What Is Bitcoin & How Does It Work?

Caroline Bowler

When Bitcoin launched in early 2009, it was seen as a bit of a novelty in the tech world. A currency allowing anonymous transactions that had its value dictated entirely by the market? Coming on the heels of the GFC — and the attendant bank bailouts, which did little to alleviate the financial issues affecting everyday people in the process — it was easy to see the appeal that it offered to prospective buyers. Yet it was initially confined to a relatively small corner of the internet, largely attracting an audience of colourful characters who worked within related fields.

Of course, it wasn’t long until a wider audience picked up on the trend. And in 2021, Bitcoin and other cryptocurrencies are no longer the domain of tech-obsessed eccentrics — they've moved into the limelight, offering opportunities for those seeking a new frontier of investment.

Bitcoin — what is it?

Cryptocurrency — at least as we would recognise it today — was born with Bitcoin. Though the initial Bitcoins released to the public were sold for mere fractions of pennies, plenty of enthusiasts were soon hailing it as a replacement for traditional currency. Some went so far as to suggest it would radically overhaul the current financial system and bring greater equity to building wealth.

Not to say that this enthusiasm was universal. Sceptics were eager to paint it as a future Betamax — interesting technology that would never catch on with the general public. The risk of hacks, the inherent volatility in an unregulated currency and the absence of any physical product were all cited as significant problems.

A little over a decade on, both the early enthusiasts and the sceptics alike appear to have been slightly off the mark. While it’s unlikely to replace traditional currencies any time soon, Bitcoin is now daily front-page news. The market is watched closely by financial and tech experts alike; irrespective of how you feel about it as a phenomenon, it’s clear that it’s set a precedent.

Importantly, the presence of other large-scale cryptocurrencies has also suggested that it represents a potentially lucrative investment opportunity and an effective way to generate additional income within your portfolio. But for those who came in late, it’s entirely natural to be wondering “What is bitcoin all about?” or “How does cryptocurrency work?” At BTC Markets, we specialise in providing a variety of cryptocurrency-related services, including prices, staking, buying and trading. That’s why we’ve put together this guide on what bitcoin is and how it works — so that if you’re new to the world of understanding bitcoin and cryptocurrency, you can easily get up to speed.

I want to know the Bitcoin basics — for example, what is bitcoin?

So, what are Bitcoins? In the simplest possible terms, they’re a form of digital money. You can use them to buy things or accept them as payment, just like any other form of currency. What is the purpose of Bitcoin then? After all, we already have money, not to mention a wide variety of ways to purchase items in-person and online.

Well, one of the big drivers behind the initial interest in Bitcoin was to do with its potential for privacy. Digital transactions tend to leave a pretty big (figurative) paper trail, which can potentially be traced back to the purchaser. Bitcoin, by contrast, doesn’t do this. While all transactions carried out with Bitcoin are publicly recorded on the Blockchain (more on that in a moment), the identities of those participating are not. To further obscure their identities, most Bitcoin users will automatically update their ISP after each transaction, to further reduce its traceability.

While these privacy considerations have grown less important since Bitcoin has become a more mainstream hit, there are still other appealing features for many investors. Bitcoin is unregulated by a central authority, such as a government or bank; its worth is purely what the market dictates at a given moment. This is attractive to many investors as it doesn’t cap the earning potential of investing in it, while also being appealing to people of certain ideological bents — people concerned about the influence banks have on public policy, small government advocates, Libertarianism and Anarcho-capitalists, to name a few.

Additionally, there are only a certain number of Bitcoins that will ever be produced — around 21 million. That might sound like a lot, but if you factor in the fact that many have already been bought up and the clock is ticking on future releases, it becomes a simple case of supply and demand. So while it’s not a traditional “collectible” in the same sense as, say, baseball cards, art or luxury cars, there is a desire among many investors to secure their own little piece of history along the way.

This is by no means a definitive list of the reasons that people purchase Bitcoin; for some people, it’s as simple as seeing a prospect to make money, without necessarily having much interest in the philosophical or technology that underpins the process. But at BTC markets, we’re staunch believers that having an understanding of the underpinnings of investment is a critical part of the process and helps you make more informed decisions.

Blockchain, peer-to-peer tech and Bitcoin mining

So if Bitcoin doesn’t have a physical presence and is purely digital, how can you be assured that you actually own some of it — or can spend it safely? How does Bitcoin work?

Everyone with Bitcoin has a digital wallet, access to which is via a special code known only to you. It’s not radically different to a payment system like PayPal or other forms of online banking; when you make a purchase, you input your code and confirm accordingly. But the secret of how Bitcoin works and is able to keep track of all of these transactions lies in the attendant Blockchain. Essentially a large-scale collection of data, Blockchain lodges every transaction with Bitcoin form that takes place in digital form. The Bitcoin or Bitcoins used are recorded, though not the details of the wallets involved, the purchased items or exchanged goods. All transactions that have taken place are viewable to the public and are updated in real-time to maintain integrity.

