What is Bitcoin and How Does it Work?
This post may contain affiliate links, which means I may receive a small commission, at no cost to you, if you make a purchase through a link.
What is Bitcoin?
Bitcoin has become a key name in the financial market with millions of people and institutions investing in it. This article targets to answer the question of what is Bitcoin and how it works.
Bitcoin is an open-source decentralized cryptocurrency that is run on blockchain technology. Satoshi Nakamoto, the anonymous bitcoin creator, intended to create a transactional digital currency that would eliminate the need for 3rd parties such as central banks.
To achieve this, he came up with the idea of enabling peer-to-peer computer networks to verify transactions. Bitcoin’s abbreviation is BTC.
Satoshi Nakamoto bought the bitcoin.org domain and released the first Bitcoin whitepaper known as; A Peer-to-Peer Electronic Cash System. This white paper contains the fundamentals of its operations. It also forms the basis of introducing the world to cryptocurrencies.
Some analysts believe the release of the bitcoin whitepaper in 2008, a time when the world was undergoing a global financial crisis, was a strategy to bring hope in a decentralized system at a time when customers had lost hope in the banking sector.
According to the whitepaper, “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”
Through the use of cryptography, Bitcoin’s development was a success. It was launched on the 9th January 2009 with Satoshi proceeding to mine the genesis block of 50 bitcoins.
Satoshi Nakamoto worked on the bitcoin network with other developers until 2010 when he withdrew from the project and was never heard from again. `
How Does the Bitcoin Blockchain Work?
The Bitcoin cryptocurrency runs on blockchain technology. A blockchain is a decentralized ledger that records transactions happening on the network. Decentralization of the networks helps eliminate the need for middlemen during transactions.
Whenever a transaction happens on the network, it is recorded in a block. You can’t alter these recordings making the system safer than most traditional payment technologies.
The bitcoin blockchain is among the many in existence today such as the blockchain that powers the Ethereum ecosystem. However, the bitcoin blockchain was the first of its kind, borne from Nakamoto’s idea of using a chain of blocks to verify transactions.
Some of the other key terms to know when understanding the blockchain include;
Nodes
This refers to the computers that maintain the blockchain through peer communication. Nodes are the computers responsible for verifying transactions on the blockchain. Let us look at the example of Jane who wishes to send 5 bitcoins to John.
- The nodes will confirm that Jane has at least 5 bitcoins in her account.
- Upon verification, 5 bitcoins are debited from Jane’s account and credited to John’s account.
- Once all the nodes verify and validate this transaction, it is recorded on a block making it visible on the network where everyone can see a transfer of 5 bitcoins between 2 wallet addresses.
Block time
This refers to the time taken to mine a block of cryptocurrency. For bitcoin, the block time is roughly 10 minutes. For every 10 minutes, a new block is added to the bitcoin blockchain.
In addition, all the nodes record and update the new block. All this happens without any central oversight, signifying the ability of decentralized systems.
Block size
It is the size of blocks on a blockchain. Initially, blocks on the bitcoin blockchain had a 32MB limit size before Nakamoto changed the limit to 1MB in 2010. However, the 1MB block size limit causes transaction processing problems such increase in transactional fees and delays in processing transactions.
Bitcoin still retains the 1MB block size, although proposals have been made to remove the limit. To achieve independence on the network, each node stores a copy of the blockchain.
The bitcoin blockchain is using the SHA-256 algorithm that allows for the existence of 2256 private keys, making it incredibly difficult for fraudsters to get hold of individuals’ private keys.
Bitcoin addresses comprise public and private keys. You can share your public key without compromising the safety of your crypto wallet. Avoid sharing your private key since it grants complete access to your wallet.
The network only recognizes the private key as the proof of ownership of a crypto wallet. Therefore, should you lose your private key, you lose access to your wallet and all the coins in it.
Mining
Bitcoin has a maximum supply of 21 million coins. Currently, over 18.9 million are already in existence. It is estimated that the 21 million coins will have been mined by 2140 due to Bitcoin’s halving reward policy.
Mining
This is the process of verifying transactions, thus creating additional blocks into the blockchain. Miners are awarded bitcoin tokens for verifying transactions/mining blocks.
