Not only is Bitcoin the first cryptocurrency, but it’s also the best known of the more than 5,000 cryptocurrencies in existence today. Financial media eagerly covers each new dramatic high and stomach churning decline, making Bitcoin an inescapable part of the landscape.
While the wild volatility might produce great headlines, it hardly makes Bitcoin the best choice for novice investors or people looking for a stable store of value. Understanding the ins and outs can be tricky — let’s take a closer look at how Bitcoin works.
What Is Bitcoin?
Bitcoin is a digital currency created in January 2009. It follows the ideas set out in a whitepaper by the mysterious and pseudonymous Satoshi Nakamoto.1 The identity of the person or persons who created the technology is still a mystery. Bitcoin offers the promise of lower transaction fees than traditional online payment mechanisms and, unlike government-issued currencies, it is operated by a decentralized authority.
Bitcoin is a type of cryptocurrency. There is no physical bitcoin, only balances kept on a public ledger that everyone has transparent access to. All bitcoin transactions are verified by a massive amount of computing power. Bitcoin is not issued or backed by any banks or governments, nor is an individual bitcoin valuable as a commodity. Despite it not being legal tender in most parts of the world, bitcoin is very popular and has triggered the launch of hundreds of other cryptocurrencies, collectively referred to as altcoins. Bitcoin is commonly abbreviated as “BTC.”
How Does Bitcoin Work?
Bitcoin is built on a distributed digital record called a blockchain. As the name implies, blockchain is a linked body of data, made up of units called blocks that contain information about each and every transaction, including date and time, total value, buyer and seller, and a unique identifying code for each exchange. Entries are strung together in chronological order, creating a digital chain of blocks.
“Once a block is added to the blockchain, it becomes accessible to anyone who wishes to view it, acting as a public ledger of cryptocurrency transactions,” says Stacey Harris, consultant for Pelicoin, a network of cryptocurrency ATMs.
Blockchain is decentralized, which means it’s not controlled by any one organization. “It’s like a Google Doc that anyone can work on,” says Buchi Okoro, CEO and co-founder of African cryptocurrency exchange Quidax. “Nobody owns it, but anyone who has a link can contribute to it. And as different people update it, your copy also gets updated.”
While the idea that anyone can edit the blockchain might sound risky, it’s actually what makes Bitcoin trustworthy and secure. In order for a transaction block to be added to the Bitcoin blockchain, it must be verified by the majority of all Bitcoin holders, and the unique codes used to recognize users’ wallets and transactions must conform to the right encryption pattern.
These codes are long, random numbers, making them incredibly difficult to fraudulently produce. In fact, a fraudster guessing the key code to your Bitcoin wallet has roughly the same odds as someone winning a Powerball lottery nine times in a row, according to Bryan Lotti of Crypto Aquarium. This level of statistical randomness blockchain verification codes, which are needed for every transaction, greatly reduces the risk anyone can make fraudulent Bitcoin transactions.
How Does Bitcoin Mining Work?
Bitcoin mining is the process of adding new transactions to the Bitcoin blockchain. It’s a tough job. People who choose to mine Bitcoin use a process called proof of work, deploying computers in a race to solve mathematical puzzles that verify transactions.
To entice miners to keep racing to solve the puzzles and support the overall system, the Bitcoin code rewards miners with new Bitcoins. “This is how new coins are created” and new transactions are added to the blockchain, says Okoro.
In the early days, it was possible for the average person to mine Bitcoin, but that’s no longer the case. The Bitcoin code is written to make solving its puzzles more and more challenging over time, requiring more and more computing resources. Today, Bitcoin mining requires powerful computers and access to massive amounts of cheap electricity to be successful.
Bitcoin mining also pays less than it used to, making it even harder to recoup the rising computational and electrical costs. “In 2009, when this technology first came out, every time you got a stamp, you got a much larger amount of Bitcoin than you do today,” says Flori Marquez, co-founder of BlockFi, a crypto wealth management company. “There are more and more transactions [now, so] the amount you get paid for each stamp is less and less.” By 2140, it’s estimated all Bitcoins will have entered circulation, meaning mining will release no new coins, and miners may instead have to rely on transaction fees.
How to Use Bitcoin
In the U.S. people generally use Bitcoin as an alternative investment, helping diversify a portfolio apart from stocks and bonds. You can also use Bitcoin to make purchases, but the number of vendors that accept the cryptocurrency is still limited.
Big companies that accept Bitcoin include Overstock, AT&T and Twitch. You may also find that some small local retailers or certain websites take Bitcoin, but you’ll have to do some digging.
That said, PayPal has announced that it will enable cryptocurrency as a funding source for purchases this year, financing purchases by automatically converting crypto holdings to fiat currency for users.
“They have 346 million users and they’re connected to 26 million merchants,” says Spencer Montgomery, founder of Uinta Crypto Consulting. “It’s huge.”
You can also use a service that allows you to connect a debit card to your crypto account, meaning you can use Bitcoin the same way you’d use a credit card. This also generally involves a financial provider instantly converting your Bitcoin into dollars. “Crypto.com and CoinZoom are two services that have regulation in the U.S.,” Montgomery says.
In other countries — particularly those with less stable currencies — people sometimes use cryptocurrency instead of their own currency.
“Bitcoin provides an opportunity for people to store value without relying on a currency that is backed by a government,” Montgomery says. “It gives people an option to hedge for a worst-case scenario. You’re already seeing people in countries like Venezuela, Argentina, Zimbabwe — in countries heavily in debt, Bitcoin is getting tremendous traction.”
That said, when you use Bitcoin as a currency, not an investment, in the U.S., you do have to be aware of certain tax implications.
