What is Bitcoin and How Does it Work?

What is Bitcoin?

It’s hard to go a single day without hearing something about Bitcoin – but what is Bitcoin and how long has it been around? Simply put, Bitcoin is a digital currency that allows peer-to-peer payments within a decentralized network without the need for an intermediary. 

The first mention of Bitcoin appeared with its whitepaper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. The paper was written by Satoshi Nakamoto and launched on 31 October 2008. The whitepaper outlined a vision for a new form of digital currency that would enable secure, verifiable, and irreversible transactions without relying on trusted third parties. This concept of a decentralized currency wasn’t entirely new, but Nakamoto’s innovative approach to solving the double-spending problem set this pioneering currency apart from anything else in the past.

The currency was launched in the following year on 3 January 2009 when the genesis block of Bitcoin was mined. What made it special was the fact that it included a headline from the same day labeled “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”. Both the whitepaper and Bitcoin were a critique and a direct response to the then-recent financial crash caused by central banking. Bitcoin currently sits at a market cap of nearly 1.3 trillion.

Who created Bitcoin?

We mentioned the name Satoshi Nakamoto but not much is known about the mysterious figure behind Bitcoin. Even more than a decade later, there are a couple of theories floating around about the identity of the Bitcoin creator.

Satoshi Nakamoto is a pseudonym

Nakamoto may be a fairly common Japanese name,almost nobody claimed to be the creator of Bitcoin. All those who did were never proven to be legitimate. So many speculate that there is no invdividual Satoshi Nakamoto; instead, it’s just a pseudonym and it could very easily be more than one person.

Satoshi Nakamoto is Dorian Nakamoto

Dorian Nakamoto had the surname and he had worked as an engineer on classified defense projects. He had the background to be the developer of Bitcoin but he furiously denied having anything to do with the famous digital asset. For being doxxed by the media, numerous crypto enthusiasts donated Bitcoin to Dorian’s wallet and he accumulated approximately 102 BTC. The wallet is now empty

Satoshi Nakamoto is Craig Wright

Last but not least, there’s the Craig Wright theory. A scientist by craft with multiple doctorates and a master’s degree in statistics, Wright was probably a decent candidate. According to some old claims from 2015, Craig Wright published a cryptocurrency whitepaper on his own website, months before the Bitcoin whitepaper was released. Journalists from Wired magazine also found transcripts where he claimed that he had been running Bitcoin since 2009. Case solved? It was later revealed that both the whitepaper and the transcripts were backdated and manipulated. To make it even worse, earlier this year, Wright was found by the London High Court not to be Satoshi Nakamoto.

To this day, the original creator of Bitcoin remains unknown. Satoshi’s crypto wallet that was used to receive the reward from the Genesis block has remained inactive ever since. The identity of the Bitcoin architect remains a mystery.

How does Bitcoin work?

We’ve covered the theories surrounding Satoshi Nakamoto but how exactly does Bitcoin work? Let’s take a look at some of the details behind Bitcoin that make it tick.

Bitcoin supply

Bitcoin has a fixed total supply of 21 million, dictated by its underlying program. This supply is released into circulation periodically via a process known as mining. There are currently 19,713,890 BTC in circulation, with the last BTC due to be mined in 2140. Once all 21 million BTC are in circulation, no authority can simply order more Bitcoin to be created, as is the case with central banks in the Fiat system. This makes Bitcoin a deflationary asset: with a fixed supply, it can maintain value over time, unlike Fiat currency which is constantly debasing due to unlimited money printing. This alone has prompted many investors to look at Bitcoin as an alternative to store their wealth and combat inflation.

Block rewards

New Bitcoins come into circulation through the distribution of block rewards. Block rewards are the incentive system that motivates miners to contribute computing power to the network. These rewards comprise newly issued awarded to miners upon successfully solving a block. By providing these incentives, the Bitcoin network maintains its security and resilience against attacks.

The network’s underlying protocol automatically halves the block reward every four years. This mechanism is designed to preserve the value of BTC over time, while maintaining an  incentive for miners. The most recent halving event (19 April 2024) reduced, the rewards from each newly mined block from 6.25 BTC to 3.125 BTC. On this schedule, the last block reward will be issued in 2140.

Bitcoin miner nodes

Miner nodes have an active role in the network, as they not only participate in consensus, but also undertake the mining of new BTC. 

The process of mining includes solving complex mathematical problems with computational power (CPU, GPU, ASIC). Mining nodes group transactions into blocks and add them to the blockchain by solving complex cryptographic puzzles. Each miner competes to be the first to create a new block and get the rewards that come with it. Once the entire network verifies a transaction, a new block is added to the blockchain, and the winning miner receives a reward. Since solving the hash puzzle first requires enormous computational power, it’s extremely unlikely for a solo miner to win the block reward. Therefore miners tend to form pools where they can work together and share the block rewards with all participants.