During the mining process, miners can opt to prioritize the transactions that pay higher fees relative to their storage size since fees paid are measured in satoshis per byte(sat/b).
In the case of bitcoin, the proof-of-work consensus mechanism requires miners to solve a complex algorithm to verify a block is applied.
Bitcoin uses a halving principle on mining rewards. Initially, the reward was 50 bitcoins per block, as seen in the genesis block. However, this reward scheme changes every time 210,000 blocks are mined.
Initially, you could mine using normal computers but as the puzzles got progressively difficult, there was a need for computers with faster and more computing power. Currently, the reward for mining a bitcoin block is 6.25 bitcoins.
Units of bitcoin
It is possible to subdivide bitcoin into smaller units up to 8 decimal places. Some of the most common terms for the smaller bitcoin units include:
- Millibitcoin– 1/1000 of a bitcoin
- Microbitcoin – 1/1,000,000 of a bitcoin
- Satoshi – 1/100,000,000 of a bitcoin. It is the smallest denomination named in honor of the bitcoin founder.
Advantages of Bitcoin
- Decentralization
The whole concept of cryptocurrencies was to create a decentralized currency void of 3rd parties like Central banks and governments enabling them to operate on market supply forces.
- Secure
Blockchain technology makes it hard to manipulate transactional details without invalidating all consecutive blocks. The only way that a person can change the transactions on a blockchain network is by controlling 51% of the computers on the network.
A fete that is almost impossible to achieve due to the presence of many miners across the world.
A point to note is that coin theft occurs mostly on online platforms that offer wallet services, and not on the bitcoin blockchain.
- Growth Potential
Bitcoin did not have any substantial value after its launch in 2009. However, it has grown to become the most popular and largest cryptocurrency in the market in market valuation,
Currently, it is trading at an average of 40,000 dollars per coin. With analysts, the coin could hit 100,000 dollars soon, its growth potential continues to rise.
Bitcoin’s first mover advantage also contributes to this success as the majority of investors use it as the benchmark.
Bitcoin ETF Approval is likely to Send Its Price Towards $100,000
Challenges of Bitcoin
- High volatility
Despite being the most popular cryptocurrency, volatility remains high making it a risky asset to invest in.
Lack of adequate regulations and decentralization elements makes it hard for third parties to manage this volatility. A factor that is common with other cryptocurrencies as well.
- High power consumption
Bitcoin faces regular criticism due to its high-power consumption during the mining process. As we get close to hitting the supply cap, difficulty in the mining process keeps growing thus requiring more energy to run the increasing computing power.
Most activists argue this need for power forces miners to tap into unclean sources of energy for power hence contributing to the environmental damage.
- Irreversible transactions
Since it operates on a decentralized network, it is impossible to reverse a transaction in case of an error. Hence, it requires utmost care when conducting transactions on the network.
Storage Wallets
You store your bitcoins in your wallet. The use of wallets is a common practice when transacting with virtual money. There are 2 main types of wallets;
- Hot wallets– These are wallets available on the internet. They are easier to have and access. However, they are also a key target for fraudsters due to the ease of accessing them. In the past, the majority of crypto theft happens on such wallets.
- Cold wallets– Unlike hot wallets, cold wallets are not connected to the internet. Some examples of cold wallets include:
- Portable cold wallets- They are portable wallets that look like flash drives and are encrypted for the safekeeping of cryptocurrency coins.
- Paper wallets – These are crypto wallets that store addresses on a piece of paper.
Although cold wallets are safer in comparison to wallets, they also come with the risk of physical loss. Once you lose your cold wallet, you lose access to all the cryptocurrencies stored in your wallet.
Conclusion on What is Bitcoin and How it Works
Over the years, Bitcoin has experienced tremendous growth to become the largest and oldest cryptocurrency in the market. In September 2021, El Salvador became the first nation to officially adopt Bitcoin as legal tender.
There are also ongoing discussions in various countries on how to regulate it and its peer cryptocurrencies. This is an indicator of a maturing market and increasing acceptability of Bitcoin into the formal financial markets.
One Comment
Pingback: