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What Is Bitcoin And How Does It Work?

By Jack Sheppard - Last updated:

The value of Bitcoin has risen rapidly over last year or so. If you bought $100 worth of the currency in July 2010, its value on the 11th January 2018 would have been $12,707,800 or just over £9,400,000.

With the value of this cryptocurrency increasing so rapidly, it’s natural that people would want to invest in it, believing that they could become millionaires overnight by investing just a small percentage of their savings. But what is Bitcoin, how does it work, and is it actually worth investing in?

Bitcoin

Bitcoin is different from traditional currencies

It is important to remember that Bitcoin does not just refer to the currency, but also the system by which it is traded. It was conceived in 2009 by Satoshi Nakamoto. In his paper, Bitcoin: A Peer to Peer Electronic Cash System, Nakamoto outlined his vision of Bitcoin as a decentralised currency.

This means that Bitcoin isn’t controlled by a central bank, the way the pound is controlled by the Bank of England, for example. It isn’t backed by any government or institution, and so in theory, its value will not be affected by events in the real world, such as a financial crash.

How did the value of Bitcoin reach such heights?

You may be wondering how Bitcoin could reach such a high value if there’s no one maintaining the system. However, rather than being maintained by just one institution, Bitcoin is maintained by every computer on the Bitcoin system.

Unlike a traditional bank, all transactions made through Bitcoin are available to see and be validated by everyone who uses Bitcoin. Every computer on the network has its own ledger of all Bitcoin transactions. When a new transaction is made, every ledger is updated to show the changes in the Bitcoin economy.

These ledgers are what give Bitcoin their value. The system isn’t based on gold or anything “real”, simply the shared belief among those using the system that the figures on the ledgers correlate to a certain monetary value.

Every ten minutes the system collates hundreds of pending transactions, and turns them into a puzzle. Individual computers then race to solve the puzzle, and once this is solved they move on to the next series, or “block” of transactions to solve. The user who solves the puzzle wins 25 Bitcoin, which at the time of writing is valued at around £222,000.

This process is called mining, as like with gold, you are virtually mining for money. This is the only way to create new Bitcoin, and is done to encourage people to maintain the Bitcoin system. People only get paid after 99 blocks have been solved, thus creating a “block-chain”. This encourages more people to participate in these puzzles and create longer block-chains, which in turn make the system more secure.

Bitcoin Mining

The production of new Bitcoin through mining ensures a steady rate of inflation for the currency. To ensure rarity and to prevent devaluing, there can never be more than twenty-one million Bitcoin in existence. At the time of writing, 16,800,000 Bitcoin have been mined, and it’s expected that the last Bitcoin will be mined in 2040. This is because the puzzles needing to be solved to mine the Bitcoin get increasingly more difficult with each block added to the chain, and so the time it takes to mine Bitcoin will gradually increase.

However, the rapid popularity Bitcoin has recently gained has meant more computers have been added to the system, and so the Bitcoin has been mined more quickly than originally expected. Thus just two years ago, it was predicted that the last Bitcoin would not be mined before 2141!

Bitcoin behaves differently from traditional currencies

International currencies

Probably the most confusing thing about Bitcoin is that it’s not strictly a currency, at least not in the traditional sense. It is a currency in that you can buy and sell things in Bitcoin. In fact, one of the reasons Bitcoin was successful was because it was the currency of choice when selling illegal items on dark web websites such as Silk Road, as it is a form of payment that is very hard to trace.

Bitcoin differs from traditional currencies however, in the way it behaves. You would expect a currency to maintain a stable value, so it will be worth roughly the same in six months as it is today, but this is not the case with Bitcoin. In this respect it’s better to see Bitcoin as a commodity or stock that gains more value the more people invest in it.

Will the Bitcoin bubble burst?

Bitcoin is highly speculative, and the rapid rate at which its value has increased gives it the same qualities as an economic bubble. This suggests that the bubble will eventually burst, and the price of Bitcoin with it. It’s easy to dismiss this theory whilst the going’s good; however we’ve recently had proof of just how volatile this new currency can be.

On the 22nd December 2017, the value of the currency plummeted from $17,500 to $12,000. It eventually rose again to $15,000 but on the date of writing had dropped down to $13,750. If you do decide to invest therefore, only invest what you can afford to lose, because what you invest today might not be worth anything tomorrow.

How to buy Bitcoin

If you do decide to buy Bitcoin, you then have the issue of where to buy from. As there is no institution controlling Bitcoin, you have to buy directly from investors. There are many Bitcoin seller scams out there that prey on first time investors unfamiliar with how the crypto-currency works, so it’s important to do plenty of research to find the best place to buy Bitcoin.

Two of the most widely used ways are online Bitcoin exchanges and ATMs, which are available at various locations around the country. These ATMs will often give you Bitcoin in exchange for cash, and so are a lot easier to use for first time buyers.

As there is no central body controlling the currency, if Bitcoin is lost or stolen, there is no one to appeal to for help, and this money is often lost. In the past, thousands of Bitcoin has been wiped from malformed addresses or people forgetting their account details. As a result, any Bitcoin you purchase should be secured in a Bitcoin wallet, so that they do not get lost or stolen.

Bitcoin wallets

Bitcoin wallet

Wallets come in the form of smartphone apps, online on web pages, and can also simply be on a physical printout. A wallet basically acts like a bank account, and as well as allowing you to store your Bitcoin, they are also where you will buy and sell your Bitcoin from.

Digital wallets will often also include an account balance, a transaction history, and many other features that make Bitcoin a bit easier to understand. Bitcoin.org/en/choose-your-wallet lists various different wallets available, and the pros and cons of using each one.

Investing in Bitcoin is risky

If you’re considering investing in Bitcoin, it’s important to see it as a commodity, as you’re effectively gambling any money you invest. Of course, it’s perfectly possible that over the coming months and years the value of Bitcoin will increase massively, however it’s just as likely, if not more so that Bitcoin will crash and you could lose everything that you’ve invested.

On the 16th January, the currency dropped by 10% in the space of an hour after the South Korean finance minister announced that South Korea may impose tougher sanctions on cryptocurrencies, and may outlaw trading on them altogether.

If the price of Bitcoin can fluctuate so much on something as speculative as this announcement, it is obviously a very risky investment.

If you do decide to invest in Bitcoin, ensure you research the currency thoroughly before giving any of your money away. This article is in no way a comprehensive guide on how to invest, merely an introduction to the currency.

Bitcoin.org is a very thorough guide, however it may not cover everything, and it’s important that you only invest when you feel you understand enough about the currency, and only spend what you can afford to lose.