What is Bitcoin and How Does it Work?

What is Bitcoin and How Does it Work? An Ultimate Beginner’s Guide to Cryptocurrency.

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Everything evolves, even money…

Until a few years ago, we only knew two forms of money: our local currency and foreign currencies such as the euro, the British pound, or the yen. The rest of the equation was completed by the ways of using it, whether it was cash, transfers, or even checks.

Everything changed when Bitcoin (BTC) arrived, and what is Bitcoin? Bitcoin is a decentralized digital currency that runs on cryptographic software called a blockchain that keeps a public and unalterable record of all transactions.

Bitcoin appeared as an alternative and solution to traditional money and its problems, as described by its mysterious creator, Satoshi Nakamoto.

Bitcoin started slowly and more than ten years later, we’re all surprised when we see on the news that a Bitcoin is worth more than $50K and that it has already surpassed gold as an international store of value.

And you wonder:

What is Bitcoin and how does it work?
What can I do with Bitcoin?
Is Bitcoin legal?

For these and other questions, I decided to create this Ultimate Beginner’s Guide to Bitcoin and Cryptocurrencies, to clarify your doubts once and for all, forever.

Let’s get started.

What is Bitcoin and how does it work?

Bitcoin is a digital currency, decentralized and supported by cryptography-based software.

That means that you can use bitcoin to pay for goods and services directly (peer-to-peer or P2P), without an intermediary – such as your bank’s electronic platform.

On the other hand, “trust” in Bitcoin is based on a cryptographic security system that prevents fraudulent operations with the currency, instead of relying on the trust offered by governments or banking institutions.

“Basically, each bitcoin is a file stored on your device – smartphone or computer – that runs on cryptographic software (blockchain) that keeps a public and unalterable record of all transactions.”

What can you do with Bitcoin?

With each day, Bitcoin and the rest of the cryptocurrencies are more and more integrated into the economy and society.

Many people already see cryptocurrencies as something normal and have become used to using them as part of their day-to-day needs for different purposes. Let’s look at the main uses of Bitcoin today.

1. Paying for goods and services

The first time Bitcoin was used was to pay for a product: two pizzas at the Papa John’s restaurant chain. 10,000 bitcoin were paid – about $30 at that time.

It doesn’t matter if it’s a pizza or a piano that’s more than 200 years old, Bitcoin is increasingly accepted as a form of payment for buying and selling, forming part of many eCommerce platforms in different categories.

Let’s name just a few:

1.1 Travel:

1.2 Videogames:

1.3 Online shopping:

1.4 Computers and electronics:

1.5 Other:

2. Protection against inflation

One of the main drawbacks of traditional money is that it can be controlled by central banks and governments.

These entities can print enormous sums of fiat currency into the market and manipulate interest rates, thus causing the devaluation or appreciation of the value of the currency, even if said value doesn’t correspond to the real value of the economy of a country.

This has happened throughout history and continues to happen both in poor developing countries and in superpowers like the United States.

Many people have realized this and have chosen to use Bitcoin as a means to protect the value of their money against the problem of inflation since this cryptocurrency has a superior ability to preserve the value of money – something similar to gold.

3. Online trading

Another of the main uses of Bitcoin today is to serve as an investment instrument in international markets. This is possible thanks to exchange platforms like Binance.

Through this and other similar platforms, you can use your BTC to exchange them for other fiat currencies – such as USD and EUR – and cryptocurrencies around the world, play with the fluctuations of market prices, and thus make a profit with your exchange.

In this simple way, you can participate in international financial markets without using fiat money.

4. Carrying out international transactions

The international financial system is the traditional platform for capital mobilization across borders. This has allowed the emergence of large companies that are essential for the development of the economy in different countries.

However, not everyone can access the capital market, even less without the help of banks.

Bitcoin changed that. Thanks to the emergence of Decentralized Finance (DeFi), now anyone in the world can make international investments or simply send money to or from their country using the blockchain on which Bitcoin is based.

On top of that, transaction fees can be much lower than those of banks depending on the cryptocurrency you use.

5. Investing

As you already know, the value of Bitcoin has varied a lot since its inception; from zero USD in 2009 to the all-time high of $60K recently.

Those people who had the luck or the vision to acquire tens, thousands, or hundreds of thousands of bitcoin in their early days, may now find themselves enjoying their profits on a beautiful island in the Caribbean or Indonesia.

It’s not known exactly whether the value of Bitcoin will continue rising – although many experts say it will – but the growth potential of Bitcoin and other cryptocurrencies has attracted – and it’ll continue attracting – many investors, large and small alike.

What is a blockchain?

We previously said that blockchain is the technology behind Bitcoin; this technology is what allows the cryptocurrency to work as we know it.

