What Is Bitcoin, and How Does It Work?
Bitcoin isn't as complex as it sounds. We break down the crypto concept so you can understand it and decide if it's for you.
|The Reader’s Digest Version:
As we move into the next evolution of the internet, tech buzzwords are making their way into the mainstream. But unless you’re really keeping up on the future of tech, you probably have a lot of questions, namely: What is the metaverse? What is web3? What is cryptocurrency and, for that matter, what is bitcoin? Considering you’ll be hearing more about digital currencies in the coming years, it’ll pay (possibly literally) to know bitcoin’s definition.
“Bitcoin is the oldest and most well known type of cryptocurrency, which is a decentralized, digitized, non-state form of money—like a virtual version of American dollars,” says Monica Eaton, co-founder, owner and chief operating officer of Chargebacks911, a fintech cybersecurity company. “Unlike traditional money, which is printed, regulated and backed by a state government, bitcoin doesn’t require a bank, so it can be bought and sold independently via a peer-to-peer network.”
What is bitcoin?
Bitcoin is a type of digital currency that’s minted electronically. So unlike a dollar bill, you can’t hold it. A decentralized network outside the governance of any country’s economy or government manages bitcoin, like all other cryptocurrencies.
When did bitcoin start?
The Bitcoin.org URL was purchased in August 2008, and the system went live in January 2009, but despite the growth of bitcoin and other cryptocurrencies since then, there’s been an air of mystique around who created bitcoin. Fourteen years later, all we know is that bitcoin was created by Satoshi Nakamoto.
“And you’d think Satoshi Nakamoto would be world-famous by now,” says Eaton. “But the trouble is, we don’t really know who Satoshi is, since the name is almost certainly a pseudonym for a person or even a collection of people.”
In late 2021, when bitcoin peaked in value, Nakamoto’s holdings were estimated to be worth up to $73 billion. “Whoever he is and wherever he might be, he’s among the most successful investors in world history,” Eaton says.
Why was bitcoin created?
It all began with a white paper. “The white paper was initially distributed to a select few hundred individuals devoted to cryptography via email, with bitcoin’s main principle and mission on the first page,” says Gai Sher, an innovation and tech attorney with extensive experience assisting crypto clients. It stated, “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”
With the creation of bitcoin, Nakamoto intended to create a currency more secure than fiat money, which is government-issued legal tender. “Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers,” the white paper stated.
As our world has become increasingly digitized, we’ve had to become more aware of hackers and potential scams such as phishing, cash app scams, Venmo scams and Facebook Marketplace scams. And while people have been victims of cryptocurrency scams, the issue isn’t with the currency itself but with criminals taking advantage of people, which happens when large amounts of money are made and lost.
How does bitcoin work?
To understand how cryptocurrency and bitcoin work, you’ll need to learn a new vocabulary and system of computing and track this modern form of digital currency. It’s not as straightforward as coins and paper money produced by the United States Mint and the Bureau of Engraving and Printing, which have been the norm for far longer than anyone reading this has been alive. But when coins and paper replaced shells and bits of metals, they, too, seemed abstract and challenging to understand.
Once you can answer the most important question—what is bitcoin?—dig into the details to really grasp the concept. All it takes is an easy-to-understand explanation of how bitcoin works, how to mint it, how to buy it and what you can purchase with it. Luckily for you, we’ve simplified all that information in this guide to bitcoin.
What is blockchain?
“Each bitcoin transaction is known as a block, and the record of all the transactions is called a blockchain,” explains Nick Ranga, senior cryptocurrency and forex analyst for AskTraders. The blockchain is essentially a database.
“Unlike traditional ledgers, where a single entity, like a bank, stores the only copy and makes changes at will, blockchains are distributed across thousands of computers, and anyone can keep their own copy,” says Omid Malekan, a nine-year veteran of the crypto industry and an adjunct professor at Columbia Business School, where he lectures on blockchain and crypto. “The ledger is immutable, and existing entries cannot be changed.”
Here’s how it works: New transactions—the sale or purchase of bitcoins, for instance—are entered into this digital ledger in batches, called blocks. Each block links to the previous one using cryptography—hence the name cryptocurrency.
Without a central bank to control things, how does the system—the blockchain—stop people from spending the same bitcoin multiple times? “When you buy things using normal currencies, the central bank can check the transaction to make sure the same funds leave your bank account and are sent to the person selling the item you bought,” Ranga says. “Cryptocurrencies have no central bank, and this is where bitcoin mining comes in.”
