What is Bitcoin and how does it work?: The questions that worried everyone at least once in 2017: Bitcoin how does it work and what is Bitcoin?
Bitcoin is made up of two words, “Bit” and “Coin”. If you cut the information in computers into smaller pieces, you will find 1s and 0s. These are bits. You already know the coins.
… and what are Bitcoins?
Bitcoins is just the plural of Bitcoin. They are coins stored in computers. They are not physical and only exist in the digital world! This is why Bitcoin and other cryptocurrencies are often referred to as digital currencies.
It might seem quite confusing at first, but in this guide I’m going to make it as easy as possible – welcome to Bitcoin for Dummies! By the end of the guide, even beginners will understand what bitcoin is, how to buy bitcoin, and how bitcoin works. Let’s get started!
How does Bitcoin work? What is Bitcoin and why was it invented?
Let’s start with the basics …
There are three types of people in this world: the producer, the consumer, and the middleman. If you want to sell a book on Amazon, you have to pay a hefty 40-50% tax. It’s the same in almost all industries! The intermediary always takes a large part of the producer’s money.
To understand how Bitcoin works, it’s important to know why it was created. Bitcoin was invented to eliminate one type of middleman: banks. If you need to wire 5,000 USD from your country to your friend in the UK, that money must go through a bank in your country. They charge a fee for the processing. Once the money gets to the UK bank, your friend’s bank charges a fee as well.
It’s not just the fees that are a problem, it’s the data they store. Banks store a lot of private data about their customers. Many banks have been hacked over the past 10 years, which is very dangerous for users.
In addition, banks can freeze / block user accounts at any time. They have too much control over the users of the banks and have abused their power. They also played an important role in the 2008 financial crisis. Bitcoin started in 2009, right after this crisis. Many people believe that the crisis was one of the reasons for the creation of Bitcoin.
FUN FACT
Who created Bitcoin? The creator of Bitcoin is unknown. The name used was Satoshi Nakamoto, but it was a false name and no one knows who the real creator is.
The solution was to set up a system without authority (such as a bank). A single authority should not have the power to control people. Banks and governments controlled currencies. It was therefore necessary to create a new currency.
Bitcoin is the solution: it doesn’t have a single authority. It means no banks, no PayPal, no government to be able to tell the bank to freeze your account. It’s awesome, isn’t it? The question that worries everyone must now be: “Bitcoin how does it work and what is Bitcoin?”.
How does Bitcoin work?
The creator of Bitcoin developed three main concepts for Bitcoin, which are essential for understanding how Bitcoin works:
- Cryptography
- Supply and demand
- Decentralized networks
Decentralized networks
When you go to your internet browser and type in “www.google.com”, your computer initiates a conversation with Google computers. Then the two computers start talking to each other, and your browser displays images, buttons, etc. If Google’s servers were down for some reason, you wouldn’t be able to see these images and buttons. This is because the data is stored on a centralized network, it is in the same place.
To understand how Bitcoin works, it is essential to understand what a decentralized network is. In a decentralized network, data is everywhere. If Google used a decentralized network, you would still be able to see the data because it is everywhere and not in one place. This means that Google would never be offline!
Cryptography
During World War II, cryptography was widely used. He converted radio messages into code that no one could read. To read it, you need to convert the original message back. To do this, you needed a key. It was possible thanks to mathematical formulas!
Bitcoin uses cryptography in the same way. Instead of converting radio messages, Bitcoin uses cryptography to convert transaction data. This is why Bitcoin is called a cryptocurrency. Knowing this brings you one step closer to understanding how Bitcoin works.
Bitcoin does this using the blockchain . The creator of Bitcoin invented blockchain technology!
Supply and demand
Last week when John visited the bakery, there was only one cake left. Four other people wanted him too. Normally the cake only costs $ 2. But because 4 other people wanted the cake, he had to pay $ 10 for it.
This is the main concept of supply and demand: when something is limited, it has more value. The more people who want it, the higher the price will be. It’s the same as rare vintage cars.
