What Is Bitcoin? – Complete Explanation
Bitcoin is a decentralized electronic cash system that was born and lives entirely on the internet. It’s a digital currency that provides safe and easy peer-to-peer online transactions and doesn’t depend on any central authority. Bitcoin is the first and most famous of the around 50,000 cryptocurrencies currently competing for attention and value.
Bitcoin and these others are known as cryptocurrencies because they’re secured via cryptography. There aren’t any shiny physical bitcoins you can sink your teeth into, only records of balances stored on a partially encrypted public ledger. The encryption part keeps the bitcoins and their owners safe, and the public part keeps the transactions honest. Since everyone can see them, transactions are hard to undo and almost impossible to forge.
This public ledger is called a blockchain, a chain of blocks of data. Bitcoin and every other cryptocurrency are all based on blockchains. Anyone can keep a copy of Bitcoin’s blockchain, the comprehensive account book of the cryptocurrency’s network, on their computer. These are known as nodes.
Every single transaction is broadcast publicly to every node on the Bitcoin network for verification. Transactions are verified once a majority of nodes affirm that they follow the right data structure. Every few minutes, all the latest verified transactions are gathered by bitcoin miners into a chunk called a block and permanently appended to the blockchain in exchange for bitcoin-based rewards. Rather than being issued from a single central authority like a traditional currency, this decentralized, computationally expensive process of mining is how bitcoins are created.
Instead of using your name or social security number, you’re known on the cryptocurrency network by your public encryption key. Just like you’d keep your physical coins in a physical wallet, you can hold your virtual bitcoins in a digital wallet, either in software or hardware form.
Bitcoin has value because its users find it to be valuable, much like gold or any fiat currency. In the world of atoms, there’s no such thing as bitcoins or encryption keys, or digital wallets. There’s only a network consensus about asset ownership.
This consensus-based value has risen dramatically since Bitcoin’s public launch in 2009. In 2010, a man in Florida paid 10,000 bitcoins for two pizzas. In 2021, the price of one bitcoin hit $64,000 USD.
At its conception, the total amount of bitcoins that can be mined was algorithmically capped at 21 million. This is a hard limit embedded in the software that can’t be altered. The enforced scarcity has led to many expert predictions that bitcoin’s price will continue to rise over time as more people and larger institutions flock to the network to use it as a kind of digital gold to hedge against inflation. The prediction according to Bitcoin’s current mining trajectory is that the network will reach its hard limit of 21 million around 2040.
Bitcoin: An Exact Definition
Bitcoin is a decentralized online currency based on cryptographic proof and network consensus rather than trust in a central authority.
How Does Bitcoin Work?
The system relies on a voluntary network of computers around the world called nodes that run the Bitcoin operating code and keep copies of its blockchain.
Bitcoin’s blockchain is a collection of digital data blocks containing information about each transaction. This includes the total value, the seller and buyer, the time and date, and a unique code to identify each transaction. Blocks are assembled in a chronological chain to create an organized digital record that’s easy to verify and search.
Exact copies of the blockchain are distributed periodically and automatically to every node in the Bitcoin network. Anyone can access a public node to look up past transactions or watch current transactions roll in, in real-time. Although it’s impossible to edit blocks that have already been added, anyone can add new blocks as long as they use the correct mathematical format, verified by the majority of nodes.
On the surface, it sounds risky that anyone can add to the blockchain, but combined with the total public transparency and the obligatory majority verification, this open-source nature actually makes the network more trustworthy. You can be sure that every bit of data on the blockchain has been peer-reviewed by thousands of third parties to make sure the encryption patterns are correct and every aspect of the syntax, scripts, and signatures is on the up and up.
To get a fraudulent transaction verified onto the blockchain, you’d need to control at least 51% of the nodes on the Bitcoin network. It’s hard to nail down the exact number of Bitcoin nodes, but analysts estimate the total to be somewhere around 40,000 – 100,000 in 2021. This number gets a bit bigger every day as more people around the world join the network, making Bitcoin fraud more and more unlikely.
In the blockchain, buyers and sellers are identified by their bitcoin wallet addresses. Your address is an irreversibly encrypted version of your public key, which is an irreversibly encrypted version of your private key.
Everything starts with your private key. Your private key is any randomly-generated 256-bit number. Most people use the random number generators embedded in the Bitcoin software to create their private key, but you can also flip a coin 256 times or use your own process as long as it’s not repeatable or predictable.
Private keys are usually simplified to seed phrases of 12 – 24 words or 64-digit hexadecimal strings of letters and numbers that are a bit easier for individuals to privately store and remember. Many people write their private keys down on paper to keep them safe from hackers. If you lose the paper or forget your key, though, you’ll lose access to your bitcoin wallet address and all the bitcoins inside it.
Your public key is like your bank account number. It’s mathematically derived from your private key in a way that’s currently impossible to reverse engineer even if you had a supercomputer and a trillion years. This makes it safe to publish your public key so that people can send you bitcoin.
