What Is Bitcoin and How Does It Work?
Bitcoin is a decentralized digital currency that is exchanged between two parties without involving intermediaries like banks or other financial institutions.
As defined in a whitepaper released by the hidden inventor of Bitcoin, Satoshi Nakamoto, Bitcoin is “a purely peer-to-peer version of electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution”.
Bitcoin is the first cryptocurrency, which is a decentralized digital currency that is not regulated by a central authority. Bitcoin gives full control to users instead of financial institutions.
Over the years, Bitcoin has inspired thousands of new types of cryptocurrency that have built on its technology. It has also become popular as an asset class due to gains in its value. Here’s a closer look at how Bitcoin works and how to decide if you should invest in it.
How Does Bitcoin Work?
Bitcoin is a decentralized digital currency that operates on a peer-to-peer network. It was created in 2009 by an anonymous individual or group of individuals under the pseudonym Satoshi Nakamoto. The basic idea behind Bitcoin is to enable secure, decentralized transactions without the need for a centralized intermediary, such as a bank or government.
Here’s a brief overview of how Bitcoin works:
- Transactions: Bitcoin transactions are electronic transfers of value between Bitcoin wallets. A wallet is simply a collection of cryptographic keys that are used to sign transactions and prove ownership of bitcoins.
- Blockchain: Transactions are recorded in a public ledger called the blockchain. The blockchain is a distributed database that is maintained by a network of nodes or computers around the world. Each block in the blockchain contains a record of several transactions and a unique cryptographic hash that links it to the previous block in the chain.
- Mining: Transactions are validated and added to the blockchain through a process called mining. Mining involves solving complex mathematical problems that require a lot of computational power. Miners compete to solve these problems, and the first miner to solve a problem earns a reward of newly minted bitcoins.
How Does Bitcoin Mining Work?
In the Bitcoin ecosystem, there is a network of miners who use their CPUs to process transactions.
- Once a user who intends to send Bitcoin enters the public address, and number of Bitcoins to be sent and affixes the private key to generate the signature, the encrypted information is then sent to the network of miners who are given the task to verify whether there is sufficient balance to transfer and authenticate the transaction.
- The faster the CPU of the miner, the greater the chances that they will verify and that miner gets rewarded in Bitcoins for facilitating the transfer.
- Here the miner’s job is only to provide CPU power, which automatically runs the Bitcoin program to validate Bitcoin transfers. There is no manual intervention by the Bitcoin miner.
- Once the transaction is processed by a Bitcoin miner, this number of transactions is then broadcasted to the network of miners who get the copy or download of the same block.
- These blocks through a timestamp mechanism are stored in a sequential or chronological order forming a blockchain. Each miner in the network is supposed to have the updated and complete copy of the ledger or the blockchain if they want to facilitate transfer and earn Bitcoins.
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How to use Bitcoin
Although more than 18 million Bitcoin are in circulation — with a maximum total supply of 21 million — Bitcoin today is most commonly considered as a store of value. Many view Bitcoin as a form of digital gold rather than money in the traditional sense. Users can also transfer Bitcoin to other people and pay with Bitcoin for purchases from a very limited number of businesses.
Major companies that accept Bitcoin as a payment method include Overstock, Microsoft (NASDAQ: MSFT), and AT&T (NYSE: T). If you buy Bitcoin or another cryptocurrency via PayPal (NASDAQ: PYPL), you can use it to pay for purchases from any retailers that accept PayPal Checkout.
Bitcoin is stored in a crypto wallet. When it’s bought, sold, traded, or used for purchases, it’s transferred from one Bitcoin wallet to another. There are two types of crypto wallets:
- Hot wallets: These wallets are connected to the internet and are generally free to use.
- Cold wallets: For added protection, cold wallets aren’t connected to the internet. The most common types of cold crypto storage are hardware devices.
How to buy Bitcoin
Here’s how to buy Bitcoin:
- Set up an account on a cryptocurrency platform.
- Complete the platform’s identity verification process.
- Deposit money from your bank account.
- Buy the amount of Bitcoin that you want.
There are several places to buy Bitcoin. It’s sold on cryptocurrency exchanges, as well as by select stock brokers and some payment apps. Cryptocurrency exchanges offer the most features, so they’re well-suited for serious crypto investors.
Since Bitcoin is the most popular cryptocurrency, Bitcoin trading is available on just about any exchange. These are a few of the best-known and highly-rated exchanges:
- Coinbase (NASDAQ: COIN): Launched in 2012 as a way to buy Bitcoin through bank transfers.
- Gemini: Founded by Tyler and Cameron Winklevoss in 2014 and the first to offer Bitcoin futures contracts.
- Binance: A worldwide platform that’s been experiencing regulatory challenges, Binance also has a U.S. platform (Binance.US) and has been listing Bitcoin since its 2017 inception.
After you choose an exchange and create an account, you can verify your identity with a driver’s license, passport, or other valid identification typically issued by a government. This step is required for tax reporting purposes and to prevent criminal activity such as money laundering.
Most exchanges accept multiple payment methods. Transferring money from your bank account almost always minimizes your fees, making this the best option.