Bitcoin uses this same concept. The supply of bitcoin is limited. Bitcoin is produced at a fixed rate, which will decrease over time – it will be halved every four years. Bitcoin has a limit of 21million coins; once there are 21 million Bitcoins, no more Bitcoins can be created. How many Bitcoins are there at the moment? Well, currently (03.05.18) 16.9 million Bitcoins have been created. We still have a long way to go before we reach 21 million!
So that partially answers “How does Bitcoin work and what is Bitcoin?”, But it doesn’t answer everything. To really understand how Bitcoin works, we need to move on to how Bitcoin transactions work …
How does Bitcoin work and what is Bitcoin? How are the transactions going?
Now let’s see how these concepts work together. To record transactions, we need to put them in a database (like an excel sheet).
This should normally be stored somewhere in a centralized network. But since Bitcoin uses a decentralized network, the Bitcoin database is shared. This shared database is known as the Distributed Ledger. It is accessible through the blockchain. To learn more about blockchain technology and understand how Bitcoin works best from a blockchain perspective, read the Blockchain Explained guide.
To send Bitcoin to a person, you need to digitally sign a message saying, “I am sending 50 Bitcoins to Peter”. The message would then be broadcast to all computers on the network. They store your message on the database / ledger.
How does Bitcoin work and what is Bitcoin? Can someone fake my identity?
When you create a Bitcoin wallet (to store your Bitcoin), you are given a public key and a private key. Public and private keys are a collection of long letters and numbers; they are like your username and password. Both are very important to really understand how Bitcoin works.
People need your public key if they want to send you money. Since it’s just a bunch of numbers and numbers, no one needs to know your name, email address, etc. This makes Bitcoin users anonymous!
As for your private key , you should never let anyone see it. On the blockchain, your private key is your identity. You use your private key to access your Bitcoin. If anyone sees it, they can steal all of your Bitcoin – so be extra careful!
So yes, technically your identity can be forged. If someone gets your private key, they can use it to send Bitcoin from your wallet to their wallet. That’s why you need to keep your private key very, very secure.
Your real identity (your name, address, etc.) cannot be tampered with, as you do not need to use it to send or receive Bitcoin.
How does Bitcoin work and what is Bitcoin? can someone spend bitcoin twice?
Bitcoin transactions are aggregated and stored in blocks. These blocks are linked to each other in a series. This is why it is called a blockchain.
Each transaction in the block contains a public key. If it’s your Bitcoin, it will be your private key written there. Because each block is connected to the previous block, no Bitcoin can be spent twice.
Let’s see how Bitcoin works with concrete examples. If someone tried to send the same Bitcoin twice, here’s what would happen:
- David sends John a Bitcoin
- The transaction is stored in a block of the blockchain
- The next day David tries to send the same Bitcoin to someone else
- Bitcoin transaction goes into the current block of the blockchain
- Computers running the blockchain check the last block used by Bitcoin.
- In the last bitcoin usage block, the transaction indicates that the bitcoin has been sent to John’s public key
- Since it is not John’s public key that is on the Bitcoin that is sent in the current block, the computers that run the blockchain do not allow the use of Bitcoin.
How does Bitcoin work and what is Bitcoin? what if someone tries to tamper with the blocks?
If someone tries to change the transaction data in any of the blocks, they will only change it in their own version, like a Microsoft Word document stored on your computer.
For the change to be made, the shared database must be controlled by 51% of the computers on the network.
How does Bitcoin work and what is Bitcoin? what if someone controls 51% of the computers on the network?
It is possible, but it is almost impossible to achieve. Even if a person hacks 51% of the computers on the network (also known as nodes), there is another layer of security hampering them.
To add new blocks to the blockchain, they must be mined. This process is called mining because the nodes that do it are rewarded with Bitcoins, like gold miners who are rewarded with gold.
