how does bitcoin work

The COVID-19 pandemic has raised health concerns around using cash for our daily purchases, and this has made people value contactless payments a lot more. However, card payments aren’t the only touchless ways to buy and sell goods.

In recent years, another type of digital payment system has been gaining traction – the Bitcoin system. Today, we’ll talk about the technology behind the world’s first cryptocurrency and its characteristic properties.

The First Cryptocurrency 

The dissatisfaction with our traditional financial system goes back a long way. 

In the late ‘60s and early ‘70s, it had to do primarily with convenience. People started seeing the benefits of contactless payments using credit and debit cards for the first time. But card payments also brought to light the financial system’s centralization and the growing power of governments and financial institutions in the way we manage our finances. 

For central banks to issue credit or debit cards, customers have to provide them with all sorts of personal information. To make transactions, they wait on the bank’s approval. On top of that, customers pay extra fees for the services of these middlemen.

Using cash only doesn’t solve the problem. Fiat currencies are issued and controlled by our governments which determine their value. Moreover, these legal-tender currencies are liable to inflation and devaluation.

To address the privacy issue and find a more cost-effective payment solution, software developers started testing the waters for a decentralized digital payment system. 

In 2008, the cryptographer Satoshi Nakamoto, whose true identity remains a mystery, published Bitcoin: A Peer-to-Peer Electronic Cash System, a whitepaper in which he lay the foundation for the first serviceable digital payment system that replaced the trust in intermediaries with cryptographic proof and its cryptocurrency, Bitcoin.

The software was launched as an open-source in 2009. In order to prevent inflation and create scarcity, Nakamoto hard-capped the total amount of Bitcoin to 21 million bitcoins. At the moment, over 18 million have been mined but experts predict that we won’t run out of new Bitcoins before 2140.

Bitcoin Mining Explained

Blockchain Technology

In the whitepaper, the term “Bitcoin” referred to the whole peer to peer payment network and its distributed ledger technology (DLT). The public ledger records and stores the data in separate blocks that are chained together in a mathematical process using a hash function.  

The hashing process timestamps the transactions and this allows the ledger to keep track of every transaction, add new blocks of data to the chain, and prevent anyone from altering or removing the existing data.

With time, the ledger became known as the blockchain, “Bitcoin” written in capital letters now refers to the payment system, while “bitcoin” and the abbreviation BTC denotes the cryptocurrency.

Proof of Work Consensus 

By now you’re probably wondering about the mechanism behind this peer-to-peer network. How can it be both decentralized and reliable? How does it solve the double-spending problem?

The answer lies in Nakamoto’s consensus method called Proof of Work. This method is used by the network users or “miners” who operate the network nodes to reach a consensus when “mining” bitcoins. 

In the past, you could use your computer to mine bitcoins yourself. Today, the increased mining difficulty requires expensive ASIC miners that can generate enormous computing power, and only companies or mining pools can afford to buy them. 

The nodes need computing power to solve a complex algorithmic problem, verify the incoming Bitcoin transactions, and mine the next blockchain block. Bitcoin miners run the data through an SHA-256 hash function that outputs a 32-byte hash value. Miners attempt multiple times before they get the right hash value in order to mine the next block. 

Every new block contains the hash value of the previous one. This not only prevents double-spending, but it also makes it impossible for outsiders to change the data because they would have to rewrite all the previous hash values, and this requires an unfathomable amount of computing power.

The miner broadcasts the solution to the rest of the Bitcoin network and waits for other miners to accept it and continue adding new data to it. On the Bitcoin blockchain, the mining difficulty adjusts so that a new block is generated every 10 minutes regardless of the number of miners.

The Halving

Miners earn a reward for mining new blocks. When Bitcoin was launched in 2009, the mining reward used to be 50 BTC per block. However, every 210,000 blocks the reward is cut in half. This event happens approximately every four years and is known as the halving or halvening.

The first halving took place in November 2012 when the miners started earning 25 BTC per block. In July 2016, the reward was reduced to 12.5 BTC. Finally, since May 2020, the miners have been making 6.25 BTC for every new block

Once all 21 million BTC are mined and there are no more halvings, transaction fees might be the only incentive for miners to keep verifying new transactions.

Bitcoin Pros and Cons

Why would anyone decide to use Bitcoin over traditional currencies?

First of all, Bitcoin payments are really cost-effective, especially international ones as you don’t lose money on exchange rates.

Bitcoin isn’t issued or regulated by any central authority. Instead, it’s up to the Bitcoin users and miners to keep the peer to peer network running. It also has a higher level of security. As we already explained, it’s almost impossible to surpass the amount of computing power of the Bitcoin nodes and alter the blockchain data.

Next, Bitcoin offers more privacy because you don’t have to reveal your real-world identity when creating a Bitcoin address on the blockchain. Instead of your real name, what other users see is an encrypted address called a public key

This is the address that others can use to send you BTC. When you make a transaction yourself, you sign it with a private key that only you have access to.

On the other hand, Bitcoin and digital currencies, in general, are notorious for their volatility. Their prices go up and down based on the market climate and demand. However, as the first and most popular crypto, the price of Bitcoin remains pretty stable in comparison to altcoins.

Where Can You Buy Bitcoin?

Now that you know the basics of Bitcoin, if you’re interested in making your first Bitcoin investment, the easiest way to buy any virtual currency is through cryptocurrency exchanges. It’s important to find a reliable one because you want to avoid potential Mt. Gox scenarios.  

One of the most popular Bitcoin exchanges is Coinbase, a US-based brokerage that you can access from your computer or smartphone. Once you register and link your bank account, Coinbase allows you to buy, sell, trade, or transfer Bitcoin via ACH, wire transfers, or debit card payments (credit cards aren’t supported).

This platform also provides a secure digital wallet, so you don’t have to look for third-party Bitcoin wallet providers. 

Purchasing Bitcoin with cash is only possible on peer to peer exchanges where you can find nearby sellers that would accept to meet you in person or use a local Bitcoin ATM instead.

Notice: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. Authors may own the crypto currency they discuss. The information and content are subject to change without notice. Visionary Financial and its affiliates do not provide investment, tax, legal or accounting advice. This material has been prepared for informational purposes only and is the opinion of the author, and is not intended to provide, and should not be relied on for, investment, tax, legal, accounting advice. You should consult your own investment, tax, legal and accounting advisors before engaging in any transaction. All content published by Visionary Financial is not an endorsement whatsoever. Visionary Financial was not compensated to submit this article Please also visit our Privacy policy; disclaimer; and terms and conditions page for further information.

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