What is a Bitcoin and How Does it Work - A Beginner's Guide to Bitcoin
Bitcoin Explained: What It Is and How It Works?
Being the first implementation of the “cryptocurrency” concept, Bitcoin remains the most valuable and popular crypto asset. The concept itself was introduced in 1998 by Wei Dai. He proposed a new form of money that uses cryptography to control its issuance and transactions.
What Is Bitcoin (BTC)?
Bitcoin (BTC) is a form of digital currency which allows secure transactions without intermediaries. It operates free of any central authority or banks. The generation of new Bitcoins and transaction validation are done collectively by the network members. Thus, no single entity can control Bitcoin, block or cancel its transactions.
The term “Bitcoin” is also used to refer to the open source protocol which enables the connection to the Bitcoin network. The protocol is open source and is being developed collectively in a transparent manner. All the technical specifications and the design of the Bitcoin system are described in the white paper which was published by Satoshi Nakamoto in October 2008.
Bitcoin gave rise to an entire cryptocurrency industry, serving as the inspiration for the creation of many other digital currencies, the so-called altcoins (alternative coins).
Key Takeaways
- “Bitcoin” refers to a censorship-resistant digital currency and to its underlying technology;
- On October 31, 2008, Satoshi Nakamoto published an article entitled “Bitcoin: A Peer-to-Peer Electronic Cash System”, in which he described Bitcoin as a fully decentralized electronic cash system which eliminates any trusted third parties;
- The monetary unit of the Bitcoin payment system has the ticker symbol BTC.
History of Bitcoin
The Bitcoin white paper was released in 2008 by an individual or a group of people under the pseudonym Satoshi Nakamoto. The software and the open-source code were released later in 2009.
The launch of the Bitcoin mainnet (main network) took place in January 2009. On January 3 of the same year, the first block of Bitcoin was created — the genesis block. The exact time was 6 p.m. 15 min. 05 seconds (Greenwich Mean Time). This day is widely celebrated by the crypto community.
Nakamoto released the first open-source Bitcoin software client on January 9, 2009. Anyone who installed the client could begin using the Bitcoin network to mine the BTC cryptocurrency and create blocks of transactions.
On January 12, 2009, the first Bitcoin transfer was made. In order to test the system, Satoshi sent 10 BTC to a computer scientist and cryptographer, Hal Finney. The transaction was recorded in block #170 and had a fee of 0 BTC back then. Bitcoins were first used to purchase real goods on May 22, 2010. American programmer Laszlo Hanyecz bought a pizza for 10,000 BTC, valued at around $41 back then.
December 30, 2009, is known as the first day of the Bitcoin mining difficulty increase due to the inflow of participants into the network. This date can be called the birth of a full-fledged decentralized network.
The last day when Satoshi Nakamoto reached out to the community was December 16, 2010. Bitcoin, however, continued its development, gaining higher and higher popularity and wider adoption in different spheres and services. Nowadays, cryptocurrency can be used to book flights, hotels, and shop for different goods. Some governments are even using Bitcoin as an official currency.
Who Invented Bitcoin?
Until now, the true identity of Bitcoin creator Satoshi Nakamoto remains a mystery. The only information known is the one he left upon the registration on 2PFoundation.ning.com. He gave April 5, 1975, as his birthdate, and Japan as a country of residence.
But given that the Bitcoin documentation is published in proficient English language, researchers and journalists assume the information is false. Also, Satoshi always wrote his messages in English, and the Bitcoin software was not localized for Japanese. Hence, the assumption is that the programmer (or group of programmers) behind Bitcoin comes from an English-speaking country.
How Does Bitcoin Work
Basically, Bitcoin consists of three components that come together to create a decentralized payment system:
- Peer-to-Peer Network;
- Bitcoin (BTC), the native cryptocurrency;
- The Blockchain Ledger.
Bitcoin operates on a peer-to-peer or P2P network, meaning that the computers participating in the network are peers to each other. All the computers, also called nodes, are equal and exchange data without any central server. The nodes that validate new blocks of transactions to record them on the blockchain are called miners.
With each new block, new BTC coins are created. BTC is a decentralized electronic unit that acts as an alternative to fiat currencies (dollars, euros, and others). The coin is subdivided by 8 decimal places. The smallest unit is named after the creator of this blockchain, Satoshi. The coin acts as “fuel” in the network — transaction fees are paid in BTC.
Each Bitcoin transaction is recorded and stored on the blockchain. Only the sender and recipient addresses are recorded, but not their personal information. Users can directly connect their computers to the network and download its public ledger with either the more recent data or the entire transaction history.
Bitcoin's Blockchain Technology
The underlying technology that Bitcoin operates on, blockchain, is an open, distributed ledger. Blockchain allows cryptocurrency transactions to be verified, stored, and sequenced in an immutable and transparent way. These characteristics allow for a trustless payment system.
