Man's hand holding a bitcoin

What Is Bitcoin, And How Does It Work?

11-minute readApril 14, 2021

Bitcoin has come a long way from being a triviality paid attention to buy technology enthusiasts and experts in high finance to become a topic of the 21st century zeitgeist. Still, there’s a certain amount of black box mysticism surrounding Bitcoin and cryptocurrency in general. It’s still worth asking the question: What Is Bitcoin and how does it work? You’ll find the answers here.

In addition to this, we’ll cover how Bitcoin can be used, how it’s earned and a few frequently asked questions. Before we get there though, let’s make sure we touch on the basics of cryptocurrency.

What Is Cryptocurrency?

Bitcoin is a type of cryptocurrency, which is a decentralized virtual currency. Unlike most traditional currencies that are based on paper and coins, there is no central bank that issues and controls the money supply. Rather, everyone has a record of every transaction. Money is sent from person to person with others in the chain verifying transactions by solving complex math problems.

We’ll go much deeper into how all this works in later sections, but for now, think virtual currency handled based on peer-to-peer transactions with no centralized bank controlling it all.

What Is Bitcoin?

Bitcoin is just one of many cryptocurrencies, but it’s certainly the one that’s the most popular and has captured the attention of the public. Bitcoin with a B is the system of cryptocurrency, while bitcoin with a b represents a single unit of that cryptocurrency.

Bitcoin has a goal of improving on the existing monetary systems in several ways. For starters, transactions are secured by very strong encryption, so you don’t have to worry about someone getting in the middle of the transaction and taking money from either the party paying or the party being paid.

If parties are using bitcoins in an international transaction, you don’t have to wait for the banks to clear it and do a currency exchange. It’s also possible with some effort to anonymize yourself during the transaction.

As a virtual currency, bitcoins don’t have a physical form. They exist entirely digitally. Although Bitcoin was early to the game, it’s no longer the only game in town. Some major competitors include Ethereum and Litecoin, with new upstarts in the cryptocurrency space constantly joining the market. Still, by market cap, the total value of Bitcoin is just over four times the value of its nearest competitor, Ethereum, according to data from early April 2021. There are even several competitors that have been split off from the original Bitcoin code base, so when viewing the value of the original bitcoin on any given day, you’ll see it abbreviated BTC.

While the concept for cryptocurrency has been around since at least 1998, the initial code and proof of concept was created in 2009 and shared with the cryptography mailing list by Satoshi Nakamoto. Not much is known about Nakamoto’s identity and it could be a pseudonym, but he made the project open source, which allows others to examine the code and make changes to the algorithm and other operational parts of the currency system. However, for the changes to be adopted into the code base, the community as a whole has to agree to them.

The open-source nature of Bitcoin has led to some of its competition. If a group doesn’t have the votes to get some change made to the system itself, they can take the existing code and spin it off. Any changes made after that point are considered a fork of the original system and a separate cryptocurrency. This has led to competitors like Bitcoin Cash and Bitcoin SV.

How Does Bitcoin Work?

If you’ve read any news stories about Bitcoin, you probably have seen that it operates on something called blockchain technology.

A good analogy for blockchain is a checkbook. Initially, the blockchain is just a record of a bunch of data that can’t be changed once it’s been added to the ledger. But imagine if you shared copies of that checkbook with the rest of the members of your family. Further, imagine that when your son or daughter entered something new into the checkbook, all the copies of the checkbook updated. This is essentially how blockchain works. It’s a continuously synced record owned by no single person – a public ledger. Although the concept of blockchain was initially developed for Bitcoin, it’s now being used in fields as diverse as shipping logistics and car mileage tracking.

The Bitcoin network is an example of peer-to-peer lending or transactions. The bitcoins can be transferred from one person to another, and because everyone has a copy of the decentralized ledger and can verify transactions, there’s no need for a central authority like a bank.

In order to verify that the transactions are legitimate, they have to be verified by other users on the network. This is done by having the transaction recorded in a block and verified by having someone solve a mathematical proof-of-work tied to that transaction. Because the mathematical equations are so complex, people called bitcoin “miners” use specialized computer equipment to solve these cryptographic challenges. In exchange for doing the work of solving these transactions, which is only possible by testing billions of calculations per second, they get paid in bitcoins.

Because Bitcoin relies on a peer-to-peer system, all transactions are stored collectively across everyone’s computers as transactions are constantly confirmed and added to the blockchain. Any bitcoins you have are kept in a wallet with a private key that is either on your computer or other digital device, or any service that stores this for you.

What Is Bitcoin Worth, And How Is It Determined?

We often don’t think of actual money this way, but like any other tangible item, there’s a supply and demand for currency. If the United States decides to print more money, the money currently in the market holds less value. If the U.S. decides to take money out of circulation, the money that’s still being circulated has greater value, but it’s also harder to get money if you want to borrow it for loans.

