What is Bitcoin and How Does it Work?

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Bitcoin was the first digital currency, also known as cryptocurrency, to be revealed to the world back in January 2009. At first many were sceptical about the survivability of the coin, while other early adopters saw the benefits of this fast and cost-effective payment method. It soon became one of the preferred options for those who wanted not only the safest but also an anonymous payment method. It is also increasingly being seen as a store of value against inflation, especially now with the 2020 Covid-19 crisis.

It took some companies a bit longer to buy into this cryptocurrency payment method. Most only started to accept it as late as the mid-2010s. It’s highly volatile history also counted against it for some time, although its safety aspect made believers of some doubters. To understand this unique form of electronic or rather digital money, we need to take a step back to where it all started.

The Creation of Bitcoin

In 2008, on the 18th of August, the bitcoin.org domain name was registered. The cryptography mailing list posted Bitcoin: Peer-to-Peer Electronic Cash System on the 31st of October 2008, authorised by Satoshi Nakamoto. He implements the blockchain software in January 2009 as an open-source code.

Although the true identity of Nakamoto is unknown, he mines the genesis block, which is the starting block of the Bitcoin network on the 3rd of January 2009. Cypherpunk, Hal Finney is the first to download the bitcoin software a few days later on the 12th of January and Nakamoto rewards him ten bitcoin. Laszlo Hanyecz, a programmer, is the first to use 10,000 bitcoins to buy two pizzas at Papa John’s.

Before Nakamoto disappears in 2010 he mined about a million bitcoins, according to a blockchain analyst. At that stage, control and the network alert key land in the hands of Garvin Andresen, who becomes the lead developer.

The first users of the cryptocurrency are the black markets, Silk Road accepts bitcoin payment only from February 2011. Transaction numbers climb to 9.9 million, which came to around $214 million. It is also the year in which the price of bitcoin increases from $0.30 to $5,27 per coin before year-end. By the 8th of June the next year the value of one bitcoin is $31.50 and then it drops to $11,80 within a month. Bitcoin prices look the same in 2012 when it starts at $5.27 and reaches $13.30 by the end of the year. Significant growth takes place in 2013, the price starts at $13.30 and in January 2014, it’s $770. The People’s Bank of China forbids financial institutions from using the virtual currency in December 2013.

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Bitcoin Trading

The price of bitcoin starts rising in 2017, in October it reaches $5,000 and doubles by November. In the same year, its price reaches almost $20,000 by December. Critics and commentators talk of a price bubble similar to the 17th century Dutch Tulip mania.

Within weeks the price of bitcoin comes tumbling down and its value falls to below $7,000 by April 2018. It continues to decrease and by November of the same year it is $3,500. By June 2019 the price increases to $10,000 but soon falls to $7,000 again. As of 20 November 2020 the value of bitcoin is around the $18,000 level.

Bitcoin Explained

Categorizing the bitcoin cryptocurrency could lead to debate and disagreement. Some may call it an online store of value or a currency type, even a payment network. At its essence bitcoin is just code or software, a set of processes and protocols, and a digital phenomenon. It is more successful than any of the other attempts and efforts in creating a virtual currency via cryptography. Easier explained as the making as well as the breaking of codes.

Due to its popularity, bitcoin inspired many imitators, yet it is still the largest in terms of market capitalization. The Bitcoin Foundation explains the word bitcoin as a cryptocurrency entity. The full meaning or more understandable explanation is that bitcoin is a computer file. The file is storable in a digital wallet on desktop or mobile devices. It is possible to send bitcoin to a digital wallet and then to other people. All transactions are listed on the Bitcoin blockchain, which is a public ledger.

Bitcoin is not a physical currency; but balances in a public ledger. All transactions are verified via many computer nodes spread across the world which makes it completely transparent. Bitcoin is codes stored as blockchain, each block in the chain stores transactions. All the computers that run blockchain use the same list of transactions and blocks, as new transactions take place new blocks fill up.

How Does Bitcoin Work

The bitcoin balances are kept via the use of private and public keys, these are a string of letters and numbers. It is linked and created via encrypted mathematical algorithms. While the private key safeguards, it works like an ATM pin that authorizes a transaction. The public key almost works like a bank account number, it gives you access to the storing address, where you use the private key to unlock it.

