How does Bitcoin work?

So how does Bitcoin work? It's a store of value, a peer-to-peer payment method, an alternative financial system, and a whole lot more besides

Bitcoin is the world’s first and best-known cryptocurrency. Now in its eleventh year, it’s already had a massive impact on how people relate to their personal finances, investing, and digital assets in general. Bitcoin’s wild price swings usually snatch the headlines, but there’s a lot more to Bitcoin than its volatility. So, how does Bitcoin work and why is it so revolutionary? Let’s take a closer look.

How does Bitcoin work?

Bitcoin (BTC) is a digital currency (or cryptocurrency) which has no physical coins or notes. Imagine Bitcoin as a computer file that you store on your desktop or smartphone using an app called a “digital wallet”.

You can own one Bitcoin or fractions of a Bitcoin. Each Bitcoin can be divided into units called satoshis (similar to cents for the US dollar). Each satoshi is worth 0.00000001 Bitcoin. Users can keep Bitcoin and satoshis in their digital wallets, as well as sell, buy, and send them to other people.

One of the most revered characteristics of Bitcoin is its independence from central banks and governments. But how does Bitcoin work without a central authority to control the transactions?

Every transaction is recorded on a public ledger called the blockchain which can’t be tampered with or changed. Transactions are finalised quickly and securely from one peer to another. Everything happens without a third party like banks or other financial institutions.

Where does Bitcoin come from?

Bitcoin is important for many reasons: as a deflationary currency, an alternative financial system, a payment method, and a store of value to name a few. But it has also gained a lot of traction due to its underlying blockchain technology. Blockchain has the potential to disrupt more than just the financial industry.

As its name suggests, you can think of blockchain as a chain of blocks. Each new block added to the chain depends on the previous one. This code makes it impossible for users to modify records without being caught, as any change would alter the network and the block would be rejected.

Bitcoin is generated every time a new block is validated and added to the blockchain. It’s a complex process called mining that requires a large amount of computational power. Miners use specific hardware to solve the complex mathematical puzzles necessary to validate blocks and receive Bitcoin in return.

The Bitcoin blockchain was built to generate a total of 21 million Bitcoin. This means that only 21 million can ever exist. It cannot be printed like fiat currency and its scarcity increases its value while protecting users against inflation.

A brief history of Bitcoin

The origins of Bitcoin are shrouded in mystery, as Bitcoin’s creator has remained anonymous. Officially, the person who designed and wrote the code for Bitcoin is called Satoshi Nakamoto. However, no one knows whether this person exists or whether we’re looking at a group of people.

Mr Nakamoto claimed to be a man living in Japan, born on 5th April 1975. However, there’s no proof of his identity. This made many early cryptocurrency adopters believe the creator of Bitcoin was a group of cryptography and IT experts from Europe and the United States.

The world first heard of Bitcoin in October 2008 when Nakamoto published his white paper “Bitcoin: A Peer-to-Peer Electronic Cash System”. The document described Bitcoin – the first digital cryptocurrency – and the way it worked.

A few months later, in January 2009, Nakamoto released the software necessary for launching the network and mining the first Bitcoin. He was the one to create the first block on the Bitcoin blockchain, known as the Genesis block.

The creator of Bitcoin kept working on the project until 2010. Then, he passed the control of the source code to Gavin Andersen and disappeared. This move hasn’t affected the growing popularity of Bitcoin. By the end of that year, the first cryptocurrency exchange was launched.

In 2011, Bitcoin reached parity with the USD, but the price didn’t stop there. About the same time, new cryptocurrencies entered the market.

How does Bitcoin work with its volatility?

In 2014, the BTC price went down by 50% and needed more than two years to recover. It was the first time users had to think seriously about the volatility of cryptocurrencies. The pattern repeated itself in 2017 when the price hit nearly $20,000 for one BTC and plunged down to around $4,000 one year later.

Today, Bitcoin continues to be one of the most volatile digital assets on the market. So how does Bitcoin work this out to be used as a form of payment?

For now, making instant payments with Bitcoin is still a challenge for many owners. The digital coin remains an asset for long-term investments rather than a payment method for the majority of the Bitcoin community (known as HODLers).

Final thoughts

How does Bitcoin work? There’s no simple answer to this question. It’s similar to a bank transfer, but with significantly lower fees and the chance of making gains (or losses) on your investment.

The good news is that users don’t necessarily need to understand how Bitcoin and the blockchain work to invest in it. However, knowledge about market trends and risk management are certainly helpful if you’re planning to take the plunge.

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