Key Takeaways:
- Bitcoin is a digital and decentralized cryptocurrency
- It has several advantages over traditional money such as lower fees, faster transactions and increased security
- It is still in its infancy and volatile, making it a risky investment
What is Bitcoin?
Bitcoin is a digital currency that acts in the same way as traditional money.
There is no physical form, it just exists virtually. Bitcoin is not controlled by anyone, it runs in a network between his users.
The users can send and receive Bitcoin directly to each other, called peer-to-peer (P2P). So if it is a virtual copy of something which exists in reality why should we need this?
What are the Advantages of Using Bitcoin?
Before we dive deeper into the topic let us quickly look at why we would ever need a virtual copy of something we already use in reality.
Bitcoin has some major differences to traditional money, called fiat money (from Latin: fiat, ‘let it be done’) which makes it so innovative:
Decentralization
Fiat money is controlled by governments and banks.
They can multiply it if they need to.
If you want to use money, you need a bank at some point to use it in all the different ways possible. Bitcoin is different, there is no central institution controlling it. Bitcoin is controlled by no one.
All the people using Bitcoin can verify if transactions are correct, therefore not needing a third party for controlling.
Limited Supply
Fiat money can be multiplied as often as possible.
The more money, the less it is worth which we know as inflation.
Bitcoin is similar to gold. The amount of Bitcoin is limited to 21 million coins making it scarce. It is not possible to multiply Bitcoin. If something is limited it can create the opposite effect of inflation, called deflation.
This means the value increases over time instead of decreasing.
Tamper Proof
Because money can be printed, it therefore can be reproduced by anyone creating fake money.
Bitcoin has implemented different mechanisms preventing this problem.
Bitcoin cannot be reproduced. Bitcoin users don’t have to trust each other because the system ensures trust. The network has all the information to check if a transaction is incorrect and deny it.
Divisibility
Our known currencies can be divided up to two decimals.
Dollar or Euro to 100 cents each.
With Bitcoin the same concept applies but up to eight decimals. A Bitcoin is divisible into 0.00000001 BTC. This smaller unit is called Satoshi, named after the inventor of Bitcoin.
If the value of Bitcoin will increase, this divisibility will ensure that Bitcoin still could be used for the smallest purchases.
Anonymity
For a bank account you need to provide personal documents and governments can trace your transactions if needed.
This helps to make the system more secure but it also lets these institutions know what you do.
Bitcoin acts similar to cash. If you have it in your pocket and buy something with it, others can see this transaction but you don’t need to provide personal details.
You can stay anonymous and no one can trace everything you do with your money.
Control
Because there is no central institution taking care of your Bitcoin, you have full control over it.
You hold Bitcoin by yourself and can do with it what you want.
You don’t need permission or limitations to use it. There is no bank which can restrict your access to it. Bitcoin is something you really possess. No one can limit you. You can do what you want.
Bitcoins vs. Dollars
Okay, so we have some advantages but Bitcoin is just something virtual and not real you could think.
Let’s take a look at the U.S. Dollar, which is something we can hold in our hand.
It is something material with a real value behind it. But of all the existing money supply, only about 10 percent is backed by gold. The rest isn’t backed by anything, it is just printed on paper with some numbers on it.
You could say that the Dollar is nearly as virtual as Bitcoin, the only difference is that this illusion is more widely believed. Due to World War I governments needed more money for the military than they had in gold. They started to print it.
Due to the possibility to print money as much as needed, there is no value anymore lying behind it. Imagine you could just print money at home. Would there be some real value to it?
Or would it be just a nice picture printed on a piece of paper? You could of course convince people to use it as money starting with your own currency. Now you know what Bitcoin is and what benefits it can bring to you.
In the following article you will get a deeper insight about what technology lies behind the concept of Bitcoin. You will understand how Bitcoin works and why it can be a powerful solution to many problems of our today’s financial system.
The Bitcoin Whitepaper and Satoshi Nakamoto
How did Bitcoin actually start?
Back in October 2008 Bitcoin was introduced by a group or a person called ‘Satoshi Nakamoto‘ by publishing the Bitcoin Whitepaper.
