Bitcoin is made up of two words, ‘Bit’ & ‘Coin’. If you cut the information inside computers into smaller pieces, you will find 1s and 0s. These are called bits. You already know about coins.
…and what are Bitcoins?
Bitcoins are just the plural of Bitcoin. They are coins stored in computers. They are not physical and only exist in the digital world! That’s why Bitcoin and other cryptocurrencies are often called digital currencies.
How Does Bitcoin Work? Why Was Bitcoin Invented?
Let’s start with the basics…
There are three types of people in this world: the producer, the consumer, and the middleman. If you want to sell a book on Amazon, you must pay a big 40-50% fee. This is the same in almost every industry! The middleman always takes a big part of the producer’s money.
To understand what is Bitcoin, it’s important to know why it was created. Bitcoin was invented to remove one type of middleman — the banks. If you need to transfer $5000 from your country to your friend in the United Kingdom, the money must go through a bank in your country. They take a fee for processing. Once the money reaches the bank in the U.K, your friend’s bank charges a fee too.
It isn’t just the fees that are the problem, it’s the data they store. Banks store lots of private data about their customers. Many banks have been hacked over the last 10 years, which is very dangerous for the people that use banks. This is why it is important to understand How Does Bitcoin Work?
Unlike Bitcoin, banks can freeze/block peoples’ accounts whenever they want. They have too much control over the people that use the banks and they have abused their power. They played a big role in the financial crisis of 2008, too. Bitcoin started in 2009, just after that crisis. Many people believe that the crisis was one of the reasons for creating Bitcoin.
The solution was to build a system that has no single authority (like a bank). A single authority shouldn’t be given the power to control people. The banks and the governments controlled the currencies, so a new currency had to be created.
Bitcoin is the solution: it has no single authority. That means no banks, no PayPal, no government to be able to tell the bank to freeze your account. It’s great, right? The question on everybody’s mind now must be ‘how does bitcoin work?’.
How Bitcoin Works?
The creator of Bitcoin made three main concepts for Bitcoin that are essential in understanding the principles of Bitcoin:
- Supply and Demand
- Decentralized Networks
When you go to your internet browser and type in ‘www.google.com’, your computer starts a conversation with Google’s computers. Then, both computers start talking to each other and your browser shows images, buttons, etc. If Google’s servers were down for some reason, you wouldn’t be able to see these images and buttons. This is because the data is stored on a centralized network — it’s in one place.
To understand how Bitcoin works, it’s essential to understand what’s a decentralized network. In a decentralized network, the data is everywhere. If Google used a decentralized network, you would still be able to see the data, because it is everywhere and not just in one place. This means that Google would never go offline!
In World War II cryptography was used a lot. It converted radio messages into code that nobody could read. To read it, you would need to convert back to the original message. To do that, you needed a key. It was possible through mathematical formulas!
Bitcoin uses cryptography in the same way. Instead of converting radio messages, Bitcoin uses cryptography to convert transaction data. That is why Bitcoin is called a cryptocurrency. Knowing that takes you one step closer to understanding how does Bitcoin work.
Bitcoin does this using the blockchain. Bitcoin’s creator invented the blockchain technology!
Supply and Demand
Last week when John visited the bakery, only one cake was left. Four other people wanted it too. Normally, the cake only costs $2. But because 4 other people wanted the cake, he had to pay $10 for it.
This is the main concept of supply and demand: when something is limited, it has more value. The more people that want it, the more the price of it will go up. It’s the same as rare vintage cars.
Bitcoin uses this same concept. The supply of bitcoin is limited. Bitcoin is produced at a fixed rate, which will decrease over time — it halves every four years. Bitcoin has a limit of 21 million coins; once there are 21 million Bitcoins, no more Bitcoins can be created. How many Bitcoins are there at the moment? Well, currently (03.05.18), there are 16.9 million Bitcoins created. We’ve still got a long, long way to go before it reaches 21 million!
How Do Transactions Happen?
Now, let us see how these concepts work together. To record transactions, we need to put them in a database (like an Excel sheet).
This would normally be stored in one place in a centralized network. But because Bitcoin uses a decentralized network, the Bitcoin database is shared. This shared database is known as a distributed ledger and it is accessed using the blockchain. To learn more about blockchain technology and understand what are Bitcoins from the blockchain perspective better, read my Blockchain Explained guide.
To send Bitcoin to someone, you need to digitally sign a message that says, “I am sending 50 Bitcoins to Peter”. The message would be then broadcasted to all the computers in the network. They store your message on the database/ledger.
What are the Advantages and Disadvantages of Bitcoin?
You should already know what most of the advantages of Bitcoin are after reading this far into the guide. However, I haven’t talked much about the disadvantages, have I? There are still some advantages I haven’t talked about too though, so let’s start with the advantages and then I’ll look at the disadvantages. Then you will fully know and be an expert on how does Bitcoin work question.
The Advantages of Bitcoin
✓ International payments are a lot faster than banks
✓ Fees are low
✓ Blockchain — near impossible to hack
✓ Decentralized — cannot be shut down at a single point<
✓ Transparent — you don’t have to trust anyone
✓ Anonymous — you don’t need to use your name
✓ Powered by the community — the fees are shared instead of going to a single point (i.e. a bank or PayPal)
✓ No verification for new users — anyone can use it
The Disadvantages of Bitcoin
✗ Mining uses lots of electricity
✗ Not as fast as other cryptocurrencies
✗ Fees change a lot
✗ Anonymous — used for crime
✗ Difficult to use — private keys, public keys, etc.
The invention of Bitcoin is only the beginning. Some people are using Bitcoin and other cryptocurrencies instead of banks, but it still hasn’t completely replaced banks.