As the name implies, blockchain essentially consists of a string of blocks aligned chronologically. Each block contains a cryptographic hash of the previous block, a timestamp, and transaction data. Regardless of the volume of transactions waiting to be confirmed, Bitcoin is programmed so that new blocks are added to the blockchain about every 10 minutes.
Whenever new transactions are confirmed and added to the ledger, the network updates a copy of each user's registry to reflect the latest changes. Because of the open nature of blockchain, all participants in the network can monitor and analyze Bitcoin transactions data in real time.
How Do Bitcoin Transactions Work?
In simple terms, a Bitcoin transaction is when one participant sends a certain amount of Bitcoin they own to another participant. For a common user, sending BTC is as simple as sending fiat currency through a mobile app.
Many people are curious about how Bitcoin transactions work under the hood. Here are the basic steps of each Bitcoin transaction:
- In order to transfer BTC to another address, the sender specifies the recipient's Bitcoin wallet address, which is a combination of numbers and letters. Then, the sender signs a transaction that contains the hash of the previous transaction, the public key, and the amount. The transaction is signed with the user’s private key.
- The transaction is sent to the network to which the miners' computers (nodes) are connected. Thus, the transaction, in which User A sends 1 BTC to User B via the blockchain, is publicly broadcast to all participants.
- The transaction is combined with hundreds of other transactions into a separate block. The transaction does not go straight to processing. First, there is a signature validation (the balance of the sender wallet is examined), only then do the miners complete the transaction.
- The block is added to the main chain.
- The recipient's and sender’s wallets display the change in balance.
How Does Bitcoin Mining Work?
New transaction blocks are created and verified by the blockchain nodes with the help of the algorithm called proof of work (PoW). Proof-of-work is the consensus mechanism to choose which network participants — miners — are allowed to verify new blocks.
To verify blocks, miners solve cryptographic equations, which requires computing power. In return for providing computing power, miners who find the right solution for the equation and form a new block are rewarded with BTC.
If there is an attempt to add an invalid block, the request will be immediately rejected and the miner will not receive a reward.
A miner’s reward consists of the transaction fee and the block reward. The block reward is effectively the only source of newly created Bitcoins. The mining difficulty is adjusted so that it takes approximately 10 minutes to find a solution for a new block.
Is Bitcoin Mining a Good Idea?
Bitcoin mining is done using special equipment — powerful hardware designed exclusively for this purpose. The profitability of Bitcoin mining largely depends on the characteristics of the mining device and the BTC price. Profit margins can change significantly due to fluctuations in the Bitcoin exchange rate.
Due to the increasing difficulty of Bitcoin algorithms, as well as the emergence of large institutional players in the mining industry, the average home miner is unlikely to cover up the cost of mining equipment and electricity. The network of Bitcoin miners is so enormous that your chances of regularly finding a valid block (and therefore receiving BTC rewards) are very low.
This state of the industry has contributed to the consolidation of miners into mining pools. To compete with the mega-mining centers, individuals can join a mining pool, a group of miners who work together and share the rewards. This makes mining profitable and increases the payback period of the equipment.
How Long Does It Take to Mine 1 Bitcoin?
The difficulty of the equation is adjusted every 2016 blocks (~14 days) to ensure that, on average, one machine will solve the equation in 10 minutes. The miner who first solves the equation and adds a block receives a reward of freshly minted 6.25 Bitcoins. After halving in 2024, the number will drop to 3.125 Bitcoins.
How to Use Bitcoin
From a user's perspective, Bitcoin is just an app or computer program that gives them access to an address and allows them to receive and spend BTC from that address.
Payment
Bitcoin acts as an alternative to fiat currencies. It can be sent or received globally almost instantly. Many cryptocurrency wallets allow users to customize the transaction fee. The higher the commission, the faster the transaction will be completed. Notably, the commission does not depend on the amount transferred. Payments are made through a wallet application on a computer or smartphone. Users need to simply enter the recipient's address, the amount of payment, and press the "send" button. Many wallets can scan the address in the form of a QR code.
Investing
One of the easiest strategies for investing in Bitcoin is to buy coins for long-term growth potential. On the one hand, the BTC's limited issuance of 21 million coins, as well as its widespread adoption, make Bitcoin a valuable asset. However, it’s important to keep in mind that the price of Bitcoin can fluctuate significantly.
Trading & Speculating
Unlike investing, trading BTC is meant to exploit short-term opportunities. All basic concepts of trading classic assets (diversification, liquidity, technical indicators, etc.) are applicable to operations with Bitcoins as well.
Is Bitcoin a Good Investment?
Investing in Bitcoin is a risky business with virtually no guarantees. You have to be aware of all possible risks, keep up with the related news, and actively apply technical and fundamental analysis. However, with due diligence, one can make a very good profit from investment in BTC.