Bitcoin denominations

• BTC
• Sats

When it comes price, we usually talk about the value of 1 BTC. But you don’t need to buy and sell in full BTC – you can also trade fractions of a coin. For example, if BTC is trading at $50,000 and you buy $25,000 worth of it, you’ll have 0.5 BTC.

You can also trade in a denomination known as a Satoshi. Named after the creator of the network, each Sat is equal to 100 millionth of a BTC.

What does Bitcoin do?

One of the most common questions surrounding Bitcoin. What exactly does it do?

• Store of Value

Bitcoin is often seen as a store of value, which earned it the nickname “digital gold”. With a limited number of Bitcoins in existence, the world’s top cryptocurrency is often a viable alternative to any fiat currency.

• Fast International Transactions

Depending on the amount that you want to transfer abroad, Bitcoin could be your best choice. Back in 2018, a user moved $194 million for the small fee of $0.1. In contrast, the traditional banking system can charge you a lot more.

• Pseudo-Anonymous Transactions

Anyone who doesn’t want to stand out can use Bitcoin to transfer value pseudo-anonymously. We’re saying pseudo because all transactions on the Bitcoin network are recorded on a public ledger that’s visible to everyone. If anyone ties your wallet to you, all the transactions you’ve made will be easily traced.

• A Trading Asset

The price of Bitcoin is still subject to a lot of volatility making it a great asset with lots of trading opportunities for both short and long trades. In 2023 alone, BTC’s price made a big recovery from the previous crash and had an increase rarely seen in the traditional stock market. Unlike the stock market, which closes on Friday, Bitcoin can be traded 24/7.

What is Bitcoin used for?

The innate characteristics of Bitcoin make it perfect for everyday use and even certain more specific areas. After all, to use Bitcoin, you just need an internet connection. This opens the door to a lot of possibilities. Here are a few examples:

• Making Purchases

Due to increasing popularity of Bitcoin globally, many vendors provide buyers with the option to purchase goods and services with BTC. This includes clothing, movie tickets, hardware, and more.  This can often be a more convenient and secure way to handle transactions.

• Store of value

As a deflationary asset thanks to its fixed supply, Bitcoin – similar to gold – can store value over time. This makes it a popular option for individuals seeking a hedge against inflation, in a system where Fiat is continually debased through money printing. And since blockchain is censorship resistant, nobody can freeze or tamper with Bitcoin stored at a blockchain address you control.

• Donations

Donations are usually done in an anonymous manner. Bitcoin fits right in with its pseudo-anonymous nature, allowing anyone to donate their desired amount without sharing any details whatsoever.

• Remittance Payments

If you’re working abroad and want to send money back home, Bitcoin can be one way to do that. It’s quick, cheap, easy, and secure and all you need is an internet connection.

• Trading

Bitcoin is traded on various cryptocurrency exchanges worldwide. Traders can buy and sell BTC to profit from price fluctuations. The volatility of its price provides numerous opportunities for speculative gains.

• Long-term Investment

Many people invest in BTC from a long-term perspective, believing in its potential to greatly increase in price as adoption grows and the technology matures.

How and why does Bitcoin have value?

Bitcoin’s value is a multifaceted phenomenon arising from its scarcity, utility, security, decentralization, and market sentiment. While its price can be volatile, the underlying factors contributing to its value have led to widespread adoption and recognition as a legitimate digital asset. 

Like all currencies, BTC derives its value from its users and the dynamics of the market’s supply and demand. As long as it retains the characteristics of money and there is demand for it, Bitcoin will continue to function as a medium of exchange, a store of value, and a vehicle for investor speculation, regardless of its current market price.

Bticoin technology explained

Three critical pieces of tech underpin the Bitcoin network:

• Blockchain technology empowers the Bitcoin network allowing users to make trustless, peer-to-peer, censorship-resistant transactions.
• The Proof-of-Work (PoW) consensus mechanism secures the blockchain without a central authority, eliminating the need for a third party in all transactions and rewarding miners for their in securing the network.
• Cryptography (hashing) strengthens the security of the Bitcoin network by encrypting information and making transactions immutable once they’re included in a block.

Blockchain

Bitcoin’s core innovation is its use of blockchain technology and the decentralized, immutable ledger that records all transactions across a network of computers. Each block contains a list of transactions, a timestamp, and a reference to the previous block, creating a chronological and tamper-proof history of all transactions.

