly every 10 minutes no matter what; when more computers are actively mining, the program they’re running gets harder (and therefore slower) to compensate. The bitcoin FAQ estimates that the final bitcoin will be mined in the year 2140, bringing the permanent circulation to just under 21 million. (Currently, there are roughly 12.4 million bitcoins in the world.)
As of this writing, 1 bitcoin = approximately USD $693. However, the bitcoin exchange rate is intentionally highly flexible.
What can you actually buy with bitcoins?
Swanky cocktails in Manhattan, a Tesla car, tickets and concessions for the Sacramento Kings, and anything you want from Overstock.com.
Also, stolen credit card numbers, drugs, guns, and pretty much anything else of questionable legality bought and sold online. It’s great for money laundering too, according to the FBI.
How do you store and spend your bitcoins? Is there any actual physical money?
Even though there are a handful of bitcoin ATMs in the world, bitcoin is not a physical currency. Spending takes place from one user’s virtual wallet to another user’s virtual wallet, via an exchange of public and private security keys.
Physical bitcoins — which can look like coins or bills, or can be any other item — are storage devices for private keys. In one way, storing private keys in physical media is extremely secure; hackers can’t access the box under your bed via a virtual back door. On the other hand, storing private keys in physical media is as insecure as keeping cash on hand; thieves can access the box under your bed via a literal back door. Or you could end up losing the external hard drive with your $5 million on it.
Is this risky? It sounds kind of risky.
There certainly is a lot of volatility in the bitcoin market. The exchange rate has shifted by over $90 this week alone.
The government backing a standard currency — like, say, the US dollar — works hard to keep its money stable. We have the Federal Reserve issuing monetary policy and acting as a central bank to keep the value of a dollar from flying up and down like the stock market does.
For the first three to four years of its life, bitcoin was actually fairly stable, as historical charts show. The price increased very gradually from roughly $0.05 per bitcoin to more like $5 per bitcoin, which is indeed a good rate of return for early investors. And that concept of “investors” is key. Bitcoin is a market full of speculators, and because it’s not tied to anyone’s monetary policy or oversight, it’s prone to boom and bust. Since the beginning of 2013, the value of bitcoin has jumped as high as $1116 and dropped to $539.
Bitcoin values from Jan. 1 2013 through Mar. 3 2014, via Coinbase.
Investment losses or devaluation are only one of the two big ways bitcoin users can be left high and dry. The other is good old-fashioned theft. While the US money you keep at a standard bank is insured against disaster by the FDIC, there is no such backstop for bitcoin wallets. If the virtual place your virtual money is stored loses it all, you’re screwed.
Speaking of losing money, what’s all this about Mt. Gox?
Mt. Gox is — or rather, was — one of the largest bitcoin exchanges, a site where people bought and sold their virtual money to each other. As Wired reports in detail, it was apparently a poorly-run, mismanaged venture, and hackers were able to gain access and siphon off bitcoins. Lots of them. About $460 million worth, on top of a 2011 hack that cost $8.75 million, and another $27 million “missing from its bank accounts.” All told, in three years Mt. Gox has somehow lost or had stolen nearly a half-billion actual dollars’ worth of alternative money.
And if you’re curious why it’s called Mt. Gox, it’s because it originally stood for “Magic: the Gathering Online Exchange” before becoming a bitcoin trading site in 2010.
So is all this “alternative money” legal? Do the feds care?
Yes, and sort of. It’s not il legal, at any rate.
The Senate Banking Committee and Senate Homeland Security Committee held hearings on Bitcoin back in November. The outcomes were largely positive for Bitcoin, with the Obama administration and Senate willing to leave Bitcoin alone for the moment.
However, the complete collapse of Mt. Gox has returned federal attention to the world of cryptocurrency. Senator Joe Manchin (D-WV) has called for a ban on bitcoins, and the Senate Banking Committee brought in Federal Reserve chair Janet Yellen to testify about the potential for regulating Bitcoin. The thing is, there is no such potential, Yellen said, at least not now. She testified that Bitcoin is “a payment innovation that’s taking place outside the banking industry,” and added:
To the best of my knowledge there’s no intersection at all, in any way, between Bitcoin and banks that the Federal Reserve has the ability to supervise and regulate. So the Fed doesn’t have authority to supervise or regulate Bitcoin in any way.”
Yellen also added, “It’s not so easy to regulate Bitcoin because there’s no central issuer or network operator,” calling Bitcoin a decentralized, global entity.
To Bitcoin developers and users, that global reach and lack of central authority is a core feature, not a bug. Meanwhile, federal prosecutors have sent subpoenas to Mt. Gox, which on Friday declared bankruptcy.
At today’s exchange rate, there’s an equivalent to $8.5 billion out there in the world in bitcoins. It seems likely that regulators and governments will want to keep an eye on where it goes in the future.
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