What is Bitcoin and How Does it Work: The Complete Guide

·

The questions on many people's minds since 2017 have been: what is Bitcoin and how does it work? Bitcoin is a word formed by combining two others: 'Bit' and 'Coin'. If you break down the information inside computers into small pieces, you'll find 1s and 0s. These are called bits. You surely know about coins.

So, what are Bitcoins?

Bitcoins is the plural form of Bitcoin. They are coins stored on computers. They have no physical form and exist only in the digital world! This is why Bitcoin and other cryptocurrencies are often called digital currencies.

It might seem a bit confusing at first, but in this guide on what Bitcoin is, I will explain it in the simplest way possible—welcome to Bitcoin for beginners! By the end of this guide, even complete newcomers will understand what Bitcoin is, how to buy it, and how to use it. Let's get started!

How Does Bitcoin Work? Why Was Bitcoin Invented?

Let's start with the fundamentals...

There are three types of people in this world: the producer, the consumer, and the intermediary. If you want to sell a book on Amazon, you have to pay a 40-50% commission. It's the same in almost every industry! The intermediary always takes a large portion of the producer's money.

To understand what Bitcoin is, it's important to know why it was created. Bitcoin was invented to eliminate one type of intermediary—banks. If you need to transfer $5000 from your country to your friend in the UK, the money must pass through a bank in your country, which will take a commission for the process. Once the money arrives in the UK, your friend's bank will also charge a fee.

The problem isn't just the fees; it's also the data they store. Banks store a lot of private data about their customers. Many banks have been hacked over the last 10 years, which puts their users at risk. This is why it's important to understand how Bitcoin works.

Furthermore, banks can freeze or block people's accounts whenever they want. They have too much control over the people who use banks and have abused their power. They also played a significant role in the 2008 financial crisis. Bitcoin began in 2009, right after that crisis, leading many to believe the crisis was one of the motivations for creating Bitcoin.

Who created Bitcoin? The creator of Bitcoin is unknown. The name used was Satoshi Nakamoto, but it is a pseudonym, and no one knows who the real creator was.

The solution was to create a system without a single authority (like a bank), so no single entity has the power to control people. Banks and governments also control currencies, so a new currency had to be created.

Bitcoin is the solution: it has no single authority. This means that banks, PayPal, or governments telling a bank to freeze your account are not needed. It's incredible, right? What everyone is surely wondering at this point is, 'what is Bitcoin and how does it work?'.

How Bitcoin Functions: Core Concepts

The creator of Bitcoin established three main concepts essential to its operation:

Let's explore each concept in detail.

Decentralized Networks

When you open your browser and type 'www.google.com', your computer starts a conversation with Google's computers. Then, both computers begin talking to each other, and your browser displays images, buttons, etc. If Google's servers go down for some reason, you won't be able to see these images and buttons. This is because the data is stored on a centralized network—everything is in one place.

To understand how Bitcoin works, it's essential to understand a decentralized network. In a decentralized network, the data is everywhere. If Google used a decentralized network, you could still see the data, those images and buttons, because they would be everywhere and not just in one place. This means Google would never stop working!

Cryptography

Cryptography was used extensively during World War II. It converted radio messages into a code that no one could read. To read them, you needed to return them to the original message. To do that, you needed a key. This was possible through mathematical formulas!

Bitcoin uses cryptography in the same way. Instead of converting radio messages, Bitcoin uses cryptography to convert transaction data. This is why Bitcoin is called a cryptocurrency. Knowing this brings you closer to understanding how Bitcoin works.

Bitcoin achieves this by using the blockchain. The creator of Bitcoin invented blockchain technology!

Supply and Demand

Last week when Juan visited the bakery, only one cake was left. Four other people also wanted it. Normally, the cake only costs $2. But because other people wanted the cake, he had to pay $10 for it.

This is the main concept of supply and demand: when something is limited, its value increases. The more people who want it, the higher the price will go. It's the same with vintage collector cars.