This ensures no single entity controls the network, enhancing security and transparency, and allowing for peer-to-peer, censorship-resistant transactions on the Bitcoin network. The consensus mechanism is known as Proof-of-Work (PoW).

Proof-of-Work consensus mechanism

The Proof-of-Work (PoW) consensus mechanism used by Bitcoin is a fundamental aspect of its security and decentralized nature. Miners compete to solve complex mathematical puzzles, which require substantial computational power. These puzzles are cryptographic hashes that, once solved, validate blocks of transactions and add them to the blockchain. The first miner to solve the puzzle gets to add the new block and is rewarded with newly issued BTC and transaction fees. This process ensures that all transactions are verified and recorded in a tamper-proof ledger, making the network highly secure against fraud and attacks.

Cryptography

Cryptography, specifically hashing, is a cornerstone of Bitcoin’s security and functionality. The network utilizes the SHA-256 cryptographic hash function to secure transactions and ensure the integrity of the blockchain. Transaction details are hashed into a fixed-size string of characters. This hash is unique and serves as a digital fingerprint. 

Miners combine multiple transactions into a block and must find a hash that meets specific criteria set by the protocol. Hashing ensures that transactions cannot be altered once they are included in a block, since any change would produce a different hash and break the chain. The hash of each block contains the hash of the previous block, creating a secure and immutable chain of transactions. 

Where does Bitcoin come from? Mining explained

There are two ways of getting BTC: you can buy or you can mine it. Bitcoin mining involves miners using their computational power (hash power) to solve complex cryptographic problems defined by the SHA-256 hash function. In return, miners have the chance to get block rewards. 

The more miners competing for the block, the more secure the blockchain becomes thanks to the increasing computational power required to tamper with it. Each miner can dedicate a certain amount of computational power called hash power. The more computational power you have, the better your chances of being the one to discover a block.

Anyone can mine Bitcoin in theory, but the huge hash power needed for the process means it’s extremely unlikely you’ll earn any block rewards via solo mining. For example, if your hash rate is at several hundred, you’ll be competing against pools of miners with a combined hash rate in the quintillions (that’s over 1,000,000,000,000,000,000 hashes). This is why huge pools are responsble for nearly all BTC mining.

Bitcoin mining options

Since mining solo isn’t a viable option, Bitcoin mining has evolved to offer different options for individuals and organizations to participate in the network, with two prominent methods being pool mining and cloud mining. 

• Pool mining involves miners joining forces in a mining pool to combine their computational power, or hash rate, to increase their chances of solving blocks and earning rewards. In pool mining, participants share the rewards proportionally based on the amount of computational power they contribute to the pool. Some pros include a steady income, a higher chance of earning and flexibility. At the same time, pools are highly centralized and rely on their operators. If anything were to go wrong, the whole mining operation could collapse.

• Cloud mining allows users to rent mining hardware from remote data centers, thus eliminating the need for purchasing and maintaining any expensive equipment. If you want to get involved in mining without the technical challenges and upfront costs of setting up a mining rig, this is a great option. You won’t have to find any additional information about how to set up the hardware or download software. In a way, you’re renting an already working miner and taking the profits.

How to start mining Bitcoin in 6 steps

If you’ve chosen cloud mining as your preferred option, you’ll just have to follow the steps on the corresponding website. If you’ve opted for pool mining, then you’ll need to take a couple of steps before you get into the actual mining.

• Decide if you’re using your PC or a bespoke ASIC mining rig

Let’s get one thing out of the way, CPUs and GPUs, at least the ones commercially used in personal computers are usually inefficient at mining Bitcoin. So much that you’ll probably be paying more than you’re mining. That’s why an application-specific integrated circuit (ASIC) is often the better choice. You can still use a CPU or a GPU but the better way to go with them would be to farm a different cryptocurrency and then receive rewards in BTC.

• Install Bitcoin mining software

Your choice here will depend on whether you’ve set for CPU/GPU or an ASIC miner.

• Decide which mining pool to join

Bitcoin mining pools are quite competitive and want to attract the most miners. Despite that, they all offer different conditions. Pick the one that suits your setup and your goals.

• Connect to a mining pool via Stratum Protocol

Enter the URL provided by the pool to connect to it via the Stratum Protocol. You can also name your miner here to help you distinguish it (if you have more than one).

• Connect your Bitcoin wallet to your mining operation

Follow the performance of your mining operation. Monitor the power consumption and hash rate of your rig and try to optimize them if necessary.