Your bitcoin wallet address is an encrypted hash of your public key. It’s also asymmetrically encrypted via elliptic curve cryptography. This makes sure that you can use your private key to verify transactions to and from your bitcoin address but that no one who knows your bitcoin address can figure out your private key.
Your bitcoin wallet that your bitcoin wallet address points to can be either a digital or physical device. Most people use digital or software wallets, which are called hot wallets by the cryptocurrency community.
Software wallets can be stored on your computer or in the cloud. You can access them via a web browser, a mobile app, or a desktop client.
If you want more security, you can also use a hardware wallet, which is a physical device like a USB stick. This allows you to keep your bitcoins in cold storage offline, away from hackers and internet vulnerabilities both known and unknown. Even if someone else gets their hands on your hardware wallet, they’ll still need your private key to access your bitcoins.
The Bitcoin key and wallet system is based on SHA-256, a cryptographic hashing algorithm created by the USA’s National Security Agency. This algorithm is capable of generating more private keys than the number of atoms in the known universe. That makes my odds of guessing your private key about the same as my odds of winning the lottery nine times in a row.
How Do You Create (Mine) Bitcoin?
The process of bitcoin mining both brings new coins into existence and helps update and maintain the network. Miners compete for the privilege of adding new data blocks full of all the latest transactions to the Bitcoin blockchain. In exchange, they’re rewarded with a number of newly minted bitcoins. But there’s a bit of a catch.
Besides just collecting the latest data, miners have to convert it into a sequence of encrypted code called a hash and include the hash alongside the plaintext data. Hashing is similar to encrypting except that the results are fixed length and one way. That means that the hash produced by your hashing algorithm will always be the same length no matter the length of the data you run through it and that you can never run a hash back through the algorithm to reveal the original data. You can, however, make sure a hash is correct by running the same data through the same algorithm and making sure you get the same hash, which is how Bitcoin hashes are verified by the majority of nodes.
The catch is that the network rules automatically change the difficulty of the hashing problem to make sure that each block will always take around 10 minutes to mine. They do this by setting an arbitrary number of zeroes that each hash must begin with. To discover hashes with the right number of initial zeroes, miners are allowed to add an arbitrary number to the data in the block. This number is called the nonce. Miners try different nonces until they find one that, together with the other data in the block, produces a hash that begins with the correct number of zeroes.
The first miner to find a correctly formatted hash of a new block gets to broadcast it to the network for verification and the subsequent bitcoin reward, plus any transaction fees from the buyers and sellers. Roughly every 210,000 blocks, around every four years, the bitcoin mining reward is automatically halved. This computationally demanding process of mining helps keep the Bitcoin network running smoothly and credibly.
In 2021, profitable bitcoin mining generally takes large amounts of high-end graphics cards and plenty of cheap electricity. Around 19 million of the 21 million possible bitcoins have already been mined. Once the final coin has been mined, only the transaction fees will continue as an incentive for this transaction bundling to continue.
Who Created Bitcoin?
Bitcoin started in 2008 with the anonymous purchase of the Bitcoin.org domain.
A few months later, a person or group under the pseudonym Satoshi Nakamoto sent out an announcement to the Cryptography Mailing List on a site called Metzdowd.com. They said they’d been working on a completely peer-to-peer system of electronic cash and posted a link to a white paper they’d uploaded to Bitcoin.org that explained the details.
In early 2009, the Bitcoin software the paper described was officially released, and the currency network was launched. Nakamoto worked anonymously for a year alongside other developers the project had picked up, making sure the initial development went according to plan. In 2010, Nakamoto withdrew from the project and hasn’t been heard from since. Their identity is still unknown.
What Are the Applications of Bitcoin?
Besides using the currency to buy things, here are a few other applications of the Bitcoin network:
- Cheaper transfers – Sending this to someone is generally cheaper and quicker than transferring fiat currencies, especially when multiple countries are involved.
- Anonymous payment – Every transaction is public, so going fully anonymous takes a few extra steps, but it’s still easier than the fiat alternative.
- Speculation – the currency’s volatility could give a stock market veteran nightmares, but its large swings are a perfect battleground for prediction experts to make or lose fortunes.
- Long-term investment – Time will tell whether Bitcoin is a sound investment or a bubble, but if the current historical price trajectory continues, investment in Bitcoin may end up being more profitable, albeit more volatile, than the stock market.
Examples of Bitcoin Use in the Real World
In 2016, the Bitcoin network released a second-layer protocol known as the Lightning Network that enables quicker transactions. That made bitcoins easier for retailers to accept, and the point-of-sale options keep expanding.
Here are a few physical and digital stores that accept payment in this currency:
- Home Depot
- Whole Foods
- Subway franchises in many countries
- Post Oak Motor Cars, where you can buy Bentleys, Bugattis and Rolls-Royces
- Certain Burger King franchises in the Netherlands