The fact that the supply of bitcoins is algorithmically controlled should theoretically over time stabilize the value of the currency. However, there’s a relatively small market in comparison to the overall supply of other currencies while bitcoins are still being released into circulation and the market is maturing. Because of this, it doesn’t take a ton of money moving around to significantly change the value of individual bitcoins.

The market for bitcoins has been extremely volatile over the years. One of the early rallies in the currency’s value started in April 2013 when the price of one bitcoin was around $13.50. By October, it was around $195. Then the equivalent of the gold rush started as the price of a single bitcoin was up around $1,075 by the end of November. This was because all sorts of new exchanges for the currency and miners were entering the marketplace at once. One of the biggest exchanges was Mount Gox. This is where many stored their bitcoins and made trades.

Then rumors started that the security of Mount Gox was lacking and there was potential fraud. People were reporting issues withdrawing money and quite a large percentage of bitcoin disappeared with no explanation. By the time the fallout from all this was totally finished, the price ended up bottoming out at $315 in the beginning of 2015. Heightened demand pushed the price back up to $1,000 by 2017. By the end of that year, the value of a single bitcoin was $20,000. At this point, analysts were making comparisons to the Dutch enthusiasm for tulips in the 17th century. Much like that bubble, the price of a bitcoin started to crater and was below $3,500 in November 2018. Because of speculation, the market is extremely volatile.

As of the date of this writing (April 7, 2021) the current price of one bitcoin was hovering around $55,869.20, according to the Coinbase exchange. It’s important to note that there is some variance depending on which Bitcoin exchange you use.

How Is Bitcoin Different From Traditional Currencies?

As a monetary system, Bitcoin differs from fiat (traditional physical) currencies in several important ways. Let’s touch on these now.

Bitcoin Is Decentralized

As a monetary system, the fact that everyone has a record of all the transactions and no single entity is in charge of the money supply makes Bitcoin unique. For perspective, we can compare this with the U.S., where the Treasury Department can both print money and control exactly how much is available in the economy because the dollar is a fiat currency.

The Federal Reserve, the central bank of the U.S., also has some influence to exert here because banks across the country are influenced by how much interest they can earn for investors by keeping that money. When interest rates are lower, banks make more loans because they don’t make as much money by holding onto current reserves. On the other hand, when the Federal Reserve wants to encourage Americans to save money and cool inflation pressures, the Federal Open Market Committee raises interest rates.

With Bitcoin, no one is in control and the money supply is controlled by a combination of the algorithm and market forces.

Supply Is Limited

The supply of bitcoins in the market will only ever be 21 million. By contrast, countries all over the world can print money and take it out of circulation essentially as they please. This can work as a bit of a hedge against inflation, although you can have fractions of a bitcoin. With the subdivisions, there’s no theoretical limit to the amount of bitcoin.

The Process Is Pseudonymous

You have the ability for Bitcoin transactions to be anonymous if you take the proper steps, and you’re always in control of your wallet as opposed to having to handover a credit card to someone.

When you make and receive payments in bitcoin, you’re not sending money from Joe Smith to Jane Doe. Rather, Joe and Jane would share a Bitcoin address. This acts as a public key where the money can be sent. These addresses allow people to make and receive payments and are the way that the transactions are stored and verified in the Bitcoin blockchain. It’s not truly anonymous because the transactions are verified by other people and therefore, they can see things like beginning and ending balances and that the money actually went from one person to another.

Because a Bitcoin address is written in the chain forever, it’s possible over time to figure out addresses that correspond to people. To guard against this, you can generate a new address within the app each time you receive a payment. However, because you usually have to identify yourself to receive goods and services, it’s very hard to be completely anonymous with anything other than actual cash.

Transactions Can’t Be Reversed

With a credit card, if someone gets your number and makes a bunch of fraudulent transactions, these are often pending for a while and can thus be reversed. With Bitcoin, every transaction is permanently written into the blockchain. Because of this, all transactions are final.

That’s not to say you can’t get a refund on a good or service. The merchant would just have to record a separate transaction paying you back.

There Are Tiny Denominations

In the U.S., we have the penny which is 1/100 of a dollar. With Bitcoin, because there’s a finite supply of 21 million BTC after which no new bitcoins will be created, the plan for the flow of commerce is to subdivide into an essentially endless number of decimals. Essentially, they want to be able to make the denominations small enough to support the free flow of commerce at all times when the value of bitcoins is compared against that of other currencies.

How To Get Bitcoins: Buying It And Mining It

There are several ways to obtain bitcoins. The simplest is to accept it as a form of payment for your goods or services. You can set up a Bitcoin wallet along with a payment terminal that accepts the coins. A terminal may not even be necessary as the details of the transaction can be exchanged between apps on phones.