What is bitcoin mining?
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“Mining is the way bitcoin transactions are confirmed,” Ranga says. “When you buy an item using bitcoin, this transaction is checked by another computer that confirms the transaction and makes a record of it. The bitcoin is then transferred to the seller, and the record of the transaction is then sent to all other bitcoin users.”
What sets bitcoin apart from some other cryptocurrencies is that a finite number of coins can be mined, and some proponents believe that scarcity adds to its value. Once 21 million bitcoins have been created, the algorithm will prevent additional bitcoin mining.
So, exactly how is bitcoin mined? The process is a little like mining gold, but instead of digging in the ground, you have to solve cryptographic problems or puzzles that the cryptocurrency’s creator put in place. It’s a bigger challenge than our human brains can handle, which is why bitcoin mining requires a computer.
“The puzzles are so difficult and unique, they can only be solved with high-tech computation,” explains Guy Gotslak, president and founder of Los Angeles–based cryptocurrency exchange My Digital Money. “This is called the proof-of-work method. The first computer to solve the puzzle successfully mines and owns the new bitcoin. That’s one way people make money in cryptocurrency, though the more common way is buying existing bitcoin from an exchange.”
Sounds like a win-win, right? You help verify transitions on the blockchain while pocketing money in the process. But there’s a major downside to the process: Just as NFTs are bad for the environment because they use the blockchain, bitcoin also has a negative environmental impact.
“The computation required to mint a new bitcoin uses an enormous amount of electricity that is environmentally unsustainable for the long term,” Gotslak says, pointing to estimates that put bitcoin’s current energy consumption at about 150 terawatt-hours annually. That’s more than the entire country of Argentina, a population of 45 million.
The environmental impact is a concern, but there are a few caveats. “Research firm CoinShares cites up to 74.1% of bitcoin’s energy consumption comes from renewable sources,” says Neil Bergquist, co-founder and CEO of Coinme. “Energy is indeed vital to the strength of the bitcoin network. However, more bitcoin production is moving to sustainable energy sources because of market dynamics, resulting in fewer greenhouse gas emissions.”
What can you buy with bitcoin?
The way we buy and sell things these days is rapidly changing. That goes for everything from home goods and clothing to NFTs and virtual real estate. When asked about the sort of things you can buy with bitcoin, Cody Garrison, co-founder of the web3 consulting firm Clearblock, said “the short answer is anything.”
Depending on whom you’re buying from, you might use bitcoin to purchase a home, as some Louisville, Kentucky, homebuyers recently did. You might shop for luxury clothing or watches—brands like Balenciaga, Gucci and TAG Heuer all accept the cryptocurrency. Or maybe you’ll invest in fine art; Sotheby’s accepts bitcoin now. You may also be able to pay for college (at Bentley University) or pay your taxes (in Florida).
“You can buy more than you think with bitcoin, as more retailers are now accepting digital currency as payment,” says Bergquist. “For example, some BMW dealerships accept bitcoin as payment, as do other independent car dealerships. You can even purchase a home with bitcoin by transferring it directly to a willing seller’s wallet or utilizing a service like BitPay to conduct the bitcoin-to-cash exchange. Also, for sports fans, the Miami Dolphins and Dallas Mavericks accept bitcoin for game tickets.”
Making a purchase with bitcoin begins with a digital wallet, and not the kind that store your credit cards electronically. Unlike loose coins, you can’t toss bitcoins into a jar on your countertop. You’ll need to store your money somewhere, and that’s what a digital wallet is for. It’ll work with services that help you use bitcoin to pay for goods.
“There are countless companies all over the world who accept bitcoin, usually in partnership with a service provider like PayPal that instantly converts the coins to dollars so the recipient doesn’t have to worry about its volatility,” Malekan says. “There are also services like Bitrefill and Moon that let users convert their bitcoin to gift cards that can be used at specific businesses, like Amazon, or prepaid credit cards that can be used anywhere.”
How do you make money with bitcoin?
When thinking about how to make money with bitcoin, don’t overlook the three methods early adopters have used to add funds to their digital wallets: mining, buying and selling the digital currency.
