The Basics of Bitcoin & How It Works (For Beginners)

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Bitcoin is a digital currency payment network developed in 2008 outside existing governing financial systems. Satoshi Nakamoto outlined the parameters of Bitcoin in the white paper as a “Peer-to-Peer Electronic Cash System” without intermediaries from financial exchanges. Bitcoin's objective is to create a transparent, immutable, and censorship-resistant digital currency for sending payments from one party to another. It was the first blockchain network to become mainstream and launch a new asset class known as cryptocurrencies.

Key facts about Bitcoin include:

  • There will only be 21 million Bitcoins ever created.
  • 18.92 million Bitcoins have been created so far.
  • The current mining reward is 6.25 BTC per block mined.
  • Roughly 900 BTC are mined every day based on the current reward.
  • The last Bitcoin is expected to be mined in the year 2140.
  • The average speed to send Bitcoin is 11 minutes.

This Is What Can Bitcoin Be Used For

Bitcoin has many use cases or applications that depend on the person who purchased or transferred the digital asset. The main purposes of Bitcoin include as an investment, as a store of value or recession-proof investment (e.g., digital gold), and to transfer value to another person or business over the internet. Several companies accept Bitcoin as payment for goods and services. A recent example is the social media company Twitter, which launched a new tipping feature. Users can gift money in the form of Bitcoin to Twitter accounts in the form of a tip.

Reasons People Are Buying Bitcoin

Bitcoin is a popular asset for investors, and it is not being used as a digital currency, as originally intended in the whitepaper. Initially, users purchased Bitcoin to conduct anonymous online transactions on the dark web. However, as anonymity shifted away from Bitcoin using centralized cryptocurrency exchanges, investors who understand the fundamental aspects of limited supply and growing demand have altered the perception from a digital currency into an investable asset. In fact, a recent survey by Grayscale has revealed 47% of Americans will invest in crypto after the 2024 election. Others even believe that Bitcoin could become a global reserve currency alongside the US Dollar.

Early adopters used Bitcoin to make everyday purchases. For example, the well-known million-dollar pizza BTC pizza was purchased in 2010. As its popularity increased among individuals, its application as a currency stalled due to heightened volatility. Investors turned to hold the digital asset to appreciate in the hopes of becoming the next Bitcoin millionaire.

So, Is Bitcoin Worth Investing In?

Investors who understand the fundamental aspects of limited supply and growing demand realize the shift from a digital currency into an investable asset value. Bitcoin is currently the 9th largest investable asset with a total market capitalization of $835.78 Billion at the time of writing. According to statistics, there are currently approximately 81 million Bitcoin wallets that were created to buy, hold and store Bitcoins. Given the fixed amount of Bitcoins and growing interest, the supply and demand equation suggests a favorable outcome. Moreover, Bitcoin can hedge against increasing inflation due to the uncontrolled printing of fiat currencies.

Bitcoin market cap compared to other assets
Bitcoin market cap compared to other investable assets. Source: Companiesmarketcap.com

Pros & Cons of Bitcoin Explained

Bitcoin developed as an alternative form of currency to the broken financial system. The pros of using Bitcoin for digital payments are that it's censorship-resistant, meaning any third party cannot alter its network and usability. It is also immutable and transparent, meaning every transaction on the Bitcoin blockchain can be seen by anyone, which can help decrease loose ends in any organization. Furthermore, Bitcoin does not rely on intermediaries to process transactions. Thus reducing processing speed and Bitcoin transaction fees for cross-border transactions compared to traditional finance.

What about the costs? How much it costs to send a Bitcoin transaction.

Bitcoin ProsBitcoin Cons
No central authority or Government can control itTransactions are slow for everyday purchases
Limited supply that cannot be manipulatedNot widely accepted as a form of currency
Widely accessible with increasing liquidityFaces unknown regulatory risk by Governments
Solves the double spend problemDifficult to use as currency due to high volatility
Transactions are verifiable on a public ledgerSteep learning curve to buy, hold and send
Bypasses traditional banking feesHard to reverse a transaction once made

On the other hand, Bitcoin is a relatively slow network compared to other forms of payment, such as credit cards and other cryptocurrencies. One of the biggest risks with Bitcoin is regulation and Government policies. As an unregulated asset or form of currency in most countries, Governments can ban Bitcoin at any time.

