How Does Bitcoin Work? (Bitcoin Simplified)

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Bitcoin is a fully digital currency, with no government to issue it and no banks needed to manage accounts and verify transactions and yet no one actually knows who invented it.

How Does Bitcoin Work?

The first thing worth acknowledging is that you don’t actually need to know the technical details to use bitcoin or other cryptocurrencies, just like you don’t need to know the details of what happens under the hood when you swipe a credit card.

Suppose you start keeping track of payments with your friends using a communal ledger. Then, as you trust your friends and the world less and less, and if you’re smart enough to bring in a few tools of cryptography to help circumvent the need for trust, what you end up with is what’s called a “cryptocurrency”.

Bitcoin is only the first well executed example of a cryptocurrency, and there are currently thousands more such cryptocurrencies available on exchanges that can be traded with traditional currencies.

Like any other digital payments, there are plenty of user-friendly applications that let you send and receive these digital currencies very easily. The difference is that the spine underlying this isn’t a bank verifying transactions, yet a smart system of decentralized trustless verification dependent on a portion of the math brought into the world in cryptography

What is Bitcoin?

Bitcoin is the first decentralized open-source, peer-to-peer network that is powered by its users with no central authority or middlemen using blockchain technology.

How Does Bitcoin Work

Bitcoin may seem like a difficult concept to wrap your head around, yet it’s actually way simpler than most people think when we describe it using analogies.

Imagine that in order to have a drink of water from a bottle in front of you, another person had to pick it up, then put the water in their mouth, and then put it into your mouth. That’s just crazy, right? Well, that’s essentially how banks, credit cards, and our traditional financial system currently works.

When you swipe your bank card to pay for groceries at the store, your bank is taking your money from your account, giving it to the grocery store for you, and then charging you for it. This is the situation with checks, credit cards, debit cards, ACH transfers, and any other exchange of money. It’s so instilled in our society and the manner in which we consider money is that it appears to be totally normal and fine generally

The reality is, the only person who has anything to gain in this arrangement is not even a person, it’s the banks. They make a profit from storing, transferring, controlling, and issuing loans off of the money you deposit into banks under the disguise that a) it’s safer with them and b) you aren’t smart or qualified enough to manage your own wealth without their services.

However, bitcoin is just like taking a drink of water from the bottle directly, except with value exchange; and the best part is, you don’t even have to be an arms-length away to do it. With bitcoin, you can send and receive value directly to anyone around the world, anytime.

One of the hang-ups people have with understanding bitcoin is just another thing we’ve been conditioned to accept as standard business practice: which is the separation between value and storage or transference of that value. So we own and store fiat currencies like US dollars as something representative of value, yet use completely separate mechanisms to actually use it, store it, and move it around.

For example, you have US dollars representing value, and you have a Bank of America account to store it in, and you have an American Express credit card to spend it, and maybe even a PayPal account to buy, sell, and manage value as well. This is a very normal concept we are accustomed to because that was pretty much all that’s been available, until the past decade.

So instead of having fiat representational value and paying financial businesses like Venmo and PayPal to store it and move it around, Bitcoin provides both a store of value and a means to transfer, and manage that value.

Bitcoin is both digital value as well as a network that can store and transfer the bits of digital value.

Who Created Bitcoin?

The creator of bitcoin is our very own modern-day Shakespeare mystery, as the only thing we know about this person or persons is their pseudonym, Satoshi Nakamoto. The true identity of this person or group of people has remained anonymous.

How Does Bitcoin Work

Satoshi Nakamoto created bitcoin and the bitcoin network using blockchain technology.

Blockchain is essentially a method of record-keeping by utilizing math and computer science, instead of accountants and bookkeepers. What most people don’t know is, the concept of blockchain was actually outlined back in 1991 and Satoshi was the first one to apply the concept of blockchain to use 20 years later in 2009 with bitcoin.

Why Did Satoshi Create Bitcoin?

The main reason that prompted Satoshi to create bitcoin was because of the problems with the traditional financial institutions and our current monetary system.

