How Does Bitcoin Work? Solving the mysteries surrounding the biggest cryptocurrency.

robertstevens

Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.

Even those whose fortunes were made entirely from Bitcoin trading don’t fully understand what it is, how it works, and why on earth it’s made speculators like themselves so immensely rich. But for the uninitiated and (rightfully) wary, it’s useful to understand roughly how this digital money, minted out of thin air by a few lines of computer code, works.

Bitcoin’s a type of cryptocurrency, which can be used for purposes as diverse as speculation and… speculation. It’s also used as a means of payment; because it exists solely online and has privacy features, it’s popular on illegal dark web sites. But more mainstream shops, such as those powered by Shopify, also support it. It’s slowly catching on.

There are thousands of cryptocurrency tokens, but Bitcoin is by far the most popular; it accounts for over 60% of the entire cryptocurrency market. As of June 18, 2020, the total value of all bitcoin in circulation is $175 billion, and a single Bitcoin is worth around $9,400.

Bitcoin was first invented in 2008, but nobody’s quite certain by whom. The only thing we know about its creator is that he goes by “Satoshi Nakamoto.” Nobody has proved that they are Nakamoto, although many have tried.

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The blockchain

Bitcoin relies upon something called the “blockchain.” In technical terms, the blockchain is a “decentralized ledger.” What this means is that everyone in the world can download a copy of the entire Bitcoin ledger. This ledger, essentially a record book, keeps track of how much Bitcoin everyone has; when bitcoin is transferred between addresses, the record book is automatically updated for everyone.

The decentralized aspect of blockchain is what makes it so revolutionary. Traditionally, these ledgers are stored on a central database, owned by the government or maintained by banks. This makes them liable to tampering—if the government controls the record, they could fudge the numbers. But, because everyone holds a copy of the records with a decentralized ledger, this risk is greatly reduced.

The veracity of this ledger is maintained by “miners,” members of the Bitcoin network that use their computers to solve complex calculations. Solving these complex puzzles verifies transactions; for solving these puzzles, miners are rewarded in bitcoin.

The blockchain itself is composed of “blocks,” which are collections of these transactions that are grouped together before being verified by computers. They are then “chained” together to form the blockchain. New blocks are then continually added as more transactions are completed and then verified.

Public and private keys

To access and send bitcoin, you’ll have to use special keys. There are two types of keys: public and private ones. These are used to complete transfers from one Bitcoin wallet to another.

Every Bitcoin wallet—akin to a digital bank account—has a private key, composed of a complex series of letters and numbers. It’s used to access your Bitcoin wallet and sanction transfers of bitcoin between wallets.

There is also a corresponding public key, which is used to produce Bitcoin’s equivalent of a mailing address. (All of this is anonymous. Names, phone numbers or emails are unattached to Bitcoin addresses).

To send bitcoin to your friend, first get them to tell you their public address. Enter it into your Bitcoin wallet and then sign off on that transaction using your private key.

Mining

Once you send your transaction, it’ll have to be validated before it reaches your friend. Validation has to be done by someone else; it’s a way of ensuring that the transaction is confirmed by everyone else on the blockchain.

For your transaction to be validated, it’ll be placed into a “block” of transactions.

Blocks can only be validated if a very specific number is added onto the end of them. This number, worked out through a series of complex calculations, will start with 19 zeros.

The only approach to finding this hash is by a brute-force approach: testing out as many numbers as possible until the correct one is found. Once the number is found, the block is verified. This process of searching is called Bitcoin mining.

This is a very computer and energy-intensive process, requiring specialized mining computers built specifically for the purpose of finding these numbers. As a reward for all of this work, the network will create some Bitcoin, and give it to the miners that crunch the correct number.

Halving

There is, however, a piece of monetary policy baked into the Bitcoin blockchain. Every 210,000 blocks, or approximately four years, the reward for successfully mining a block halves.

This event, known as the halving, was designed with scarcity in mind. The maximum supply of bitcoin is 21 million, so, some day in the distant future, all of the bitcoin will have been mined and no more will be released into circulation.

Keeping bitcoin scarce means that it retains its value. In 2009, every block mined yielded 50 bitcoin to lucky miners. This number has since been reduced to 6.25 bitcoin per block. 18 million bitcoin has already been mined. It’s predicted that the final bitcoin will be minted in 2140.

How does buying and selling bitcoin work?

So, how do you buy bitcoin?

Exchanges

Exchanges are one way to buy bitcoin. To buy bitcoin from exchanges, you’ll have to sign up, most likely provide some sort of identification, then buy it using your corresponding fiat currency. Sometimes you’ll have to first buy a “stablecoin,” a cryptocurrency that’s pegged to the value of a fiat currency, and then trade that stablecoin for Bitcoin.