A recent example is China, which blacklisted Bitcoin, mining, and any banks dealing with cryptocurrencies. Another limitation is the high energy resources required to mine Bitcoin to validate transactions and create new Bitcoins.

This Is How Bitcoin Works

Bitcoin is an open, secure, and public decentralized payment system. Its three major components are the blockchain network, wallets, and Bitcoin miners. Each is vital in sending, verifying, and receiving Bitcoin from one wallet to another.

1. Blockchain Network

Bitcoin was the first cryptocurrency to use blockchain technology to track every transaction cryptographically. As the name implies, the blockchain is a distributed digital record that accounts for every transaction on the network. It is made of blocks that can fit a specific number of transactions. Every transaction contains a date, time, total value, buyer and seller, and unique identifying code.

The blockchain is a distributed public ledger, meaning everyone can access it, and every transaction can be viewed and audited by the public. This makes it possible to trace Bitcoin by finding the Bitcoin transaction ID. The blockchain uses cryptographic logic to track accountable wallet balances. Each transaction then helps the network keep track of the exact wallet balance, as the network uses chronological block order to do so.

Bitcoin hashrate from the whitepaper diagram
How bitcoin transactions work. Source: Bitcoin White Paper.

2. Bitcoin Miners

Miners are what make the Bitcoin network operate. They provide the necessary processing power to verify transactions on the blockchain and keep balances in check. Miners are rewarded for their network contribution; however, Satoshi Nakamoto added a condition that increases the pay-out difficulty based on the number of miners that make up the network. Miners are the ones who change the numbers in users' wallets and make sure that transactions are approved between users.

Moreover, Bitcoin halving was introduced after the genesis block in 2009 to moderate the speed at which new Bitcoins are rewarded to miners. Essentially, the halving occurs roughly every 4 years and reduces the miner's reward for each block. This increases the network's longevity by continuing to incentivize Bitcoin miners without endangering the value of the network too quickly.

3. Bitcoin Wallets

Bitcoin wallets are a major component of transactions on the Bitcoin network between persons. Wallets can be physical devices, software, or mobile phone applications. Each type of Bitcoin wallet comprises two critical components of a Bitcoin wallet to send and receive transactions on the blockchain.

Ledger nano X
Ledger Nano wallet to store Bitcoin.

The first is the public key, or a user's Bitcoin (username), which people use to send and receive transactions. The public keys are cryptographically generated and include a hash number that anyone can share. There are minimal risks associated with sharing the wallet address unless users want to stay somewhat anonymous. An example of a Bitcoin public address is shown below. However, the most common representation is a unique QR code that can be copied and pasted easily to send Bitcoin to another wallet.

1AHRa5Q9Jt1uhWAxL417oE79ikXhwM6gAe

Secondly, private keys are the seed phrases used to sign off transactions. Bitcoin private keys are secret numbers that prevent other users from accessing their wallets, protecting them from theft. A private key also helps users access their Bitcoin wallets from anywhere in the world. The key can also recover Bitcoins from a hardware wallet that has been physically lost or stolen. An example of a Bitcoin key in the hexadecimal format is:

E9873D79C6D87DC0FB6A5778633389F4453213303DA61F20BD67FC233AA33262

In most cases, Bitcoin owners will not use the private key in its numerical value to access their wallets. Instead, each Bitcoin wallet generates a simple root seed phrase (like a password) to encode the private key for ease of use.

Let's Explain Bitcoin Mining

Bitcoin implements a consensus mechanism called proof-of-work, where miners solve complex mathematical equations to add new transactions to the blockchain. Bitcoin's consensus mechanism denotes that new blocks are generated and added to the blockchain approximately every 11 minutes.