If you have the tools to do it, bitcoin mining can help you bring in extra money, above and beyond the crypto you buy and sell. “Mining can be profitable,” Malekan says. “But it requires technical knowledge, a significant capital investment in specialized hardware and access to cheap electricity.”
Buying and holding
Early adopters who bought bitcoin have been rewarded. Even over the past seven years, bitcoin has gone up about $19,811, or around 8,736%, offering a better return on investment than almost anything.
As of Sept. 6, 2022, one bitcoin was worth $19,077.07, which sounds like a lot, but it’s low compared with bitcoin’s previous high of $67,567 on Nov. 8, 2021. At the time, there were 18.9 million bitcoins in circulation, bringing the market cap to around $1.29 trillion.
“The price of bitcoin and other cryptocurrencies tends to fluctuate quite a lot, so they are a risky investment, but they offer many opportunities to make a profit if you buy and sell at the right time,” Bergquist says. “Many experts predict that bitcoin will start to recover over the next year or two and start to climb back toward new highs.”
Because bitcoin is volatile, some people trade it actively. “There are also bank-like entities that pay interest to those who deposit coins with them, but most are unregulated, and several have failed this year alone, leaving their depositors in a lurch.”
If you’re willing to weather the wild swings, here’s how to buy bitcoin: You can use centralized online exchanges or online brokers—Robinhood, Public.com and Sofi are good options—to buy and sell, making the purchase with either existing cryptocurrency or a fiat currency like U.S. dollars. More advanced investors might opt to use a decentralized, peer-to-peer transaction.
And if you’re really in it for the long haul, buy when bitcoin is down, then hold onto it until much further in the future. You never know: You might be able to use your earnings on a space tourism trip decades from now.
Don’t go into crypto trading assuming you’ll be able to buy and sell with daily price swings. “As with stocks or other investments, day trading is not recommended, unless you can commit to learning and following the ups and downs full time,” Gotslak says. “The most popular way to make money with bitcoin is to buy and HODL [hold on for dear life]!”
Proponents of cryptocurrency believe that bitcoin is only going to get more valuable with time and that now is the time to start investing. “If you believe decentralized finance is the way of the future and that bitcoin is the foundation of [decentralized finance], then buy now while it’s low and watch it grow over time,” Gotslak says.
Your pal wants to borrow $100, so you loan it to him, then collect interest. That’s the concept that inspired crypto lending. Certain cryptocurrency platforms allow you to lend your bitcoin to other investors and earn interest in the process. It’s important to know that this, too, is a risky investment.
The future of bitcoin
There’s no doubt that bitcoin and other cryptocurrencies are here to stay. “Many governments around the world are developing new laws in order to regulate cryptocurrencies to make sure they are safe for everyone,” Ranga says. “Cryptocurrencies are already well established as an investment product, but there is also a whole world of applications for blockchain technology being worked on.”
What is bitcoin going to be used for in the future? That’s anyone’s guess, though you might see digital coins accepted by more and more retailers, including those you visit in the metaverse using virtual reality. Ranga doesn’t think we’ll ever do away with dollar bills, though. “Cryptocurrency is unlikely to ever completely replace regular currency, but it has the potential to change our future financial landscape in many different ways,” he says.
Malekan studies bitcoin not only as an investor (he got in early in 2013) but also as an author, lecturing professor and consultant who speaks about what he calls the intersection of the old and the new. He sees a bright future for the digital coin.
“Despite its constant volatility and endless controversy, bitcoin continues to amass believers for technological, financial and ideological reasons,” he explains. “Some people view its fixed supply as a good hedge against inflation, while others appreciate its global footprint and universal access. I make my living sitting in the middle, educating the skeptics on the world to come and the faithful on what they may have missed.”
- Monica Eaton, co-founder, owner and chief operating officer of Chargebacks911
- Gai Sher, senior counsel in innovation and technology with GreenspoonMarder
- Bitcoin.org: “Bitcoin: A Peer-to-Peer Electronic Cash System”
- Federal Trade Commission: “What to Know About Cryptocurrency and Scams”
- Nick Ranga, senior cryptocurrency and forex analyst for AskTraders
- Omid Malekan, adjunct professor lecturing on blockchain and crypto at Columbia Business School and author of Re-Architecting Trust
- Guy Gotslak, president and founder of My Digital Money
- Neil Bergquist, co-founder and CEO of Coinme
- Cody Garrison, co-founder of Clearblock