In our current financial system, bank accounts and credit cards are luxuries most people around the world don’t qualify for, don’t have access to, or simply can’t afford. Even if you do have bank accounts and credit cards, they can be frozen, restricted, and closed at any time without warning, and except for each and every holiday known to mankind, most banks operate only 9 AM to 5 PM on weekdays. And even if all of your accounts are clear for the moment, the only thing you store in them or use within them, are debt repayment instruments.

Yes, our hard-earned money, stored in bank accounts is just a debt repayment instrument created by the government so you can pay debts like credit cards, mortgages, bills, loans, etc.

You might ask, doesn’t the money have inherent value as well, isn’t it backed by something, representative of the issuing country’s GDP, or something similar? Well, money is a bit of an abstract word, and its true definition is a medium of exchange in the form of coins and banknotes, in addition to being assets, property, and resources owned by someone or something.

The type of money that is stored in the traditional bank accounts is called fiat. And the basic definition of fiat is:

Fiat is a pronouncement, arbitrary decree, or command given by a person or group of people that have absolute authority to enforce it.

When you combine the word fiat, with the word money: The definition of fiat money is a legal form of money issued and backed by the government which means that the government issued a decree that fiat money is to be used in the economy as a medium of exchange for goods and services.

So all of the “money” we have in our bank accounts is intrinsically useless, valueless, and is only a form of debt repayment or medium of exchange.

Keeping all this in mind, Satoshi Nakamoto created Bitcoin.

Satoshi created bitcoin to mitigate the following:

  • Banks, credit cards, and other financial instruments are not widely available to all people around the world
  • By design, value and the means of exchanging the value are created as separate systems to generate profit for financial institutions
  • Financial institutions are in complete control over people’s money, they can reverse transactions, freeze or close your account at any time for any reason
  • All the fiat money in bank accounts is a debt repayment instrument, not an actual form of value

Bitcoin was made as a path for people to store and send value far and wide, whenever, anyplace, at basically no expense, without using a financial business or fiat currency.

How Does Bitcoin Have Value?

The simplest answer is supply and demand.

As demand for bitcoin increases and the supply decreases, it causes the price of bitcoin to increase.

Many individuals have lost confidence in the government, stock market, and financial system on the loose. Since the printing of cash, even cash reserves are a losing proposition because printing more money is the same thing as trying to cut a pizza into smaller pieces to feed more people. It’s not going to end well.

Bitcoin was really intended to be a hedge against our present financial system.

Bitcoin was born during a crisis and was built to survive a crisis. It’s been around for well over a decade now, and for the first time ever, we are seeing bitcoin decouple from the traditional stock markets and prove itself as a safe haven in times of uncertainty.

Previously, bitcoin and the cryptocurrency market’s performance commonly corresponded with the stock market.

However, in recent months, we are now seeing the stock market open and close at a loss, while the crypto markets increase. This inverse movement reveals that cryptocurrency is separating, or decoupling, from traditional financial assets and becoming more distinguished as a different type of financial asset.

What is Bitcoin Blockchain?

How Does Bitcoin Work

The primary element that makes bitcoin so unique as a digital currency and payment network is its underlying blockchain foundation.

The reason blockchain makes the phenomenon of bitcoin possible is by using principles like math and science, eliminating the need for accountants, bookkeepers, banks, or governments.

The simple and the plainest way to understand the word “blockchain” is by separating the word “block” from the word “chain.”

So, imagine a list of transactions showing payments sent to and from people getting listed one after the other as they occur. Then, once the maximum amount of transaction data in the list has been reached, the list of records becomes a block of data. This block of data is then added behind a previous block of transaction data linked together with a chain.

So the word “blockchain” simply represents groups of transactional data linked together. So, the plainest and simple explanation of the bitcoin blockchain is this:

The bitcoin blockchain is a record of bitcoin transactional data stored on a network of computers around the world.

There are 3 pillars of blockchain technology that make bitcoin blockchain unique. These are:

  • Decentralization
  • Transparency
  • Immutability

Decentralization

Decentralization means that no one person, corporation, government, authority, or any entity controls any aspect of the data recording and storage process.