How to buy Bitcoin

If you just want to buy some Bitcoin, you’ll have a couple of options with the quickest and safest one being a centralized exchange (CEX). Some of the top crypto CEXes include Binance, Coinbase, OKX, Kraken, Bybit, and KuCoin. By using a centralized exchange, you’ll be able to directly buy Bitcoin with fiat money.

Choose a crypto exchange

Find an exchange that’s available in your region and do some research on their fees and security reputation. 

Complete the KYC process

To be able to use the exchange and buy Bitcoin, you’ll have to complete a Know Your Customer (KYC) process. You’ll have to provide some personal information and a photo of an ID document.

Buy BTC using credit or debit card

Once you’re done with the KYC process, you can pay for your BTC using a supported payment method. This will deduct the amount from your balance and deposit BTC in your wallet on the exchange.

Consider your custody options

The final choice is entirely up to you. Will you keep your Bitcoin on the exchange or send it to another wallet? Any crypto enthusiast will tell you “Not your keys, not your coins”. If anything goes wrong with the exchange in the future, the fate of your Bitcoin will be uncertain.

On the other hand, sending Bitcoin to a non-custodial wallet comes with its own considerations. For example, you’ll need to safely store your seed phrase and password. 

If you don’t have a Bitcoin wallet yet, you can create one on Bitcoin.org. Add your Bitcoin wallet address to your mining software. This can vary depending on the software you’ve chosen but it’s the most crucial step so you can receive your mining rewards.

Risks of Bitcoin

Investing in Bitcoin carries several risks that potential investors should carefully consider.

• Market volatility is one of the most significant risks, as Bitcoin’s price can fluctuate wildly within short periods, leading to potential losses. 
• Another one is regulatory risk. The legal status of Bitcoin varies across jurisdictions, and future regulatory changes could impact its value and accessibility. 
• Security risks are inherent due to the digital nature of Bitcoin as exchanges and wallets can be hacked, and without proper security measures, funds can be lost permanently. 
• Centralization of the Bitcoin mining community has given rise to questions about the security of the protocol, and whether a 51% attack might be possible in future. The network’s robust security has withstood the test of time so far, but the evolving Bitcoin ecosystem should also be monitored for security threats.
• Future adoption is also something that has to be considered. Will Bitcoin continue to go mainstream or get abandoned at some point in the future? The uncertainty of Bitcoin’s future as a currency or store of value could affect its long-term viability.

Advantages of Bitcoin

When compared to the traditional banking system, Bitcoin offers several compelling advantages that have contributed to its growing popularity and adoption. 

• Decentralization is one of its key benefits, as Bitcoin operates without a central authority, reducing the risk of government interference and control. 
• Transparency is another key advantage of blockchain technology. Anyone can view any Bitcoin transaction that’s ever taken place thanks to its immmutable public ledger. This is a far more transparent environment than the complicated and opaque banking sector. 
• Accessibility is another key benefit. Bitcoin can be used by anyone with an internet connection, offering financial services to unbanked and underbanked populations worldwide. 
• Low transaction fees compared to traditional banking and remittance services make Bitcoin an attractive option for international money transfers. 
• Additionally, inflation resistance is a significant draw, as Bitcoin’s supply is capped at 21 million coins, preventing the devaluation associated with fiat currencies. 

Closing thoughts

Bitcoin holds a significant place in the modern world as a pioneering digital currency that has reshaped perceptions of money and financial systems. Its decentralized nature challenges the traditional financial institutions, offering individuals greater control over their assets and transactions. By leveraging blockchain technology, Bitcoin ensures security, transparency, and immutability, fostering trust in a system without central oversight. It provides a viable financial option for the unbanked and underbanked populations, enabling global access to financial services. Bitcoin also serves as a hedge against inflation and economic instability, attracting investors seeking to preserve and grow their wealth. As a store of value and medium of exchange, Bitcoin’s influence continues to expand, highlighting its importance in the world’s economy and its potential to redefine global financial landscapes. After the approval of some major Bitcoin ETFs, we can’t help but wonder, where will Bitcoin go next?

Frequently asked questions

Is Bitcoin a good investment?

Despite being around for over a decade, Bitcoin is still quite volatile. While it offers substantial potential, this also means a much higher risk. Investors should thoughtfully assess their risk tolerance and investment objectives before venturing into the Bitcoin market.

What is the Bitcoin Halving?

The Bitcoin Halving occurs every four years and reduces the block rewards earned by miners by 50%. This decrease in the number of bitcoins entering the market increases scarcity, potentially driving up its price if market conditions remain constant.

What is a Bitcoin address?

A Bitcoin address is a unique identifier serving as a virtual location for sending or receiving Bitcoin transactions. Don’t mistake this for a wallet device or interface that can store the private keys  for multiple addresses.