In this document the concept of Bitcoin was explained as a peer-to-peer electronic cash system. Our current fiat money has some disadvantages which were addressed with this new virtual currency.
Until now we use our well-known financial system. We need a trusted third party which verifies that a transaction is correct. They hold our money and verify that we actually have the money to spend. Without banks the financial system wouldn’t work.
This gives them not only control but also data about everyone using this system. They are also expensive in fees and slow in transactions. Banks have to pay for their buildings and financial experts.
They can also limit how you can use your own money. If there would be a payment system which could build trust by itself, third parties wouldn’t be needed.
The solution presented in the Bitcoin Whitepaper was a timestamp server which records cryptographically signed transactions in a public ledger. The technology behind this solution is called Blockchain, also known as Bitcoin network or Bitcoin protocol.
This system ensures the verification of every Bitcoin transaction by the participants in the system itself to eliminate the double-spending problem.
What is the Double-Spending Problem?
Imagine you have a dollar in your pocket which you would like to give someone else.
If you give it away the other person gets this dollar and you don’t have it anymore.
You cannot give this dollar to another person because you physically gave it away and you and the other person can confirm that this transaction happened. Now think about whether this dollar would be a virtual dollar.
If this were a virtual file on your computer, it wouldn’t be as easy to do the same thing. If someone would send this file to you, how could you know that the person didn’t make a copy of it before sending?
Or maybe this virtual dollar was already spent and you got only a copy of the original file? This is called the double-spending problem. It means that someone could potentially spend the same money twice.
The traditional financial system solves it through banks acting as trusted third parties verifying all transactions within their ledgers so this problem cannot happen. The double-spending problem is solved this way but it now leads to a new problem.
If the third party has the control over the ledger, they can now easily put more virtual dollars into the system.
They can observe every transaction between you and others, they can cancel it, freeze your bank account and know generally a lot about your money and your personal details.
They could also fake transactions opening the doors for corruption, which is common practice in many regions all over the world. For the concept of Bitcoin to work, we need a ledger, too. The Blockchain provides us a ledger which is not controlled by a central institution.
What is Blockchain Technology?
The Blockchain is a ledger, which is public, digitally distributed and decentralized through a network.
It solves the double-spending problem without the need of a third party.
What does that all mean?
- The Blockchain is public.
Anyone can take a look into the ledger where every transaction ever done is stored. You can look into the ledger without restrictions. - The Blockchain is digitally distributed.
Instead of one ‘Bitcoin Blockchain’ there are existing just copies all over the network. Every user can get a copy. It will then get part of the system as a synced copy. - The Blockchain is decentralized.
No one controls a master copy. Every user can have a copy of the ledger which is as important as every other copy. With thousands of ledger syncing with each other no one can control all of them.
If the Blockchain is public, then everyone can see your information, so it sounds worse than just a bank. All transactions and account balances are public and recorded in it and synced through the network.
But no personal details are revealed leaving you anonymous.
How Does the Blockchain and Bitcoin Work?
A user gives one bitcoin to another one.
This transaction is recorded in the ledger and then automatically synced in all copies of the ledger within the network.
All ledgers are compared with each other and if all copies are matched, the transaction gets approved.
If someone would try to cheat and alter his ledger e.g. spending a bitcoin without actually having one, the other copies would detect that this ledger is not matching with the rest and therefore the transaction would not be approved.
In addition, every transaction ever happened is recorded in the Blockchain so the real ownership can be also proved. The system knows where every bitcoin is. The ledger stores all Bitcoin transactions in it.
All copies of the ledger are constantly compared with each other to ensure they all match. This is how the Blockchain works. This was a bit simplified but it shows why Bitcoin has the potential to be a revolutionary solution.
It can eliminate third parties, solving the double-spending problem and giving people full control over their money. Without a third party transactions can be faster and cheaper because no one has to check it and you don’t have to pay for such service.
Also, no one has your personal details.
What is Bitcoin Mining?
We now know what Bitcoin is and how it works.
The next question is how Bitcoin is actually created? No central institution controls it so who creates it?