Instead of data being stored in one place, like one computer in one office, data is stored on multiple computers all around the world which makes decentralization possible.

For example, we currently have a central banking system controlled by the government, a central authority, which issues fiat currency that can reside in accounts controlled by Banks or other similar centralized entities. Each of these entities is in complete control of where and how their data is recorded, stored, and managed. They can decide what type of servers to use, where the servers are located, and how their security protocols work.

In contrast, blockchain allows transaction data management to be decentralized on a network of computers around the world using open-source software and any changes to the blockchain protocol have to go through a consensus process that no one person, company, or government has control over to protect the integrity of the network.

Interestingly, blockchain permits transaction data management to be decentralized on a network of computers around the globe using open-source programming and any progressions to the blockchain protocol need to experience a consensus cycle that no individual, company, or government has control over to ensure the integrity of the network.

So instead of a centralized entity deciding how and where all their data is stored on certain servers in certain locations, a decentralized blockchain network is distributed on many devices all over the world. That is the true essence of “decentralization”.

Transparency

Right now, most of the citizens of any country don’t have the foggiest clue of how all of the cash is spent by the country. We just need to believe the government or reach our own conclusions from media news.

Regardless of whether the government needed to show us where each penny went, it would be extremely easy for them to forge or manipulate any data they chose to share with us since they control their own data and make their own reports. This scenario is neither transparent nor trustworthy.

So, let’s imagine a different scenario where everyone had access to a live, running ledger of where every single dollar was spent by the government at any moment in time. Basically, everyone could see a full disclosure of how our government is managing our money. Now, this scenario is more transparent and trustworthy.

Transparency in blockchain describes how transactional data is recorded on a public ledger that is available for anyone and everyone to see. This ledger of transactions is saved on a network of computers around the globe which makes it inconceivable for the data to be changed or altered.

Immutability

Blockchains are intended to be immutable. All things considered, when a block is kept in touch with a blockchain, it can’t change. Each block of information, for example, facts or transaction details, continue to utilize a cryptographic guideline or a hash value. This usefulness of blockchain technology guarantees that nobody can encroach in the framework or alter the information spared to the block.

Immutability simply means that the data recorded and stored on the blockchain cannot be changed, forged, or altered. This is achieved through math and computer science, more specifically through cryptography & blockchain hashing processes.

How Bitcoin Blockchain Works?

Blockchain uses math and computer science to record and store data in a way that ensures once new data is added, it is verified, it is unmodifiable, and it is distributed across a vast network of computers around the world.

So it’s hard to destroy, and no one person or entity controls the data or network, creating a safe and transparent environment.

How Does Bitcoin Work

Bitcoin is a great use case of this blockchain technology. It is used as being a digital ledger for a digital currency that people can use as a form of payment to send to and from each other or hold as a store of value, similar to gold.

The bitcoin blockchain is basically a live, running ledger that keeps records of all the bitcoin transactions.

The structure of the bitcoin blockchain is a network of computers around the world with bitcoin software installed on them. Data is transferred throughout the network of computers each time a transaction occurs.

Computers that maintain blockchain networks are commonly referred to as nodes and these nodes validate the transactions, add the transactions to their copy of the ledger, and then broadcast the ledger changes to all of the other computer nodes on the network in the form of a block.

Each block of transactions has a programmed maximum amount of data it can store and on average, every 10 minutes or so, a new block of bitcoin transactions is created, validated and published to the bitcoin blockchain.

The key addition is that in the event that there is a clash between two different blockchains with similar transaction histories, you concede to the longest one, the one with the most work put into it.

If there’s a tie, wait until you hear of an additional block that makes one longer. So despite the fact that there is no central authority, and everyone is maintaining their own duplicate version of the blockchain, if everyone consents to offer preference to whichever blockchain has the most work placed into it, we have an approach to reach a decentralized consensus.

