What is Bitcoin? How Does Cryptocurrency Work?

How does the world's most popular cryptocurrency work?

If you're looking for a primer on Bitcoin, you've come to the right place. It's important to remember that Bitcoin and cryptocurrencies are not just digital money — they're part of a broader concept called decentralized ledger technology, or blockchain. Blockchain is essentially a public electronic ledger that helps prevent fraud and double-spending without the need for a financial intermediary like a bank. The blockchain is maintained by tens of thousands or even millions of computers, each one keeping track of all transactions ever made on the blockchain. For more info about how it works, see this blog post.

1. What is Bitcoin? How does Bitcoin work?

Bitcoin is a digital currency that was created and is held electronically. It is not printed like dollars or euros – they are produced by people, and increasingly businesses, running computers all around the world, using software that solves mathematical problems. The Bitcoin network works by harnessing individuals’ greed for the collective good. Those who run the Bitcoin software agree to include transactions in the public ledger that represent a specific amount of Bitcoin. Every time someone wants to spend Bitcoin, they try to publish a block containing their transaction to the blockchain. Whichever block has the most votes is accepted and added to the chain. This eliminates the need for trusted third parties like banks to double-spend each other. In 2021, Bitcoin has a limited number of coins: 21 million.

Each Bitcoin is subdivided into one or more coin denominations because they have different economic values. In late 2019, one Bitcoin was worth about $23,000. If you wanted to buy a large number of them, you could buy them on the open market, rather than having to shut down businesses that accept Bitcoin and buy them via private parties at a markup. Because Bitcoin is regulated by the state, a company can’t simply issue a Bitcoin address and spend the money without obtaining special permission from a government regulator. Bitcoin transactions are verified by encrypted data contained in the blockchain, and this allows individuals to identify the source of the funds, verify the transaction, and strengthen their money against possible fraud — basically, the same value protection we have against bank fraud.

Most Bitcoin transactions take place via Bitcoin ATMs, rather than the traditional banking sector because these ATMs are subject to less regulatory oversight, including low compliance costs. Bitcoin is also accepted at several businesses like Overstock.com, Gyft, and Shopify, which allow merchants to accept Bitcoin through integrated Bitcoin software. ATMs Cannot support Bitcoin transactions, however, which means merchants must either buy Bitcoin as physical dollars or acquire it as a cryptocurrency and trade it through an exchange, like Coinbase for the U.S.

2. What are the benefits of using cryptocurrency?

Cryptocurrency is a type of digital currency that uses encryption techniques to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Cryptography is used to secure transactions and to control the creation of new units of a particular cryptocurrency.

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3. Where can I get Bitcoins from?

There are many ways to get Bitcoins:

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4. What is a blockchain and how does it work?

A blockchain is a growing list of records, called blocks, which are linked using cryptography. Each block contains a cryptographic hash of the previous block, a timestamp, and transaction data (generally represented as a Merkle tree root hash). By design, blockchains are inherently resistant to modification of the data. For more info about Bitcoin’s research paper on the blockchain, see this academic paper, and here’s a broader explainer video (scroll down to 4:50 for the tech talk).

As a cryptocurrency, Bitcoin’s blockchain ensures that if I send you money with Bitcoin, we’ll know that we’ve actually sent the money (hence the name, Bitcoin), and the transaction will propagate throughout the entire blockchain for everyone to see. (The Bitcoin protocol’s update rule is what stands between spammy Redditors and their 50 BTC in a month.) To generate new blocks, Bitcoin uses a process called proof-of-work. This involves rapidly performing computations (called hashes) that try to find a cryptographic brute-force way to generate new blocks at a rate that remains constant. To perform a proof-of-work challenge, a computer runs a full node, which is essentially a program running on the full blockchain that simply tries random “hacks” to find a cryptographic proof. Each node receives a proof for each block it solves. Eventually, all the computers will fail with an inherited proof, effectively throwing away any work that the node may have done. It’s this proof-of-work that Bitcoin uses to verify that transactions and blocks are being sent from me to you. Only nodes that have solved the proof-of-work challenge can add new blocks to the chain.

Once a certain number of blocks have been added to the chain, new blocks are added to the end of the blockchain every 10 minutes. These new blocks are called “rewards” and are issued to the entry-point node, which can validate the new block header of the next block, *and* all the entries in the Merkle tree that node owns (a client really just means a computer which owns and runs a full node).

5. How to store your Bitcoins securely, and why you should use a hardware wallet.

The best way to store your Bitcoins is through a hardware wallet, which are small devices that store your private keys offline. The most popular hardware wallets on the market today are the TREZOR and Ledger Nano S. These wallets allow you to store your Bitcoins on a small device that connects to your computer through a USB cable. Hardware wallets like these deal with two types of threats: theft and virus attacks. When your hardware wallet is stolen, the thief can either copy your private keys offline or connect to the blockchain and broadcast the transaction — making it visible to everyone else.

First, let’s talk about what hardware wallets can & cannot do. Unlike physical Bitcoin holdings (your wallet), fiat currency (the medium or official currency of a country) cannot be copied without the owner’s knowledge and permission. Thus, Bitcoin accounts — and all accounts that have crypto in them — are secured by the same cryptography behind Bitcoin transactions. Had someone obtained your Bitcoin, they could not spend your crypto without also retrieving your private key, thereby invalidating the transaction. Anybody with access to your hardware wallet can access your crypto holdings.

You may notice that purchasing Bitcoin directly on exchanges may be cumbersome. Because crypto holdings are decentralized, it is difficult, if not impossible, to buy one crypto asset and instantly transfer the same amount to another crypto asset. It is also difficult, if not impossible, to send large transactions in many crypto assets without first converting one crypto asset to another, thereby creating an inflationary bias in currencies like bitcoin. This is one of the fundamental flaws of modern banking — financial intermediaries that we use to send dollars to friends and family can create inflation in the dollar, and vice versa. You can solve this Bitcoin transaction bottleneck problem by using a hardware or software wallet to send the crypto to another address, such as the one you control.

There are two kinds of hardware wallets on the market today: TREZOR and Ledger Nano S.