While theoretically not impossible to hack or edit, it would be extremely difficult for any bad actor (or even a substantial collective of bad actors for that matter) to garner enough computing power to be able to modify the Blockchain. This has helped ensure the integrity of the Blockchain for more than a decade. In fact, since being introduced as part of Bitcoin, Blockchain technology has actually been adopted for a wide range of other purposes. It’s proven an effective means of signing and lodging contracts, as well as protecting cloud storage backups for business data. Its usage will likely continue to grow in the coming years as it’s adopted across new industries.

There’s no centralised storage point for all this Blockchain data, either; that would be counter to the stated ethos of Bitcoin, while also potentially rendering it more vulnerable to hacking or other data breaches. Rather, it’s maintained via a peer to peer collective of computers — and this is where Bitcoin mining comes in.

Blockchain relies on power from computers all over the world, loosely networked together to both process its data and store transactions as they occur so that there’s a single source of truth. While in theory, this is a simple process for any modern computer, Blockchain artificially increases the difficulty in order to deter fraud, via a technique called “hashing”.

This is quite a resource-intensive process for computers and accordingly, there needs to be an incentive to encourage participation — the internet is rarely altruistic merely for the sake of it — so when these users contribute the processing power of their computers, there’s a chance of being rewarded with Bitcoins. Thus, Bitcoin mining was born.

The simpler explanation runs something like this:

  • Provide your computing power to solve algorithms that help back up the Blockchain data
  • Be rewarded with bitcoins for your efforts
  • The more computing power you can provide, the more bitcoins you’ll be provided with as a reward

People who lend their computing power to the process unsurprisingly known as “miners”. As you might expect, this has created all manner of professional miners, looking to make their fortune with their spare PC hardware. But it’s not so simple — the rate of reward for contributing shifts over time. As more bitcoins are released into the marketplace, more transactions take place and the amount of processing power continues to increase, Bitcoin undergoes “halving” — essentially, the reward that miners receive is halved. At present, this takes place around every 4 years; theoretically, it could speed up or decrease depending on the number of transactions taking place, but it has remained relatively constant for Bitcoin’s lifespan so far.

So as you might expect, most people who invest in Bitcoin are not miners; while discussion continues about its value within the crypto community, it’s certainly not the quickest or most efficient way to get involved. The bulk of investors have either purchased or traded for their Bitcoin.

Bitcoin explained — the history of Bitcoin

Understanding the current state of Bitcoin also requires an understanding of its history; it didn’t emerge out of a vacuum, but rather arrived at a time when tech had caught up to existing ideas.

Though Bitcoin has garnered the lion’s share of the press since it launched, it actually wasn’t the first cryptocurrency. Attempts to create a digital, untraceable currency date back to at least the 1980s; the increasing rise of EFTPOS transactions or electronic bank transfers for large amounts of money also brought attendant privacy concerns. These ideas were further developed during the 1990s, but an effective way of executing them still proved elusive; a combination of insufficient tech and internet speed rendered it an unlikely prospect.

Though not forgotten, the idea of electronic currency stayed relatively dormant for a number of years. It would not be until 2008 when it re-emerged in the popular consciousness, with the publication of a whitepaper by an individual or collective identifying themselves as “Satoshi Nakamoto”. This whitepaper outlined the key principles behind Blockchain, as well as providing Bitcoin’s definition. But it wasn’t till January 2009 that Bitcoins actually began to see release to the general public, as the first batch began to trickle out.

Many of the early details of Bitcoin’s history still have a shroud of mystery over them. Satoshi Nakamoto has never been definitively identified, despite considerable journalistic energy devoted to the question. It’s speculated that Nakamoto’s true identity (or identities) may be connected to some of the earlier cryptocurrency pioneers due to points raised and referenced in their initial whitepaper, though it’s entirely possible that this is merely the result of Nakamoto expanding on this previous work. A number of claimants have also come forward to identify themselves as the holder of this nom de plume since 2009, though their legitimacy has always been contested.

But whether an individual or group of people, Nakamoto likely has a wide range of reasons for keeping their identity secret. First and foremost, there’s the lure of good storytelling — mystery builds intrigue and this has undoubtedly helped build and maintain interest in Bitcoin over its history. And in addition to its obvious tech potential, it’s hard not to see an element of social commentary mixed in. Given its birth relatively soon after the GFC, it’s also possible that the creation of bitcoin was also a piece of sly political commentary. To some degree, bitcoin highlights the transient nature of currency itself. It only has value because as a collective, we’ve agreed that this is the case — but of course, this can also be applied to any sort of transactional relationship.

Whatever their reasons, Nakamoto appears to have dissociated themselves from the project in 2010 — perhaps not coincidentally, the year when the first known commercial purchase with Bitcoin took place. Their exact reasons for departing are as mysterious as their appearance in the first place — until someone is definitively identified as Nakamoto, it’s something of a D.B. Cooper situation.