Bitcoin uses this same concept. The supply of bitcoin is limited. Bitcoin is produced at a set rate, which is reduced over time—it halves approximately every four years. Bitcoin has a cap of 21 million coins; once 21 million Bitcoins exist, no more can be created. How many Bitcoins exist currently? Well, as of mid-2023, over 19 million Bitcoin have been created. There is still a very, very long time until it reaches 21 million!

So, that partially answers "what is Bitcoin and how does it work?" but it's not the complete answer. To understand Bitcoin's operation, we need to move on to Bitcoin transactions...

How Are Transactions Carried Out?

Now, let's see how these concepts work together. To record transactions, we need to put them in a database (like an Excel sheet).

This would normally be saved in one location on a centralized network. But because Bitcoin uses a decentralized network, the Bitcoin database is shared. This shared database is known as a distributed ledger and is accessed through the blockchain.

To send Bitcoin to someone, you need to digitally sign a message saying "I am sending 50 Bitcoins to Peter." The message will then be broadcast to all computers on the network, which will store your message in the database/ledger.

Key Security Features

Can someone steal my identity?
When you create your Bitcoin wallet (to store your Bitcoin), you receive a public key and a private key. Public and private keys are a long combination of numbers and letters; they are like your username and password. Both are very important for understanding how Bitcoin works.

People need your public key if they want to send you money. Since it's a combination of numbers and letters, no one needs to know your name, email, etc. This makes Bitcoin users anonymous!

As for your private key, you should never let anyone see it. On the blockchain, your private key is your identity. You use your private key to access your Bitcoin. If someone sees it, they can steal all your Bitcoin—be very careful!

So, technically, your identity can be stolen. If someone obtains your private key, they can use it to send Bitcoin from your wallet to theirs. For this reason, you must keep your private key very, very secure. However, your true identity (your name, address, etc.) cannot be stolen because you don't need it to send or receive Bitcoin.

Can someone spend the same Bitcoin twice?
Bitcoin transactions are grouped and stored in blocks. These blocks are linked together in a series. This is why it's called a blockchain, or chain of blocks.

Each transaction in the block is assigned a public key. If it's your Bitcoin, your private key will be what is written. Because each block is connected to the previous one, no Bitcoin can be used twice.

If someone tried to send the same Bitcoin twice, here is what would happen:

  1. David sends one Bitcoin to Juan.
  2. The transaction is stored in a block on the blockchain.
  3. The next day, David tries to send the same Bitcoin to someone else.
  4. The Bitcoin transaction goes to the same block on the blockchain.
  5. The computers running the blockchain check the last block where the Bitcoin was used.
  6. In the last block where the Bitcoin was used, the transaction says the Bitcoin was sent to Juan's public key.

Since it's not Juan's public key where the Bitcoin is being sent in the current block, the computers running the blockchain do not allow the Bitcoin to be used.

What if someone tries to alter the blocks?
If someone tries to change the transaction data in one of the blocks, they will only change it in their own version, like a Microsoft Word document saved on your computer.

To make the change, they would need to do it in the shared database, which is everyone's version. To achieve this, they would need to control 51% of the computers on the network.

What if someone controls 51% of the computers on the network?
This is possible but almost impossible to achieve. Even if someone hacked 51% of the computers on the network (also known as nodes), there is another security barrier in their way.

To add new blocks to the blockchain, they must be mined. This process is called mining because the nodes that do it are rewarded in Bitcoin—like gold miners being rewarded with gold.

In mining, nodes must process Bitcoin transactions and verify their authenticity. To do this, they must solve a mathematical problem. When the problem is solved, the block of transactions is verified, and a new block is created. Each block has a new problem and a new solution for the miners to find.

The first node to solve the problem gets new Bitcoins. Mining uses a lot of electricity, so miners are remunerated!

Here's what would happen if a hacker controlled 51% of the nodes and tried to change a block:

  1. The hacker changes the data in the block so the Bitcoin is sent to their public key.
  2. Because the data in the block has changed, there is a new mathematical problem, and the hacker must solve it.
  3. The electricity the hacker needs to solve the problem costs more than the Bitcoin in the block is worth.
  4. The hacker could continue and solve the problem but would lose money.

