Cryptocurrency explained: Bitcoin

*This article was updated in August 2021.

Main points

  • Bitcoin (BTC) is the world's first, most popular, and most valuable cryptocurrency.

  • Bitcoin is a decentralized currency that runs on a distributed ledger available across a massive network of computers worldwide that use the mathematical principles of cryptography to verify transactions and eliminate the risk of fraud.

What is bitcoin?

Anyone looking to buy bitcoin should have a good understanding of what it is. As a relatively new concept, Bitcoin can be tough to wrap your head around. In the simplest terms, it is a cryptocurrency - a currency or asset that is entirely digital.

Unlike the paper dollars, you have in your wallet with George Washington, Lincoln, and maybe a Ben Franklin, all of which are backed by the U.S. government, Bitcoin has no central government supporting it. Instead, it is based on a decentralized system that uses complex mathematics to verify transactions. Let's break it down further.

Bitcoin is decentralized

All major currencies around the world are managed and controlled by that country's central bank. In the USA, that’s the Federal Reserve. But Bitcoin? There is no central bank. Instead, it starts as a public journal or ledger that tracks and records all of the payments. This ledger is distributed, meaning a copy of it exists on thousands and thousands of computers worldwide. Anyone can access this ledger anywhere in the world as long as they have internet access.

So, instead of having one central ledger in one location (Federal Reserve), the ledger is decentralized with no central authority governing it. This distributed, decentralized ledger contains a record of all bitcoin transactions arranged in sequential "blocks."

As with any payment ledger, there needs to be a level of trust where everyone can agree that all the information is fair and accurate. But, how can everyone be sure that the ledger is correct? This is where complex mathematics, known as cryptography, comes into play.

Bitcoin is cryptographic

Why use cryptography? This mathematical process allows a one-way calculation using two keys - one called Public and the other Private. Remember being a kid and using milk to write secret messages and then you could only see or read them if you had an iron handy to make the ink turn brown. This is similar.

You take what you want to be secret and combine it with the Public key. This creates an entirely unintelligible message. Now here is where the magic happens. The only way to turn it back into something you can read is to combine it with your Private key, a key only you have and that you keep safe and secure.

So how does this help us with a Bitcoin transaction? Let's say you have five bitcoins. On the Bitcoin ledger is a record with your unique bitcoin wallet address that states you have the five bitcoins. If you want to send 1 of your bitcoins to another wallet, you need that wallet's Public key - this allows anyone to deposit bitcoin to that wallet. But spending? Only the person with the Private key can withdraw or spend the bitcoin in a particular wallet. All transactions are recorded in the ledger - who deposits where, and who withdraws, and from which account. 

Each bitcoin transaction must be cryptographically verified to ensure that people trying to send payments actually own the bitcoin they are trying to send. This method of verification is called a “hash function.” Bitcoin uses a specific hash function called SHA-256. It allows the computers to record transactions as a chain of blocks, each block containing recent transactions. So Bitcoin’s blockchain creates an automated system of trust based on mathematics. 

Bitcoin is immutable or unchangeable

Bitcoin's ledger is built so that it can never be changed or updated once a transaction has occurred. Instead, a new transaction must be added to the chain of transactions. The ledger is what is called an immutable or unchangeable file of records or a database. This means that new information can only be added to the chain over time and cannot be deleted. Once the information has been confirmed in the blockchain, it is permanent and cannot be erased.

How does bitcoin work?

Bitcoin works using a technology called blockchain. Through blockchain technology, data is spread across many different computers called nodes that manage and record transactions. Transactions are grouped into blocks and added to a chain. Each block on the Bitcoin blockchain is composed of a list of around 500 recent transactions.

Bitcoin uses a process known as Proof-of-Work (PoW). This process is how computers agree on which group of transactions will be added to the blockchain next. The guiding principle behind Bitcoin founder Satoshi Nakamoto’s vision is that everyone trusts the ledger that has the most work put into it. This works by combining the blockchain’s distributed, cryptographic, and immutable features by organizing the ledger into blocks where each block is a list of transactions paired with the PoW.

Bitcoin mining

Computers adding new blocks to Bitcoin’s blockchain are called miners. Miners listen for transactions being broadcast, collect them into a block, and then solve the cryptographic puzzle based on the transaction data in the block, the PoW, and the hash to add the new block to the chain.

Once they solve that puzzle, they broadcast that they have added the block. Miners are rewarded every time they solve the puzzle and add a new block to the chain. This reward is how the miners are compensated for their work in processing Bitcoin transactions.

From the miner's perspective, each block is like a mini lottery where everyone is guessing numbers as fast as possible until one lucky individual finds the unique number that works with the block.

Mining rewards

The Bitcoin protocol works in a way that it should take ten minutes to find a new block. Every 210,000 blocks, or about 4 years, the reward for mining gets cut in half. Currently, the reward for adding blocks to the chain is 6.25 bitcoin. Because this reward decreases geometrically over time, it means there will never be more than 21 million bitcoin in existence. 

However, this doesn't mean miners will stop earning money. In addition to the block reward, miners also pick up transaction fees. Bitcoin transaction fees are associated with the time it takes to add transactions to the chain. For example, bitcoin has higher transaction fees than litecoin because it takes four times longer for bitcoin blocks to be added to its chain than litecoin. 

Final thoughts

Bitcoin has revolutionized the way we view money. Since its creation, miners have been investing their time and computational power into the cryptocurrency. This initial investment by miners, paired with the transparency of blockchain technology, helped create a snowball effect of trust over time.

As confidence and trust in bitcoin grow, demand grows alongside it as more people decide to invest. The price of bitcoin is determined by the economic principles of supply and demand. This means that as demand increases, then the price per BTC is also increased.

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