Bitcoin is the first digital currency to facilitate instant payment via peer-to-peer technology. Bitcoin miners process the blockchain transaction and are motivated via rewards, such as the fees paid in bitcoin as well as the release of new bitcoin. In July 2020, it is estimated that there are around 3 million coins still to be mined. Another way to learn more about the virtual currency is to compare it to fiat currency.

Fiat Currency vs Cryptocurrency

What is the difference between fiat currency and cryptocurrency?

Fiat Currency

  • Each country traditionally has their unique currency
  • Mostly a physical currency that exists in notes and coins
  • Centralized banking system
  • Based on credit of economy
  • Value of international currencies are directly tied and related to supply & demand
  • Highly controlled and stable while staying legal around the world
  • Fiat currency enables central banks to control economy via interest rates, liquidity

Cryptocurrency

  • Form of virtual or digital currency
  • Digital cryptography technology verifies and secure transactions
  • A decentralized system not managed or controlled by a central bank
  • Fully transparent, anyone and everyone can see all transactions
  • Highly volatile which hugely affects value

Blockchain

The bitcoin network operates on a protocol called blockchain. Once you understand the basics it is straightforward. A blockchain consists of one chain of blocks of information.

For example, chronologically arranged information appears like this: 16N4yPu7UMsP3tRARmu9Ar7BZ sent 0.00348 bitcoin to 1PAY2Pj8KdiQtr3wmireyJPK5b on September 20, 2018, between 12:50 and 12:55 a.m.

The information theoretically can be a string of 0s and 1s, which mean it may include bond trades, contracts and emails. In theory, a contract regardless of its type between two agreeing parties can be set up in blockchain. It completely removes the need for a third party, and it opens many possibilities such as peer-to-peer finance options. For example, decentralized saving and loans.

The bitcoin blockchain holds all transaction information, which is a list of users sending and receiving bitcoin. Blockchain is also referred to as a distributed (meaning it is public) ledger. Meanwhile, there is no central authority controlling or managing bitcoin transactions.

BitcoinBlockchain
CryptocurrencyLedger
Powered via blockchain technologyMany uses beyond Bitcoin
Simply & increase speed of transactionsProvide safe & secure peer-to-peer transactions
Currency limited to tradingTransfer anything from stocks to currencies
AnonymityTransparency
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Bitcoin Mining

The process used to create new bitcoin is called bitcoin mining. A good way to explain it might be to use gold mining as an example. There is a limited amount of gold beneath the earth and mining it can be a costly affair. As gold is a relatively rare metal, and takes a lot of effort to mine, it has a higher value than other metals. Equally, it takes a lot of computer power and number crunching to mine a single bitcoin. A series of blocks is part of the blockchain, each block holds bitcoin transactions. A new block is produced on the network around every 10 minutes.

Bitcoin Miner

Anyone wishing to be a bitcoin miner needs to download and run the proper software.

The miner needs to sacrifice space and devote processing power to take part in mining activities. The Bitcoin protocol holds a limited supply of just 21 million coins, the last of which is expected to be mined around the year 2140.

Puzzle Solving Mining

After downloading the software, the bitcoin miner is ready to start, computers involved in the mining process take a huge number of transactions and places them into a puzzle. Solving the puzzle involves nodes competing with others to be the first to get to the solution. To get to the solution the nodes must use SHA-256, which is the hash cryptographic function.

Miner Rewards for Mining

At the start, the reward for mining was 50 BTC per block, although with time it decreases to 25 BTC by 2012. A further reduction reduced it in 2016 to 12.5 BTC per block. The number of coins mined per block decreases by half roughly every four years. In May 2020, the reward was halved again and is now 6.25 BTC per block.

Bitcoin miners can also earn in addition to mining coin, they earn transaction fees for sending the cryptocurrency from one wallet to the other. Wallet holders pay the fees and the more they pay, the quicker the transaction takes place.

Risk Control & Management

The way the system is set up has one major benefit, it is extremely difficult if at all possible, to compromise the system. To achieve it, it would require that nefarious parties rewrite it completely. A process not only challenging but also requires enormous computing power. Above all, anyone planning such action must control the bulk of the Bitcoin mining hash power.

