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How Does Bitcoin Work? A Comprehensive Guide

By Amir Shalev | Last update: 6/8/2023

Bitcoin is the original cryptocurrency that started it all, way back in 2010. Since its inception, thousands of other cryptocurrencies have been created, but Bitcoin still maintains the largest market cap by far. It is widely regarded as a true means to store value and hedge against inflation. Read here to learn in simple terms all about how Bitcoin works, here’s what I’ll cover:

How Does Bitcoin Work

Bitcoin operates as a digital asset that can be housed either on a cryptocurrency exchange or within a digital wallet. You have the option to own an entire Bitcoin or just a fraction thereof, known as Satoshis. Each Satoshi, which is named after the creator of Bitcoin, is a hundred millionth of a single Bitcoin.

bitcoin - the original cryptocurrency

Blockchain Technology

  • At the heart of Bitcoin lies a revolutionary technology called the blockchain. This open-source coding infrastructure acts as a transparent and tamper-proof ledger of transactions.
  • These transactions are divided into units known as “blocks,” which are sequentially “chained” together, thus creating an unalterable and transparent record.
  • This system ensures a common understanding of ownership amongst all Bitcoin users.

Public and Private Keys

  • A Bitcoin wallet consists of a public key and a private key. These keys work in unison to enable the wallet owner to authorize and digitally sign transactions.
  • This mechanism underpins the main functionality of Bitcoin: secure ownership transfer from one user to another.

Bitcoin Mining

  • The process of Bitcoin mining is implemented to uphold the system’s integrity.
  • Users across the Bitcoin network confirm the authenticity of transactions through mining, ensuring their alignment with prior transactions.
  • This procedure effectively safeguards against double-spending, making it impossible for users to spend Bitcoins they do not own or have already spent.

How does Bitcoin mining work?

Bitcoin mining involves the addition of new transactions to the Bitcoin blockchain – a task that’s far from simple. The process is dependent on a mechanism called proof of work, which requires computers to solve intricate mathematical puzzles in order to validate transactions.

To encourage miners to support this labor-intensive system, the Bitcoin protocol offers a reward of 6.25 BTC for every new block added. At the current Bitcoin price, this translates to nearly $190,000.

Over time, however, Bitcoin mining has become an increasingly challenging feat. The Bitcoin code has been designed to continually increase the difficulty of its puzzles, thereby requiring an ever-increasing amount of computing power. Nowadays, Bitcoin mining necessitates high-grade computing machines and a substantial amount of affordable electricity to succeed.

Moreover, the profits from Bitcoin mining have gradually declined, further complicating the task of covering the rising computational and electrical costs.

“Back in 2009 when Bitcoin was still in its early stages, the reward for successfully mining a block was much greater than it is now,” comments Nick Szabo, a blockchain, cryptocurrency, and smart contracts pioneer. “With the ever-increasing number of transactions, the rewards for each successfully mined block are decreasing.” By the year 2140, it is projected that all Bitcoins will have been mined and entered circulation, leaving miners to rely solely on transaction fees as compensation for their efforts.

What is Bitcoin Used For? 

Digital Gold (source: Smarterum.com)

People use Bitcoin in many different ways, making it a versatile player in the digital world.

Digital ‘Gold’

Some view Bitcoin as a kind of ‘digital gold’. Like real gold, Bitcoin is limited in supply, making it valuable. This scarcity means it can act as a safety net against inflation and a valuable resource for long-term savers.

A Simple Way to Send Money

For others, Bitcoin is a useful tool for transferring money. Its digital nature and typically low transaction fees make it a quick and affordable option for sending money worldwide, bypassing traditional banking systems’ red tape and fees.

A Playground for Tech Enthusiasts

There are also those who see Bitcoin as an exciting new technology to experiment with. Bitcoin’s decentralized setup breaks the mould of traditional financial systems, offering a new level of financial freedom and privacy. It can act as a starting point for people keen to learn more about the wider world of crypto, blockchain, and decentralized tech, also known as Web3.

A Learning Tool and Investment Opportunity

Lastly, many people use Bitcoin to learn about and invest in the world of digital currencies. This not only helps increase their understanding of this groundbreaking technology but can also potentially deliver financial gains.