However, this technology can also be used independently of Bitcoin to create other cryptocurrencies or many other things.

A blockchain is a distributed or decentralized database. This means that it’s not located in a single place nor controlled by a single person or institution, but rather, it’s spread over different nodes (computers, users), which hold the same importance within the network.

It’s like a ledger. This ledger is replicated identically at each node that makes up the chain. Each new transaction that is carried out or each new block that is created is also replicated in each of the nodes.

There is no single entity that has all the information since it’s distributed in real-time among all the nodes.

Each time a new block (information unit) is created, it contains the information of all previous transactions. To validate each new block within the chain, the base software poses a mathematical challenge to the nodes, and the first to solve it, will send the (unique) solution to the rest of the nodes.

If the majority certify that the result is correct, that block is accepted by all, and thus becomes part of the chain, adding new information to the database.

Thus, the network works by consensus among all parties. Once a transaction is approved in the master book, it can no longer be deleted or modified. It is permanent.

This is how blockchain replaces trust in a third party with mathematical truth, which is infallible – like saying that one plus one equals two. There is no possibility of fraud: everything is transparent and auditable by everyone, and in addition, everything is encrypted.

What is Bitcoin mining?

We previously said that the creation and validation of a new block within a blockchain implies solving a mathematical problem (proof of work). This is known as mining.

Mining can be done by individuals or by groups of people working together, and it has two purposes: the creation of new currencies and acting as a supervisory agent in the network to confirm the veracity of the transactions.

This activity is neither easy nor free, since it consumes a large amount of computational resources and electricity. Although at the beginning it wasn’t like that, nowadays powerful computers are required to perform very complex equations from time to time.

Every time a miner or group of miners manages to solve the mathematical problem presented by the network and produces a new block, they must include in the header of the block, the hash or cryptographic summary of the block that precedes it – which was the last validated block of which they’ve knowledge – and transmit it to the rest of the nodes until reaching the entire chain.

Once the new block has been fully validated, the miner or group of miners who created it receives an incentive or reward: a certain amount of bitcoin – BTC 12.5 today.

This is how new bitcoin are created to be added to the blockchain.

Anyone can mine. As long as you have the hardware and software to do it, and the more teams that develop it in the same space and time, the better. Otherwise, it wouldn’t be profitable nowadays.

What is a Bitcoin wallet?

Once some bitcoin have been mined, the next step is to make use of them through the action of buying, selling, or storing them away safely.

It’s at this point where Bitcoin wallets come into play, which is basically software that connects to the Bitcoin blockchain and allows you to manage the so-called public and private keys. It’s as if it were a bank account, but on the blockchain and exclusively online.

The private key is a very long number that works as a kind of password that represents a certain number of bitcoin. Remember that your bitcoin exists at all times on the blockchain. Having access to a private key is having access to a certain number of BTC within the blockchain.

If you lose your private key, you lose access to your coins. You should never show it to anyone.

On the other hand, the public key is similar to the private key, except that you can show it to anyone who wants to send bitcoin to your wallet.

An analogy is like when you use your email: your email address would be the public key that others can use to send you messages, while your password would be like your private key, which gives you access to the content of your email. Would you give it to someone?

Depending on what you want to do with your BTC, whether it’s simply to store them or accumulate a certain number for the payment of goods and services, you can choose different types of wallets. Not all serve the same purpose, so let’s see how they classify:

1. Custodial wallets

In simple words: a custodial wallet is one in which your private keys are stored or “guarded” by a third party. Most of the online wallets that work through a web page interface on the internet are of the “custodial” type.

Custodial wallets store private keys on the servers of a company that provides this service. This means that they’re in control of your funds at all times. Some of these wallets are usually also presented in desktop and mobile versions.

The main advantages of these types of wallets are:

  • You can access your funds anytime, anywhere – as long as you have an internet connection.
  • You don’t have to deal with complicated technical issues – great for beginners.
  • In most cases, they charge very low fees for each transaction.

The negative aspect of custodial wallets is that because there is a third party controlling our funds, it’s very easy for them to decide at any time to close the business, and run off with our money. They are also very prone to hacker attacks. Mt. Gox is a great example of the latter.

Some of the best-known platforms that operate as custodial wallets are:

2. Non-custodial wallets

With a non-custodial wallet, you are responsible for the security of your private key. You are the custodian of your funds.

These wallets allow you to store your funds without the need for a constant internet connection and can work in any format, including web, mobile, desktop, hardware, and paper.

In the case of hardware wallets, these are usually like memory sticks that store the public and private keys as they would with any other type of file.

