What Is Bitcoin and How Does It Work? [Complete Guide]

TL;DR

• Bitcoin is the world’s first digital currency, and it is completely decentralized. 
• The features of Bitcoin include decentralization, distributed control, transparency, lack of intermediaries, permissionlessness, censorship resistance, etc. Its disadvantages include slow transactions and a lack of regulations.
• As for their production, Bitcoins are mined, which involves a proof of work consensus mechanism. The transactions on the network are validated by miners who receive BTC in return for their efforts.
• The currency derives its value from its scarcity (capped at 21Mn) and the fact that it’s deflationary.
• Bitcoin can be regarded as a medium of payment as well as an investment tool. You can invest in Bitcoin either through crypto exchanges or Mudrex’s Coin Sets.

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Introduction

One word: Magic. 

No? Not buying? Well, let us prove it today. To be honest, the pieces of technology like distributed ledger, cryptography, and Byzantine fault tolerance were there even before Bitcoin existed. But the way Satoshi Nakamoto brought it together is just phenomenal. So if you have been scratching the surface of Bitcoin off late and wondering why it has got everyone so interested in a short period, hang on. You are going to find the answers today.

After all, the claim of ‘digital gold’ is pretty bold. But then, a market cap of roughly $500 billion also speaks for itself. So today, we try to answer what is Bitcoin? Why is it currently selling for $20K a piece? How is it changing world economics, one block at a time? Buckle up. This one is going to be wild!

What Is Bitcoin, and Who Created It?

Bitcoin is the world’s first digital currency. A whitepaper published in 2008 defines Bitcoin as a peer-to-peer electronic cash transaction system. One might feel that Bitcoin is very similar to UPI or other modes of electronic cash transfer. Well, turns out that when you send Bitcoin to your friend, there is absolutely no intermediary involved. In other words, it is entirely decentralized.

This decentralization has inherent benefits like censorship resistance, independence from fiscal policies, and global accessibility. But who ensures everything is in place if there is no central authority? This is done with the help of miners who validate transactions in return for a reward.

Bitcoin saw the light of the day in January 2009. It was introduced by an anonymous entity that goes by the name ‘Satoshi Nakamoto.’

Ever since then, it has become the talk of the town. Hitting an all-time high of $68K, often the vision of hitting $100K hijacks the coffee conversations. With that being said, many other cryptocurrencies have spawned in the ecosystem. Some try to replace Bitcoin, while others want to explore the realm of securities etc.

Features of Bitcoin Cryptocurrency

The reason Bitcoin has garnered so much interest is that it tends to touch base with a lot of different industries. Some of its features are disruptive for the traditional financial, and some of it interests the technology geeks as it is a tech marvel. At the same time, it also plays with the economic model of fiat currency and also opens up the era of decentralized software. 

Let us discuss the features of Bitcoin in detail.

1. Decentralized

You saw this coming from miles away. But it is still worth discussing because it is incredible how an asset worth a trillion dollars could be run without anyone’s intervention. There is no headquarters or CEO of Bitcoin. In fact, even the founder/founding team of Bitcoin cannot make changes to it.

Any changes to the network have to be agreed upon by all the miners (nodes) to take effect. In case someone wishes to disagree with the way Bitcoin is running, they are free to fork it and create a parallel version of it. This way, at all times, nodes and the general public decide how much value to allot to a particular chain. Some examples of Bitcoin forks are Bitcoin Satoshi Vision (BSV), Litecoin (LTC), Bitcoin Cash (BCH), etc.

2. Distributed

The fine line of difference between decentralized and distributed often trumps one. When we say decentralized, it has more to do with control, and when we say distributed, it is usually in the geographical context.

Bitcoin runs on a distributed ledger called a blockchain. This ledger is maintained by ‘nodes’ across the globe. Currently, there are 80,000+ nodes in the ecosystem, helping maintain the security of Bitcoin.

Having a distributed network also ensures that there is no single point of failure. Bitcoin will continue to run even if a few nodes fail due to electricity/any other issue. This ensures a 100% uptime for Bitcoin.

3. Transparent

Blockchains offer transparency like never before. Even with Bitcoin, all the transactions are recorded in the publicly visible ledger for anyone to see. Apart from that, there is no subjectivity involved in achieving the consensus (agreement) between the nodes. There are set protocols (rules) to ensure that consensus is achieved transparently.

4. Peer-to-peer

Okay. It’s time we compare Bitcoin with our very own UPI technology. Multiple parties get involved when you send money using UPI to one of your friends. The UPI platform, your bank, receiver’s bank, etc. Not only this causes a slight delay in the process, but you also need to incentivize these players for the effort they have put in. Not to mention that this is good within India only. Overseas payments are a different ballgame altogether.

Now Bitcoin eliminates this entirely. As a sender, you sign the transaction using your private key, and the Bitcoin is received by the receiver. Of course, miners would validate this transaction, but they do not have the unsolicited powers of withholding this transaction as banks do.

