How bitcoin works: an easy explanation for beginners

Bitcoin is the most famous cryptocurrency in the world, but for many it remains a mystery how it actually works. In this post, the AI will explain in simple terms what bitcoin is and how it is used, in order to provide a useful guide for those who are completely unfamiliar with the subject.

We will discover together how it was born, how bitcoins are created, how transactions are managed and what the advantages and disadvantages of this innovative digital currency are. We will deepen its technical functioning by illustrating what mining, blockchain and bitcoin wallets are.

What is Bitcoin and how was it born

Bitcoin is a cryptocurrency, that is, a virtual currency that exists only in digital form and uses cryptography to secure transactions. It was created in 2009 by Satoshi Nakamoto (here is the chronology), pseudonym of a person or group of people still unknown. The idea behind Bitcoin was to develop a decentralized peer-to-peer electronic payment system that did not rely on a central authority like a bank.

What is the Bitcoin protocol and its characteristics

The Bitcoin protocol is the set of rules governing the Bitcoin network. It was devised by Satoshi Nakamoto as an innovative solution to create a decentralized digital currency.

The main characteristics of the protocol are:

Proof-of-Work: consensus mechanism that guarantees network security and issuance of new bitcoins

Blockchain: shared and immutable digital ledger of all transactions

Pseudonymous bitcoin addresses: enable transactions without revealing personal identity

Open source protocol: the code is public and anyone can modify it to improve it

What is the blockchain and how it works

The blockchain is a shared and immutable digital ledger that stores all bitcoin transactions from its creation to today.

It works like a huge distributed ledger on thousands of computers around the world. Each bitcoin network node has a copy of the blockchain updated in real time. When a new transaction is executed, the nodes verify it and insert it into a new “block” of the chain.

Blockchain technology is decentralized and no one can manipulate or delete the data. This allows maximum transparency and security of transactions.

Why Bitcoin is unique

Bitcoin differs from all other cryptocurrencies for a number of reasons:

• It was the first project to solve the “double spend” problem in the digital realm without a central authority
• Its network is the most secure, with over 100 quintillion hashes per second protecting it
• It is completely decentralized and no one really controls it, not even its creators
• It has a predetermined and predictable monetary policy, with only 21 million bitcoins that can ever exist

Bitcoin as a deflationary instrument

Unlike normal currencies managed by central banks, Bitcoin’s supply is limited and cannot be inflated at will. This makes it a deflationary instrument: over time, existing bitcoins will tend to increase in value relative to available goods and services. A bit like what happened with gold, which today has a purchasing power much greater than in the past.

How are bitcoins created

Bitcoins are generated through a computational process called “mining”. It works like a sort of mathematical lottery in which miners participate by providing the enormous computing power of their computers.

We can imagine mining as an athletics (track) race where runners are the miners. To win, they must be the first to solve complex cryptographic and mathematical calculations. The first to solve the problem can add a new block to the blockchain and receive the bitcoin reward.

The more mining power they have available, the better their chances of solving the problem first. That’s why over the years miners have created “mining farms”, centers with thousands of powerful computers dedicated to bitcoin mining.

How bitcoin transactions work

Bitcoin transactions involve transferring tokens from one bitcoin address to another. Addresses consist of a random sequence of letters and numbers. To authorize a payment, the address owner uses public/private key cryptography: the private key authorizes the transfer, while the public key identifies the address.

Practical example of a bitcoin transaction

Let’s take Mario who wants to pay for the pizza with Luigi. Luigi generates a new bitcoin address from his wallet and communicates it to Mario. The address looks like a random sequence of 26-35 alphanumeric characters. When Luigi provides the agreed service, Mario uses his private key to authorize the transfer of satoshis (fractions of bitcoins) from his personal wallet to Luigi’s address communicated previously. The transaction is announced and verified by all nodes of the Bitcoin network within minutes. Luigi can check that the payment went through and, if desired, convert the bitcoins received into Euros in his bank account.

What are the advantages of Bitcoin

• Decentralized: there is no central authority, the network is collectively managed by users
• Anonymity: bitcoin addresses are not linked to one’s personal identity
• Fast transactions: global payments require just minutes to confirm
• Low transaction fees: no high fees as in traditional systems

What are the disadvantages of Bitcoin

• Price volatility: the price fluctuates sharply
• Low adoption in payments: few merchants accept it as payment method
• Complexity of use: the underlying technology can be difficult to understand for non-experts
• Possibility of losing funds: if the private key is lost, the bitcoins are lost forever

How to buy your first bitcoins

To buy bitcoins it is necessary to sign up for an exchange platform, connect your bank account or credit card and buy the cryptocurrency. The most used platforms are Coinbase, Binance, Crypto.com. You then need to transfer the bitcoins to a personal wallet to secure them.

How to safely store bitcoins

There are various types of wallets to store bitcoins:

• Web wallet: online services that hold cryptographic keys on your behalf
• Mobile wallet: smartphone apps for bitcoin on the go
• Desktop wallet: software to install on your own PC, with high security
• Hardware wallet: physical devices similar to USB sticks to store bitcoin offline
• Paper wallet: private keys printed on paper, basic but safe system

Experts recommend using a combination of multiple wallets to diversify risks for those holding large amounts of bitcoin, but if you are just starting out now it is too early to think about.

Conclusion

We have seen how Bitcoin is a revolutionary peer-to-peer digital currency system. Despite its flaws and risks, it offers undoubted advantages that make it an interesting alternative payment instrument.

Since its launch in 2009, Bitcoin has grown exponentially:

• Its value has risen from a few euro cents to thousands of euros per bitcoin
• Its market capitalization exceeded $900 billion in 2021
• Over 100 million people are estimated to own or have used bitcoin
• More and more institutional players, hedge funds and listed companies invest in bitcoin as a store of value

The future will tell if it will establish itself as a new global currency, but certainly the blockchain technology underpinning it is destined to change the world of finance as we have known it so far. Major players such as central banks and tech giants are experimenting with “institutional” versions of cryptocurrencies that could one day supplant the predominance of traditional monetary systems.