What is Bitcoin, and how does it work?

Key takeaways

• Bitcoin is a decentralized digital currency operating without a central authority. It was created to address weaknesses in traditional financial systems.
• Bitcoin operates on blockchain technology, ensuring secure and transparent transactions, and it uses a mining process to add new blocks to the chain.
• Bitcoin’s benefits include decentralization, security, accessibility, and privacy, but it also faces challenges like scalability and high transaction fees.
• The future of Bitcoin includes developments like the Lightning Network for faster transactions and support for non-fungible tokens (NFTs), but it also faces competition from other cryptocurrencies and the rise of stablecoins.

Bitcoin for beginners

Bitcoin (BTC) has become so mainstream that it has been mentioned on an album by global superstar rapper Eminem, appeared in the popular series The Big Bang Theory, and continues to grow in pop culture and everyday discourse.

Those who do hold Bitcoin can withdraw their crypto in cash anywhere in the world, with many online retailers and even physical stores accepting the digital currency as legal tender. 

But what is Bitcoin? 

A popular and often-used Bitcoin definition is:

Bitcoin is a decentralized digital currency that operates without a central authority.

However, questions still remain: How does Bitcoin work? Is Bitcoin real money? What is the blockchain? Even, “What is crypto?”

This article discusses the basics of Bitcoin to help people understand what it is today. It covers its history as the first crypto, its comparison with traditional money, how to buy it and its use as a speculative asset.  

Why was Bitcoin created? 

For centuries, people have relied on various forms of currency, from shells and stones to gold and government-issued paper money. However, these traditional financial systems have always carried certain vulnerabilities. 

Centralized control by banks and governments means that single entities can print or manipulate money at will, leading to issues like inflation. 

Traditional financial systems are often slow and inefficient. Transferring money across borders, for example, can take several days and incur high fees. For many people around the world, especially those in developing countries, access to banking services is limited or non-existent, leaving them excluded from the global economy.

The birth of Bitcoin

During the 2008 financial crisis, a mysterious figure named Satoshi Nakamoto proposed a radical solution: Bitcoin. Nakamoto’s vision was a decentralized digital currency that operated on a peer-to-peer network, allowing people to transact directly without the need for intermediaries like banks. 

This innovation was built on a groundbreaking technology known as blockchain, which ensures the security and transparency of transactions.

Did you know? The first recorded use of a digital currency was in the early 1990s with a system called eCash. However, it wasn’t until Bitcoin’s introduction in 2009 that digital currencies truly took off, thanks to its innovative use of blockchain technology and decentralized network.

Bitcoin was created to address the fundamental monetary problems that emerged following the 2008 crisis. It offered a fixed supply of 21 million coins, making it a deflationary asset over time. Its decentralized nature meant that no single entity controlled it, providing protection against the risks of centralization. 

As a result, Bitcoin transactions have become fast, borderless and cost-effective, opening up financial opportunities to millions of people previously excluded from the system.

Bitcoin history: A timeline of key events and milestones

Learn about the fascinating history of Bitcoin, its key events and the turning points that have influenced the cryptocurrency industry. 