Risks of Investing in Bitcoin
Investing in Bitcoin, like investing in any other asset, comes with certain risks. Here are a few to consider:
- Bitcoin is volatile. In one day, its value can either jump or drop by 30%. There is never a guarantee that you will see any returns from your investment;
- Except for a few countries such as El Salvador and the CAR, Bitcoin is not recognized as legal tender. The security of Bitcoin transactions is not legally guaranteed. Any risks associated with BTC trading are entirely on the investor's shoulders;
- Many platforms that provide the ability to buy, sell or store Bitcoins are not regulated. Also, exchanges are lucrative targets for hackers;
- Bitcoin payments are irreversible. Once a transaction is made, there is no way to get the funds back. So if you send your coins to someone by mistake, basically you lose them forever;
- There is also a risk of losing access to your Bitcoin wallet. In the case of the loss of a private key, it is almost impossible to restore access.
Can Bitcoin be Converted to Cash?
Some investors may sooner or later need to cash out their profits.
There are several ways to get fiat currency for your Bitcoins:
- Using a cryptocurrency debit card, such as BitPay;
- Selling Bitcoins for cash on a centralized exchange like Coinbase or Redot;
- Using a P2P exchange;
- Cashing out through a Bitcoin ATM.
How To Make Money From Bitcoin?
There are several options for making money from Bitcoin. The most obvious one is to buy Bitcoin and hold it in the hope that its value will increase. Speculators can profit from constantly buying Bitcoin at a low price and selling it at a higher price.
Another approach is to become a Bitcoin miner and receive rewards in BTC. At this point, however, the mining industry has become very competitive. It requires significant investment and high processing power to start mining. Still, small players can join a mining pool and share rewards with other pool participants.
Final Thoughts
Bitcoin is considered to be the true technological revolution. As a trailblazer, it has earned the trust of a significant number of private and institutional investors alike. With other cryptocurrencies on the market, Bitcoin remains the leading asset in terms of capitalization and decentralization.
Bitcoin’s value is often compared to that of a precious metal. Just like gold, Bitcoin has a limited quantity and has select use cases. Its underlying technology, the blockchain, has applications across financial services.
FAQ
Is Bitcoin a Cryptocurrency?
Yes, Bitcoin is the first cryptocurrency and still remains the leading asset on the crypto market.
What Is BTC?
BTC is Bitcoin’s ticker symbol. This ticker functions as an identifying marker and helps to distinguish Bitcoin on exchanges and other applications.
Is Bitcoin a blockchain?
Blockchain is a technology that powers Bitcoin, which is a decentralized network with a digital currency. There are also other cryptocurrencies out there with their own blockchains.
How Do Bitcoins Work?
Bitcoins can be sent from one user to another with the use of online applications. All the transactions are recorded on a public ledger and are visible to everyone. The ledger does not reflect any personal information and is not controlled by any central authority.
What Are Bitcoins Used For?
Bitcoins can be used to make online payments across the globe. There are several companies out there accepting Bitcoins, including Startbucks and PayPal. You can also book flights and hotels with Bitcoins.
How Are Bitcoins Used?
Bitcoins can be purchased, sent, received, traded, or stored via an app or an exchange, such as Binance or Bitcoin Wallet. Most of the apps have a user-friendly interface similar to that of the traditional banking service app.
How Is a Bitcoin Created?
Each new Bitcoin is created in the process of transaction validation by miners. Bitcoins are minted during the creation of each new block, on average every 10 minutes. According to Bitcoin’s source code, the maximum amount of Bitcoins to be ever created is 21 million.
How do I check a Bitcoin transaction?
Any Bitcoin transaction can be tracked using block explorers i.e. btcscan.org. Enter a TXID (transaction ID) in the search bar to see its details. Alternatively, you can enter the desired wallet address. Then you will see all the information about transactions associated with the address.
What is Bitcoin secured with?
Bitcoin is not backed by anything. The value of Bitcoin is determined by its technology and scarcity.
Is Bitcoin a Ponzi Scheme?
Bitcoin does not guarantee income as Ponzi schemes do. The demand for Bitcoin works as fuel for its price.
What Happens if I Lose My Bitcoin Wallet Key?
A private key is unique to your Bitcoin wallet, you can only recover it with a secret phrase you get when you set up a wallet, depending on what wallet and encryption you’re using. Losing access to private keys means losing access to your BTC. There are also services offering account backup services.
Is the Supply of Bitcoins Limited?
Bitcoin supply is limited to 21,000,000 BTC. Once the last coin is mined, which should happen around 2140, there will be no more opportunities to mint new BTC.
If No More Coins Are Created, Will New Blocks Be Created?
The blocks will continue to be created to keep the blockchain running. Miners will be rewarded with transaction fees, to incentivize them to maintain the network.
Is Mining a Waste of Electricity?
Spending electricity to create and provide a free money system can hardly be called a waste of electricity. In addition, the services necessary for the operation of today's widespread monetary systems, such as banks and credit companies, also waste energy, and probably more than Bitcoin.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.