When you want to make a transaction, you just have to connect the stick to a computer with an Internet connection. Once your transaction is finished, you just remove your memory stick and you’ll have the security of offline storage again.

Paper wallets work in a similar way to hardware wallets. In this case, the keys are printed on a piece of paper. Typically, the keys are printed in the form of a QR code, so that they can be quickly read by some electronic device to perform transactions.

Next, the keys are temporarily transferred to a software wallet. Once your transaction is complete, the software generates a new public and private key that you can reprint on paper for the security of cold storage.

By not requiring a constant internet connection, non-custodial wallets allow you to store your funds in the medium and long term, making them ideal for those who want to save or invest.

The main advantages are:

  • You are in full control of your funds.
  • The risk of a hacker attack is greatly reduced.
  • You don’t need to go through “Know Your Customer” (KYC) processes to verify your identity.

The main disadvantage of these wallets is that if you permanently lose access to your wallet, you lose your funds forever. Also, they are not suitable for constant trading due to the rapid changes of the market.

Some of the non-custodial wallets that we can find in the market are:

2.1 Web:

2.2 Mobile:

2.3 Desktop:

2.4 Hardware:

Where do I buy Bitcoin?

Today, the most popular way to get bitcoin is by buying it on crypto exchanges.

Crypto exchanges work in a similar way to traditional exchange houses that operate with fiat currencies. The main differences are that crypto exchanges operate exclusively online and are for exchanging cryptocurrencies.

There are basically two types of exchanges: centralized (CEX) and decentralized (DEX), each with its own pros and cons.

The main difference between the two types of exchanges is that CEX are controlled by an organization – usually a company – that acts as a regulator for transactions.

On the other hand, DEX don’t have a regulatory body, since they operate entirely on the blockchain and transactions are performed directly between users.

In this link, you can get more information about the differences between centralized and decentralized exchanges, Centralized vs Decentralized Exchanges.

An important aspect to note is that you don’t need to invest thousands of dollars that a bitcoin is worth today to buy this cryptocurrency, since you can buy it in fractions called, Satoshi.

Once you have paid for your bitcoin, either through fiat currency or another type of cryptocurrency, you’ll have to wait an average of about 10 to 15 minutes – depending on the exchange – to receive your bitcoin.

Now that we’ve clarified some points, let’s see below what are some of the most popular exchanges today.

Coinbase
Coinbase is one of the largest exchanges in the world and the most popular in the United States. This exchange is very easy to use, allows you to buy Bitcoin in addition to other cryptocurrencies, has a high volume of liquidity, has a presence in more than 40 countries, and follows Money Transmission and e-Money Regulatory Compliance worldwide.

Binance
Another of the big exchanges on the market. Although Binance allows you to buy Bitcoin, this exchange mainly focuses on altcoin trading. The best thing about Binance is that it has much lower fees than other platforms, in addition to offering a greater variety of cryptocurrencies than many of its competitors. It’s suitable for more advanced users.

Kraken
A very popular and reliable exchange that, although it doesn’t offer as much variety of cryptocurrencies in addition to Bitcoin – about 20 cryptocurrencies – makes up for it with other attractive features for investors. A wide variety of payment methods, presence in more than 150 countries, high liquidity, low rates, and excellent technical support make the difference.

Gemini
This popular exchange was founded by the famous Winklevoss twins, the first Bitcoin millionaires. This exchange has a great reputation in the industry, it’s USA-based and its managers work hard so that the business operates according to the regulations of each country where it has a presence (more than 50). It allows making deposits through bank account and wire transfer and offers more than 30 cryptos to buy and sell.

Bisq
Up to this point, we’ve only talked about centralized exchanges (CEX). For its part, Bisq is one of the best decentralized exchanges (DEX) on the market. This exchange is designed so that people from any country in the world can have access to the crypto world; it offers a huge variety of payment methods (about 30), is accessible from any device and its fees are very low (less than 1%).

Remember that being a DEX, you’ll be in full control of your funds.

Changelly
Founded in 2015, Changelly is another DEX-type exchange that has gained quite a bit of popularity recently. Changelly allows you to perform operations instantly and pay by credit, debit card, and cryptocurrency. It offers more than 150 cryptos to choose from (including BTC), has extremely low fees, and allows you to transfer your cryptos to a private wallet without major difficulties.

eToro
eToro is a very popular cryptocurrency exchange and investment platform that has a very useful feature for those who want to enter the investment world: copy trading.

Copy trading allows you to track and copy the investments of experienced and professional investors to reduce risk in your own investments. In addition to this, it allows you to trade not only Bitcoin and other cryptocurrencies, but also a good variety of assets.

Is Bitcoin legal?