• 2008: Satoshi Nakamoto published the Bitcoin white paper on Oct. 31.
• 2009: The first Bitcoin block (Genesis Block) was mined on Jan. 3.
• 2010: The first real-world Bitcoin transaction occurred, with a Bitcoiner paying 10,000 BTC for two pizzas on May 22. BitcoinMarket.com — the first Bitcoin exchange — is established.
• 2011: Bitcoin reached parity with the United States dollar in February. The Silk Road darknet marketplace launched. Litecoin (LTC) was released in October.
• 2012: The first Bitcoin halving occurs on Nov. 28.
• 2013: Bitcoin’s price surpassed $100 in April and $1,000 in November. The US Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued guidelines for digital currencies. China’s central bank prohibited financial institutions from using Bitcoin.
• 2014: Mt. Gox exchange collapses in February. Microsoft begins accepting Bitcoin.
• 2015: The BitLicense regulatory framework is introduced in New York.
• 2016: The second Bitcoin halving occured on July 9. By year-end, Bitcoin’s price rose to nearly $1,000.
• 2017: Bitcoin reached an all-time high of $19,000 in December. Bitcoin Cash (BCH) was created on Aug. 1. The Chicago Board Options Exchange and Chicago Mercantile Exchange launched Bitcoin futures trading.
• 2018: Bitcoin’s price dropped to around $3,000 by December. Major companies were exploring blockchain technology. The Lightning Network is launched.
• 2019: Bitcoin’s price recovered to around $10,000 by mid-year. Facebook announced its cryptocurrency, Libra (later Diem).
• 2020: The third Bitcoin halving occurred on May 11, with increased interest in Bitcoin as a store of value due to the COVID-19 pandemic.
• 2021: Bitcoin reached a new all-time high of over $60,000 in April. Tesla bought $1.5 billion in Bitcoin and briefly accepted it for payments. El Salvador adopted Bitcoin as legal tender in June. China intensified its crackdown on crypto mining and trading.
• 2022: Bitcoin’s price fluctuates between $30,000 and $60,000. The SEC approves the first Bitcoin futures ETF. Ethereum transitions to proof-of-stake.
• 2023: Bitcoin gains acceptance among institutional investors and businesses. Brazil and Argentina explore adopting Bitcoin as legal tender. Developments in decentralized finance and NFTs integrate Bitcoin further into the crypto ecosystem.
• 2024: The fourth Bitcoin halving occurs, reducing the mining reward to 3.125 BTC. Bitcoin adoption continues to grow. Technological advancements and regulatory developments shape the future of Bitcoin.

How does Bitcoin work? 

Bitcoin operates on a technology called blockchain. The blockchain is essentially a digital ledger that records all Bitcoin transactions ever made. 

Things will get quite tricky here, so bear with us as we move through the technicalities of the blockchain, and then we’ll reward you with a neat metaphor that will make things much clearer. 

This ledger is distributed across numerous computers, known as nodes, all around the world. This distribution ensures that the system is secure and transparent, as everyone can see the transactions, but no single entity controls the ledger. 

This distribution also makes it difficult to make false transactions for the benefit of bad actors. If a person tries to change the Bitcoin ledger to add more funds to their account than they have, the whole distributed network would have to agree, which is virtually impossible to get right. 

Another aspect of Bitcoin that adds to its security is the process known as mining. To record new transactions onto the blockchain, a “miner” must encode those transactions into a format that is acceptable to the network. In other words, the miner is tasked with “writing” the true transactions on a block in the Bitcoin blockchain.

This requires the use of a hashing algorithm called SHA-256, which turns readable data, such as the transaction information, the timestamp, the previous block header, and so on, into a single, long, cryptic alphanumeric string. 

Sounds interesting? You can try playing around with this algorithm here.

The miner then adjusts the input bit by bit by adding meaningless letters and numbers (this added information is called the “nonce” value) until a hash that is small or “neat” enough is reached, as required by the network. This “neatness” is usually dictated according to the number of leading zeros in a hash and isn’t predictable, meaning there’s much trial and error involved. 

Once a miner reaches an acceptable format, the rest of the network ought to validate its authenticity by checking that the inputs are valid and, of course, the miner isn’t lying about the neatness (which changes every two weeks, if you weren’t already confused enough).

Upon majority approval, the “proof” is verified, a new block is added to the chain and the miner is rewarded with some newly minted Bitcoin and the user transaction fees from the block that was just mined out. 

Understanding Bitcoin mining

Bitcoin mining is notoriously complicated and can be difficult to understand, but the process is not too foreign if we use a more real-world example to explain it. 

Imagine you’re in a classroom and have to write down a full page with about 2,000 transactions. You need to record who is sending what to whom and at what time. 

The key is to write it in a way that impresses the teacher with a unique style and to do it before any of your classmates do. The tricky part is that no one knows what kind of handwriting the teacher likes, so everyone keeps trying different styles until the teacher approves one. 

When the teacher approves someone’s work, they will ask everyone else in the class to check that the transactions that were written were valid (after all, she only cares about the handwriting). If 51% or more of the class agree that the transactions are correct, she’ll accept the work and reward the lucky author with new Bitcoin. Then a new teacher comes in, the transactions change, and the process starts all over again.

When it comes to Bitcoin mining, the pupils in the class are an example of mining computers. Each computer is trying to solve an equation by putting forward a random string of numbers that only the Bitcoin blockchain knows. 

As soon as that number is correctly put forward, the blockchain accepts the equation, creates a new block (or page in the ledger), and rewards the miner who got it right with a Bitcoin reward — just as the pupil who used the right handwriting led to the teacher approving it.

