Bitcoin transactions have limitations: A Bitcoin transaction can
take as long as 10 minutes to confirm. Transactions are also
irreversible and can only be refunded by the Bitcoin recipient.
These limitations do not exist with conventional currencies,
where debit and credit transactions are confirmed within
seconds; certain transactions can also be reversed for valid
reasons by the originator, without having to rely on the
Bitcoin balances are not insured: This means that if you lose
your Bitcoins for any reason – for example, your hard drive
crashes, or a hacker steals the digital wallet in which your
Bitcoins are stored, or the Bitcoin exchange where you held a
balance went out of business – you have little recourse.
Currency balances held at banks, on the other hand, are
insured against certain events such as bank failure by
agencies like the Federal Deposit Insurance Corporation in
Let’s say you want to test the Bitcoin waters. The first thing you
need to do as a new user is install a digital wallet on your
computer or mobile device. This wallet is simply a free, opensource software program that will generate your first and
subsequent Bitcoin addresses. There are three types of
wallets – a software wallet (installed on your computer), a
mobile wallet (which resides on your mobile device) or a Web
wallet (located on the website of a service provider that hosts
Bitcoin uses public key encryption4 techniques for security. This
means that when a new Bitcoin address is created, a
cryptographic key pair consisting of a public key and private
key – which are essentially unique, long strings of letters and
numbers – is generated.
Each address has its own Bitcoins balance, so all you need to
do is acquire a number of Bitcoins that will be held at one of
the addresses in your wallet. You can acquire Bitcoins through
a number of ways – by buying them from a Bitcoin currency
exchange such as Mt. Gox or Bitstamp, or through a service
like BitInstant that enables fund transfers between Bitcoin
exchanges and supports various payment mechanisms.
Note that all Bitcoin transactions are stored publicly and
permanently on the Bitcoin network, which means that the
balance and transactions of any Bitcoin address are visible to
anyone. Experts therefore recommend that Bitcoin owners
create a new address for each transaction as a means of
ensuring privacy and enhancing security.
Once you have created a Bitcoin address and have acquired
Bitcoins, you can use them for an online transaction with a
company that accepts Bitcoins as a payment mode. The
company will send you the Bitcoin address to which you can
send your Bitcoin payment. You direct the payment to that
address; while the transaction takes place within seconds,
verification can take 10 minutes or longer.
All Bitcoin transactions, without exception, are included in a
shared public transaction log known as a “block chain”. This is
to confirm that the party spending the Bitcoins really owns
them, and also to prevent fraud and double-spending.
Why does transaction verification or confirmation take so long?
Because the complex algorithms involved in Bitcoin mining
(see description below) take time to solve, even with immense
computing power at one’s disposal.
Lets see some examples.
An Example of a Bitcoin Transaction
Let’s assume you want to make an online payment to a company
– call it BitChamp – using 5 Bitcoins that you have in an
address in your digital wallet. Here are the steps in the
BitChamp creates a new Bitcoin address and directs you to
send your payment to it. This creates a private key (known
only to BitChamp) and a public key (available to you and
anyone else). Note that just as a seller does not need to know
your physical identity if you pay cash, you do not need to
disclose your real identity to BitChamp and can remain
You instruct your Bitcoin client (the free Bitcoin software you
first installed on your computer) to transfer 5 Bitcoins from your
wallet to the BitChamp address. This is the transaction
Your Bitcoin client will electronically “sign” the transaction
request with the private key of the address from where you are
transferring the Bitcoins. Recall that your public key is
available to anyone for signature verification.
Your transaction is broadcast to the Bitcoin network and will be
verified in a few minutes. The 5 Bitcoins have been
successfully transferred from your address to the BitChamp
Note that only the first two steps involve action by the seller and you
respectively. The latter two steps are automatically executed by the
Bitcoin client software and Bitcoin network. As well, storing the private
key attached to an address safely and securely is of the utmost
importance; otherwise, anyone who obtains the private key can control
the Bitcoins at that address and use them fraudulently.