5. Permissionless

Ha. Another point in favor of Bitcoin. Have you ever tried to get a bank account opened? It’s a clunky process that involves endless documentation and signatures. And even after you comply with all that, you are asked to wait for a specific period before making your first transaction.

Even the online process of opening an account requires an in-person video call with an executive who verifies your documents on the go.

Please bear in mind that I am assuming that there are no hiccups such as minimum age, minimum income, minimum balance, your dressing sense, and whatnot. Okay. Maybe I went a little overboard with the dressing sense.

Bitcoin? Well, all you need is an internet connection. You don’t even have to create an account to use Bitcoin. All the transactions that follow the protocol rules go through without anyone reaching out to you for verification.

6. Pseudo anonymous

You will not be asked for your SSN or Aadhar card before transacting on Bitcoin. There is no KYC if you want to join the party. All transactions on Bitcoin are tied to an address (a randomly generated alphanumeric string) and NOT you as an individual.

7. Censorship resistant

It is virtually impossible for the authorities to ban Bitcoin. The only way to get rid of Bitcoin is to shut down the internet permanently. Bitcoin is not stored in an account where the government could exercise control and freeze your assets. It is held in a wallet whose private key is in your custody. Think of it as holding your assets in a safe with a PIN.

What Are the Pros and Cons of Bitcoin?

If you are still with us, it is that moment in this article where we highlight some of the key reasons why Bitcoin is an absolute kicker of an asset. At the same time, we would also talk about certain downsides of Bitcoin, which will help you build a smarter narrative.

Bitcoin Pros

Let us start with the positives of Bitcoin.

1. Accessibility and inclusion

Bitcoin offers transactions at a much lower price to a broader audience. As discussed above, you only need an internet connection to get started with Bitcoin. It does not care about your history or identity. This opens the door for many unbanked individuals to get onboarded to the financial ecosystem. Furthermore, these transactions can be conducted from anywhere in the world at any time of the day.

2. Decentralization

We have been talking about this for a while now, but why is it so important? Let us take the fiat system (your native currency like INR, USD, EUR, etc.) head on.

Money is managed by a central bank in any mature economy. These banks control the supply of money. Imagine that your country goes to war and needs excessive money to fund it. It is very easy for central banks like RBI/Federal Bank to print that money.

But printing this money comes at a cost. Since more of something decreases its value (economics 101), the value of your money goes down. From an alternative lens, since increased money is now chasing the same amount of produced goods, the purchasing power of the money decreases. This phenomenon is known as inflation. A common man faces the brunt of increased prices in such a situation. A situation caused by centralized decision-making.

Since Bitcoin is fixed at a supply of 21M with pre-decided rules for creating it, no central authority can intervene and artificially inflate or deflate its supply.

Bitcoin Cons

Time to explore the flip side of the coin. Like literally.

1. Speed

Bitcoin isn’t well equipped to scale at the moment. The transaction speed is slow and can only process up to 5-7 transactions per second. While several workarounds are being developed to overcome this shortcoming, currently, this is the best we have.

2. Subject to legality

Bitcoin is not recognized as a legal tender in most world economies except El Salvador. This puts additional pressure on its demand because many individuals are on the fence, waiting for the government to regulate this.

How Are New Bitcoins Produced?

The process of creating new Bitcoins is called mining. You see, the miners (nodes) we have talked about so far are hard-working folks. I mean, they may or may not work hard, but their system definitely breaks a sweat. So every time a transaction happens on the Bitcoin blockchain, it is stored in something called a memory pool (or mem pool in short).

Then these miners come along and try to pick these transactions, put them in the block and append this block to the blockchain. But since it is a democratic, permissionless network, anyone could try to do that. And since it doesn’t cost anything, they could try to enter malicious transactions in the blockchain for their personal gain.

To avoid this situation, a mechanism was built called proof-of-work. This relies on the idea that if a lot of work has to be done to create a block, everyone will think twice before defrauding the system.

This work is done in the form of computation, where miners use their equipment (graphic cards) to predict a random number that satisfies specific rules. And the miner who predicts this number first wins the race.

As a reward, they get some Bitcoins. The number of Bitcoins also keeps getting halved every four years roughly. It started with a Block Reward of 50 BTC and then reduced to 25, and so on. Currently, a miner receives 6.25 Bitcoin for each successful validation.

How to Use Bitcoin? Bitcoin Use Cases

Bitcoin has definitely earned a name as a store of value. People like to hold Bitcoin as a hedge against inflation, just like gold. But there are multiple other use cases of Bitcoin as well. Let us talk about them in detail.

1. Bitcoin as currency

Payment using Bitcoin is emerging as a strong use case these days. To pay via Bitcoin, you need to own a wallet that would store the keys to access your Bitcoin. This wallet can be either hardware like Ledger and Trezor or a software wallet like Metamask and Trust wallet.

On the other side, businesses can accept Bitcoin as payments by deploying the QR code that has their address to receive Bitcoin.

In a peer-to-peer scenario, things are very similar. You simply need to ask the receiver about their public address and then use your wallet to send money. Voila!

