What is Bitcoin? And How Does It Work?

Investing
Updated: 23rd Feb 2021
Written by Sean Graytok
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Investing
December 21, 2020
Written by Sean Graytok

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After bitcoin’s infamous collapse in 2017, it is back to all-time highs. Recently this cryptocurrency reached $24,000 per coin in December 2020. Its recent bull market has made it the center of attention again, but this time it might be different.

Before we speculate on Bitcoin’s future, let’s answer a question that most people are embarrassed to ask: What is Bitcoin?

Read on to find out what Bitcoin is, how it works, and more. This guide will make sure you are armed with the right and knowledge before you take the plunge into the world of crypto and buy bitcoin.

How Does Bitcoin Work? Is Bitcoin Safe?

What is Bitcoin?

Bitcoin is a digital currency that was created in 2009 by the anonymous “Satoshi Nakamoto.” This person, or group of people, published a whitepaper that describes the invention of the first digital currency.

Satoshi’s new electronic cash system is fully peer-to-peer and does not require a trusted third party. This means Bitcoin is decentralized and not controlled by a single entity like a government or bank.

Additionally, Bitcoin users can remain anonymous even though the currency’s transaction history is recorded and available to the public on the blockchain.

While some claim the blockchain can solve every problem known to man, it is simply a public record of Bitcoin transactions in chronological order.

The maximum and total amount of bitcoins that can ever exist is 21 million. There are currently 18.5 million in existence, leaving 2.4 million left to be created, or “mined.” Only so many bitcoins can be mined per year, and estimates suggest the final bitcoin will be mined in the year 2140.

We’re only a hundred words in, and you might have some questions. Cryptocurrency? Satoshi? Blockchain? Do not worry. We take the complexity of Bitcoin and will ensure you are a seasoned expert in due time.

Learn More: How to Buy Bitcoin

How Does Bitcoin Work?

There are no physical bitcoins, just balances kept on the blockchain. This technology requires enormous amounts of computing power and is handled by individuals who “mine” bitcoin.

The average Bitcoin holder does not need this processing power to own the asset. There are hundreds of mobile apps that make buying and selling Bitcoin easy.

At its core, blockchain technology is a decentralized ledger system that creates, trades, distributes, and stores Bitcoin.

Blockchain removes the need for a central authority, such as a bank, to approve transactions. Moreover, the system guarantees the network is verifiable and unchangeable.

Is Bitcoin Safe?

The technology that supports and enables Bitcoin is mathematically secured by the proofs we mentioned earlier. The Bitcoin network has never been hacked and continues to prove itself secure, functional, and more than capable.

Although, there have been successful attacks on bitcoin exchanges, such as Mt. Gox in 2014 and Coincheck in 2018. This is not indicative of a problem with the underlying Bitcoin network.

These events were the result of inadequate security and negligence on the part of the exchange. Today there exists insured exchanges that have never been hacked.

The growing interest in Bitcoin will continue to improve its security as more and more resources are allocated to its success. A key component of security is storage.

How to Store Bitcoin

While users can buy and sell Bitcoin with U.S. dollars on exchanges like BlockFi, Coinbase, Gemini, and eToro, they can also store their assets in a “Bitcoin wallet.” A Bitcoin wallet is like your physical wallet, it just exists on the Bitcoin network.

The wallet contains your private key(s) which allow you to spend bitcoins allocated to it in the blockchain.

You can have several Bitcoin wallets, but each wallet can only control the bitcoin that is stored in it. The wallet enables you to pay a specific amount to a particular recipient.

Additionally, these wallets can be “hot wallets,” or they can be kept in “cold storage.” Hot wallets are always connected to the internet, while bitcoin in cold storage is kept offline.

As you can imagine, leaving your bitcoin in a hot wallet is less secure than having them in cold storage.

Hot wallets are free software, while cold wallets are hardware and cost money. Cold wallets vary in security and resemble USB drives.

Why Does the Price of Bitcoin Change?

In addition to being a medium of exchange, some people speculate on the spot price of bitcoin. Just like investors trading stocks, bitcoin traders are looking to buy low and sell high.

The macroeconomic laws of supply and demand apply to bitcoin too. The price goes up when consumers buy more bitcoin because its available supply decreases. Ultimately, this action increases its scarcity.

On the contrary, if several traders sell their bitcoin, the more available shares are available for purchase. Thus, increasing its supply and decreasing its scarcity.

