Bitcoin Explained: What Is Bitcoin And How Does It Work?
Bitcoin is a type of cryptocurrency and global money system that is purely digital. It doesn’t have any banknotes to print, coins to mint, or a centralized authority to control it. Bitcoin can be used to buy a couch off of eBay or to book a hotel for your next vacation. Many people also simply trade Bitcoin, without using it to purchase anything. Similar to the Dollar or the Euro, Bitcoin can be used to purchase virtually anything. Moreover, Bitcoin is used as a store of value – similar to gold and real estate.
Bitcoin offers investors an alternative asset class that offers diversification from traditional securities and bonds. Similar to other investment classes, Bitcoin requires a basic understanding of the fundamentals and how the market works. As Warren Buffett has said, “Risk comes from not knowing what you’re doing.”
Why is Bitcoin Important?
As countries moved off the gold standard in the 20th century, including the United States, the idea that currencies can hold value without physical assets to act as collateral was established. However, this shift also placed significant power with national governments and banking authorities to manage the supply of money and avoid inflationary (or deflationary) forces on the local economies. Unfortunately, this power can be easily abused by a corrupt politician or political party.
A recent example can be seen in Venezuela, where inflation exceeded 929,790% in 2018 alone under Nicolas Maduro. In order to help visualize what this means for the average Venezuelan, Reuters produced a series of photos illustrating how much it now costs for common household items.
Odds are that you do not live in Venezuela. So why are Bitcoin and cryptocurrency so important for you?
As a result of COVID, the US and other countries have executed actions to increase the supply of money – a practice is known as “quantitative easing” – in order to support their local economy. The result is a deflationary effect on the US dollar, as well as a significant reduction in yields that investors can receive from Treasury bonds.
At the same time, there is an increasing preference by consumers to use digital payments over cash in an attempt to safeguard themselves from COVID. In response to this trend, PayPal has come forward to enable customers to buy, sell, and use Bitcoin for day-to-day transactions in a way that’s indistinguishable from customers using their credit card or mobile payments. With 28 million merchants accepting Bitcoin overnight, it’s official: Bitcoin is now mainstream.
While Bitcoin has similarities to traditional currencies, there are two main differences between them. The primary difference is how it is issued and governed.
Bitcoin is a currency that is created and supported by an interconnected network of computers that are distributed around the world. The community, which operates these computers, has created a system that governs itself and introduces new monetary policy based on general agreement (or “consensus”) across the members. There is no single person or authority who has controlling ownership of Bitcoin.
In contrast, this differs from the traditional financial system where governments and central banking authorities have full control over the entire process. The central ownership of financial systems creates situations where corruption and inflationary strategies can seep into national economies, as seen in numerous countries throughout the world. Furthermore, Bitcoin differentiates itself from paper and coin currency by having a finite supply. The founder of Bitcoin created a governing system that would ensure a limit of 21 million Bitcoin.
Who Founded Bitcoin?
The true identity of the Bitcoin founder remains a mystery. Moreover, whether the creator of the network was a person or a group is yet to be determined. The prior analysis could, however, help demystify and identify the creator of Bitcoin.
Nonetheless, there are few facts about him or them. In the early days, a male account holder operating under the alias “Satoshi Nakamoto” said he was a 37-year-old from Japan. Later on, a deeper analysis of his writing style and English levels revealed reasonable doubts about his claims.
Furthermore, evidence from Satoshi Nakamoto’s sleeping cycles indicates that he was likely American and a very skilled programmer who valued his privacy.
Satoshi Nakamoto left the development of the Bitcoin network to Gavin Andersen in mid-2010 and has never resurfaced or commented in any Bitcoin forum ever since.
Satoshi mined the first Bitcoin block—called the Genesis, and by the time he left, it is said he owned one million BTC worth over $10 billion at current prices.
Who Controls Bitcoin?
Before he departed Satoshi Nakamoto was the lead developer of the Bitcoin system. This lead developer role was primarily focused on enhancing the Bitcoin system with new software developments and addressing any technical issues that arose.
From a control and ownership perspective, the Bitcoin system was under the hands of the community. Specifically, this control fell to members of the community – known as “miners” – who devoted time and resources to maintain and secure the Bitcoin system. Miners are distributed and the network has become even further decentralized, increasing its security and independence from governments and central authorities.
How Does Bitcoin Work?
As previously noted, the Bitcoin system is decentralized and distributed. Computer and computer systems – known as “nodes” in the cryptocurrency world – power the Bitcoin system throughout the world.
The Bitcoin source code is open-source and without a central authority. Therefore, developers can propose changes to improve the network either making the Bitcoin system more secure, scalable, or efficient.
Before changes are made, their proposals must first be discussed by the community and receive support from most miners. The open-source nature of the Bitcoin source code and its community explains why the network is robust with comparatively low transaction fees.
