Blockchain, Wallets and Private keys simplified

Most people get involved, without understanding the concept of cryptocurrencies. Trying to answer to newcomers, I came up with a simplified story that will help anyone to understand the cryptocurrency concept.

Most people think that cryptocurrencies are data moving around the internet. No!

Let's start with the blockchain. I don't want to get in details, but let's assume that it's an immutable ledger that it is secured with cryptography. It is very difficult to alter or delete entries, because you need the 51% of the hashing power of the network, to do that.

Bob sends Bictoins to Alice. A transaction is recorded on the blockchain “Bob sent 1 Bitcoin to Alice”. Let's stick to the wallet software that Alice uses. It reads the transaction on the blockchain, and shows 1 Bitcoin in her wallet. Whatever wallet Alice uses, will show 1 Bitcoin, because it finds it out, by reading the transaction on the blockchain. Within the Bitcoin network, we don't use names, but Bitcoin addresses. Any wallet software that has proof that the user owns the Bitcoin address, shows the same result. It is not read from any data or any storage media. It is read from the blockchain transaction.

Then, the next problem arises. How can I prove to the wallet software that I am the owner of that address? That's where private keys come in. To create a Bitcoin Address you need a generator that creates a key-pair. A private key and a Bitcoin Address are generated. The Bitcoin Address is given to the public to receive coins, and the private key must be kept secure. When a device fails, or is lost somehow, a new device you get, needs a new wallet software. How Alice can prove to the new software that she is the owner of a specific Bitcoins address? The wallet software has a function called “import private keys”. Alice uses that function and then the corresponding Bitcoin Address is installed into the new wallet software. The wallet reads the blockchain and finds the transaction “Bob sent 1 Bitcoin to Alice”, so that Bitcoin, is shown in the new software wallet, and it is available for Alice on her new device.

You understand now, that if someone gets the private key of a Bitcoin address, he can import this into his wallet, so his wallet has that address. That 1 Bitcoin from Bob goes to him, because the wallet thinks that he is the owner of the corresponding address, that before was Alice’s. The loss of the private key, has a result of coin loss for Alice. If a cryptocurrency user has a wallet, he MUST have access to the private keys. If he doesn't, he is in the mercy of the wallet creator, to get his coins.

To make a transaction, a miner fee must be paid, to the miner that puts the transaction on the blockchain. Cryptocurrency exchanges, create Bitcoin wallets, on their servers, to allow transfers between users, without fees in their user's exchange wallets. This helps a lot when trading, but it is not good for keeping, because there is no blockchain entry, and the user does not have access to the private keys. If something happens to the exchange, all coins in the user's wallets can be lost, because the users do not have the private keys to import them on a new wallet software. This is exactly the problem when Bitcoins are lost. People read this in the news, and get afraid of Bitcoin. If you have a wallet with your private keys kept safe, your are safer than anything else offered today. This is because, the blockchain cannot be wiped out, and as long as internet exists, you will have your transactions recorded on the blockchain.

To increase security, it is advisable to create a new Bitcoin address for every transaction. This results in hundreds of addresses and hundreds of corresponding private keys. To solve this problem, a new kind of wallet software was created. It is called a deterministic wallet. Deterministic wallets, have a seed, so each time you create a Bitcoin address, it is calculated in a special way. If you import the seed, to another software wallet, the same series of key-pairs will be created. So instead of keeping all the private keys, you just keep the seed. When you enter the seed to a new wallet software, the same key-pairs are generated, and the bitcoins stored in the addresses show up in the wallet. If Alice uses a deterministic wallet, she can import the seed in any deterministic wallet software, and the same Bitcoin addresses and private keys are generated. The software will read the blockchain and find the transaction: “Bob sent 1 Bitcoin to Alice”, so 1 Bitcoin will always be shown in Alice's wallet.

To keep the private keys safe from hackers, a hardware wallet is the best choice. The addresses are generated on the hardware wallet, and they are not stored on the computer, so it gets very difficult for hackers to steal them. When you want to make a transaction, the wallet software connects with the device, gets the private key and signs the transaction. In case that Alice wants to send 0.5 Bitcoins to Johnny, she uses the “Send” function of her wallet to send to the Bitcoin address, Johnny gave her. When this is done, the wallet software calculates the amount of the two Alice's transactions, and shows the result 0.5 Bitcoins.