The second way to get bitcoins is to buy them from an exchange. People make their bitcoin investments available for trading and you can buy it like you would buy a stock or bond. There are various exchanges where you can buy bitcoin. You should shop around to get the best price.

The final way is through bitcoin mining. Bitcoin miners get paid for verifying the transactions that are taking place on the Bitcoin network. Without the miners, the payment system doesn’t work.

This work is done by solving an extremely hard mathematical proof. Essentially, computers test a ton of calculations until they get the answer that solves and verifies the new transactions. The people who do this have set up entire buildings with the computers to do this specialized work. That’s a lot of computing power. So, it’s an investment to get into that game.

How To Use Bitcoin

Once you have bitcoins, there are several ways to use them. You can make payments to friends and merchants on your computer or from your phone. There are even point-of-sale terminals that support the transactions.

Beyond purchasing power, you can also use one of the exchanges to trade them as an investment in the same way you would for any other part of your portfolio.

Potential Dangers Of Bitcoin

As with any investment and indeed any currency, Bitcoin has some risks associated with it. Let’s run through a few of these.

  • Volatile value: As mentioned above, the exchange value of bitcoins to any other physical currency is very up and down. If you’re looking for something that’s a stable store of value, this isn’t it at the moment. The price can also vary between the Bitcoin exchanges.
  • Payments aren’t reversible: Once a transaction is made, it’s permanently written into the blockchain record, so you may have a hard time getting your money back. This would require a separate transaction. 
  • Transactions may be unsecured: Because of the transparency that’s built into the system, it’s possible to figure out who is making what transactions if addresses aren’t being swapped out frequently. Additionally, if you put your money into cryptocurrency exchanges or digital wallet services, you’re putting your trust into their security practices rather than relying on your personal wallet. There’s also no FDIC guarantee like there would be on your bank account if things were to crash. If you lose your private key, you lose your bitcoins.

Is Bitcoin A Good Investment?

Those looking at bitcoins as a potential investment opportunity should have a healthy appetite for risk. While it’s true that there is the potential to make a lot of money, there’s also the potential to lose a lot of money with an investment that is this up and down.

For most people, it’s probably best to wait on investing in bitcoins until the market stabilizes. In any event, if you’re considering dabbling in bitcoins, you should speak to a financial advisor.

Bitcoin FAQ

Now that we’ve taken a deep dive into how the whole thing works, let’s take a minute to answer several frequently asked questions. 

Is Bitcoin Legal?

Countries have generally declared Bitcoin to be legal. With that said, it’s important to note that no country has adopted Bitcoin or any other virtual currency as its legal tender. At some point, if you were to want that money invested in the bank, you would have to convert it to dollars in the country where you reside or are investing. Per IRS guidance, bitcoins and similar forms of cryptocurrency are treated as personal property for tax purposes.

How Many Bitcoins Are There?

There are 21 million total bitcoins in the world supply. The algorithm is set up such that that’s all there will ever be. When they run out of new coins to mine, the existing coins will be subdivided, so there’s no theoretical problem with this limitation of the money supply. It seems that 21 million is probably an educated guess. The goal was to get it so that by the time the currency was subdivided into 0.001 BTC, it would be worth about one unit of whatever traditional currency it was being converted into or compared against. The actual math to getting to that 21 million number has to do with the number of blocks being added into the blockchain every hour for 4 years multiplied by the size and the rewards to miners from verifying transactions. 

What Is Bitcoin Halving?

As mentioned above, people who verify Bitcoin transactions, also known as miners, are rewarded with bitcoins. Because there are only ever going to be 21 million blocks in the chain, the number of bitcoins given first solving one of these mathematical proofs is halved every 210,000 blocks. The current word for validating each new block is 25 bitcoins. 

What Can I Buy With Bitcoin?

Bitcoin is a digital currency designed to spend like cash. In theory, you can use it to buy anything. There’s one well-known story where a programmer traded 10,000 bitcoins for two pizzas. Given the value, I imagine he now regrets this.

The catch here is that you have to make sure the retailer or institution is willing to accept bitcoins. Whether they’re likely to do that may depend on the transaction. As an example, your mortgage servicer may be unlikely to let you make your payment with bitcoins anytime soon because of the volatility of the currency. How do you know what the bill was if you can’t count on a stable conversion rate?

Summary

Bitcoin is the best-known and most valuable of a new class of virtual currency. With Bitcoin, all transactions are digital, recorded and verified in a transaction log known as a blockchain. As with any currency, its value is determined by the law of supply and demand, but as a currency that has yet to gain wide adoption and stabilize, the value of individual bitcoins is more volatile than most other investments.

Be sure to review the pros and cons of investing in bitcoin as you would any other financial investment. And for more information on all things personal finance, check out the Rocket HQSM Learning Center.

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