So who are all these individuals with bitcoin software introduced on their computers around the globe validating transactions and for what reason would they need to do this? Well, bitcoin transactions are verified and broadcasted to the network through a cycle called mining and this cycle is finished by miners.

Miners are the individuals or pools of individuals that utilize their computational power with a bitcoin program installed on them to keep up the bitcoin blockchain. Maintaining the blockchain includes keeping the bitcoin transaction ledger perfect, steady, and lasting by gathering new transactions into blocks and distributing them to the remainder of the network for verification.

For a new block to be accepted by the network, miners compete with each other using computing power to verify transactions in exchange for rewards.

These rewards are set up to incentivize miners that partake in the mining process to guarantee the bitcoin network keeps on being audited and basically kept up.

Each block has a unique hash that is generated by the miners when validating the block.

The technical details of mining are very complex but the basic concept you need to know about bitcoin mining is that miners are rewarded with bitcoin each time they verify a new block of transactions.

What’s more is that mining rewards are a blend of recently minted bitcoins that were not beforehand circulating, and transaction fees of bitcoin that were at that point circulating.

Bitcoin Total Supply

The total amount of bitcoin that can ever exist is 21 million.

A characteristic that Satoshi Nakotomo programmed into bitcoin was a cap on its maximum supply.

Satoshi implemented a maximum supply of bitcoin so it would mirror an inflation rate similar to gold and thinking back to the mining process, you will start to see many similarities between bitcoin and gold, which were all by design.

Bitcoin was created to be like a digital gold of sorts. There are existing bitcoins presently available for use, and there are some bitcoins not circulating at this moment.

New bitcoins are minted into circulation during the mining process when new blocks are verified. Currently, the amount of new bitcoins entering into circulation is 6.25 bitcoins per block, and it takes approximately 10 minutes to verify a block.

Another characteristic Satoshi programmed into bitcoin is what’s called “halving“.

Halving refers to the reduction in bitcoin block rewards issued to miners by half.

Block rewards halve after every 210,000th block, which on average turns out to be approximately every four years. The most recent halving decreased the block reward from 12.5 bitcoins to the current rate of 6.25 bitcoin.

About 900 new bitcoins enter into circulation every day until the next halving event, making the annual inflation rate 1.8%.

The advantage of having a fixed supply is that bitcoin’s inflation rate will eventually reach 0% once the last bitcoin has been mined.

The last bitcoin will be mined in the year 2140

A fixed supply and high demand creates scarcity, which typically increases the value of assets like gold, and same thing can be expected to play out in the case of bitcoin as well.

Another advantage of a fixed supply is that you won’t experience issues like we will experience in the future with the fiat currencies. Bitcoin was programmed in such a way that new bitcoins enter into circulation at a fixed rate that halves overtime to curb inflation, and the new bitcoins are distributed to miners proportionally to the amount of work they produce.

On the other hand, fiat currencies don’t have a fixed supply, so at any time, the government can print more fiat. Newly printed fiat is not equally distributed to people who are producing in the economy like in the case of bitcoin miners. The people or corporations closest to the government’s money printer get first dibs on the new, free money, typically in the form of low-interest loans, which is not a fair, neutral way of adding fiat money into circulation.

In response to war, pandemics, and other calamities, various governments have printed an unprecedented amount of fiat which will eventually result in hyperinflation and devaluation of their local currencies, which will greatly reduce the purchasing power of their fiat currencies over time.

In contrast, the power of bitcoin will increase in terms of purchasing over time as the available supply will continue to decrease, as long as the demand remains steady and most likely increases.

What if 21 million bitcoins aren’t enough?

Luckily, bitcoin is divisible.

Similar to how the dollar can be divided into smaller units like quarters, nickels, dimes, and pennies, bitcoin can also be divided.

Satoshi or Sats in short, is the smallest unit of bitcoin.

One Satoshi is one hundred millionth of a bitcoin, or bitcoin to the eighth decimal place, which is represented as a decimal followed by 7 zeros and then a 1.

Here is a table showing the different denominations of bitcoin.

