Bitcoin: What Is It And How Does BTC work?
You've probably heard Bitcoin called a lot of things: a cryptocurrency, digital money, fake money, the future of money, money for criminals. Lately, "digital gold" is in vogue.
Which one is correct? Well, depending on your perspective, it's a little bit of all of them.
Formally, Bitcoin is "a purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution".
That's the first line of the Bitcoin whitepaper, which is a call for the overthrow of the entire world financial system that devolves into a very complex technical manual.
What it means is Bitcoin is a way of sending and receiving money – "transferring value" is the favoured term – that is entirely outside the banking system and does not use the pounds, dollars, euros, yuan, pesos or other national currencies created and controlled by governments.
That's what was intended by the mysterious creator of Bitcoin, who used the pseudonym Satoshi Nakamoto. In reality, the answer to the question "What is Bitcoin and how does it work" is a bit more involved.
What is Bitcoin?
To explain Bitcoin, start with the fact that it is the first cryptocurrency – a decentralised digital currency that two people can use to send or receive payments without the need for a middleman like a bank.
Every Bitcoin transaction is recorded on a publicly accessible digital ledger called a blockchain that effectively cannot be changed once an entry has been made.
At its core, Bitcoin's meaning is to provide one thing: trust.
Because Bitcoin transactions are peer to peer, there is no need for a trusted – and potentially untrustworthy – intermediary. That can be a bank if you're paying with a debit card or cheque, Mastercard or Visa if you're paying by credit card, a payment processor like PayPal if you're transferring funds digitally, or the government if you're using the banknotes they print.
Instead, the Bitcoin system relies on mathematics, cryptographic proof that the transaction is valid, to make the system "trustless" – which means that the sending and receiving party do not need to rely on a middleman. (The use of the term "trustless" to mean "trustworthy" also means you should never, ever allow computer scientists to name things normal people might use.)
Bitcoins are digital tokens with a value influenced by supply and demand, the cost of mining, and levels of adoption. Each Bitcoin can be divided into 10 million units called a satoshi, just like there are 100 pennies in a dollar or a pound. This was necessary because there is a finite number of Bitcoin – no more than 21 million will ever exist. As their value grows, it will be necessary to divide them into smaller and smaller units of currency if they are to be used for day-to-day payments.
History of Bitcoin
Bitcoin is something entirely new, one of the few major innovations in payments since people realised that the process of trading eggs directly for lumber is more burdensome than carrying around hunks of a soft yellow metal that everyone seemed to want.
The use of gold coins died out in the 19th century, replaced by paper currency backed by gold or silver – the Gold Standard. Then came fiat currency in the 1970s. And now cryptocurrency.
Bitcoin's history is tied directly to the economic woes of the subprime mortgage crisis of 2007, which was still raging by the time the Bitcoin blockchain minted its genesis block on January 3, 2009.
That block contained a message that effectively acted as a timestamp, proving its authenticity. It read: "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks." This was a headline from a story in that day's newspaper that focused on the subprime mortgage crisis. It is also widely seen as a shot across the bow of the wider financial system, whose greed had sent the economy tumbling.
By cutting out those payment intermediaries, Bitcoin was designed not just to make payments faster, cheaper and more secure, but to ultimately replace the traditional financial system. Over the years, it's evolved from a buying cryptocurrency that was worth only a few cents to an asset held by millions. BTC also managed to achieve a $1 trillion market cap in just 12 years – a milestone that took Apple 42 years to achieve.
Here's the thing: it is a volatile asset. Bitcoin's price history shows that fluctuations of 5% or more in a single day are common, and that's partly down to how this cryptocurrency doesn't have a central bank calling the shots.
That has led to many spin-off cryptocurrencies that fork the Bitcoin blockchain – introducing changes to the Bitcoin code – that aim to create coins that are more useful as actual currencies. Examples include Bitcoin Cash, Litecoin and Bitcoin SV.
We've seen a number of milestones over the years, too. Bitcoin was shown to be a viable payment method when two pizza pies were purchased for 10,000 BTC back in 2011. BTC went on to break through $1,000 for the first time in 2017, followed by a new all-time high of $19,783 that same December. That price threshold would only be broken again three years later. And then, in September 2021, history was made when El Salvador became the first country in the world to accept Bitcoin as legal tender
How does Bitcoin work?
The Bitcoin network is built on a blockchain, which is a kind of database with two very important features – it is decentralized and it is immutable. This is where the cryptographic trust comes in.
Immutable simply means that a Bitcoin transaction cannot be changed, erased or reversed. All you can do is add a block of new transactions to the end – like adding a link to the end of a chain. Each of those blocks is cryptographically connected to the blocks before and after it, so altering one would be obvious.
Because an entry on the Bitcoin blockchain ledger is permanent, you don't need to trust any intermediary, whereas a traditional database can be changed. If someone with access to the bank's systems deletes your current account's balance, it's gone until you convince the bank it has made a mistake.
Bitcoin is decentralised in that it runs on a distributed blockchain network where tens of thousands of individual computers all over the world – "nodes" – have a complete and up-to-date copy of the entire blockchain. This has two benefits. In practice, it cannot be shut down by a corporation, court order or government legislation – there are just too many nodes spread across the globe.
In addition, that means the network is wide open to the public, with every transaction visible to anyone. But Bitcoin transactions are not anonymous, they are pseudonymous, and here's where we touch on the "crypto" part of cryptocurrency. Every Bitcoin has a public key code – a long string of letters and numbers. Anyone can track each time that particular Bitcoin moved (and where) back to when it was first mined.
Each Bitcoin also has a second cryptographic key code, called a private key. This is the equivalent of a PIN for a bank card, with one crucial difference: if the private key is lost, the crypto cannot be retrieved.
The reason Bitcoin trading is only pseudonymous is because, somewhere along the line, it may need to be exchanged for fiat currencies like pounds and dollars. That means you would have to connect to the banking system, which needs to identify its customers. This is how detectives and the taxman have been able to track down drug dealers, money launderers and criminals.
The Bitcoin network has several flaws, starting with the reality that it is too slow to scale up to a true payments network. It can handle just six transactions a second, compared with Visa's 24,000. However, developers are working on future updates to make the blockchain more efficient.
Another is the proof-of-work mining process used to validate transactions and add them to the Bitcoin blockchain.
A race to solve a mathematical problem to win the right to mine a new block and be rewarded in newly created Bitcoin sounded great. But Nakamoto didn't foresee that the skyrocketing price of BTC would create an arms race for ultra-fast computer chips that would price all but a few large, well-funded groups out of the market – while sucking up so much electricity that Bitcoin is considered a global warming threat. There has been speculation that developers could consider switching the blockchain to proof-of-stake in the future, but a lot of this may depend on how Ethereum's migration goes first.
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