The motivations of these investors vary greatly and contribute to the asset’s volatility. Some are long time holders and believe bitcoin will become the global reserve currency.

Others just trade the spread looking to make a quick buck. And some individuals hold so much bitcoin that their decision to sell could move the entire market.

Remember, you can buy fractional shares of a bitcoin. So, while the price maybe tens of thousands, you can own as little as $1 worth of the digital asset.

Pros

  • There is a fixed supply of bitcoin, making the asset a hedge against inflation and designed to appreciate.
  • It is an anonymous peer-to-peer payment network.
  • You are the owner of your assets and do not require the permission from the government or bank to send and receive it.
  • It has a high liquidity compared to its inflation-hedged partner Gold.
  • Since its decentralized and doesn’t require a banking system, Bitcoin trades and can be sent or received 24/7.
  • It is highly portable asset and cannot be physically seized from you.
  • It is the most widely known cryptocurrency and benefits from this network effect.
  • You can own fractional shares of Bitcoin.

Cons

Many of the same “pros” can be perceived as “cons” when things do go wrong. Additionally, several of these disadvantages can be mitigated with proper education and security.

  • You lose your bitcoin if you lose your private keys.
  • Bitcoin is dependent on the internet.
  • Most exchanges charge high trading fees in relation to commission-free stock trading.
  • Not every service or person accepts bitcoin as payment.
  • Bitcoin is volatile, and double-digit pullbacks are common.
  • Transaction speeds can be slow, and fees can be high.
  • It takes time to learn about Bitcoin.
  • Ensuring its security requires effort on your part compared to keeping money in a bank.

Is Bitcoin a Bubble?

There is a large group of people that think it will replace Gold, crack $1,000,000 per coin, and become the global reserve currency.

Others are just as confident that it’s one big Ponzi scheme and well on its way to $0. We think it is reasonable to fall somewhere in between these two camps.

Both sides have had their day in the sun. Bitcoin famously surged to $20k levels in 2017, only to free-fall 45% in just five days. Bitcoin dropped as low as $6,000 just five weeks after the crash.

Is Bitcoin a Bubble?

On the other hand, Bitcoin’s late 2020 bull market has awakened its believers.

Bitcoin fell like every other asset early in the pandemic, going below $4k, but has since recovered in a historic way. The cryptocurrency reached $24k in December and is up more than 200% YTD.

Bitcoin has been around for more than ten years and has recovered from more than one crash.

While it is impossible to know for sure, Bitcoin does not appear to be in a bubble. That is not to say its price won’t get cut in half again, but the asset is likely here to stay. Only time will tell.

Related: Is bitcoin a Good Investment?

How Does Bitcoin Make Money?

Bitcoin with a capital “B” refers to the entire Bitcoin network. This includes mining, creating the coins, powering the blockchain, updating the software, and so much more. The lower-case “b” is used to refer to the digital asset that is traded or stored.

Bitcoin “makes” money and bitcoin does not. Users pay transaction fees when they buy, sell, and transact bitcoin to reward the people powering the blockchain.

But bitcoin does not have earnings calls to announce its free cash flow and expected growth.

Think of bitcoin as “digital gold.” Gold does not make money on its own, but people agree that it is valuable and scarce.

Therefore, an infrastructure and distribution network is established for gold. People get rewarded for mining, distributing, and storing the metal. It works the same with Bitcoin.

Bitcoin’s market cap is over $400 billion. As of writing this article, there are only 12 publicly traded companies with a higher market cap than Bitcoin.

Learn More: How to Trade Cryptocurrency

Is Bitcoin Legal?

Bitcoin is 100% legal in the United States and in most places on Earth. Only a few countries have outright banned it, while others have made it partly legal.

These countries typically have authoritarian governments that want to maintain maximum control over its people and currency.

A decentralized asset may empower the individual a bit too much for their liking. Some countries do not define the legal status of Bitcoin and its related crypto instruments, while others are changing their existing laws.

The Internal Revenue Service (IRS) classifies bitcoin as property rather than currency. This means that you will pay property tax on any bitcoin sale.

Is Bitcoin Real Money?

Money is a 10,000-year-old technology that was invented to facilitate trade. Money reduces friction when exchanging things of value, such as services or goods.

Government-backed paper money, or fiat money, is a 40-year-old iteration on this technology called money. Using precious metals as money is no more “real” than money made of paper or computer bits.

Internet money is the next stage of money’s development. We went from exchanging precious metals for thousands of years to creating paper to represent those metals.