Before Bitcoin can be used we have to create it through a process called Bitcoin mining. We have a limited supply of 21 million bitcoins, but we don’t have them all yet. Similar to gold, mining is the process to gather new bitcoin.
Bitcoins are not hidden somewhere in the internet to be actually mined. What happens is that the Bitcoin miners solve a cryptographic problem to create new Bitcoins.
Through this process they maintain the ledger containing where all Bitcoin transactions are recorded. Every time a new transaction happens, it has to be verified by the ledger.
Because the ledger is maintained by the Bitcoin miners, they add this new record within the mining process to the ledger. To further protect the ledger from being hacked, the ledger is sealed through this computational work.
The computational work required to solve the problem acts as a security layer. If someone would try to hack the ledger, he would need the same computational power. There is not only one miner doing this but thousands.
They all do this mining process competing with each other resulting in more and more of this computational power needed. Why do they make this effort?
They do this because the first miner who solves the problem gets a reward, new bitcoins. Currently, the reward is worth 6.25 bitcoins. The reward gets halved after 210,000 blocks are created, which takes four years. This is known as Bitcoin halving.
If a miner solves the problem he adds during it a batch of transactions into one block of transactions. This new block will then be stored into the ledger. It is added to the long chain of previous blocks, therefore Blockchain.
Now you could think that the miners have the control over the ledger, so they act as a third party like a bank. This is not the case, because the miners are competing with each other to be the first to add the next block to the Blockchain.
They maintain the ledger, but every miner has a copy of it. There is no central version of the ledger, it is stored by every participant in the system, so no one can trick the system.
But this security measure is not enough, there is also the cryptographic aspect. This computational work takes time because the computers used by miners try to solve a cryptographic problem.
Understanding Bitcoin’s Proof-of-Work Mechanism
To add a new block to the chain, Bitcoin uses cryptographic problems miners need to solve.
These problems need a lot of computational power to solve, which is not easy. Solving the problem results in a ‘proof of work’.
The miner’s solution is the proof that he has done the required computational work. The problem he has to solve involves an algorithm, called hash function. A hash function takes an input, and then produces an output (called hash) from it.
The hash function always produces the same output, a string with 64 characters. It’s not possible to reverse this function. The input you give it gets mixed up in a way that you can’t go back from the output you get.
If you change the input just slightly, the output will be completely different. The miners take the information of all transactions of the current block and the dates from the timestamps.
The reference to the previous block is added to this information to find a hash with a certain number of leading zeros. They run the hash function checking if their hash works. If it’s not working, they try another hash.
This is done a billion times until an acceptable hash is found. This problem has to be solved in about 10 minutes, which is why a new block is added to the Blockchain every 10 minutes.
If the miners solve it faster, the difficulty is increased and vice versa. This ensures that it takes 10 minutes for every new block to be added to the Blockchain. The new block gets sent to every other participant, which they can run and then verify that it is correct.
The newly created block is then added to the Blockchain with the hash of the previous block as a reference. If a hacker now wants to change a transaction, he would need to modify the block where the transaction is stored.
Because the block is now changed, a new problem has to be solved to find a new hash. The current solution can’t be reused, because the input has changed.
Every block has a reference to the previous block, so the hacker has to alter all blocks that come after his target block. With the immense computational power needed it would be practically impossible to do.
The hacker would need more power than all miners together. So the more computational power a miner has, the more likely he will create the next block.
This competitiveness ensures that the difficulty to modify the Blockchain increases making it harder to hack.
How to Buy Bitcoin?
Now that we know how Bitcoin works, we certainly are eager to finally buy some of it.
There are many different places to buy bitcoin.
You can buy bitcoin on Bitcoin exchanges, at ATMs, peer-to-peer exchanges or through services like PayPal. You can even buy it directly from another person.
For beginners the safest place is to buy bitcoin on a crypto exchange, like you would buy stocks on an exchange, too.
Crypto exchanges are a convenient and secure option to buy bitcoin. There is a wide variety of different well-established crypto exchanges. There are three main steps you need to follow:
- Choose a place to buy bitcoin
- Decide which payment option you would like to use
- Buy bitcoin
As stated, crypto exchanges are the most straightforward option. But you could buy bitcoin at other places, too.