In mining, nodes need to process Bitcoin transactions and verify that they are real. To do this, they must solve a mathematical problem. When the problem is resolved, the transaction block is verified and a new block is created. Each block has a new problem and a new solution for minors to find.
The first node to solve this problem receives new Bitcoins. Mines consume a lot of electricity, so you have to reward the miners!
Some more concrete explanations of how Bitcoin works: here’s what would happen if a hacker controlled 51% of the noNge a block:
- The hacker will modify the data in the block so that the Bitcoin has been sent to its public key
- Because the data in the block has changed, there is a new math problem and the hacker needs to solve it
- The electricity the hacker needs to fix the problem costs more than the Bitcoin in the block is worth
- The hacker can go ahead and fix the problem, but will lose money
As you can see, it is almost pointless for a hacker to carry out an attack on the blockchain. This is why it is so secure.
How does Bitcoin work and what is Bitcoin? What are the advantages and disadvantages of Bitcoin?
You should already know what are the advantages of Bitcoin after reading this in the guide. However, I didn’t talk much about the downsides, did I? However, there are still a few pros that I haven’t talked about, so let’s start with the pros and then take a look at the cons. Then you will know full well and be an expert on how the Bitcoin issue works.
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The advantages of Bitcoin
✓ International payments are much faster than banks
✓ Fees are low
✓ Blockchain – almost impossible to hack
✓ Decentralized – cannot be stopped at a single point <
✓ Transparent – you don’t have to trust anyone
✓ Anonymous – you don’t need to use your name
✓ Community powered – charges are shared instead of going to a single point (i.e. bank or PayPal)
✓ No verification for new users – anyone can use it
No verification for new users: why it’s so important
With Bitcoin, anyone can send money to each other anywhere in the world. There is no KYC (Know-Your-Customer) process: you don’t have to use ID to open a Bitcoin wallet. In a bank, you must use your username when you create an account. For this reason, hundreds of millions of people around the world do not have a bank account. They cannot send or receive money. But now with Bitcoin they can finally!
International payments: a big advantage
If you want to send international payment, it will normally take more than 3 days with your bank and cost you around $ 10-15 or more. It is different in each country, but it is still expensive and takes a long time.
If you send it using Bitcoin, it will only take about 10 minutes. Sometimes it takes longer (up to an hour or more), but it’s still much faster than the 3 or more days banks take. The fees for Bitcoin change often and developers try to keep it as low as possible. Right now (03.05.18), it’s around $ 1 on average.
It’s cheap because there is no intermediary (banks, PayPal, etc.) to pay! This is what Bitcoin is all about.
Bitcoin has many advantages, but also has some disadvantages: How does Bitcoin work and what is Bitcoin?
The disadvantages of Bitcoin
✗ Mines use a lot of electricity
✗ Not as fast as other cryptocurrencies
✗ Fees change a lot
✗ Anonymous – used for crime
✗ Difficult to use – private keys, public keys, etc.
Fees and speed: bitcoin is almost 10 years old
Bitcoin started in 2009, remember? Well, it’s been almost 10 years! Since then, a lot of newer cryptocurrencies have been created much faster than Bitcoin. Additionally, Bitcoin’s fees have sometimes gone up to $ 28!
The fees got high because the popularity of Bitcoin was too heavy for the Bitcoin network – too many users were using it. This is something that Bitcoin developers are trying to improve, and so far it seems to be working. Like I said earlier, Bitcoin’s fees drop to $ 1!
Bitcoin is not very easy to use
Private keys, public keys, opening and using a wallet, etc. It is not very easy for people who are not confident in using a computer. When you want to send someone a payment, you have to type a long series of numbers and letters (their public key) into your computer.
It’s like when internet browsers were first launched – you had to type a long number in the address bar. Later, the addresses (www.) That we use today replaced it. Bitcoin needs to become easy to use so that anyone can use it, just like browsing the internet.
