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How does Bitcoin work?

How does Bitcoin work?
Image source: Getty Images

You may have been hearing all about digital currency non-stop because of prices shooting up. But you might be wondering how Bitcoin actually works and what all the fuss is about.

Let’s take a look at how this cryptocurrency works in plain and simple English to get a handle on why it’s so popular.

Why do I need to know how Bitcoin works?

It might surprise you to hear that a lot of people who choose to invest in Bitcoin don’t actually understand how it works. Understanding Bitcoin may seem daunting, but you don’t need to be a computer whiz to get it.

If you’re thinking about buying Bitcoin, you should make sure you have a clear picture of how it functions, just as you would with any investment.

Although Bitcoin involves technology, the theory behind it is more to do with accounting and money than computers. So, if you remove all the tech stuff, it can be a bit easier to grasp.

What is the point of a digital currency?

At its core, the Bitcoin protocol is just one big electronic accounting ledger. This distributed ledger is called the blockchain. Think of it as a digital financial record, showing every transaction. Instead of having to write down a list of spending and transfers, it’s all done electronically.

Unlike regular accounting books or software, the Bitcoin public ledger can’t be manually changed and no single person, bank, or business controls it.

The reason Bitcoin has become so popular is that it aims to use technology to improve certain issues associated with currencies and money.

Throughout history, our use of money and the ability to account for it has evolved and adapted along with our technology. Cryptocurrency and blockchain technology may be the next step in that monetary and accounting evolution.

How does Bitcoin work?

Bitcoin is the creation of the mysterious Satoshi Nakamoto and at its simplest, is just a piece of software.

The key thing to remember is that all blockchain does is create a secure way to record who owns what. An electronic record of how much money you own is what you see if you open up your bank balance online. The unique thing about Bitcoin is that the electronic record is international and not controlled by a bank.

Here is a brief summary of how the Bitcoin network began and continues to work:

  1. The blockchain code and software are created.
  2. Bitcoin ‘miners’ use computing power to verify ‘blocks’ which include transactions on the network. This is a ‘proof of work’ system, and miners are the equivalent of accounting auditors.
  3. These miners receive bitcoins as rewards for maintaining and updating the blockchain. Over time, the amount of bitcoins generated as a reward decreases through a process known as ‘halving’. It then takes more computing power to earn the same number of bitcoins.
  4. Miners can put bitcoins into digital circulation so people can buy and sell them using a Bitcoin wallet.
  5. Any transaction on the network is irreversible and broadcast to everyone. Which helps prevent stealing or double-spending.

Can Bitcoin be converted to cash?

The idea behind this digital currency was to replace banks and cash. But for now, you will often see the value of a Bitcoin in dollars or sterling.

It is possible and quite straightforward to convert Bitcoin into cash on exchanges like Coinbase.

However, there are fees to convert it and the price can change hugely in minutes. People converting Bitcoin into cash also need to make sure they fully understand the tax implications.

How does Bitcoin make money?

Bitcoin doesn’t actually make money. It is only worth what people are willing to pay for it. The fact that a Bitcoin cannot be duplicated and there will only ever be 21 million in existence makes it rare. The price goes up due to supply and demand.

Many people trust the Bitcoin network because it works using maths rather than economic policy. For countries with unstable currencies or governments, something like Bitcoin would be an appealing place to store your wealth.

For those of us living in more stable circumstances, the use case is much less obvious. You can’t really spend it anywhere and the price is volatile. The price moves around a lot because it’s hard to value a Bitcoin. It’s a new area of finance and money, so there’s nothing to compare it with.

Bitcoin has been compared to the Dutch 17th-century tulip mania where something that was basically worthless was suddenly extremely valuable purely as a result of demand.

Bitcoin is more complex than flowers. The network effect of all the miners and computing power used across the world does give it value. How to quantify that value is still up for debate.

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