What is Bitcoin? And How Does It Work?

(This article is not financial advice. Ensure to do your research before putting in your money in this volatile asset)

TL;DR

Bitcoin is a digital currency. It is completely virtual. There are no physical bills. Bitcoin is decentralized. Decentralization helps any two people send bitcoin to each other without the involvement of middlemen like banks or other financial authorities.

What is Bitcoin?

Bitcoin is a decentralized digital currency.

Created by a pseudonymous person called Satoshi Nakamoto in 2009, both popularity and price of bitcoin have surged since then.

Source: CoinMarketCap

Source: CoinMarketCap

The value of 1 bitcoin reached more than $61,000 on 13th March 2021.

In case you are thinking that buying 1 bitcoin is out of reach, don’t worry. Bitcoin is divisible and getting a small fraction of bitcoin is possible.

Depending on the need

  • Bitcoin can be used as a transfer of value like money or commodities
  • Or as an investment/store of value like a digital gold

How is a bitcoin transaction different from other transaction methods such as a bank transfer?

Let’s look at the steps involved in a transaction done by bank transfer

  • Banks first check their records (ledgers) to see if we have enough money for the transaction to go through.
  • If we have enough money in our account, banks transfer the required amount to the destination account
  • Post-transaction, banks update their ledgers to reflect the change in balances of both sender and receiver. They also add other details such as the time of the transaction.

The banks or financial authorities manage their ledgers and are responsible for updating them.

The difference between Bitcoin and a traditional financial authority is decentralisation.

In bitcoin transactions, there is no need for a central intermediary to validate the transaction and update the ledgers for us.

If a bank is not part of the transaction then who will verify & validate the transaction?

Instead of putting the trust with one central authority, multiple copies of the ledger are made. These copies are available to the participants in the bitcoin network. Any participant in the network who participates as a full node can get access to a copy of the entire ledger and update it.

This distributed ledger is a chain of blocks (Blockchain).

Each of the blocks has multiple transactions inside them. As and when new transactions happen they are clubbed into a block. The blocks are validated and are added to the previous blocks in the blockchain in a real-time consensus mechanism.

The process of confirming the transaction and updating the ever-growing ledger is known as mining.

How can anyone update the ledger?

Updating the ledger involves solving a complex puzzle generated by the system. These puzzles are mathematical equations that are hard to solve but easy to verify. (For example, a Rubik’s cube is hard to solve. But once it is solved we can easily verify if the solution is correct or not.)

Those who solve these puzzles are known as Miners.

Not everyone can be a miner. Earlier it was possible to update the ledger using personal computers. But nowadays as more and more people are using bitcoin, powerful computers are needed to solve the puzzle.

How to trust that the ledger can’t be tampered with?

Manipulating the ledger is difficult as its copy is available to other miners. If one record is tampered with, there will be a mismatch in the records of other miners. This mechanism makes the bitcoin ledger immutable.

What is in it for the miners?

As compensation for their time and effort, miners get rewarded per block added to the blockchain. The current reward per block is 6.25 bitcoin. Miners also get any transaction fee associated with that particular transaction.

How is privacy maintained if the ledger is transparent?

The network can’t know who is the person the bitcoin belongs or to whom it is being sent. Only the public addresses (Think of it as a bank account number) of sender and recipient are shown. Figuring out to whom this public address belongs is impossible.

How to buy bitcoin?

A convenient way to buy bitcoin is from digital currency exchange.

The exchanges operate 24*7 and let you buy even a small fraction of bitcoin. Each exchange has different features and fee structure.

Few of the popular ones are

  • Coinbase
  • Binance
  • Kraken
  • Gemini

Where to store your bitcoin?

When you buy bitcoin from digital currency exchange, they keep the custody of the bitcoin for you.

But if you want to have custody of your coins, then you need a wallet.

Bitcoin is a virtual currency. It is stored in the blockchain. Wallet gets you to access to your coins on the blockchain. Wallets store the keys needed to prove that you own the coins and you want to access them.

Why is bitcoin becoming popular?

One of the reasons why bitcoin has become so popular is because people are using it as a hedge against potential inflation.

Inflation is the rise in prices of goods and services. A sandwich used to cost 1 dollar in 1950. Now a sandwich costs 5 dollars. The purchasing power of a currency decreases with time. 5 dollars in 1950 could have gotten you 5 sandwiches but now you can get only 1 sandwich.

The key factor of rising inflation is an increase in the supply of money.

But unlike the traditional currency, there is a limited supply of bitcoin. Only 21 million bitcoin can ever be created.

Another reason why bitcoin’s popularity is rising because of institutional adoption.

Corporates are also now accumulating bitcoin. Tesla acquired ~$1.5 billion worth of bitcoin recently. Few of the other top institutional investors include Grayscale investments, MicroStrategy and Square Inc.

It is highly unlikely that institutional interest in bitcoin will suddenly disappear. This adds to the confidence of the individuals who are looking to enter into the world of bitcoin.

With bitcoin getting more mainstream media attention, we can expect even more adoption by individuals and institutions.

Related Reads


If you liked this article, please subscribe to get similar free articles making crypto understandable right in your inbox.