How Does Bitcoin Work? A Simplified Beginners Guide

Have you ever asked yourself, “How does Bitcoin work?” As one of the most adopted cryptocurrencies, this question is often surrounded by a lot of confusion for Bitcoin beginners. That’s why we decided to break it down and offer the most insightful content around this subject matter.

How Does Bitcoin Work?

Bitcoin works by digitally exchanging anonymous encrypted codes across a peer-to-peer network. Let’s first get the basics right:

  • Blockchain refers to a decentralized public ledger that records all Bitcoin transactions.
  • A crypto wallet (hot & cold wallets) is a software or hardware medium that stores public and private keys associated with your Bitcoins to enable you to send or receive funds. Hot wallets are accessible online and facilitate peer-to-peer transactions, while cold wallets store private keys offline on a physical device.
  • A private key is an alphanumeric code that enables users to make transactions by verifying ownership of the funds in a crypto wallet.
  • A public key (AKA address) is a cryptographic code that allows users to receive Bitcoins in their wallets.
  • Bitcoin mining refers to creating new Bitcoins and releasing them into circulation in the blockchain.
  • Transaction broadcasting refers to sending transaction data to the Bitcoin peer-to-peer network.
  • Proof-of-work is the algorithm that secures the Bitcoin network by ensuring transactions are validated and confirmed on a blockchain before opening a new one.

a summary of how bitcoin works

To better understand how Bitcoin works, let’s assume I have a book I want to give out to you. I’ll just have to pass it directly to you from my hands. You’ll take complete control of the book while I remain with nothing. Besides, you can as well surrender ownership of the book and give it to anyone at your discretion, and the cycle can continue as long as possible without limitations.

Now imagine you were doing these exchanges online. There will be blocks of data created in the process, and shall be recorded in a public ledger where all previous exchanges can be tracked. These peer-to-peer transactions will be broadcasted into a blockchain with no central authority. Transactions on the network will be synchronized, and any user of the digital ledger can inspect them.

The rules in the digital ledger are preset, and no single user can alter the system to favor them, like acquiring a copy of the book. Smart people maintain and secure the system, and you too could join the process. As a reward for the hard work done, you could be rewarded with like 25 digital books.

That’s the only way to create more digital books in the system. In real life, that’s how Bitcoin works. This system is the Bitcoin protocol, and the digital books are what is Bitcoin.

How Blockchain Technology Works in Bitcoin

Blockchain technology is the engine that runs the Bitcoin network, and understanding how it works is critical to answering the question of how does Bitcoin work.

When users transact on the Bitcoin blockchain, a block will be created to represent that transaction. The transaction is then broadcasted via nodes through the peer-to-peer network for validation.

Verified transactions involve contracts, records, cryptocurrency, and any other meaningful information. Once verified, transactions are combined to create new data blocks on the public ledger. Cryptographic hashes create a secured block with each new transaction, secured and attached to other blocks.

Miners rely on the proof-of-work consensus mechanism to verify and validate transactions on the Bitcoin blockchain. This mechanism automatically determines which miner submitted a specific block and awards them with new Bitcoins. These incentives positively impact the blockchain in terms of security by verifying the accuracy and authenticity of blocks. Besides the proof-of-work mechanism, Bitcoin blockchain technology ensures the blockchain is immutable and resistant to alterations.

What Is Bitcoin Used For?

Bitcoin was created as a countermeasure to the restrictions of fiat transactions. Due to its increasing popularity, it has expanded usage to cover areas like:

  • Value storage – Users treat Bitcoin as a store of value or digital gold because of its limited nature. Some users also use it as a hedge against the inflation of their local currencies.
  • E-commerce – Businesses like Newegg, Tesla, Overstock, and Starbucks support cryptocurrency payments. Users can make anonymous purchases without the need for their personal information.
  • Remittances – Money transfer operators can approximate the required amount for their day-to-day operations, purchase an equivalent amount in Bitcoins, and sell them for fiat currency in the receiving country.
  • Investment & Speculation – Most people tend to buy and hold Bitcoins, anticipating that they will have a value increase, and sell them in exchange for fiat currencies.
  • Digital Payments – Individuals and businesses can make fast, secure, low-cost transfers without intermediaries.
  • Donations – Some charities now accept cryptocurrencies as donations. As a donor, you stand a chance of a tax deduction with the charity not paying capital gains from the Bitcoin donation.

How Does One Own Bitcoins?

