How Does Bitcoin Work? 7 Common Questions About the World of Cryptocurrency

How does bitcoin work?

Throughout the ages, people have used different types of currency to trade in the marketplace. Bartering goods was common in a bygone era. Then came the trading of precious metals like gold and silver. Now, cash currencies are king. But the digital age has spawned a new approach: cryptocurrency. The most prominent of these new forms of currency is Bitcoin.

Odds are you’ve at least heard of Bitcoin by now, but there’s still a lot of confusion surrounding the topic. Even if you have absolutely no desire to use a cryptocurrency, it’s important to have a grasp on the basics of how they work. In this article, we’ll do our best to clear the air about how Bitcoin works as well as seven other common questions.

1. What is Bitcoin?

Bitcoin is an electronic cash system purported to be invented by a computer programmer named Satoshi Nakamoto—but there is plenty of mystery surrounding Nakamoto. Intrigue centered on Nakamoto aside, Bitcoin is completely digital without any tangible properties such as dollars, coins or even credit cards. But the difference is more than that.

“It is the first decentralized peer-to-peer payment network that is powered by its users with no central authority or middlemen,” according to Bitcoin.com. Because of that, financial institutions, governments and monetary exchanges cannot control it.

2. How does Bitcoin have value?

While Bitcoin is totally digital, it does have some parallel characteristics to more traditional currency. “For thousands of years we have been mining gold from the earth,” observes Adam Broetje of Odd Dog Media. “Gold is considered valuable because there is a fixed amount of it. Bitcoin is similar in that the Bitcoin code limits the total number of bitcoins to 21,000,000 units.” This hard cap on the number of Bitcoins is designed to never increase, which is different from monetary currency in which governments often issue more.

The value of bitcoin is also determined by the age-old law of supply and demand. “Similar to stocks or property, Bitcoin’s value is determined by buying and selling in the open market,” says Coinbase. “A Bitcoin’s price changes in real time based on the number of people who want to buy or sell it at a given moment.”

3. How do people earn Bitcoins?

You can acquire Bitcoins in numerous ways. Here are a few of the most common:

Bitcoin mining

This is the only method for earning new Bitcoins. While it might evoke images of dusty old prospectors and pickaxes, the reality is that mining Bitcoin requires serious computing power. Anyone can set up a computer for Bitcoin mining—though expensive specialized rigs are needed to make Bitcoin mining profitable. The process of mining uses this computational power to run specialized software. This software is dedicated to solving mathematical problems tied to confirming legitimate transactions and creating new Bitcoins. Every solved problem results in the miner receiving a set amount of Bitcoin.

Buying in a Bitcoin exchange

Bitcoins have created an entire new industry of marketplace dealers where you can purchase, trade or sell the digital currency. You can buy them online with most forms of traditional payment such as bank transfers, credit or debit cards or services like PayPal.

Transfers between private parties

While you’re not likely to find someone who’ll just give you Bitcoins for free, apps are springing up to help people manage their Bitcoins in a mobile world. Abra, for instance, is one of many new apps that can deposit, send and withdraw digital currency.

Playing mobile games

While certainly not a huge source of Bitcoins, some mobile games do offer payment for playing. Typically these are heavy in advertisements and require a significant time investment to earn fractions of a Bitcoin—known as Satoshis.

4. Why get a digital wallet?

Here’s another symbolic parallel to conventional currency. You keep your dollars in a wallet, right? If you’re going to start dealing in Bitcoins, you need a digital version of a wallet. Like most Bitcoin apps, there are many to choose from, each with its own functionality. The website Bitcoin offers a list of ten wallet options.

5. What is the Blockchain?

Anyone dealing with Bitcoin will soon hear the term blockchain, which is basically the digital ledger that accounts for all Bitcoin in existence and tracks all Bitcoin transactions. When Bitcoin miners are awarded with Bitcoins, it is added to the blockchain. Subsequently, all transactions occurring with Bitcoins will be shown on the blockchain, which is totally public. However, names of individuals and businesses involved in the transactions are never revealed, so use of Bitcoin is completely confidential. 

6. How do most businesses treat Bitcoin?

An increasing number of businesses accept Bitcoins, and that list is expected to grow. Well-known businesses currently accepting bitcoins includes Overstock.com, Subway, Microsoft (for content on Xbox and the Windows store), Expedia.com, Newegg.com, Dell, Bloomberg.com, Dish Network and Whole Foods, according to 99BitCoins.

7. What are the risks associated with Bitcoin?

If your Bitcoins are lost, or if you send them to complete a transaction that goes bad, they can be difficult—to nearly impossible—to retrieve. With Bitcoin, there is no standard insurance coverage or guarantee that protects owners, although some apps do have policies to protect customers.

Like anything in the digital realm, Bitcoins can become targets for hackers. In 2016, a Bitcoin exchange named Bitfinex became the victim of hackers, who stole about $70 million in value of the currency, according to Fortune. The article cites a study funded by the U.S. Department of Homeland Security that says: “… Since Bitcoin's creation in 2009 to March 2015, 33 percent of all Bitcoin exchanges operational during that period were hacked. The figure represents one of the first estimates of the extent of security breaches in the Bitcoin world.”

Additionally, the anonymity of cryptocurrencies like Bitcoin can attract unsavory actors to use the currency for buying illicit goods or laundering their ill-gotten money. Cryptocurrencies are also preferred by hackers who take computers hostage for ransom. That said, there’s nothing illegal about owning Bitcoin, but these elements could make the currency the target of a regulatory crackdown as governments catch up to the technology.

Another potential concern is volatility—the value of Bitcoin has climbed at an incredible rate, but it has also seen some strong dips in value over time. Using Bitcoin as an investment opportunity can be a bit “high-risk, high-reward,” so do so with caution.

Learn more about the ‘underground’ of the internet

Now that you have a better understanding of what Bitcoin is and how it works, there’s still plenty to learn and demystify in the tech world. One of the most intriguing areas to explore? The dark web. Learn more about the secret side of the internet most people never see in our article, “What Is Tor? A Journey Through the Deep, Dark Web.”

Gordon Hanson

Gordon is a freelance writer for Collegis Education who writes student-focused articles on behalf of Rasmussen College. He enjoys using the storytelling power of words to help others discover new paths in the journeys of life.

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