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What Is Bitcoin and How Does It Work?

April 21, 2022
10
min

Bitcoin is a digital currency that’s part of a public and decentralized blockchain, investors started to buy it as a type of alternative currency but it comes with risk.

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Bitcoin is the first and most well-known cryptocurrency. While other types of cryptocurrencies have built on the initial ideas and technology, Bitcoin remains one of the most popular and valuable cryptos.  

Bitcoin was launched in 2009 by Satoshi Nakamoto—a pseudonym used by a person or group whose identity is still unknown—as a virtual currency. It drew little attention for years after its introduction. However, even if people don’t fully understand how it works, Bitcoin has become a household name and is the biggest in terms of total market cap, which for several months in 2021 surpassed $1 trillion. Only a handful of the world’s most valuable companies were worth more.

What is Bitcoin?

Bitcoin is a decentralized and digital currency, and it is the most popular cryptocurrency. It can be used as an investment, a way to speculate, or as a form of payment. Today, Bitcoin holders can even use debit cards that are linked to their Bitcoin to use their crypto for everyday purchases.

With traditional currencies, people rely on centralized organizations, such as governments and banks, to verify and approve transactions, record account balances, and create new money. Bitcoin uses cryptographic rules, such as secret keys and digital signatures, and a decentralized network of computers to do the same things. 

In fact, decentralization is fundamental to how Bitcoin works and the ethos behind the cryptocurrency, which was developed and launched partly in response to the 2007-09 financial crisis.

How does Bitcoin work?

Several concepts and types of technology are important to understanding how Bitcoin works and how people can confidentially buy, trade, and use Bitcoin without having to rely on a central authority. 

While the crypto market changes quickly, Bitcoin laid the groundwork for how many other types of cryptos work. What follows are some of the terms and concepts needed to understand how Bitcoin and many other cryptocurrencies function.

A decentralized blockchain keeps track of all the Bitcoin

A blockchain is a network of computers that’s similar to a database. Think of a large bank that keeps track of all its customers’ accounts and the various transactions involving each account. The Bitcoin blockchain similarly records transactions to track the flow of Bitcoin.

But there are a few important details about Bitcoin’s blockchain that make it different from, say, a bank’s private database. For one, it’s public, which means anyone can look up previous Bitcoin transactions. Additionally, the blockchain is immutable, meaning verified transactions can’t be reversed or altered. The blockchain name comes from the fact that new data gets combined into a block and then added to an existing chain of blocks, which also effectively locks the previous blocks into place. 

The blockchain is also decentralized because there isn’t a single person or organization running the software that powers the blockchain. Instead, the system offers potential rewards to anyone who lends a hand. As a result, computers around the world are consistently being updated with copies of the latest version of the Bitcoin blockchain, making it nearly impossible for a central authority, such as a government, to control it or to shut it down.

Bitcoin miners verify new transactions

To have a successful and useful digital currency, users need to be sure that their transactions will be processed quickly and that people can’t hack or trick the system. Bitcoin addresses both issues with its blockchain and a proof-of-work (PoW) consensus mechanism.

When Bitcoin transactions are proposed, they are not added as permanent transactions right away. First, Bitcoin miners review transactions to verify that they conform with Bitcoin’s rules, the crypto wallet requesting the transaction owns enough Bitcoin, and that the wallet isn’t trying to spend the same Bitcoin twice.

After verifying multiple transaction requests, the miner groups them together to create and propose a new block. The block then gets sent out to other nodes, which are computers that run Bitcoin software and store copies of Bitcoin blockchain. (Miners are also nodes, but some nodes don’t mine.) 

These nodes verify that the new block builds on top of the previous block and (again) that its transactions are valid. By verifying that the block adds to the existing blockchain, they’re ensuring that previous transactions were not altered. The nodes also send copies to other nodes to keep everyone’s copy up to date. 

As the new block spreads across the network, each node repeats the verification process. While multiple proposed blocks can exist, in the end, the new block that has the most votes (i.e., the most miners proposed that block) will be added to the blockchain.

It’s a complicated process, but the main point is that every transaction is verified and validated by multiple computers, and new transactions are only approved when there’s a consensus. As a result, someone would need to control at least 51% of the mining nodes to rewrite the blockchain and hack the system. They could try to create their own version of Bitcoin and give themselves a larger balance, effectively creating counterfeit Bitcoin. However, even if a mining node they control confirms this new fake block as valid, the other miners won’t agree, and the change won’t be added to the existing Bitcoin blockchain.

The network rewards the Bitcoin miners who keep it running

In addition to helping verify transactions, Bitcoin miners also compete against each other to solve complex problems and potentially earn rewards. These rewards come from Bitcoin transaction fees and newly minted Bitcoin. 

The PoW consensus mechanism requires miners to use large amounts of computing power and electricity to solve these problems. This approach that can keep the network from getting spammed with new fraudulent blocks, because miners with bad intentions could wind up spending more on electricity than they could earn from trying to break the system. 