Bitcoin (BTC)Satoshi (Sats)
1 BTC100,000,000 Sats
0.00000001 BTC1 Sat

Standard denominations and smaller units of bitcoin make usability of bitcoin as a day-to-day currency much easier, as it would be too limited to try and pay for little things with one whole unit of bitcoin. That would be like trying to buy a bottle of water with a gold bar.

Actually bitcoin is more divisible than the US dollar and most other fiat currencies as well, as the smallest denomination of US dollars is a penny representing 1/100th of a dollar, while one Satoshi represents a 1/hundred millionth of a bitcoin.

Satoshi Nakamoto knew that in order for a currency to work in a society as a medium of exchange, it must be easily broken down into smaller increments so it can easily represent a value equal to any and all goods or services available in an economy for exchange.

So, bitcoin is more than sufficiently divisible, as it allows for quadrillions of individual units of Satoshis to be distributed to anyone around the world.

How To Send, Store and Recieve Bitcoins

How Does Bitcoin Work

To store and transfer bitcoin, you need to use bitcoin wallets. There are several types of bitcoin wallets and some types are more secure than others.

The two general categories of bitcoin wallets are:

  • Hot wallet
  • Cold wallet

Hot storage wallets, also known as software wallets, are wallets that are installed on smartphones or computer and connected to the internet. However, they are not half as secure as cold wallets.

Cold storage wallets are separate, physical devices that are not connected to the internet. The most popular choices for cold storage wallets are Trezor and Ledger. Different types of cold storage incorporate paper wallets and more tough materials like wood or fireproof metal wallets.

Cold storage hardware wallets are the most secure kind of bitcoin wallet to use since they are not associated with the internet where you hazard getting hacked.

All bitcoin wallets by and large comprise of two things:

  • Private key
  • Public key

These keys are also referred to as addresses.

What is a Private Key?

A private key in regards to bitcoin wallets is a secret 256-bit alphanumeric number that is randomly generated using cryptographic math functions.

The degree of randomness used when generating a private key is so random that there are more possibilities of creating unique private keys than there are atoms that exist in the entire known universe.

So the odds of creating a duplicate private key are nearly impossible.

A private key is the most important thing to be careful about as a bitcoin holder. Since your private key gives total and full control over any bitcoins related to it.

Anybody can make irreversible bitcoin transactions using a private key, which simply means that you can send bitcoin to some other individual or spot without you having the option to fix the transaction.

What is a Public Key?

Similar to private keys, the public key is also an alphanumeric number. However, it is derived straightforwardly from the associated private key by utilizing cryptographic mathematical capacities.

The whole function operates in such a way that it’s impossible to reverse engineer a public key to figure out the corresponding private key and a public key or address is used only to receive bitcoin from others.

You cannot use a public key to send bitcoins, you can only use it to receive bitcoins. So you could post your public key anywhere such as on a public website and anyone who comes across it can send you bitcoins.

Using those public keys, anyone in the world can donate to the associated address without gaining access to the funds stored in it.

Private keys are for spending bitcoins and public keys are for receiving bitcoins.

Example

Think about your traditional bank account i.e. if you have one. You can provide anyone with your bank account number and routing number to receive an electronic transfer from them. However, using just a routing number and account number, they cannot access your actual bank account to spend your money. So think of the combination of a bank routing number and bank account number as your public key or address.

Anyone can use it to send you money.

Now think about your online banking account username and password. Using your online bank account login credentials, depending on how your bank operates, someone could access your account and transfer funds from it. So think of your online bank account username and password combination as your private key.

What are Digital Signatures?

In the real world, your handwritten signature looks the same no matter what document you’re signing. However, a digital signature is much stronger, because it changes for different messages.

The public key and private key are considered as digital signatures.

At first, it might seem like digital signatures shouldn’t even be possible, since any data that makes up the signature can just be read and copied by any computer, so how do you prevent forgeries?

The way this works is that everyone generates a pair of a public key and private key, each of which looks like some string of bits.

A digital signature looks like a string of 1’s and 0’s, commonly something like 256-bits, and altering the message even slightly completely changes what your signature on that message should look like. Properly said, producing a signature involves some function that depends both on the message itself, and on your private key.