Buying bitcoin from exchanges is one of the easiest ways to buy bitcoin, particularly if you want to use them for trading. Bitcoin bought on exchanges can be traded immediately against other cryptocurrencies. Trading is by far and away the most popular use of cryptocurrency: $24 billion worth of bitcoin is traded each day, as of June 17, 2020.

But whereas Bitcoin wallets are non-custodial, meaning that you control the keys to your Bitcoin, most exchanges are centralized: They control your keys and hold custody over your bitcoin. Consequently, exchanges are not necessarily the safest place to store your bitcoin.

Because Bitcoin’s such a new phenomenon, these exchanges aren’t always well regulated. Back in 2014, for instance, an exchange called Mt. Gox, at the time responsible for about 70 percent of all Bitcoin trading, was hacked. Its wallets, which contained about $450 million worth of cryptocurrency at the time, were drained. Most of that money is still unrecovered.

If you are looking to buy your bitcoin as a long-term investment, or to buy items online, then you should take your Bitcoin off the exchange and store it in a hardware or software wallet. But for ease of use, exchanges work well. The most popular and reputable ones are Binance and Coinbase.

ATM

Despite being digital, Bitcoin’s found a way into the real world. It can be withdrawn and bought from Bitcoin ATMs. You scan a QR code at the ATM, pay money with fiat currency, then wait for the transaction to clear. Then, the ATM should transfer some bitcoin to your wallet. There are several thousand scattered around the world, generally concentrated in major cities, and your nearest can be found using Coin ATM Radar.

Peer-to-Peer

There is another way to buy bitcoin: peer-to-peer; in other words, to buy it from others. This can be done face-to-face or via email, but peer-to-peer exchanges such as Paxful make things easier.

They offer the opportunity to buy bitcoin directly from other private holders instead of from an exchange. Some of these peer-to-peer services offer bitcoin for specific fiat currencies that are not usually offered by regular cryptocurrency exchanges, which can be very useful if you don’t have easy access to a major currency.

Paxful only serves Bitcoin, so you can’t trade bitcoin against other cryptocurrencies. But you do have a range of unorthodox methods to buy bitcoin, including Xbox, Amazon and iTunes gift cards.

Storage

Once you’ve purchased your bitcoin, you’ll have to store it in a wallet. For long term storage, there are two primary methods: the first is using a hardware wallet, the second is a software wallet.

Hardware wallets

Hardware wallets are physical objects—materially similar to a USB drive—that don’t have to be constantly connected to the internet. This makes them difficult to hack.

You will need to keep track of your hardware wallet, though, because if you lose it there is no way to recover your bitcoin. Ledger and Trezor are two of the market leaders for hardware wallets. With basic wallets retailing from $66 to $200, you will need a substantial amount of bitcoin before they’re worth the investment.

Software wallets

In contrast to hardware wallets, software wallets tend to be free. These are online wallets, a little like a bank account that you access online. Because they’re online, they can always be hacked. But for a free solution for holding small amounts of bitcoin, they are a solid choice. Top ones are Binance’s wallet, Coinbase’s Trust Wallet and Xapo.

How to make money with Bitcoin

There are three main ways to use Bitcoin to make money.

The first of these is mining. However, gone are the days when your humble home computer could turn a profit off mining. If you want to make money now, you’re going to need a dedicated mining computer to make a substantial profit.

These machines are expensive, and you’ll also have to pay for all of the electricity. However, if you have the money to buy a rig, then Bitcoin mining can be lucrative. Keep in mind that mining revenues will halve every four years. Also, consider joining a mining pool, where your computer power is grouped with other people’s, to mine Bitcoin faster.

The second method is holding Bitcoin as an investment against fiat currency. This can be very profitable: the currency peaked at $20,000 in 2017, and has made a few people very rich. Notably, the Winkelvoss twins have holdings in Bitcoin that were valued in 2017 at over $1 billion.

However, Bitcoin is volatile and unpredictable, so you must also be willing to face severe losses. Just this year, the price has varied between $5,000 and $10,000. (There are many alternatives to making money off savings, such as WS Save.)

The final method to make money off Bitcoin is using it to trade against other cryptocurrencies. Many exchanges have listings offering different cryptocurrencies against Bitcoin, similar to currency pairings in forex trading or stocks trading (like with WS Invest). This is subject to a lot of volatility, too, and you should only get involved in this space if you have a coherent strategy and money that you can afford to lose.

Pros and cons of Bitcoin

ProsCons
Independent from central governmentsNot accepted by major e-commerce sites, such as Amazon
Can be traded against other cryptocurrenciesBitcoin mining is harmful to the environment
More liquid than other cryptocurrenciesExchanges could shut down or be hacked
Doesn’t distinguish cross-border transactionsTrading is illegal in some countries
PrivateHigh price volatility

Last Updated July 1, 2020

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