- ATMs:
They are slowly appearing all over the world giving us the possibility to buy bitcoin with cash. The transaction fees are higher than on exchanges and you need to open an account providing personal documents for KYC. - ETFs:
You can invest in Bitcoin over ETFs or other investment vehicles. This is similar to the same investment options you have with stocks. This is another good option to invest without actually buying bitcoin directly. - P2P:
You can buy bitcoin from a private person through an P2P-exchange or in person. This is the best option regarding fees but riskier. People could try to scam you.
Due to the complexity of this topic beginners should avoid this kind of buying.
There are other possibilities to buy bitcoin and they will surely increase in the future as Bitcoin will be adopted more and more.
Invest in Bitcoin on Crypto Exchanges
If you want to buy on a crypto exchange, you first need to decide which exchange you would like to use.
This decision will depend on your location as the most important factor.
Different countries have different regulations. You will need to provide personal documents for KYC purposes. Crypto exchanges are regulated by governments so you can’t buy bitcoin anonymously.
The advantage is that due to that regulation crypto exchanges are relatively secure. After you have opened an account you can now transfer bitcoin to this account. From there you are able to buy and sell bitcoin.
Depending on your exchange you will have different payment methods available. The most used payment methods are bank wire transfers or credit and debit cards. Sometimes there is a possibility to use PayPal or Apple Pay.
You can buy in the same way as on traditional exchanges through market orders or stop and limit orders etc. Selling your bitcoins happens the same way.
You can store your bitcoins on the exchange and sell it or you can deposit bitcoins from another location into the exchange. This leads to another big topic within the Bitcoin space. How can you store your bitcoins?
What Are Bitcoin Private and Public Keys?
Just as with fiat money in a bank account, you need to store Bitcoin somewhere.
After you have bought bitcoin on the exchange you can of course leave it within your account.
This option is not bad, because it is convenient to quickly trade your bitcoins, but there are other and safer options. Similar to fiat money, you can store Bitcoin in a wallet.
There are many kinds of wallets you can use and some security measures you need to know about like private or public keys. After you have purchased bitcoin, you want to store it in the same way as if someone would transfer money to your bank account.
Your bank account is where you store your money. Bank accounts have unique account numbers for every person and a password to access it.
Public Key
A Bitcoin wallet acts in the same way.
Every wallet has a wallet address which can be shared with others so that they can transfer bitcoins to this address.
This address is your public key. The public key is used as your ‘bank account number’. This address is important so always check if the address is correct. If you miss a character or type it incorrectly, you can lose the bitcoins you wanted to send or receive.
Bitcoin transactions are irreversible so keep that in mind and double-check your wallet addresses!
Private Key
In addition, there is another key called the ‘private key’.
This acts as your password for your wallet.
Like a password you should keep it secret, not sharing it with anyone. If someone has your private key, he can transfer the bitcoins from your wallet. You generally don’t see your real private key.
Most wallet providers try to be user-friendly and encode the private key to make it more memorable. This user-friendly version of the private key is known as a ‘seed phrase’. This is a phrase containing up to 24 simple randomized words.
Your wallet hides the private key behind this seed phrase. Because you use the seed phrase instead of the private key, the seed phrase is generally your password to access your bitcoins. Store it safely in different places, because you can’t recover a private key.
Do not write it down somewhere digitally or take a photo because someone could access it.
Types of Bitcoin Wallets (Hot and Cold Wallets)
The two main types of wallets are called ‘Hot wallets’ and ‘Cold wallets’. They have pros and cons.
- Hot wallets
These wallets are connected to the internet. They can be stored online on an exchange or mobile devices. They are less secure, but more convenient (faster). - Cold wallets
They cannot be accessed through the internet and typically there is some hardware needed to store bitcoins. This makes them more secure but less convenient.
Hot Wallets
Because of their constant connection to the internet, hot wallets are suitable for cases where you want to quickly trade bitcoins.
The most convenient hot wallet is the one you have on your crypto exchange.