Mining Energy Consumption

One of the main concerns is the huge amount of energy it takes to mine bitcoin. Estimates on how much energy gets consumed during mining is approximately 2.55 gigawatts per year. To give a better understanding of the quantity, this is equal to over 80% of the yearly power use of Ireland.

Bitcoin Users

The number of bitcoin users according to a study by the Cambridge University in 2017 was estimated at 5.8 million. In 2019, the number of users around the globe increased to more than 34.6 million. The person owning the highest number of bitcoin is the founder, Satoshi Nakamoto who owns over one million coins, which currently makes him a multi-billionaire.

But why do so many people worldwide use cryptocurrency? The main reasons include freedom, fees, less risk, security and transparency. Below is a quick explanation of each of the main reasons:

Freedom of Payment

In terms of freedom, bitcoin makes it possible for users to receive or send the cryptocurrency anywhere at any time. It simply removes bureaucracy, borders and bank holidays. It gives users the control they need to manage their money.

Fees – You Choose

Many wallets allow you to decide the fee when you send bitcoin and when you receive bitcoin, it comes without fees. Higher fees simply speed up the confirmation part of transactions. The big benefit is that the fees are not related to the transfer amount. This means the fee stays the same for sending 1 or 50,000 bitcoins.

Lower Risk – Merchants

Bitcoin transactions are irreversible and secure, while it does not expose the users personal or sensitive information. This offers protection to merchants by preventing fraudulent chargebacks. The virtual currency encourages growth in allowing merchants to expand into markets where fraud rates are high, or where credit cards are not accepted or available.

Control & Security

As a bitcoin user you control your every transaction, it is a way of preventing merchant from adding any charges. A bitcoin payment does not reflect your personal information, which massively increases your protection in terms of identity theft.

Transparency

Transparency is as high on the list of why bitcoin is popular as its anonymity. No organization or individual can manipulate or have control over the coin. Since it is cryptographically secure, it is favoured for being transparent and neutral.

Getting Started with Bitcoin

Before you can buy bitcoin you first need to create storage space or a place to keep it safe. This is called a wallet and wallets comes in different forms to cater to the user’s preference in terms of access, storage and security.

Wallets do not store cryptocurrency but rather private keys that are essential in accessing the bitcoin address. The keys are needed in transactions and if lost, the user will lose access to his/her bitcoins.

There are five types of bitcoin wallets, including paper, hardware, online, mobile and desktop.

Paper Wallet

A paper wallet consists of two QR codes, generated via a nominated service. One of the codes is the public key and the other is the private key.

Hardware Wallet

Wallets stored on portable devices holding private keys that facilitate payments.

Online Wallet

Web-based wallets store private keys on servers that are connected to the internet and offer instant access to funds from anywhere in the world via any device.

Mobile Wallet

Favoured by most users, it places funds in the hands of the user at all times. Payments are easy due to QR-code scanning, while a simple tap against a reader reduces the need of supplying personal information.

Desktop Wallet

Installed on a desktop computer, desktop wallets offer complete control over funds and budget safety. It allows the downloading of network blocks and offer an increase in security.

Cold Storage Harware Wallets

Cold storage hardware wallets are USB devices that allow you to store your cryptocurrency safely offline thus minimising the chance of it being hacked. Popular brands are Ledger and Trezor.

Getting Your Bitcoin Wallet

You can easily download your wallet from Bitcoin.org, offering wallet apps for Mac, Linux, Windows, Android and iOS. The most user-friendly and the easiest to use is an online wallet. One of the most used is the Coinomi wallet that also supports other coins.

Six Steps in Creating a Bitcoin Wallet

  1. Visit the Google Play Store or the App Store
  2. Search and download a wallet app according to name
  3. Open the app and record your 24-words recovery phrase in a safe place
  4. Set a strong password
  5. You can now add bitcoin to the wallet
  6. To receive bitcoin, you need to use the receiving address

Bitcoin Receiving Address

  • The receiving address for bitcoin is comparable to a bank account number
  • Every wallet has a distinctive address for receiving bitcoin
  • The receiving address is what you need to share with others
  • It informs them how to send coins to you via your wallet
  • The BTC address always starts with either a 3 or 1
  • The BTC address is automatically generated via the wallet

For sending or receiving bitcoin, always copy & paste the wallet receiving address, which lowers the chance of making an error. Remember all transactions via the cryptocurrency are irreversible.

