Bitcoin is a digital currency that is free from any central control or oversight by banks or governments. Instead, it relies on peer-to-peer software and cryptography.
A public ledger records all Bitcoin transactions and copies are kept on servers around the world. Anyone with a free computer can set up one of these servers, called a node. Consensus on who owns which coins is reached cryptographically through these nodes, rather than relying on a central source of trust like a bank.
Each transaction is sent publicly to the network and shared from node to node. Every ten minutes or so, miners combine these transactions into a group called a block and permanently add them to the blockchain. This is the final ledger of Bitcoin.
Just as you would store traditional coins in a physical wallet, virtual currencies are stored in digital wallets and can be accessed through client software or a range of online and hardware tools.
Bitcoins can currently be divided by seven decimal places: One thousandth of a Bitcoin is called a milli and one hundred millionth of a Bitcoin is called a Satoshi designated.
In truth, there are no bitcoins or wallets, only an agreement between the network to own a coin. A private key is used to prove ownership of funds to the network during a transaction. A person could simply remember their private key and not need anything else to retrieve or spend their virtual money, a concept known as a "brain wallet."
What is the purpose of Bitcoin?
Bitcoin was created to send people money over the Internet. The digital currency was intended to provide an alternative payment system that operates free of central control, but is otherwise used in the same way as traditional currencies, with the added benefit of inflation protection as Bitcoins are capped at 21,000,000.
Are Bitcoins safe?
The cryptography behind Bitcoin is based on the SHA-256 algorithm, which was developed by the US National Security Agency. Cracking this is practically impossible, as there are more possible private keys that would need to be tested (2256) than there are atoms in the universe (estimated between 1078 and 1082).
There have been several high-profile cases where Bitcoin exchanges have been hacked and funds stolen, but these services invariably stored the digital currency on behalf of customers. What was hacked in these cases was the website, not the Bitcoin network.
Theoretically, if an attacker could control more than half of all existing Bitcoin nodes, he could create a consensus that he owns all Bitcoin and embed it in the blockchain. But as the number of nodes grows, this becomes less practical.
A realistic problem is that Bitcoin operates without central authority. Because of this, anyone who makes a mistake in a transaction on their wallet has no legal recourse. If you accidentally send Bitcoins to the wrong person or lose your password, there is no one to turn to.