After you buy bitcoins they are automatically stored in that kind of wallet. If you want to sell bitcoins, you just can instantly trade them. This is an advantage for people who want to trade often.
Even if you don’t want to trade your bitcoin it can be useful to have some of your bitcoins stored there to quickly do transactions if needed. The disadvantage is that if you use a hot wallet through a web provider they store your private keys for you.
And remember who has your private keys has access to your funds. Your web provider could access your bitcoins or restrict your access to it.
You can use wallets on mobile or desktop applications (called software wallets) where only you have access to your keys. But because these devices are connected to the internet, a hacker could potentially steal your private keys.
Cold Wallets
Hot wallets are called so because of the connection to the internet.
Cold wallets aren’t connected, they are offline.
Someone would have to steal it physically from you to access your funds. The most common cold wallets are hardware wallets and paper wallets. For paper wallets you can create a seed phrase with a generator and then write it down on paper.
Bitcoins are not really stored on your wallets, it’s rather the access to them which is stored on it. Because of this you can use just a piece of paper. Using a generator can be risky because it’s something from the internet where potential hacks can occur.
The safest place is a hardware wallet. They come in the form of a usb stick and you can store your bitcoins on it. They are not connected to the internet and can be stored in a safe place. There is of course a risk of losing them or someone could steal them.
If you store your seed phrase in a different place from your hardware wallet, you have a secure setup for your storage.
What Are the Risks of Bitcoin?
As most crypto sources state (this article, too), is that Bitcoin is the future with many advantages.
Everyone is advertising Bitcoin as the new gold you can’t miss.
If you want to get a complete overview, you have to look on the other side of the medal. As great as Bitcoin is, there are some risks and disadvantages you have to pay attention to.
Volatility
Bitcoin is relatively new (introduced in 2009), therefore it’s extremely volatile.
It can change a few thousand dollars within several weeks.
Bitcoin needs to be adopted by the masses so the volatility can start to decrease. This market is young and needs time to develop. This is a common problem with new markets, people don’t know it and prices swing in every direction.
But this is just a problem if you buy at a high Bitcoin price and then after a big drop you sell at low prices because you fear you will lose everything. If we look at the past 10 years, Bitcoin is steadily growing.
If you hold it long enough, like you can do with stocks, chances are high that your Bitcoins will grow in value. For long-term investing, volatility is not a problem and Bitcoin acts as a store of value.
For short-term it can be dangerous but provide possibilities to make profits if you are experienced. But nonetheless it is something you should consider.
Bitcoin is Not Suitable for Payments
Due to the high volatility you could think that Bitcoin as payment is not suitable for everyday usage.
Today I can buy a car and tomorrow Bitcoin is worth only half meaning I need double the amount to buy this car?
This is right and currently one of the biggest problems of Bitcoin. But do not forget that this is a young market. Every new market has to develop until it balances and stays on a stable level.
This will take time but then Bitcoin will become more and more suitable for that purpose. This is one of the trade-offs Bitcoin has for the advantages it gives to us. Over time this trade-off will be less of a problem.
Bitcoin Has No Intrinsic Value
This is one of the main points for people to criticize Bitcoin.
It is just a virtual file or virtual numbers without any value behind it.
Only the people believing in Bitcoin create this value by investing in it. This is true, Bitcoin is only a virtual thing but with a special and unique purpose creating value. Due to the technology behind it, Bitcoin is physically limited and this makes it scarce.
There is no possibility to multiply it as you can do with fiat money. Another big point giving it value is the decentralized nature of Bitcoin. No one has control over Bitcoin. The scarcity and the decentralization are the same characteristics as gold.
Gold is limited and no one has the control over the whole supply. Governments can only try to get as much as they can. For the first time, each person can store value in something with full control.
No need for a third party controlling or storing it for you. This makes Bitcoin unique.
Bitcoin Needs a Lot of Energy
Bitcoin mining needs a lot of computational power.
To run these machines, a lot of energy is used.
In the first step this critique seems plausible. Big amounts of energy are used to mine Bitcoin just for the sake of capitalism, which seems not really ecologic.