Bitcoin’s PoW approach has been widely criticized because it requires so much energy. Digiconomist estimates Bitcoin use will use over 200 terawatt-hours of energy in 2022 and has a carbon footprint similar to the entire Czech Republic. The energy usage could also increase as the available supply of new Bitcoin decreases and the math problems become more challenging. About 19 million Bitcoin were in circulation as of March 2022; the total supply is capped at 21 million.

Some other cryptocurrencies use a proof-of-stake (PoS) mechanism to accomplish a similar goal with less energy. Rather than requiring people to solve problems, the PoS mechanism works more like a raffle. People can stake their crypto for a chance to win more, but also risk losing crypto if they (or the validator they’re aligned with) stop verifying transactions or try to cheat the system. 

Public-key cryptography helps create a trustless system

Bitcoin is referred to as a trustless system because users can trust Bitcoin as a whole without having to trust other users or rely on a central authority. Partially, this stems from the consensus mechanism and the fact that transactions can’t be reversed. 

Additionally, Bitcoin uses public-key cryptography (PKC), which lets third-parties verify someone owns Bitcoin without giving the third-party a way to access or spend it. It also means someone can accept Bitcoin without having to know or trust the sender—the system verifies that they have the Bitcoin to send and ensures the transaction won’t be reversed. 

PKC relies on people having pairs of private keys and public keys that are mathematically linked. When someone wants to receive Bitcoin, they’ll share a public address that’s based on a public key. The Bitcoin is locked to that public address once it’s sent, and the only way to unlock it is with the private key that’s paired with that address’s public key. 

When the person decides to use the Bitcoin, they’ll sign the transaction request using their private key. Bitcoin miners can use the paired public key to verify that the transaction request is coming from the rightful owner, but the private key never gets revealed. In this case, the rightful owner simply means the person has the private key. But if someone’s private key is stolen or lost, their Bitcoin could be taken from them or become inaccessible. 

Because people don’t have to register for a Bitcoin address using their real identity, the use of cryptographic keys also allows people to buy and sell Bitcoin without revealing their personal information. However, Bitcoin isn’t completely anonymous because every transaction is tied to a public address, and it may be possible to figure out who created that address.

Bitcoin wallets let people use their Bitcoin

Bitcoin wallets are how people actually connect with the Bitcoin blockchain to use their Bitcoin. These crypto wallets create and store their users' private and public keys, which lets them create public addresses to receive Bitcoin, and verify that they’re the owner with the associated private key. 

Technically, nothing holds or stores Bitcoin because the Bitcoin blockchain doesn’t create accounts for users. Instead, the blockchain records how much Bitcoin each party’s addresses have after each transaction.

Many individuals and companies develop Bitcoin wallets with different functions and features. For example, there are hardware wallets that are USB-like devices that can be plugged into a computer to use Bitcoin, and software wallets, which are mobile, desktop, or browser-based programs that serve a similar purpose. 

Hardware wallets may be a “cold” wallet while they’re kept offline—a safety measure that can help protect it from hacking. A wallet becomes “hot” once it’s connected to the internet, although many software wallets are always connected. 

Rather than creating and managing their own Bitcoin wallets, some investors choose to open an account at a centralized cryptocurrency exchange, such as Binance, Coinbase, Crypto.com, Gemini, or Kraken. It’s similar to creating an online bank account or stock-trading account, and the exchanges take over the creation and management of the crypto wallets.

Risks of investing in Bitcoin

The price of Bitcoin has skyrocketed since its launch in 2009. While it originally cost a fraction of a penny per Bitcoin, the all-time-high in November 2021 was nearly $69,000 per Bitcoin. However, the price is highly volatile, meaning it might not be a good fit for investors who can’t tolerate a lot of risk. Other risk factors include: 

  • Regulation: Governments may crack down on cryptocurrencies in general or Bitcoin specifically, which could reduce its value or certain people's ability to access or use Bitcoin. 
  • Security: Using a purely digital currency opens up the risk that the system or an individual wallet could be hacked. While the Bitcoin blockchain hasn’t been hacked before, it’s theoretically possible. 
  • Fraud: There are many Bitcoin-related scams that aim to separate investors from their crypto. Even if someone’s wallet is secure, they could accidentally share their private key (giving someone else control of their Bitcoin) or send Bitcoin to a scammer’s address. In either case, it might not be possible to get the crypto back. 
  • Competition: While Bitcoin is one of the original cryptocurrencies, there are many others. It's possible that Bitcoin's price may drop if it’s no longer popular. 

The bottom line

Bitcoin is a digital currency that’s part of a public and decentralized blockchain. People can set up and use Bitcoin wallets to buy and spend Bitcoin, and the Bitcoin blockchain relies on Bitcoin miners to process and verify transactions. In turn, these miners can earn Bitcoin rewards. 

As its popularity increased, investors also started to buy Bitcoin hoping it would increase in value, rather than as a type of alternative currency. But Bitcoin comes with a number of risks that may make it unsuitable for investors with a low tolerance for price volatility and the uncertainty of this new asset class.

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