As you can see, it would be almost useless for a hacker to complete an attack on the blockchain. This is why it is so secure. For those looking to track these complex processes in real-time, you can view real-time tools that monitor blockchain activity.

What Are the Advantages and Disadvantages of Bitcoin?

You probably already know most of Bitcoin's advantages after reading this far into the guide. However, I haven't talked much about the disadvantages, right? There are also some advantages I haven't covered, so let's start with the advantages and then examine the disadvantages. Afterward, you'll know perfectly and be able to explain like an expert—what Bitcoin is and how it works.

The Advantages of Bitcoin

No Verification for New Users: Why This is So Important
With Bitcoin, anyone anywhere in the world can send money to others. It doesn't have a KYC (Know Your Customer) process—you don't need identification to open a Bitcoin wallet.

With a bank, you need identification when you apply for an account. For this reason, hundreds of millions of people around the world do not have bank accounts. They cannot send or receive money. But now, with Bitcoin, it is possible!

International Payments: A Major Advantage
If you want to send an international payment, it normally takes your bank 3+ days, and they will charge you a fee of $10-15 or more. It's different in each country, but it remains expensive and slow.

If you send it using Bitcoin, it will only take about 10 minutes. Sometimes it takes a little longer (up to an hour or more), but it's still much faster than the 3+ days banks take. The fee Bitcoin charges changes a lot, and developers try to keep it as low as possible. It is often significantly lower than traditional wire fees.

It's cheaper because there are no intermediaries to pay (like banks, PayPal, etc.)! This is precisely what Bitcoin is about.

The Disadvantages of Bitcoin

Fees and Speed: Bitcoin's Evolution
Bitcoin started in 2009—that's over a decade ago! Since then, new cryptocurrencies have been created that are faster than Bitcoin in terms of transactions per second. In the past, Bitcoin fees have also risen significantly during periods of high demand.

The fees increased largely because Bitcoin's popularity was too much for the network—too many people were using it. This is something Bitcoin developers are trying to improve with network upgrades, and progress is being made.

Bitcoin Isn't Very Easy to Use
Private keys, public keys, opening and using a wallet, etc. It's not very easy for people who don't know much about computers. When you want to send a payment to someone, you have to type a long combination of numbers and letters (their public key) into your computer. User experience continues to improve with newer wallets and services.

Electricity and Environmental Impact
As mentioned before, the electricity costs for mining are high. Miners are rewarded with Bitcoin so they can continue to make money. However, the electricity used by miners affects our environment (now you know a downside of how Bitcoin works).

Other cryptocurrencies use different mining systems that use much less electricity. This system is called PoS (Proof of Stake).

Remember that in the Bitcoin system, the miner who verifies the block first is the one rewarded with Bitcoin? This system is called PoW (Proof of Work). It's like a race, right?

Proof of Work
All miners work on the same block at the same time, trying to win the race. This means all miners are using electricity for every block that is created.

Proof of Stake
In Proof of Stake, or PoS, only one miner can mine the block. When the next block is created, another miner is chosen to mine it. This way, only one miner is using electricity for each block. It's much cheaper and better for the environment!

Bitcoin's Criminal History
Since you don't have to use your identity, Bitcoin has often appeared in the news for being used by criminals. You've probably heard of something called Silk Road. This was a market on the dark web—an anonymous part of the internet accessed using a special browser.

On Silk Road, you could buy many illegal things, and Bitcoin was the currency used. Silk Road started in 2011 but was shut down in 2013 by the FBI.

This was very bad for Bitcoin, and some governments tried to ban Bitcoin for this reason. This is the most famous example of Bitcoin's misuse, although crime can occur with any type of currency.

How Can I Buy Bitcoin?

Now that you know what Bitcoin is, how it works, and its positives and negatives. The only thing left to explain is how to buy it. So, how do you buy Bitcoin?

There are three main options.

Exchange Broker

This is the simplest method, but you normally have to use your identity. This means using your name, address, and driver's license/passport. The fees for a currency exchange broker typically cost 1-5%, but it depends on your location and payment method.

The good thing is you can pay via bank transfer, debit/credit card, and even PayPal. Using an exchange broker is like going to a travel agent to convert your local currency into foreign currency (like USD for JPY, for example).

