What are Bitcoins and How Do They Work?

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I often get asked to explain what exactly a Bitcoin is, and I can understand the confusion as picturing this ‘magic internet money’ can be difficult, because they don’t physically exist.

Put simply, Bitcoin and the hundreds of other cryptocurrencies out there, are chunks of data sent from one person to another that reside on blockchains.

This data has a monetary value which can vary significantly from day to day as cryptocurrencies can be notoriously volatile.

Bitcoins are described as digital or virtual currency because they they cannot be picked up or held. Whenever you see a picture of someone clutching a shiny gold bitcoin, it’s a novelty item and not for use in the real world!

As the use of physical cash dwindles, digital transactions are becoming the norm for most people.

Your money already exists as data in a bank’s computer which is then transferred to others when you pay for something.

People say cash is king but these days it’s losing its crown.

How are Bitcoins created?

Bitcoins are created by powerful computers when they solve extremely complex mathematical problems. This is called mining.

Transactions on the Bitcoin network are ‘confirmed’ during this mining process when a minimum number of computers connected to the network agree that the transaction is valid.

People buy specialised computer hardware to carry out the mining process, called ASCI miners.

They hope to be the first to confirm a new group of transactions, known as a ‘block’. This block is then added to the blockchain and the miner is rewarded with Bitcoin.

Can I mine Bitcoins on my home PC?

It’s no longer possible to mine Bitcoins on a home computer because of the complexity of the process involved and the cost of the electricity.

As you can no longer mine Bitcoin at home, the easiest way to get hold of some is use a cryptocurrency exchange and I’ve written this handy beginner’s guide to buying Bitcoin to explain how.

The supply of Bitcoin is limited

The word cryptocurrency is used to describe Bitcoins and the thousands of other ‘tokens’ and altcoins (alternatives to Bitcoin) which have been created in recent years.

These include cryptos like Ethereum (ETH), Litecoin (LTC) and Cardano (ADA), together with stablecoins, like Tether (USDT), and so-called meme coins such as Dogecoin (Doge) and Shiba Inu (Shib).

You may also like: What are stablecoins?

The integrity of cryptocurrency transactions is kept secure by advanced cryptography techniques, hence the name.

There will only ever be 21,000,000 Bitcoins in existence. Each of these ‘coins’ can be broken down into 100 million ‘Satoshis’.

A Satoshi can be further broken down into a millisatoshi – ie one thousandth of a Satoshi.

The name Satoshi comes from the pseudonymous enigmatic creator of Bitcoin, Satoshi Nakamoto, whose identity remains a mystery to this day.

As time goes by will slow down in a process known as ‘halving’. This is a protocol hard coded into Bitcoin. It means the reward for mining a block is cut in half every 210,000 blocks and reducing the rate at which new Bitcoins are released.

The last Bitcoins will be mined somewhere around the year 2140. Then, miners will be incentivised by transaction fees rather than mining rewards.

How do Bitcoin transactions work?

Bitcoins pass from person to person without any third-party involvement (ie a bank) aside from the computers – known as nodes – which process the transactions.

In this sense, Bitcoin can be described as a decentralised system where the asset (Bitcoin) owner has complete control over their money.

These computers are located around the world and no one person or institution controls them.

Related link: Can Bitcoin and the Blockchain be shut down?

Is Bitcoin completely anonymous?

Bitcoin transactions are not completely anonymous as there is always a permanent record of all transactions and wallets which is publicly available.

Often people can connect these addresses with personal information you’ve given to an exchange during sign up.

Some people use what’s known as a ‘Bitcoin Mixer’ or ‘Cryptocurrency Tumbler’ in an attempt to disguise their transactions.

You may also like: Is Bitcoin anonymous or can transactions be traced?

The blockchain explained

Crypto transactions are entered onto a digital ledger – known as the blockchain – which cannot then be altered by anyone else. It is ‘immutable’.

In simple terms a blockchain is a chain of ‘blocks’ of information arranged in a chronological order.  In can also be described as a list of every Bitcoin transaction ever made which is constantly being added to.

The blockchain is also known as the distributed ledger because it is sent to all participating computers for validation.

The ledger is repeatedly checked by a network of computers, meaning Bitcoins cannot be double spent. Additionally, all transactions are irreversible.

Theoretically this ledger can include any information, such as names or marriage certificates, and even contracts between people, known as ‘smart contracts’.

The Ethereum project promotes a platform where smart contract systems are employed in the rapidly growing sphere of ‘decentralised finance’ (DeFi), such as peer-to-peer loans.

Crypto wallets explained

To use Bitcoins you need a wallet. This is presented as a long alphanumeric string that acts as an address that is unique to you and is created using an app or by an exchange.

Anyone can then send Bitcoins to you using this address alone. You can also buy Bitcoins using ‘real’ money and have them sent to your wallet.

Online wallets are widely available but are sometimes seen as insecure due to a number of high-profile hacks. Additionally, in most cases you do not have control over your ‘Bitcoin keys’.

However, exchange security as dramatically improved in recent years and for the less tech savvy they’re the simplest option for storing crypto.

There are dozens of free to use wallets available. A good starting point is Blockchain.com or you could try Trust Wallet.

Private keys and seed phrases

When you create a wallet you are given public and private keys. If you lose your private key, you lose your Bitcoins forever.

A private key, also known as a ‘seed’, is what’s used to sign a transaction and prove the origin of the coins.

Offline wallets, such as hardware wallets like those made by Trezor and Ledger, are seen as more secure as they can’t be accessed by hackers.

However, they can be lost, damaged or stolen. Anyone using this method of Bitcoin storage should take multiple precautions to keep a copy of their keys safe so they can retrieve their assets.

How to spend Bitcoins

You might be wondering how you cash out your Bitcoins once you’ve accumulated some.

The short answer is you sell them on an exchange for regular – or ‘fiat’ – cash. There are numerous exchanges that enable you to do this.

Additionally, in some large cities you’ll find Bitcoin ATMs which enable you to withdraw regular cash from your Bitcoin wallet. These are few and far between though.

Bitcoin and other digital currencies are widely used to buy products and services online, but have yet to gain traction in physical shops, with only a few outlets using them.

However, cryptocurrency as an asset is growing exponentially with each year that passes and it is highly likely that Bitcoin will enter mainstream use at some point.

Increasingly it’s viewed as a store of value in a similar way to gold. As a result, large financial institutions are including it as an asset class in their portfolios.

There are already several futures Bitcoin ETFs on the market, and several spot Bitcoin ETFs have now been approved on the US.