Oh, and what was that purchase for? Not gold, stocks or bonds or anything similar. It was for two Papa John’s pizzas at a price of 10,000 Bitcoins and it attracted considerable media attention at the time. Just think how many more pizzas those 10,000 Bitcoins could purchase today!

Subsequently, Bitcoin would initially gain popularity on the dark web; black market websites such as Silk Road used it as a primary form of currency to protect the privacy of those involved in the transaction and the privacy of the vending website itself. This gave Bitcoin something of a seamy reputation at the time, though subsequent years have seen it move away from these origins. As more reputable customers began to get involved, it would rapidly emerge as a legitimate investment opportunity.

So what seemingly began as a mix of tech experiment and social commentary has grown into a substantial investment opportunity — and industry — within the last few years. Perhaps unsurprisingly, competing cryptocurrencies have launched in its wake. While some have been markedly successful, few have captured the public’s imagination in quite the same way.

Why invest in Bitcoin?

From an investor standpoint, Bitcoin and other cryptocurrencies represent a number of advantages. It’s not beleaguered with the legacy issues that pervade some of the more traditional forms of investment, while also presenting a genuinely new product to the market. Some of the other main advantages include:

  • Cryptocurrency represents an alternative way to park your savings and potentially earn a much larger return in the process. While shares and high-interest accounts can both be effective ways to park your savings, neither dividends nor interest rates are likely to offer the same level of returns that cryptocurrencies can under the right circumstances.
  • Bitcoin and other cryptocurrencies have attracted worldwide interest; it’s not solely constrained to one country. This naturally means there’s a wider range of interest in the field, and a bigger market to stimulate interest.
  • You’re in control. If you like to take a direct hand in your investment portfolio, cryptocurrency can be an excellent option, letting you move with the market without needing to burden yourself with onerous paperwork.

Preparing for risk

Any investment inherently contains risk and you should be sure never to invest more than you can afford to lose. Bitcoin is an interesting mix of factors; it contains some of the risks that you would find in any investment, as well as a number of new factors due to its comparative youth. Unlike gold, for example, we don’t have an extensive history of how it performs over time.

  • Perhaps the most obvious risk associated with Bitcoin (or any other form of cryptocurrency, for that matter) is the potential for wildly fluctuating values. Almost everyone associated with cryptocurrency has a story about the time they “bought too late” or “sold too early” and missed out on a huge amount of money as a result. Sometimes these stories are even true!
  • Bitcoin is relatively new territory as an investment and that brings an attendant level of risk. Keen observers will have noticed the influence that social media can exercise over cryptocurrency prices — though to be fair this is hardly the only investment that can be affected in this manner.
  • Theft, while not as common as it was in the early days of cryptocurrency, is also still a risk. Cryptocurrency is more akin to cash than property or shares; once it’s lost, it’s gone. Wallets can be hacked, so make sure that your ISP is regularly changed and that you never give out your code to anyone, to minimise the risk.
  • The quantity of Bitcoin is also inherently limited, which is a double-edged sword. While these restrictions can obviously increase the potential long-term value of Bitcoin, it’s also reliant on sustained consumer and investor interest beyond the final release of Bitcoin.

Bitcoin into the future

So, what is Bitcoin in 2021? While it seems unlikely that cryptocurrency will entirely replace more conventional currency around the world, there’s no question that it has attracted considerable interest both as an investment opportunity and as a potentially viable way of conducting transactions into the future. Though it’s difficult to say what Bitcoin’s meaning will be a decade from now, given its rapid ascent it does seem likely that cryptocurrencies are here to stay for the foreseeable future.

Regulation of some sort also seems likely. What form this will take is difficult to say, as cryptocurrencies aren’t traditionally “owned” by any central authority in a manner similar to banks or governments. However, regulations are starting to pop up around the world (particularly in the USA), though they’re currently inconsistent and will likely continue to evolve as the cryptocurrency market itself evolves.

The results of this will likely be twofold; while the same extreme profits may no longer be possible once cryptocurrencies become more tightly regulated, it’s also likely that there will be fewer instances of outright busts. Despite all the buzz around cryptocurrency, not all have been successful and the need for some greater form of consumer protection will likely develop.

Discover more about Bitcoin with BTC Markets today

Interested in learning more? Make sure you check out our regularly updated features to learn more about what’s happening in the world of Bitcoin and other cryptocurrencies. Our FAQs also has a variety of great Bitcoin information.

And if you’re looking to get started with Bitcoin investments, at BTC markets we can help you to start investing in Bitcoin or a range of other cryptocurrencies, including Ethereum, Ripple and Litecoin. We can also talk you through the steps required to utilise Bitcoin and other cryptocurrencies as part of your self-managed super fund. Get in touch with us today and create your own account to get started as soon as possible — we look forward to hearing from you soon.

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