Each Bitcoin is essentially a computer file stored inside a “digital wallet”. You can get yourself acquainted with the different types of wallets that store Bitcoin and other cryptocurrencies. People can send Bitcoin (or parts of Bitcoin) to each other from wallet to wallet. Each transaction is recorded on the public ledger known as the blockchain. There will be only 21 million BTC ever created. Right from launch in 2009, the Bitcoin system rewarded full nodes for channeling computing power and securing the network.
What are Bitcoin’s Main Properties?
It Uses Encryption and Guarantees Anonymity
The sophisticated encryption software used in Bitcoin is referred to as “military-grade” and is thought to be impenetrable.
Transactions are Instant and Permanent
Cryptocurrency transactions are recorded on the blockchain, and since the blockchain is immutable (unchangeable), once a transaction is made it becomes permanent and irreversible. Additionally, by cutting out the middleman (like a bank or any other institution), you also cut down the time it takes for your transaction to occur. Sending and receiving a Bitcoin does not require an endless number of working days, rather it is done within a matter of minutes or even seconds on elevated networks. This also works to eliminate all the processing fees that such institutions often impose on users.
It Exists in a Decentralized, Peer-To-Peer Network
Unlike conventional cash, Bitcoin is not governed by a single entity such as a person, bank, government, or regulatory authority. This results in a system that is free of monetary policies, immune to bank and system collapses, and that is free of the constraints of exchange rates.
What are the Main Advantages of Bitcoin?
Given the decentralized and distributed nature of Bitcoin, there are several key advantages that it possesses over traditional government-issued currencies.
Bitcoin is new-age money where you can send Bitcoins worth billions of dollars across borders straight from your hard disk. Unlike gold or cash, you do not have to worry about physically moving the amount securely.
2. Censorship Resistance
As we know, the Bitcoin network is highly decentralized which makes Bitcoin immune to local-specific regulations. Unlike credit cards and bank accounts, there are no limitations on who can own and use Bitcoin, so long as they have an internet connection. Centralized systems with governing bodies can decide to implement new policies and restrictions without consulting or providing notice to impacted citizens or businesses. This cannot happen with Bitcoin since there is no single regulatory authority.
The Bitcoin network is a secure network that has significant advantages over traditional banks and credit card companies. The decentralized and distributed nature offers significant protection against hackers who are unable to target a single computer server (or a small number of servers) to access customer information. Any effort would be futile since they would never be able to identify who or where the millions of independent computers are that each has a copy of the latest Bitcoin “block of data”.
Furthermore, Bitcoin offers its owners much greater identity theft protection than banking and credit cards since the customer’s real name and address are never used. Instead, each Bitcoin owner is identified by a series of 26-35 letters and numbers that represent their address on the blockchain. This address cannot be accessed unless a special digital password – known as a “private key” – is used to initiate and validate the transaction. An example of how secure this is would be this: it would take a hacker over 10 billion years to break into your Bitcoin account. Financial institutions are hacked many times every single day.
How to Purchase Bitcoin?
1. Bitcoin ATMs and Exchanges
A simple way to purchase Bitcoin would be to head to a Bitcoin ATM (they are scattered in cities across the world) and to use your debit card or hard cash (in any currency) to purchase some Bitcoin.
2. Sell products/services for crypto
Another way includes selling products and services and accepting payment in Bitcoin. You would just need to set up your digital wallet for people to forward the Bitcoin to you.
3. Or you can mine Bitcoin
Mining for Bitcoin (think of it similar to mining for gold) means setting up your computer(s) to solve complex equations and get rewarded with Bitcoin in return. Mining is not as simple as it sounds since it requires heavy-duty high functioning computers that could end up running high electricity bills.
Is Bitcoin a Good Investment?
Simply put, Bitcoin is valuable because people are willing to trade goods and services for it. Much like the Aztecs of Mezoamerica decided that cocoa beans were valuable enough to trade (with 100 beans buying you a hen!), our current events determine that Bitcoin is indeed valuable.
Furthermore, Bitcoin differentiates itself from paper and coin currency by having a finite supply. The founder of Bitcoin created a governing system that would ensure a limit of 21 million Bitcoin. When governments and entities print and issue an overflow of cash currency, that currency becomes devalued. Due to its finite nature, no one can generate an endless supply of Bitcoin, making the risk of its devaluation significantly lower.
How is Bitcoin Regulated?
At this time, there are still legal issues surrounding Bitcoin in some jurisdictions. For example, countries like China have banned the trading of Bitcoin and crypto.
In the United States, anybody can trade, own, or mine virtual currencies; but there are different ways that US government agencies and financial regulatory bodies classify Bitcoin and cryptocurrency. As it relates to buying and selling Bitcoin, the Internal Revenue Service (IRS) classifies Bitcoin as property, which differs from stocks and bonds which are taxed based on capital gains or income on your annual tax return. Taxes can be complicated, but we break it down in easy-to-understand terms in our Getting Started in Bitcoin and Cryptocurrency video course for those who want more information.