Current estimations of the Cambridge Center for Alternative Finance says that about 76% of the energy used for Bitcoin comes from renewable energy sources.
Mining farms even started to use stranded gas to power the mining farms which otherwise would be unused. Companies that are pumping gas always have a portion of it which has limited utility and is flared.
This is wasted energy they could use to maintain a mining farm using this wasted energy and earning money with it. But in the end, Bitcoin does need energy. The question is, is it worth it for the value Bitcoin can bring to us?
Think about all the electricity we are using today. Is everything of it really necessary producing real value we need?
FAQ
Is Bitcoin Actual Money?
This question has been hotly debated since it first came into existence a decade ago.
Skeptics argue that Bitcoin is simply a speculative asset and not a reliable form of currency.
Proponents point out the increasing number of retailers and businesses that accept Bitcoin payments as proof that it can be used as a medium of exchange. In terms of legal tender, Bitcoin still doesn’t have the same status as traditional currencies.
The question is if governments will start to accept it. First countries started to accept it as an official form of payment. The growing popularity and acceptance as a form of payment gives Bitcoin the potential to become an important part in the future of the digital economy.
Can You Turn Bitcoin Into Cash?
Turning Bitcoin into cash is simple, but it does require a few steps.
First, you’ll need to find a reliable platform to convert Bitcoin into fiat currency.
There are many exchanges available so it is important to research each one carefully to ensure they are licensed and regulated. Once you’ve found an exchange that fits your need, you will need to create an account and transfer your Bitcoin to it.
After you sell your Bitcoin you can withdraw your fiat money in forms such as bank transfers or credit and debit cards. This is the fastest and most convenient way to turn your Bitcoin into cash.
Do Banks Accept Bitcoin?
Banks have been slow to accept cryptocurrencies, and in most cases, they still don’t accept them as a form of payment.
Some banks are starting to explore the potential of the blockchain, but most are cautious and skeptical.
It doesn’t surprise, as Bitcoin is a direct competition to traditional money, which the business of a bank rely on. Time will tell if banks will accept it in the feature. If the acceptance of Bitcoin grows, so will the possibility of banks accepting it.
How Does Bitcoin Make Money?
How Bitcoin makes money is a common question asked by many individuals interested to use Bitcoin as a currency.
Bitcoin makes money through the process of mining, which involves solving complex mathematical equations to verify and validate transactions on the blockchain network.
Miners receive rewards in the form of newly generated Bitcoins for their efforts, which they can then sell on the market or hold as an investment.
Additionally, Bitcoin can also be bought and sold on cryptocurrency exchanges like other assets, with its value determined by market supply and demand.
This means that investors can profit from buying when Bitcoin’s price is low and selling it when the price of Bitcoin increases.
How Bitcoin Works: Simple Explanation
How Bitcoin works can be a complex topic, but it can be explained in a simple way.
Bitcoin is a digital currency that operates on a decentralized network called the blockchain.
Transactions are recorded on the blockchain network, which is made up of a series of connected computers around the world. When a user sends Bitcoin to another user, the transaction is verified and validated by miners who are rewarded with newly generated Bitcoins.
This ensures the security and integrity of the network, as transactions cannot be altered or deleted. Bitcoin can be stored in digital wallets and used to make purchases, and its value is determined by market supply and demand.
Conclusion: What is Bitcoin?
What is Bitcoin?
Bitcoin is something special which can give you more independence in your life. Bitcoin is a digital currency that operates on a decentralized blockchain network.
It offers several advantages over traditional fiat currency, such as lower transaction fees, faster transaction speeds, and increased security.
While it is not yet widely accepted by mainstream businesses, there are many crypto exchanges where you can buy and sell Bitcoin.
Bitcoin’s unique proof-of-work mechanism, which is used to validate transactions and create new Bitcoin, is what makes it secure and decentralized. However, Bitcoin is not without its risks, including its volatility, lack of regulation, and potential for hacking.
Overall, Bitcoin is a fascinating and innovative technology that has the potential to revolutionize the way we think about money and transactions. Bitcoin will change our future but it is still in the beginning.
The more people understand the potential the faster Bitcoin will establish. Be a part of it already today!
