6 MIN READ
An Easy Guide for Anyone Who’s Still Wondering How the Heck Bitcoin Works
Bitcoin: a confusing, controversial currency whose name has made the rounds across the internet in the past few years. Today, it’s as popular as ever and is booming in price, although prices are highly volatile. Just this week, bitcoin reached a peak value of $11,377.33 on Nov. 29, then lost over a fifth of its value the next day.
Many, though, are still unclear about what its purpose is. What can digital currency buy, what gives it such high value, and how does its price shoot up so high all of the time?
What Is Bitcoin, and What’s All the Buzz About?
Bitcoin is a digital currency created in 2009 by an anonymous person or group under the alias Satoshi Nakamoto. The creator(s) capped its circulation at 21 million bitcoins when they introduced the currency. At the time of this writing, approximately 16.7 million bitcoins were in circulation, according to bitcoinblockhalf.com.
Bitcoin is completely digital, so there’s no such thing as a physical bitcoin you can hand to your BFF after they spot you during your lunch date.
Wait. So it’s internet money?
That’s one way to think of it. You can send bitcoin electronically and transfer it to anyone around the world. Its network doesn’t exist on the internet you and I use in day-to-day life, but yes, it is bought, sold and transferred via a computer network.
OK, but how?
Here’s where it gets confusing. Bitcoin is sent through a network, named… bitcoin. How original, right? Your credit card transactions might be sent through a payment network such as American Express or Mastercard. In bitcoin‘s case, payments are sent through the bitcoin network.
This network is decentralized, which means no single person or company runs it — computers do, and volunteers maintain it.
This differs from traditional currencies, which are regulated by a central bank, such as the U.S. Federal Reserve. These banks have the ability to print or withdraw money based on market fluctuations to keep it steady.
Then where does it come from?
New bitcoins are created through a process called mining, and anyone with a strong enough computer can become a miner. During this process, bitcoin miners are the resources that help verify bitcoin transactions between users all around the world.
The network cuts the amount of bitcoins generated in half about every four years. At this rate, all 21 million bitcoins will have been mined by around 2140.
If bitcoin isn’t regulated, then who is keeping track of its exchanges?
Each bitcoin transaction is associated with data; the bitcoin network then combines the data of multiple transactions to create a puzzle.
Bitcoin transfers are stored on the bitcoin network in a giant public database known as a blockchain. Think of the blockchain as a giant book of public records. To create the chain, someone has to put the blocks together — which is where miners come in.
Miners use sophisticated computer hardware and software to solve these puzzles, The Washington Post explains. By doing so, miners verify the data and make sure specific funds aren’t spent twice.
After verifying a block of transactions, the miner currently receives a reward of 12.5 bitcoins, which was worth more than $132,000 as of Dec. 1.
The reward for mining a block is cut in half for every 210,000 blocks mined, or about once every four years. It dropped from 25 bitcoins to the current 12.5 bitcoins in 2016; it’s expected to be cut in half again to 6.25 bitcoins in 2020.
Since the bitcoin network isn’t regulated, isn’t it vulnerable to hackers?
Since there are people who help maintain the network — the miners, remember? — this means they could just alter it to give them more bitcoin… right? Actually, It’s highly unlikely; the computers would recognize the change and would in all likelihood ignore it. The network is open source with a ton of developers working to improve its code and monitor changes. To date, bitcoin has never been hacked. Experts agree that’s unlikely in the short term, although that doesn’t mean it can never happen.
Makes sense. But what gives bitcoin its value?
People bid on bitcoin exchanges every day. Its price fluctuates with the number of people who bid on it. The higher the demand for bitcoin, the higher its price and perceived value. But skeptics say the fact that its value is dependent upon how many people want to buy it, and nothing tangible backing it up, is where the digital currency fails. More on that later!
How do you buy bitcoin?
You can easily buy bitcoin through platforms such as Coinbase. These platforms also act as digital wallets where you can store your bitcoin.
Coinbase allows you to purchase and exchange bitcoin with your bank account or credit card. It also converts bitcoin into your local currency and claims to keep it secure.
Why People Care So Much About Bitcoin
You can use bitcoin to purchase things anonymously, reducing the risk hackers will get access to your sensitive information. Credit or debit cards, by comparison, are usually linked to bank accounts, Social Security numbers and more.
This anonymity also makes it criminals’ payment method of choice for everything from ransom to purchasing drugs on the darknet. That said, these criminal activities make up just a small percentage of all bitcoin transactions, The New York Times reports.
Bitcoin is commonly used to save money without it losing value in countries with high inflation, like Argentina and Venezuela. It’s also popular for international money transfers, which are nearly instant.
Bitcoin exchanges are also nearly instant and usually carry fees of around 0.25%, whereas money transfers via banks take time to process and come with higher service fees.
Is There a Bitcoin ‘Bubble’?
The price of bitcoin is soaring. But does that mean we should all ditch our dollar bills and invest now?
Some people, such as famed investor Warren Buffett, argue against it saying there’s a “bitcoin bubble” that will eventually burst.
This “bubble” refers to people buying more and more bitcoin, betting its price will continue to increase. However, skeptics like Buffet say the burst will come when daily bidding and exchanges slow, which will drop its price significantly.
Buffett says Bitcoin isn’t a “value-producing asset,” meaning there isn’t anything tangible backing it. People only buy it because its price keeps increasing, and they want a piece of the pie when they cash out. It isn’t creating earnings or generating steady returns. The prices constantly fluctuate, meaning someone could lose their entire investment at any moment.
A small bitcoin bubble burst in 2013, when bitcoin prices dropped from $1,150 to under $500,
Bitcoin enthusiasts, however, argue that major fluctuations are normal for any developing system. Michael Rauchs, a cryptocurrency and blockchain expert at the Judge Business School at the University of Cambridge, told The Independent that he “would put it in the same category of revolutionary new technologies like the internet.”
“World-changing systems tend to be accompanied by bubbles in their early stages,” he said. “What’s happening now is completely normal.”
As with any investment, there is a risk –– so deciding whether to invest or not is a personal choice.
Kelly Anne Smith is a junior writer and engagement specialist at The Penny Hoarder. Catch her on Twitter at @keywordkelly.
This article contains general information and explains options you may have, but it is not intended to be investment advice or a personal recommendation. We can't personalize articles for our readers, so your situation may vary from the one discussed here. Please seek a licensed professional for tax advice, legal advice, financial planning advice or investment advice.