The private key guarantees that no one but you can create the signature and the way that it relies upon the message implies that nobody can simply copy one of your signatures to forge it on another message.

Now the public key comes into play to verify that a signature is valid. All it does is that it determines if the output is true or false to indicate if this was an authentic signature created by the private key associated with that public key.

The idea is that it should be totally infeasible to locate a valid signature on the off chance that you don’t have a clue about the private key.

How Does Bitcoin Work?

Every transaction shows the remarkable hash per singular transaction made by the miner and the public addresses related to the transaction. These public addresses depict a blend of wallets on cryptocurrency exchanges, software wallets, hardware wallets, and a wide range of various wallets individuals are using to transfer bitcoins.

Bitcoin blockchain aka the public ledger shows a lot of information about the transactions without revealing the identity of the people sending and receiving bitcoins.

Bitcoin transactions are not completely anonymous though, so if anyone had some knowledge about the amount of bitcoin transacted, the date and time, and the public addresses involved, he/she could use the public ledger to trace activity.

Bitcoin Wallets

As far as bitcoin wallets go, I highly recommend investing in a hardware wallet like the Trezor One or Ledger Nano X for storing and transferring bitcoins, as they are a safe form of cold storage.

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Make sure you only buy hardware wallets from the correct official websites to avoid getting a compromised device.

Warning: Never buy a used hardware wallet.

Bitcoin Price Prediction

The programmed halving events decrease the supply of new bitcoin entering into circulation and the price of bitcoin increases when supply decreases and demand increases. So, the new supply of bitcoin decreases by 50%, and the demand for bitcoin during these uncertain times is likely to increase.

If you look at the historical data of the price of bitcoin following previous halving events, you see the price increasing nearly 10-fold, several months after the halving takes place.

If you take a brief look at the historical data of the price of bitcoin following past halving occasions, you see the price expanding almost 10 times, a while after the halving happens.

After the first halving in 2012, bitcoin went from around $10 per bitcoin to over $1,000 per bitcoin.

After the second halving in 2016, bitcoin went from $1,000 up to $20,000 and settled around $10,000 per bitcoin.

The third halving happened in mid-May of 2020 and many more halving events are likely to follow.

So, is $100,000 per bitcoin in the cards in the coming years? or Is $1,000,000 per bitcoin possible in the future?

Only time will tell.

21 Reasons Why We Believe Bitcoin Is The Future

  • Bitcoin is fast.
  • It is globally accessible.
  • It is the biggest decentralized currency.
  • Low transaction fee.
  • It has the potential to erase fiat currency from the world.
  • It is encrypted and very secure.
  • You are its sole owner.
  • The number of bitcoins is finite. So owning one will put you at an advantage.
  • No taxes.
  • Zero inflation risk.
  • Fewer chances of fraud than fiat currency.
  • It is based on the blockchain platform.
  • It is completely transparent.
  • All transactions are publicly accessible.
  • A great medium to buy other altcoins.
  • It is pseudo-anonymous.
  • Much less risk of theft than traditional currencies.
  • Appreciating in value since its inception.
  • High fungibility.
  • Highly durable and divisible.
  • YOU ARE YOUR OWN BANK.

Do Not Buy Bitcoin if :

  • You are impatient.
  • You can’t handle temporary failures.
  • You think banks are safe and better.

Final Thoughts

During times of uncertainty, more and more people are starting to flock to transform their fiat into something they believe will retain its value over time, and almost certainly increase substantially over time.

If you reference data from past halving events that occurred during the longest traditional market bull run in history, anything is possible in the crypto world.

From $0 per bitcoin to over thousands per bitcoin, bitcoin is proving to be one of the only stores of value we have the opportunity to invest in where we can experience our wealth exponentially increasing over time.

Another important thing you should do is invest in a hardware wallet like the Trezor One or Ledger Nano X.

That’s all.

Thanks for reading. I hope this article was helpful on how does bitcoin work.

Don’t forget to share.

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