Electricity and the environment
As I said earlier, electricity costs for mines are high. Miners are rewarded with Bitcoin, so they always make a profit. However, the electricity used by miners is very bad for the environment (now you know a few drawbacks to the question of how Bitcoin works).
Other cryptocurrencies, such as NEO and Lisk, use a different operating system that uses much less electricity. This system is called PoS (Proof of Stake).
Remember that in the Bitcoin system, the miner who checks the block first is the one who is rewarded with Bitcoin? This system is called PoW (Proof of Work). It’s like a race, isn’t it?
Proof of work
All the miners are working on the same block at the same time, trying to win the race. This means that all the miners use electricity in each block created.
Proof of stake
In the PDS, only one miner can mine the block. When the next block is created, another miner is chosen to mine it. In this way, there is only one miner who uses block electricity. It is much cheaper and better for the environment!
Bitcoin’s criminal record
Because you don’t have to use your identity, Bitcoin has been in the news a lot for use by criminals. You might have heard of something called Silk Road . It was a dark web marketplace – an anonymous part of the internet that must be opened using a special browser.
On the Silk Road you can buy a lot of illegal things and Bitcoin the currency used. Silk Road started in 2011 but was closed in 2013 by the FBI.
It was very bad for Bitcoin, and some governments tried to ban Bitcoin for this reason. This is the best example of how Bitcoin can be used, although crimes can happen with any currency.
How does Bitcoin work and what is Bitcoin? How to buy Bitcoins?
You now know Bitcoin how it works and what Bitcoin is. It remains only to learn how to buy Bitcoins. So how do you buy Bitcoin?
There are three main options.
Broker exchanges
This is the easiest way, but you normally have to use your identity. This means using your name, address and a passport / driver’s license. Brokers trading fees are usually between 1-5%, but it depends on your location and how you pay.
The good thing is that you can pay using wire transfer, debit / credit card, and even PayPal. I recommend Coinbase because it’s easy to use, reliable, and you can use PayPal. If you don’t live in Europe, Australia, or North America, I recommend Coinmama.
Using a broker exchange is a bit like going to a travel agent to convert your local currency into a foreign currency (like USD for JPY, for example). However, with Coinbase and Coinmama, etc., the broker converts your local currency to Bitcoin.
P2P (peer-to-peer) exchanges
They are like brokerage exchanges, but they don’t use a middleman – there is no broker. For example, John can send Amy money and Amy will send John Bitcoins. There is no broker, so they pay no fees!
Amy will still have to pay John the Bitcoin, as P2P exchanges use an escrow service. When John asks Amy for Bitcoin, it is sent to escrow. When John pays Amy his money, escrow sends him his money. John and Amy have no control over the escrow, so it’s always fair. And fair trade is one of the essentials in understanding how Bitcoin works.
Some sellers on P2P exchanges will ask you for ID, but others will not. It is therefore possible to use P2P exchanges to buy Bitcoins anonymously. You can even pay in cash (paper money)!
You can also pay by bank transfer! I recommend using LocalBitcoins.
Bitcoin ATMs
It is the less common way to buy Bitcoin. There aren’t many Bitcoin ATMs around the world, so you’ll need to use this card to see if there is one near you. If so, you can go ahead and buy your Bitcoin in cash, but the fees are steep – 5-10%.
To learn more about Bitcoin ATMs, P2P exchanges, and brokerage exchanges, see our How to Buy Bitcoin guide. In this guide, I give you full instructions on setting up your wallet, verifying your identity, and buying Bitcoin with each payment method.
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How Bitcoin Works and What Is Bitcoin: The Conclusion
The invention of Bitcoin is just the beginning. Some people use Bitcoin and other cryptocurrencies instead of banks, but it still hasn’t completely replaced banks. What are your thoughts? Do you think Bitcoin will replace banks? Or should we improve first?
By answering the questions above, you can test what you have learned in this guide. You can also try to answer the question “Bitcoin how does it work and what is Bitcoin?” In just three sentences. Give it a try – it will help you remember what you have learned. Post your answer in the comments!
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