Bitcoin mining is the primary method of owning Bitcoins. However, there are other ways, including:

  • Purchasing from Banks – Some crypto-friendly banks like Bank of America, Ally Bank, Goldman Sachs, and JPMorgan Chase now support the buying and selling Bitcoins through their online banking interface.
  • Crypto exchanges – Reputable crypto exchanges like Coinbase and Bitstamp support Bitcoin purchases using fiat through easy-to-use and straightforward processes.
  • Bitcoin ATMs – Nine years after the introduction of the first Bitcoin ATM, users can now purchase Bitcoins using particular debit or credit cards. The purchased Bitcoins will be deposited into your preferred crypto wallet for utilization. Users can also buy Bitcoins in specific retail stores.
  • Investment firms – Investment firms like Robinhood, Webull, and TradeStation allow users to sign up and buy and sell Bitcoins easily.

Sending & Receiving Bitcoins

You only need to understand some of the technical details of cryptocurrencies to understand how Bitcoin works regarding sending and receiving funds. All you need is a crypto wallet, and you’ll be ready. Here is the process simplified:

To crypto beginners, sending Bitcoins might sound like rocket science. On the contrary, it’s a straightforward process that requires little information. You only need to know the recipient’s address and the amount to be sent. Bitcoin wallet addresses are a string of case-sensitive alphanumerics varying in length from 26 to 35 characters. The addresses can also come as a QR code that can be scanned by your phone to have the wallet address translated.

Here is the simplified process of sending Bitcoins:

Step 1: Log in to your crypto wallet.
Step 2: Select ‘Send’ crypto.
Step 3: Enter the recipient’s wallet address.
Step 4: Enter the Bitcoins to send.
Step 5: Confirm the transaction and send.

Sending Bitcoins can be done via your mobile device or computer. Some Android and iOS apps like Cash App may let you send Bitcoins without having a wallet. Instead, they store your Bitcoins on your behalf. Through them, you can send Bitcoins to users on the same platforms without using traditional crypto wallet addresses. In this case, the service provider has custody of your Bitcoins the entire time. We do not recommend this option to buy and deposit Bitcoins since a user’s funds are not entirely under their control.

A recipient just needs to provide their wallet address to receive Bitcoins. Log in to your wallet, generate an address, and share it with the sender. On receiving your address, the sender is responsible for sending you the funds through their wallet software. Sending Bitcoins has few requirements since the sender does most of the work.

Security tip: Always double-check the recipient’s address before sending funds. A single typo could lead to a permanent loss of funds.

How to Store Your Bitcoin

As a user, you’re given instant ownership of any Bitcoins you purchase. The use of private and public keys ensures Bitcoin safety for your funds. A public key encrypts your wallet address, while a private key decrypts the private key, giving you access to your funds. Bitcoin is safely recorded, stored, validated, and encrypted on the blockchain. The Bitcoin blockchain technology is very advanced and secure, and it would take centuries to hack the Bitcoin blockchain.

There are two ways to store Bitcoins, custodial and non-custodial.

Non-custodial Wallet

Also known as self-custody wallets, non-custodial wallets let the user take full responsibility for the funds’ management. These wallets come as hot and cold wallets and let users control their Bitcoins.

Non-custodial wallets come in different forms, browser-based (as extensions), hardware wallets, and mobile-based (downloadable mobile apps). Hardware wallets like Ledger and Trezor are considered the most secure since they are easily accessible and manageable offline.

For account recovery purposes, users are issued 12 randomly-generated words used as seed phrases as a backup mechanism in case they lose access to their original device. If a user loses their seed phrase, they automatically lose access to their funds, and any user with the seed phrase can access the Bitcoins and take over their control.

Custodial Wallet

In custodial wallets, a third party has control of users’ private keys. The user’s Bitcoins are fully controlled by a third party, managing a user’s wallet key, protecting their funds, and signing transactions. We do not recommend this option of storing Bitcoins since users have minimal control over their funds.

Custodial wallets offered by exchanges like Bitstamp and Coinbase come as mobile or web apps. Users use the wallet provider’s interface to manage their funds and make transactions once logged in. They entrust the custodial wallets to secure their funds through intense security measures like two-factor authentication (2FA), email confirmations, and biometric checks like facial and fingerprint recognition.

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FAQs

A Bitcoin wallet is a device or software that lets users store and spend their Bitcoins.

Bitcoin is purchased primarily on crypto exchanges. However, users can buy Bitcoins from banks like JPMorgan Chase, Bitcoin ATMs, and investment firms.

Demand and supply forces in the crypto market determine the price of Bitcoin.

Yes. Bitcoin can be converted into cash easily on crypto exchanges like Binance, Bitstamp, Kraken, Coinbase, and Gemini.

A cryptocurrency network verifies a transaction when a validator solves a mathematical puzzle. For example, in Bitcoin, the network uses proof-of-work to validate transactions and helps prevent cyber attacks on the blockchain.

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