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What Is Bitcoin & How Does It Work?

Updated: Aug 3rd, 2022
Kevin Groves
Kevin Groves
What Is Bitcoin & How Does It Work?

Cryptocurrencies have transformed into a world-changing technology as they've offered an alternative way to interact with financial systems outside the control of governmental and financial institutions. This article will help people understand how Bitcoin works, what are the benefits and drawbacks of using Bitcoin and why it is important.

What Is Bitcoin?

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. The objective of Bitcoin is to create a transparent, immutable, and censorship-resistant digital currency to send payments from one party to another. Key facts about Bitcoin include:

  • There will only be 21 million Bitcoin ever be 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.

What Can Bitcoin Be Used For?

Bitcoin has many use-cases or applications that depend on the person that has 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 has launched a new tipping feature. Users can gift money in the form of Bitcoin to Twitter accounts in the form of a tip.

Why Do People Buy Bitcoin?

Bitcoin is a popular asset for investors instead of using it as a digital currency as it was 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 that understand the fundamental aspects of limited supply and growing demand has altered the perception from a digital currency into an investable asset.

Early adopters used Bitcoin to make everyday purchases. For example, the well-known million-dollar pizza BTC pizza purchase 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 price in the hopes of becoming the next Bitcoin millionaires.

What Are The Pros & Cons of Bitcoin?

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 fees for cross-border transactions compared to traditional finance.

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 due to 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. Other limitations include the high energy resources required to mine Bitcoin to validate transactions and create new Bitcoins.

How Does Bitcoin Work?

Bitcoin is a decentralized payment system that is open, secure and public. The 3 major components involved with how it works are the blockchain network, wallets and Bitcoin miners. Each component plays a vital role in sending, verifying and receiving Bitcoin from one wallet to another.

1. Blockchain Network

Bitcoin was the first cryptocurrency that used 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. The blockchain is made of blocks that can fit a specific number of transactions. Every transaction contains a date and time, total value, buyer and seller, and a 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. 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 exact.

how bitcoin transactions workhow bitcoin transactions workHow 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 that change the numbers in users' wallets and make sure that transactions are approved between users.

Moreover, a process called 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 mined. This increases the longevity of the network by continuing to incentivize Bitcoin miners without endangering the value of the network too quickly.

3. Bitcoin Wallets

Bitcoin wallets are major component of how transactions on the Bitcoin network are transacted between persons. Wallets can take the form of a physical device, software or mobile phone application. Each type of Bitcoin wallet comprises of two critical components of a Bitcoin wallet to send and receive transactions on the blockchain.

Ledger Nano Bitcoin walletLedger Nano Bitcoin walletLedger Nano wallet to store Bitcoin.

The first is the public key, or a users' Bitcoin (username), which is used for people to send and receive transactions. The public keys are cryptographically generated and include a hash number that can be shared with anyone. There is no risk 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 be used to 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. A simple root seed phrase (like a password) is generated with each Bitcoin wallet which is used to encode the private key for ease of use.

What Is 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 to solve mathematical equations. In return, the miners are rewarded with a miners fee of 6.25 BTC per block which are 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. For more information, read this article on the best Bitcoin mining pools to use.

Bitcoin minersBitcoin minersBitcoin 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. Even with the development of ASIC miners, miners are joining a pool of multiple miners to increase the likelihood of finding a block reward. The mining rig is connected to mining software which integrates the hardware to the Bitcoin network. The software can be used to monitor performance, power consumption and earnings. It is therefore essential to pair the mining rig with the best Bitcoin mining software to optimize and manage the Bitcoin 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 during a set period. In addition, miners are validators, ensuring that transactions are approved and added to the network.

Is Bitcoin Safe?

Bitcoin uses cryptographic data to conduct Peer to Peer (P2P) transactions. Each transaction that occurs 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 successfully penetrate. As Bitcoin is not developed by any government or central body, its value is ensured by the trust users place in its network and its growing adoption. To date, the Bitcoin network has never been hacked or compromised.

Is Bitcoin A Good Investment?

Bitcoin and cryptocurrencies, in general, are highly volatile assets because they are part of an unregulated market. Bitcoin is a new market and behaves like the penny stock market as it can be heavily influenced by external factors, not purely economic - such as social media attention. However, Bitcoin's volatility has an upside because it can generate higher gains than the stock market, which is why investors are increasing their exposure with Bitcoin price estimates by industry experts of more than $100,000 within the next 12 months.

Bitcoin is a good investment despite frequent price corrections and growing concerns around regulations. The Bitcoin price has historically outperformed traditional assets each year. The digital currency has been labeled as the "best-performing asset of the last decade". Furthermore, according to research by Charlie Bilello from the firm Compound Capital Advisors, Bitcoin has produced an average annualized return of 230% which is more than 10 times higher than the second-ranked asset class.

How Do You Buy Bitcoins?

Bitcoin can be bought through cryptocurrency exchanges, brokers or directly from other owners of the asset. The most popular method to obtain Bitcoin is using a cryptocurrency exchange. Other ways include Bitcoin ATM's, peer-to-peer owners, CFD's and index funds. Read our guide on how to buy Bitcoin for a step-by-step tutorial.

  • Centralized exchanges are the most commonly used way to purchase Bitcoin because users have access to a broader spectrum of cryptocurrencies. However, users must register and complete a KYC to interact with the exchange. Fiat to crypto exchanges such as Coinbase and Crypto.com are regulated exchanges, meaning they operate within the boundaries set by governmental bodies. Additionally, trading platforms like Binance are not fully regulated; however, users can still purchase and trade bitcoin with fiat, stablecoins like GUSD or other cryptocurrencies.
  • Decentralized exchanges are a new form of financial interaction as they do not rely on intermediaries such as market makers to conduct transactions. Users need to connect with their wallets to access the DEX - decentralized crypto exchange and swap tokens between one another. A DEX takes funds from a liquidity pool to swap tokens with every transaction taking place on the blockchain.
  • Brokers such as eToro and Plus500 allow investors to gain exposure to Bitcoin through financial brokers that offer several financial tools such as futures that are not available in DEX's or restricted in certain jurisdictions on centralized exchanges. Users have to register with a broker beforehand and have sufficient capital because brokers also ask for a management fee for their services.
  • Cryptocurrency ATMs are available where crypto is legal or regulated, allowing users to purchase Bitcoin or other blue-chip cryptocurrencies. Users can buy Bitcoin at the ATM using their credit or debit card and require a Bitcoin wallet address to receive their BTC into their account.
  • Peer-to-Peer is a straightforward way for users to purchase Bitcoin by having someone send Bitcoin to their address. This can be either as a friend or when purchasing a service such as Paxful. Users need to have a Bitcoin address and ask the buyer to send the transaction to their wallet and provide them with the transaction hash to ensure the transaction has been made.

Where To Buy Bitcoin

The best method to obtain Bitcoin with fiat currency is to use a licensed and trusted provider that is available in your country. These platforms allow Bitcoin to be obtained using the traditional currency and support local deposit methods. Examples of the best Bitcoin exchanges that are available in multiple regions include Binance, Coinbase, FTX, Kraken and Gemini.

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Where Do You Store 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 have the entire block history downloaded to update the token value. Bitpay, TrustWallet, or cryptocurrency exchange's account wallet such as Coinbase are an example 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 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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Kevin GrovesKevin GrovesKevin Groves

Kevin started in the cryptocurrency space in 2016 and began investing in Bitcoin before exclusively trading digital currencies on various brokers, exchanges and trading platforms. In 2019, he started HedgewithCrypto to publish informative guides about Bitcoin and share his experiences with using a variety of crypto exchanges around the world.

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