What Is a Bitcoin and How Does It Work?

Author & Guarantor: Anton Yurchenko
13 min read

What is a bitcoin and how does it work? This is particularly the question that all crypto-newbies seek to find an answer to. Besides, “what is bitcoin and is it safe” is also a question asked by each real profy in the crypto industry, since the crypto domain evolved dynamically!  

What is Bitcoin (BTC)?

Before getting involved in the cryptocurrencies world, you have to know what is a bitcoin! Let’s briefly—but in details— see what is a bitcoin?

Bitcoin Is

Bitcoin (BTC) refers to a digital token within its own blockchain. A digital token is a cryptographically encrypted file that is stored on the Bitcoin blockchain. 

“Bitcoin is like anything else: it’s worth what people are willing to pay for it.”

Stanley Druckenmiller

The term bitcoin can be used in two ways:

  • It’s the name of a cryptocurrency unit, 
  • It’s the decentralized public peer-to-peer network protocol.

Blockchain Is

The blockchain is an open book of accounts. All transactions are saved in it. Figuratively, it can be compared to a bank employee and/or system that keeps a record of when you deposited or withdrew some money from your bank account. 

Bitcoin Transfer Is

A bitcoin transfer is logged in the digital ledger, the Bitcoin blockchain. The special thing about the blockchain is that it’s not managed by a single bank employee, but is partially or completely stored on every computer within the network. This means that Bitcoin users no longer have to rely on individual banks to manage their money. 

The decentralized architecture of the Bitcoin blockchain 

  • Offers the advantage that banks are superfluous as middlemen
  • Ensures a high level of transparency and security.

Anyone interested can publicly view the transaction network’s account book at any time. This gives Bitcoin users the opportunity to build trust in blockchain technology.

How Does Bitcoin Work?

Transactions in the Bitcoin network are verified by miners using the proof-of-work algorithm. The so-called SHA-256 algorithm is used as a basis. 

Transaction Confirmation Time

On average, the confirmation of a transaction takes around 10 minutes. In reality, it can take significantly longer. This is due to the large number of transactions that the miners can hardly handle. 

Users either have to pay more or have to wait longer for their transactions. 

For micropayments, the additional fees that would be incurred are not worthwhile. Therefore, small amounts in particular have to wait several days for confirmation.

The result was a lack of scalability, which means that the cryptocurrency hasn’t made the leap yet to a means of payment in everyday use. 

Like Ethereum and other larger cryptocurrencies with the same problem, Bitcoin also tries to increase scalability with different approaches in order to be able to guarantee more data throughput. This includes the use of the Lightning Network, which is ultimately intended to relieve the main chain of the blockchain. 

The Benefits and the Possibilities

It’s advantageous that bitcoin 

  • Was originally designed as a decentralized payment method 
  • Was created as an alternative to the classic banking system
  • It’s cheaper and faster to commit transactions
  • Each transaction is irreversible, which prevents chargebacks, which are often associated with expensive fees.

In some parts of the world, bitcoins are still a more efficient and cheap way to transfer money across borders. Many users also appreciate the pseudo-anonymity that the blockchain offers them. 

However, the cost and speed advantages of Bitcoin are increasingly dwindling as newer blockchain projects with better technology and scalability hit the market, while traditional channels work to improve their systems at the same time.

What Is Bitcoin Mining?

Bitcoin mining is the process for bitcoins to be created. Mining primarily ensures that transfers in Bitcoin are written to the digital account book. Anyone around the world with Internet access can download the protocol and use their computer’s computing power to generate bitcoins. 

Bitcoins are distributed as a reward when a transaction block on the Bitcoin blockchain has been calculated. For each transaction block generated, 12.5 Bitcoin are currently distributed as a reward. This is currently roughly equivalent to $725,000.

Calculations

Transaction blocks in the Bitcoin blockchain are calculated using a so-called hashing algorithm:

  • A hashing algorithm works with a hash function
  • The hashing algorithm is the SHA256 cryptographic encryption algorithm
  • It takes the transaction information already mentioned, encrypts it, concatenates it with the last hash block of the blockchain and assigns it to a hash value of the blockchain. 

In the case of a Bitcoin transaction, the hash value within the blockchain is the recipient’s account, the so-called Bitcoin Wallet.

Timing

The more computing power a computer makes available, the faster it can apply the encryption algorithm. 

For example, if a computer can process 350 terahashes per second (350 TH/s), it is computationally fast. The higher the computing speed, the faster transaction blocks can be integrated into the blockchain. Accordingly, miners, the operators of the Bitcoin protocol, receive more Bitcoins with increasing computing power. 

Currently the average time to create a block is 10 minutes. In addition to processing transaction data, miners within the Bitcoin network have the function of synchronizing with other computers so that the blockchain is always up to date. They also secure the system by double-checking transactions that have been processed by other computers.

Mining bitcoins from your own home computer is no longer really worth it. There are now operators of entire mining farms. In these mining farms specially manufactured graphics cards and miners are operated for the mining of bitcoins. The problem with this is that the so-called difficulty increases within the network.

SHA256 Algorithm Difficulty

There’s a degree of difficulty, which the SHA256 algorithm works with. If the difficulty is low, the algorithm has to process less data to generate a block. If the difficulty increases, a miner has to use all the more computing power in order to be able to generate a block. Mining farms are operated, for example, by the cloud mining providers. 

Cloud Mining

Cloud mining offers interested parties the opportunity to buy computing power in order to mine bitcoins. In order to receive more coins, miners usually join a mining pool. The computing power of all computers in the pool is combined in a mining pool and used for mining bitcoins. The bitcoins generated are shared among the participants.

The History of Bitcoin

On October 31, 2008, an unknown software developer—possibly several of them—proposed an electronic payment system based on mathematical evidence, using the pseudonym of Satoshi Nakamoto.

 The intention behind this idea was to create a means of payment that could be 

  • Cryptographically secured
  • Verifiable
  • Immutable, and 
  • Used independently by central authorities and governments.

By the time the white paper was published, the global economic crisis was already taking its devastating course in 2007. The bursting of the real estate bubble on the US market was seen as one of the causes of this financial crisis. 

Many people lost their homes as a result of the financial crisis. So that bankers and speculators can no longer create such bubbles, and accordingly can no longer create emergencies. 

Nakamoto wanted to provide the world with a transaction system with more integrity, through which people regain full control over their own monetary values.

Another problem that the Bitcoin blockchain was supposed to solve was double-spending. Double-spending was a major problem with digital means of payment such as eC or credit cards.

Nakamoto, whose identity hasn’t been clarified yet, dismantled the Genesis block in January 2009 and officially started Bitcoin’s blockchain. Since then, the network has been running as an open source software protocol.

The Future of Bitcoin

Bitcoin’s future is not clearly determined, yet, but it’s pretty promising and financially-sustainable. Is Bitcoin really a currency that can be used to pay for the hairdresser or your own gasoline? Or does it just serve as an investment good that can be used to make quick money? Isn’t it just laundering money?

The original idea behind the cryptocurrency was to establish an honest, trustworthy, decentralized peer-to-peer payment system. The scaling problems and strong exchange rate fluctuations make implementation as an everyday means of payment hardly possible. 

In recent times, Bitcoin therefore seems to be increasingly developing into an investment and asset. The strong growth of the past few years has attracted many traders hoping for large profit margins.

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