Explained: How Does Bitcoin Work?

bitcoins

We’ve had several readers ask about Bitcoin. What is it? How do you get it? How does it work? So, since it’s been in the news increasingly lately, I figured I’d give you a quick crash course on how Bitcoin (BTC) and other cryptocurrencies work.

Bitcoin has somewhat of a mysterious past. It was started in 2009, but its unknown by whom. The person (or persons) go by the pseudonym Satoshi Nakamoto and have never made a public appearance on behalf of Bitcoin.

The idea behind Bitcoin: it’s a virtual currency that can be transferred to anyone, anywhere. It isn’t issued by any central bank like traditional forms of currency, and it can be bought and sold anonymously online. In that sense, the market for Bitcoin could be compared to stocks. It’s assigned a value based on demand, where buying and selling influences the price. The more Bitcoin bought, the higher the price goes. The more Bitcoin is sold, the lower the price goes.

bitcoin-mining-computer

Bitcoin Mining Computer

Since Bitcoins aren’t issued by a bank in the traditional sense, the two ways to acquire it are to either buy BTC from other individuals who are selling it, or to mine it. Bitcoin mining and the science behind it is a different post for a different time. The long and short of it is this: the peer-to-peer network that makes Bitcoin run posts each buy / sell transaction back to a public log. The computers on the P2P network all work to verify the transactions through a series of complex algorithms and mathematic equations and once verified, the coins are allocated to that user.

All the computational power required to run the Bitcoin network lead miners – that is, individuals specifically trying to earn Bitcoin – to build intensely powerful computers like the one pictured here.

Once a Bitcoin (or block of 25 Bitcoins) is earned, it’s “paid” out to the user. The coin is represented by an encrypted key, which can only be decrypted by a second key. The Economist explains in this example:

In the very first transaction the creator’s computer forged 50 units of the currency. The next transaction would have involved subtracting some amount from the creator’s account and crediting it to a recipient’s. These actions, and any subsequent ones, were automatically broadcast to the entire network. At first, when the network was small and transactions few and far between, verifying them was been straightforward. The first person to confirm the new transactions would offer his updated log as the one against which any future transactions ought to be judged. Once everyone else agreed that this candidate register was indeed accurate, it would be adopted and the new transactions included in it confirmed. If anyone tried to game the system by erasing an old transaction (so he could re-use the same money again) or adding an unwarranted new one (transferring the same money as before, say), he would be promptly found out, his proposed log discarded, and the transactions rejected as invalid.

You can track the value of Bitcoin (and see transactions on the public log) using sites like Bitcoinity, pictured below.

bitcoinity-markets

Regardless of the performance ups and downs of Bitcoin, it’s here to stay. The question that still remains: how will it carve out its place in the big picture of finance? More businesses are starting to accept BTC as a valid form of payment, and banks around the world have also added Bitcoin to their list of services. This is just the beginning.

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