P2P Exchanges (Peer-to-Peer)

These are like exchange brokers but don't use an intermediary—there's no broker. For example, Juan can send money to Amy, and Amy sends Juan some Bitcoin. There's no broker, so they pay no commission fees!

Amy will always have to pay Juan the Bitcoin because peer-to-peer exchanges use an escrow service. When Juan requests Bitcoin from Amy, the Bitcoin is sent to escrow. When Juan pays Amy her money, the escrow releases the Bitcoin to Juan. Juan and Amy have no control over the escrow, so it's always fair. Fair exchange is essential to understanding what Bitcoin enables.

Some sellers on P2P exchanges will ask for identification, some will not. So, it is possible to use P2P exchanges to buy Bitcoin anonymously. You can even pay with cash (paper money)! You can also pay with a bank transfer.

Bitcoin ATMs

This would be the least common place to buy Bitcoin. There aren't many Bitcoin ATMs in the world, so you must use online maps to find one near you. If there is one, you can go and buy Bitcoin with cash, but the fees are high—typically 5-10% or more.

Frequently Asked Questions

What is Bitcoin in simple terms?
Bitcoin is a digital currency that operates without a central bank or single administrator. It's a form of electronic cash that allows online payments to be sent directly from one party to another without going through a financial institution.

How does Bitcoin have value?
Bitcoin derives its value from a combination of factors: its limited supply (capped at 21 million coins), its utility as a decentralized payment network, the cost of electricity required to mine it (Proof of Work), and market demand from those who believe in its potential as a store of value or medium of exchange.

Is Bitcoin legal?
The legality of Bitcoin varies by country. In most major economies, owning and trading Bitcoin is legal, but it is often subject to regulations concerning taxation and anti-money laundering (AML). Some countries have restrictions or outright bans. It's crucial to check the specific regulations in your jurisdiction.

Can Bitcoin be converted to cash?
Yes, Bitcoin can be converted to cash, often called "cashing out." This is typically done through cryptocurrency exchanges that allow you to sell your Bitcoin for traditional currency (like USD, EUR, etc.), which you can then withdraw to your bank account. Some P2P platforms and Bitcoin ATMs also offer this service.

What is the difference between Bitcoin and blockchain?
Blockchain is the underlying technology that powers Bitcoin. It is a distributed, immutable digital ledger that records transactions. Bitcoin is a specific application that uses blockchain technology to function as a cryptocurrency. Think of blockchain as the operating system and Bitcoin as one app running on it.

How long does a Bitcoin transaction take?
Bitcoin transaction times can vary. On average, a transaction is included in a block and receives its first confirmation within about 10 minutes. However, for larger transactions or during periods of network congestion, users may wait for multiple confirmations (each taking ~10 minutes) for higher security, potentially taking an hour or more.

Conclusion

The creation of Bitcoin is just the beginning. Some people are using Bitcoin and other cryptocurrencies instead of banks, but they haven't completely replaced banks yet. What do you think? Do you think Bitcoin will replace banks? Or does it need to improve first?

By answering the questions above, you can test what you've learned in this guide. You can also try to answer "What is Bitcoin and how does it work?" in three sentences. Give it a try—it will help you remember what you've learned.

Finally, remember to use caution and only interact with reputable platforms when dealing with cryptocurrency. To explore the technical aspects behind these platforms further, you can explore more strategies for engaging with digital assets.

Let's review how to buy Bitcoin one more time.

  1. Get a reliable cryptocurrency wallet where you can keep your assets protected. Hardware wallets are often recommended for security.
  2. Register with a well-known and regulated exchange platform.
  3. Buy Bitcoin using your local currency or another available method.
  4. Copy your Bitcoin wallet address from your personal wallet.
  5. Send your Bitcoins from the exchange to your secure wallet for safekeeping.

That's it—now you have Bitcoins!

The content published on this website is not intended to provide any form of financial, investment, trading, or any other kind of advice. BitDegree.org does not endorse or suggest buying, selling, or holding any cryptocurrency. Before making financial investment decisions, consult your financial advisor.