In theory, the handwriting style (or the length of the target hash in the case of Bitcoin) doesn’t really matter, but it makes mining more difficult. This difficulty is important in controlling how quickly new BTC is created. The complex puzzles miners solve ensure that new blocks and new Bitcoin are added to the blockchain at a steady and predictable rate.

If the class starts making these lists too quickly with different handwriting styles, the teacher will get pickier. If it’s too hard and takes longer than usual, the teacher will be less strict about the handwriting styles.

The idea is to get the “block time” as close to 10 minutes as possible. This means transactions on the Bitcoin network — provided they are in the box of transactions (called a block) that the students should write down — shouldn’t take longer than 10 minutes to process. 

Benefits of Bitcoin vs. traditional currency

One of the biggest benefits of Bitcoin is that it is decentralized, meaning no single person or group controls it. However, this isn’t the only reason Bitcoin became so valuable.

Another key benefit is the security of Bitcoin transactions. Bitcoin uses advanced cryptographic techniques to secure transactions, making it extremely difficult for hackers to alter transaction records or steal funds. 

Each transaction is verified by network nodes through cryptography and recorded on the blockchain, ensuring transparency and preventing fraud. This high level of security is particularly appealing in an age where cyber threats are a constant concern.

Bitcoin also offers unparalleled accessibility. Geographical boundaries often limit traditional banking services and exclude people without banking infrastructure access. 

Bitcoin, however, is accessible to anyone with an internet connection, allowing people in underserved regions to participate in the global economy. This inclusivity can help bridge the financial gap for millions of unbanked individuals worldwide.

While transaction fees vary based on network congestion, they are generally lower than traditional banking fees, making Bitcoin an attractive option for remittances and cross-border payments. Transaction speed and cost are additional benefits of using Bitcoin as a means of payment. 

Did you know? Bitcoin transactions can be processed in as little as 10 minutes, compared to the several days it can take for traditional bank transfers. This speed makes Bitcoin an attractive option for international payments and remittances.

Lastly, Bitcoin provides a level of privacy that traditional payment methods often lack. While all Bitcoin transactions are recorded on a public ledger, the identities of the users involved are not directly tied to the transaction details. 

This pseudonymity can offer privacy benefits for individuals who prefer not to disclose their financial activities to third parties. However, it is also the reason why Bitcoin and other blockchain-based cryptocurrencies are sometimes the currencies of choice for criminals operating on the darknet. The darknet is a hidden part of the internet where people can do things anonymously, like buy and sell goods or services without being easily traced.

That being said, Bitcoin is not entirely anonymous, and law enforcement and others can figure out people’s identities in various ways.

How to buy Bitcoin?

Today, Bitcoin can be acquired anywhere in the world. It can be purchased from cryptocurrency exchanges, via Bitcoin ATMs or through peer-to-peer transactions. The most common method involves the following steps: 

• Getting a wallet: First, you’ll need a digital wallet to store your Bitcoin. You can choose from software wallets, hardware wallets or even mobile wallets.
• Choosing an exchange: Next, pick a cryptocurrency exchange where you can buy Bitcoin. Popular options include Coinbase, Binance and Kraken.
• Registering and passing Know Your Customer checks: Create an account on the exchange and go through the identity verification process to comply with regulations.
• Adding a payment method: Link your bank account, credit card or other payment method to your exchange account.
• Buying Bitcoin: Once your payment method is set up, navigate to the Bitcoin purchase section, enter the amount you want to buy, and complete the transaction.
• Transferring off-exchange (optional): After buying Bitcoin, transfer it from the exchange to your personal wallet for better security.

How to Use Bitcoin

Once you have some Bitcoin, you can use it in plenty of ways. 

• Make payments: Bitcoin is used to pay for goods and services at many online retailers and even some physical stores that accept cryptocurrency. Alternatively, send money to friends and family.
• Trade or invest: Take advantage of Bitcoin’s volatility by trading it on cryptocurrency exchanges or holding it as a long-term investment.
• Lending: Participate in Bitcoin lending platforms where you can lend your Bitcoin to others and earn interest in return.
• Withdraw in cash: Convert your Bitcoin to cash using Bitcoin ATMs or cryptocurrency exchanges that offer fiat withdrawals, allowing you to access your funds in physical currency.