Since its creation, Bitcoin opened the door to legal questions that even today legal experts around the world are solving for.

In order to avoid delving into too many legal details, we’ll say that the legality of Bitcoin is directly related to where you are in the world. While some countries already have a more or less established regulation, as is the case of the United States, in other countries such as Russia, Bitcoin is prohibited.

If we focus on the United States, we’ll see that, for example, the purchase of goods and services with bitcoin is completely legal.

Likewise, investment operations with bitcoin are also considered legal, as long as the investment platforms meet certain requirements – mainly to enforce the Anti-Money Laundering (AML) and Know Your Client (KYC) policies.

Also, having bitcoin doesn’t make you exempt from paying taxes; if you sold or invested in bitcoin, by law you must reflect them in your account statements, according to the amount of money you have handled in the transaction.

In any case, it’s recommended that you go to a professional on this issue so that they can offer you clear advice.

Is Bitcoin safe?

We already said that Bitcoin is a very safe currency as it’s decentralized since it allows you to have full control of your funds. This means that it is very difficult for someone to steal your bitcoin – unless you are careless.

However, if you store bitcoin in order to increase your wealth, you should bear in mind that the opposite could also happen if the following scenarios occur:

  1. Its value decreases temporarily due to market fluctuations.
  2. It loses all its value because people no longer want the coin – have you ever read about the Tulip Mania?
  3. You lose all your funds due to theft in exchanges or some type of computer attack.

Remember that with Bitcoin, it’s you, the user, who must face all these risks directly.

What are the advantages and disadvantages of Bitcoin?

Advantages of Bitcoin

  • High liquidity. Being so popular and moving so much money in the market, its users can preserve most of its inherent value by converting it to fiat currencies.
  • Increasing acceptance as a payment method. Thanks to the fact that more and more e-commerce heavyweights accept Bitcoin as a payment method, today it’s possible to buy almost anything with bitcoin.
  • Lower commissions. Compared to payment methods such as credit cards and PayPal, BTC has commissions that are usually around 1%.
  • Privacy and anonymity. The system of privacy protections that Bitcoin incorporates allows its users to separate their accounts from their identities if they prefer.
  • Decentralization. Due to its decentralized nature, Bitcoin is not influenced by any political or government agencies, and not even by its own creators.
  • Anti-inflation shortage. With only 21 million bitcoin going to exist, it’s highly likely that this scarcity will bring it intrinsic value in the future, similar to gold.

Disadvantages of Bitcoin

  • Greater exposure to fraud. Due to its popularity and user base, Bitcoin has been exposed to a greater number of scam attempts, such as pyramid schemes and direct attacks.
  • The black market could damage its reputation. If over time the illegal uses of Bitcoin outnumber the legitimate uses, the cryptocurrency could face marginalization.
  • High price volatility. Since the price of Bitcoin can fluctuate extremely from week to week, it may not be appropriate for certain uses, such as long-term investments or the daily consumption of goods and services.
  • Transactions are irreversible. If you buy an item in an online store paying with BTC and they never send the item to you, the decentralized structure of Bitcoin makes it impossible for someone to respond to you for your loss.
  • The student surpasses the teacher. Bitcoin served as the basis for creating other cryptocurrencies that exceed it in technical specifications. Over time, some of these alternatives could overtake Bitcoin as the most important cryptocurrency, which could lose its value.
  • Damage to the environment. Bitcoin mining consumes large amounts of electrical energy. This is a serious pollution problem in countries like China, where electricity comes mainly from coal plants.

Is Bitcoin halal?

A growing number of scholars are beginning to hold the opinion that Bitcoin is halal.

Over the past few years, we have seen a growing trend where scholars are beginning to have a better understanding of Bitcoin and cryptocurrencies as a whole. For a deeper understanding of the permissibility of Bitcoin and cryptocurrency, please see the following blog post, Is Bitcoin Halal or Haram? 10 Scholars’ Opinion on Bitcoin. Update for 2021.

Conclusion

Bitcoin is the first decentralized cryptocurrency in history and there is no doubt that more than ten years after its creation, the invention of the mysterious Satoshi Nakamoto came to change the system, for better or for worse.

Bitcoin is today synonymous with revolution, transformation, opportunities, and more.

I hope that you now have a better understanding of Bitcoin and are in a much better position to carefully measure what you’d want to do.

If you decide to enter the world of Bitcoin and cryptocurrencies, do it carefully, step by step, and wisely. Remember the risks involved.

In any case, sooner or later, Bitcoin – or any other cryptocurrency – will end up coming into your life, since this change, revolution, technological advancement, or whatever you want to call it, is here to stay.

And in the end, Allah knows best.

Trezor Hard Wallet