In the 1970s, the United States abandoned the gold standard and has been running an experiment with fiat currency ever since.

Paper money has no intrinsic value. It is only valuable because the government says it is. In today’s world, this is the reason why any “currency” is valuable. Money needs to be:

  • Scarce
  • Divisible
  • Storable
  • Durable
  • Fungible
  • Verifiable
  • Portable
  • Difficult to Counterfeit
  • Widely Acceptable

Bitcoin is all those things and is arguably better at being “money” than money as we currently know it.

But again, the U.S. Government and other countries do not formally “back” Bitcoin. However, this may change as digital currency matures and our technological infrastructure develops.

Bitcoin Scams & Frauds

We discussed some of the infamous hacks in the earlier section. but let’s discuss some ways to mitigate fraud when using Bitcoin.

Again, the hacks did not penetrate the blockchain, but infiltrated exchanges with negligent security protocols.

  • Don’t fall for scams that say they will send you free bitcoin.
  • Only use secure exchanges that prioritize security, such as Gemini.
  • Don’t share your private keys with anyone unless you want them to have access to your Bitcoin.
  • Keep your bitcoin offline in cold storage.
  • Do not screenshot your private keys or record them on devices connected to the internet.
  • Remember where you keep your hardware storage devices (there has been billions worth of bitcoin lost or misplaced).

Where to Buy Bitcoin

It was difficult to buy and sell bitcoin in the early 2010s. Fortunately, an infrastructure has been built and continues to improve with new resources entering the space each year.

Buying bitcoin is now as easy as buying stocks and other securities. Here are a few of the best crypto exchanges:

#1. Coinbase

Coinbase is one of the most popular crypto exchanges. Its secure platform attracts plenty of first-time crypto traders looking to trade, store, and even get paid to learn about cryptocurrencies. Coinbase is planning to IPO sometime soon.

Learn More: Coinbase Review

#2. Gemini

Gemini is arguably the most secure crypto exchange on the market. Their fee-friendly platform was founded by the Winklevoss Twins, so you know it is tried and true. Gemini was the first crypto exchange to receive a bank charter from the New York State Department of Financial Services (NYDFS).

Additionally, Gemini was the first crypto exchange and custodian in the world to complete a SOC 2 Type 2 examination, which is the highest level of security compliance a organization can demonstrate.

Learn More: Gemini Review

#3. Robinhood

The pioneer of commission-free stock trading also supports crypto. Robinhood’s sleek user interface removes any friction with buying crypto. If you already have an account, just locate their Cryptocurrencies section, and buy bitcoin today.

Learn More: Robinhood Review

Bitcoin Alternatives:

There are thousands of cryptocurrencies other than Bitcoin that are called Altcoins. Each of these digital currencies was created for different reasons and operate on their own network. Here are a few popular Bitcoin alternatives.

  • Ethereum: Ethereum is a decentralized, open-source blockchain featuring smart contract functionality. Ether is the cryptocurrency of the platform that is Ethereum. It is the second-largest crypto in terms of market cap. However, its blockchain is more active than Bitcoin’s system, and some believe Ether will outperform all cryptocurrencies in the long term.
  • Litecoin: Litecoin was an early Bitcoin spinoff that started in 2011. Its technical characteristics are nearly identical to Bitcoin’s traits, such as its peer-to-peer capabilities and open-source software. The biggest difference between Bitcoin and Litecoin is their respective market caps and the algorithms that power them.
  • Ripple: Ripple is a real-time gross settlement system, currency exchanges and remittance network created in 2012 by Ripple Labs Inc. Translation: Ripple is a digital asset built for payments. It exists on its own XRP Ledger- an open-source permission less and decentralized blockchain that is faster and more scalable than other systems.

Final Thoughts: What Is Bitcoin?

There’s no shortage of bold takes on Bitcoin, but ultimately your opinion is the one that matters. Bitcoin education takes time, but hopefully, your understanding has improved after reading this article.

Contrary to what people might make you think, you don’t have to have 0% or 100% exposure to bitcoin. A rising trend in wealth management suggests investors shift 1% to 5% of their portfolio into bitcoin. It is still a high-risk investment, and different investors have varying appetites for the volatility.

More Crypto Resources:

Sean Graytok
Sean Graytok
Sean is a lifelong student of the financial, media, and marketing industries. He is a Generation Z investing expert and is on a mission to empower investors to make the most of their money.