Is Bitcoin real money? 

The Bitcoin price is influenced by its reputation as the first and most well-known cryptocurrency, but it does have intrinsic value beyond speculation. 

Features such as its deflationary nature help increase, rather than decrease, the value of the digital currency. Bitcoin has some other clear advantages over newer, more efficient networks and cryptocurrencies. 

Its decentralized nature, security, the introduction of spot Bitcoin exchange-traded funds in the United States and its growing institutional adoption collectively enhance Bitcoin’s value proposition, providing more stability and contributing to its value.

For example, Bitcoin decentralization means that no single entity controls the network, which can lead to greater security and resilience against fraud than newer, smaller networks. 

Also, Bitcoin’s security is a major benefit. It uses math to ensure transactions can’t be messed with, keeping your money safe from hackers. Plus, Bitcoin offers privacy and lets you control your money without relying on banks or governments.

Nonetheless, while many buy Bitcoin for its brand recognition, its practical use case remains limited compared to more adaptable and scalable cryptocurrencies.

What are the risks of investing in Bitcoin?

The future of Bitcoin is uncertain. The pioneering cryptocurrency has undoubtedly laid the groundwork for the entire crypto market, but it’s not without its limitations.

Bitcoin’s scalability challenge

One of the significant challenges Bitcoin faces is scalability. In its current form, the Bitcoin network is relatively slow and expensive compared to other blockchain networks. However, developments such as the Lightning Network — a layer-2 scaling solution built on top of Bitcoin — aim to address these issues by enabling faster and cheaper transactions.

However, it also doesn’t support Turing-complete smart contracts, unlike newer chains, or most famously, Ethereum. Nevertheless, the use of Ordinals and Runes on the network provides capabilities to support NFTs, enhancing its utility and versatility. These Bitcoin-native enhancements show that non-turing complete blockchains like Bitcoin can facilitate token issuance and create new opportunities for Bitcoin investors.

Competition in the crypto landscape

Bitcoin, as the original cryptocurrency, has seen many copies and attempts to improve upon it as a cryptocurrency. These newer cryptocurrencies and networks bring in many potential improvements but cannot always deliver on them because of their smaller size and lower usage by people.

For Bitcoin, transaction fees can become high during network congestion, and the time required to confirm transactions can be lengthy. Bitcoin’s use as a mainstream payment method remains limited without effective scaling solutions.

In the competitive world of cryptocurrencies, several other digital assets are vying for prominence. Ethereum, for example, offers smart contract functionality, allowing for a vast range of decentralized applications beyond simple transactions. 

Cryptocurrencies like Litecoin (LTC) and Bitcoin Cash (BCH) have been developed to improve Bitcoin’s transaction speed and cost, but they pale in comparison to newer blockchain networks like Cardano and Solana, which are designed from scratch with scalability in mind. 

One of the more promising developments in crypto is the rise of stablecoins. Stablecoins are cryptocurrencies pegged to stable assets like the US dollar, providing the benefits of digital currency without the volatility associated with cryptocurrencies. 

Stablecoins on fast networks, such as Tron, are particularly well-suited for mass adoption and integration into traditional financial systems. Tron’s network offers high transaction speeds and low fees, making it a practical alternative for everyday transactions and financial services. 

Crypto processing statistics from 2023 show skyrocketing transaction volumes in stablecoins compared to Bitcoin.

Final thoughts: Bitcoin’s speculative nature and future

Bitcoin has come a long way since its inception. It has revolutionized the financial landscape by introducing a decentralized digital currency that operates without the need for a central authority. 

Sure, Bitcoin’s role as a speculative asset is the major talking point, but many investors view Bitcoin as digital gold, valuing it for its brand recognition and deflationary nature. 

But that’s not all — Bitcoin is still a relevant network, praised for its security and high level of decentralization. Moreover, innovations like the Lightning Network aim to address scalability issues and high transaction fees, while developments such as Ordinals and Runes expand the network’s opportunities.

However, the rise of stablecoins, newer and faster chains and changing community sentiments remain key competitors to watch out for. 

Its ability to adapt and compete with newer cryptocurrencies and blockchain networks will shape Bitcoin’s future. 

While Bitcoin laid the groundwork for the entire crypto market, it must continue to evolve to maintain its relevance.

Written by Bradley Peak