Example of a wallet receiving address: 1FGbig29qjcp2GwdjV7eyPuNNtkPktZb4

Sending or Receiving Bitcoin

You need to use your wallet receiving address whether you receive or buy bitcoins. To get access to your receiving address you need to log into your wallet, it can normally be found under the “receive” button. In some wallets, the receiving address automatically change after use.

Receiving Bitcoin

Provide the sender with your unique wallet address. Multiple unique receiving addresses can be generated for the same wallet.

Sending Bitcoin

Select the “send” option in your wallet, copy & paste the other person’s wallet receiving address and fill in the value of coin you want to send.

Setting Up Backup for Bitcoin Wallet

You need to ensure that you will have access at all times to your wallet and your bitcoin. The best way to do it is by creating a backup. Wallets display a series of 12 or sometimes 24 words randomly generated, these are the recovery seed or seed phrases. These are the wallet backup phrases you need to write down and store in a very safe place. Never store it online or digitally as it could be exposed if your device is hacked.

Most Important – Wallet Safety

As much as you would look after your physical fiat currency wallet, you need to protect your bitcoin wallet. There are many ways to ensure your wallet stays safe as are listed below:

Storing Backup Details

Use a notebook or piece of paper stored in a safe place to write down your wallet provider, login name, recovery seed and password. Avoid taking a photo of the detail via your mobile device, it connects to the internet and could offer access to hackers.

Two Factor Authentication

It might sound a little complicated but 2-FA/ two-factor authentication allows you to log in via more than one device. It prevents hackers from gaining access to your password. Options include sending the code via SMS or via a Google Authenticator app. By choosing both options you maximise security.

Advantages of Using Bitcoin

  • Safety – lower risk of fraud to buyers
  • Preserve coins – zero risk of inflation
  • Affordability – low or no transaction fees
  • User-friendly – easy to use
  • Fast payments – settlements within two working days
  • Anonymity – protect users personal and sensitive details

Bitcoin Glossary & Quick Definitions

  • Bitcoin: Describes the concept of the entire network or Bitcoin itself
  • bitcoin: Describe bitcoins as a unit
  • BTC or XBT: Abbreviation for bitcoin
  • BTC: Commonly used as a unit for one bitcoin
  • BCH: Most accepted and used abbreviation for Bitcoin Cash
  • BCC: Ticker symbol once used for Bitcoin Cash at Asian exchanges
  • Bitcoin Address: Information a person needs to send you bitcoin – Each address can be used for a single transaction only. (Think of it as an email or physical address)
  • Block: Record in blockchain confirms and holds waiting transactions
  • Blockchain: Record of bitcoin transactions available to public in chronological order
  • Confirmation: Shows transaction was network processed
  • Cryptography: Mathematics allowing the creation of proofs providing the highest level of security
  • Double Spend: User trying to send bitcoins to more than one recipient
  • Hash Rate: Measuring the unit of processing power in Bitcoin network
  • Ledger: List of transactions, ID’s, balances, timestamps and other data
  • Mining Bitcoin: Process via computer hardware doing mathematical calculations to confirm transactions
  • Miner: Bitcoin user collecting pending transaction into blocks before processing as well as verifying blocks that were created by others
  • Miner Incentives: Payment for performing work and collecting transaction fees for placing transaction into blocks
  • Node: Relay new transaction to another node and keeps a copy of the ledger
  • P2P: Abbreviation for Peer-to-Peer
  • Peer-to-Peer: Systems allowing individuals to interact directly with one another
  • Private Key: String of letters and numbers used for spending bitcoins held at a specific address           
  • Public Key: String of numbers and letters deriving from the private key that allows you to receive bitcoins
  • satoshi: Smallest possible divisible unit of a single bitcoin, 100 million satoshi’s in a single bitcoin, one satoshi is equal to 0.0000001 bitcoin
  • uBTC: Small denomination of bitcoin, one uBTC is equal to 0.000001 BTC

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