Bitcoin mining involves powerful supercomputers that solve mathematical equations. In return, the miners are rewarded with a fee of 6.25 BTC per block, added to the circulating supply as new Bitcoins. As the Bitcoin network is self-regulatory, the difficulty of solving an equation increases according to the number of active miners on the network. As a result, miners use Bitcoin mining pools by adding together all the processing power to increase the chances of receiving the miner's reward. Some of the most popular mining pools are Slush Pool, Binance Pool, AntPool, and BTC.com.

Bitcoin miners
Bitcoin miner GPU's.

ASIC miners, which are heavy energy-dependent machines, are used to mine Bitcoin. Mining Bitcoin was initially profitable using mobile phones and consumer-grade video cards; however, as computation demand increased, video cards could no longer meet the network demands. Individuals who build their own Bitcoin miners and join a pool of multiple miners can increase the likelihood of finding a block reward. The Bitcoin mining rig is connected to software via the Internet or other communications technology, which integrates the hardware into the Bitcoin network. The software can monitor performance, power consumption, and earnings. It is, therefore, essential to pair the mining rig with the Bitcoin mining software to optimize and manage the mining process.

In short, Bitcoin mining is the process of adding new blocks to the blockchain by solving complex equations containing a group of transactions over a set period. Miners are also validators, ensuring that transactions are approved and added to the network.

Related: How to mine Bitcoin: What you need to know.

Bitcoin Is Relatively Safe

There are many factors to how Bitcoin has been designed that make the blockchain secure to use. Bitcoin uses cryptographic data to conduct Peer-to-peer (P2P) transactions. Each transaction on the network is irreversible and permanently stored on the blockchain. The application of unique private keys and digitally encoded transactions that are protected by Elliptic curve cryptography are near-impossible to penetrate successfully. As Bitcoin is not developed by any government or central body, its value is assisted by the trust users place in its network and its growing adoption. To date, the Bitcoin network has never been hacked or compromised.

Considering Bitcoin As An Investment

Bitcoin and other cryptocurrencies such as Ethereum, in general, are highly volatile assets because they are part of an unregulated market. Bitcoin is a new market and does not have price stability. However, Bitcoin's volatility has an upside because it can generate high gains, so investors are increasing their exposure with Bitcoin price estimates by industry experts of more than $100,000 within the next 12 months.

Buying cryptocurrencies such as Bitcoin can be a good investment despite frequent price corrections and growing concerns around regulations. Bitcoin's price has historically outperformed traditional assets each year. Furthermore, according to research by Charlie Bilello from the firm Compound Capital Advisors, Bitcoin has produced an average annualized return of 230%, more than 10 times higher than the second-ranked asset class. Most industry experts anticipate the volatility to reduce as the industry matures, thus reducing the possibility that Bitcoin will ever crash to zero.

Ready to invest? Read our guide on how to buy Bitcoin for a step-by-step tutorial on the best way to buy Bitcoin.

Storing Bitcoins

Bitcoins are stored in digital wallets. Each wallet is a unique string of 30 letters and numbers that help convey user anonymity and use a seed phrase that helps recover the wallet on any device. There are also two types of Bitcoin wallets: cold and hot wallets.

  • Hot wallets are continuously connected to the internet but don't necessarily have to download the entire block history to update the token value. Bitpay, TrustWallet, or cryptocurrency exchange account wallets such as Coinbase are examples of hot wallets. However, hot wallets are less secure because they allow hackers to exploit users' assets. There have been many instances of crypto exchanges being hacked.
  • Cold wallets can store data and assets offline and need to sync to the Bitcoin network to process and update transactions. An example is the Ledger Nano X and Trezor, which will cost between USD 60 and USD 150. Cold wallets are physical devices that can be stored and are generally safer than hot wallets because there are lower chances of being hacked. For further information, read our comparison article on the best hardware wallets for Bitcoin.
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