Charlie Lee - the founder of Litecoin
Charlie Lee – Loves Bitcoin

As Charlie Lee, the creator of Litecoin, once said, “Bitcoin isn’t just digital money. It’s a new way of looking at the world.” This forward-thinking view points to the many different ways people use Bitcoin, well beyond just being a type of digital cash.

Risks of Investing in Bitcoin

While Bitcoin’s price has seen a rapid increase over the years, attracting many speculative investors, this digital currency also comes with a significant share of risks. For instance, Bitcoin’s price skyrocketed from $7,167.52 at the end of 2019 to a staggering $28,984.98 a year later—an appreciation of over 300%. However, Bitcoin’s price has fluctuated dramatically since then, with a record high of $68,990 in November 2021 before falling to around $40,000 in the following months.

Due to these volatile price movements, many individuals invest in Bitcoin for its potential financial gains rather than its use as a medium of exchange. Despite the potential for profit, the inherently digital nature of Bitcoin and the absence of a guaranteed value present substantial risks.

Regulatory Risk

The lack of consistent regulations concerning Bitcoin and other cryptocurrencies raises concerns about their long-term survival, liquidity, and universality.

Security Risk

The majority of Bitcoin owners haven’t acquired their coins through mining operations. Instead, they trade Bitcoin and other digital currencies on virtual marketplaces, known as cryptocurrency exchanges. These exchanges, being completely digital, are susceptible to threats such as hacking, malware, and operational errors.

Insurance Risk

Cryptocurrencies, including Bitcoin, are not insured by the Securities Investor Protection Corporation (SIPC) or the Federal Deposit Insurance Corporation (FDIC). Some exchanges offer third-party insurance, but this coverage often extends only to portions of transactions involving cash.

Fraud Risk

Despite the inherent security measures in blockchain technology, fraud risks persist. For example, the SEC took legal action against an operator of a Bitcoin-related Ponzi scheme in July 2013.

Market Risk

As with any investment, Bitcoin’s value can see extreme fluctuations. Subject to high-volume trading on exchanges, Bitcoin’s price is particularly sensitive to newsworthy events. According to the Consumer Financial Protection Bureau (CFPB), Bitcoin’s price plummeted by 61% in just one day in 2013, while the one-day price drop record in 2014 was a massive 80%.

FAQs – Important Things to Know

How much is $1 Bitcoin in US dollars?

The value of Bitcoin in US dollars changes frequently, sometimes from minute to minute, as it is influenced by demand and supply in the market. This means that $1 Bitcoin will not have a fixed value in US dollars. You can find the current exchange rate on various financial websites and cryptocurrency exchanges.

How much should a beginner buy in Bitcoin?

There’s no definitive answer for this, as it largely depends on individual financial circumstances and risk tolerance. A good rule of thumb is to only invest what you can afford to lose. Start small, learn as you go, and gradually increase your investment if you feel comfortable doing so. Always ensure you understand the volatility of Bitcoin before you start investing.

What are the different ways to earn Bitcoin?

There are several ways you can earn Bitcoin:

Buying Bitcoin: You can purchase Bitcoin directly from cryptocurrency exchanges using traditional currency.

Mining Bitcoin: Bitcoin mining involves solving complex mathematical problems for which miners are rewarded in Bitcoin.

Bitcoin Payment: If you own a business, you can accept payments in Bitcoin.

Earning through Interest: Some platforms allow you to lend your Bitcoin and earn interest.

Micro Earnings: Some websites pay you in Bitcoin for completing small tasks or captchas.

Do you cash out Bitcoin?

Yes, you can cash out your Bitcoin at any time through a cryptocurrency exchange. These platforms allow you to sell your Bitcoin for traditional currency like US dollars, which you can then transfer to your bank account. Remember, the value of Bitcoin is always changing, so the amount of cash you get can vary based on the current market value.

Does Bitcoin give you real money?

Bitcoin itself is a form of digital currency and is valuable in its own right. However, if you wish to convert Bitcoin into traditional, or “real”, money, you can do so. By selling your Bitcoin on a cryptocurrency exchange, you can receive traditional currency like US dollars in return, which you can then use as you would any other money.

Final words

We will finish this article with wise words from blockchain pioneer Nick Szabo:

Bitcoin is a remarkable cryptographic achievement, but it’s important to be aware of the potential risks and pitfalls. Always do your homework before investing.

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