2. Investing and trading

Due to its fixed supply, Bitcoin has become an asset that has a constantly decreasing rate of inflation. Apart from that, it is a highly secure and sound way of storing value. Therefore, many institutions and retail investors are storing cash in Bitcoin.

Apart from that, due to its volatility, it has become an amazing asset class to trade. You can leverage its swings in either direction to take profits from short-term movement.

How to Buy or Invest in Bitcoin?

Does that mean we got you interested? I need a raise! Jokes apart, investing in Bitcoin is not difficult anymore. Here are a few ways by which you can quickly jump on to the bandwagon

1. Online exchange platforms

Have you ever invested in stocks? These online exchange platforms are very similar to that. You load your wallet using your bank account and select the price you are willing to buy Bitcoin and Voila! The moment Bitcoin reaches that price; you get Bitcoin in your wallet.

Please bear in mind that once you invest using a centralized exchange, the keys to your crypto are not with you (it’s with the exchange). Therefore, if you want full custody of your assets and want to remove that layer of trust altogether, you can withdraw your crypto to a non-custodial wallet (More on it shortly).

2. Coin Sets

Bitcoin has grown over 7000% during its lifetime. Do you think it will give similar returns over this decade? Well, the narrative has started to shift towards using blockchain for other purposes like decentralized applications, etc. In such a case, investing in a broader theme would be better than particular crypto. Coin Sets by Mudrex give you an amazing opportunity to do just that. Feeling lucky already? You can start your investment journey by investing in the Blue-chip crypto Coin Set, a basket of cryptos with Bitcoin and other top players in the industry.

Securing Bitcoins: Hot Wallets Vs Cold Wallets

While picking crypto is an important task, understanding their storage is even more important. With great power comes great responsibility. We say this because once you go decentralized, you cannot expect someone to help you to retrieve your lost password. This is because you were the only one who had it in the first place. So you can kiss goodbye to your crypto if in case you miss your private keys.

To top it all, the responsibility of keeping them safe is on you as well. This involves picking the right storage and wallet, depending on your usage. Let us talk about them in detail for now.

1. Hot wallets

Nope. It’s not what you think. It has nothing to do with this wallet’s temperature or physical appearance. Instead, it has to do with the fact that it is connected to the internet or not. A hot wallet is connected to the internet at all times.

This can be a wallet provided to you by the crypto exchange, where you do NOT hold the private keys and hence are not the rightful owners of your crypto.

This time even Joey gets it.

Alternatively, other hot wallets like Metamask and Trust wallet sit as an extension on your browser and allow you to access your crypto on the blockchain. In this case, the keys to sign a transaction are under your total control. If at all you need to recover your wallet, you need to remember its seed phrase (A 12-24 word randomly generated phrase). And if you forget this phrase, you might as well forget your crypto too.

2. Cold wallets

You get the drift. Cold wallets aren’t connected to the internet. This makes them even more secure as compared to self-custody hot wallets. Since your keys never go online, the chances of a hack are further minimized.

Typically, these cold wallets look like a pen drive and store the keys to crypto on the blockchain. Some examples of the cold wallet are Trezor wallet, Ledger wallet, etc.

How Does Bitcoin Have Value?

Isn’t it mind-boggling to see a completely digital asset beating all other investment classes worldwide? But what has led to this? Why is Bitcoin so valuable after all? Here are a few reasons we believe in Bitcoin:

1. Scarcity

Bitcoin derives its core value from its scarcity. So the purpose of the advent of Bitcoin was to get rid of state-controlled money. Why? Because governments could print an endless amount of it and thus reducing the value of your hard-earned saved money.

Even the genesis block (the first ever block on the Bitcoin blockchain) had this message encoded: Chancellor on brink of second bailout.

Therefore, Bitcoin was coded to have a limited supply from the beginning. There can be no more Bitcoin than 21M. Ever. While comparing it with gold, just think how technological advancements might yield more gold from the mines as expected, but Bitcoin? It’s the most complicated form of money known to mankind.

2. Disinflationary

Another important aspect of Bitcoin is that not all 21M was mined at once. They are being released into the ecosystem at a decreasing rate. Miners can create new Bitcoins at a rate that is getting halved every four odd years.

Currently, this rate stands at 6.25 BTC per block and will reduce further to 3.125 BTC per block in 2024.

Is Bitcoin a Good Investment?

Given the immense popularity of Bitcoin and the network effects it has created in the past decade, it is believed that this asset is here to stay. Bitcoin has outperformed all other assets in the past decade and might continue to do so as the masses adopt it.

Additionally, Bitcoin is also entering the mainstream investment scene through ETFs. This would allow traditional investors to take exposure to Bitcoin through government-regulated entities.

Is Bitcoin Legal? and What Is the Future of Bitcoin?

Buying and selling of Bitcoin are legal in most countries of the world. Some governments have tried to impose taxes on the sale and purchases to generate a revenue stream for themselves. Apart from that, all key economies of the world are currently trying to regulate the cryptocurrency space. This would help safeguard the retail investors and increase adoption.

As far as the future is concerned, we believe that sooner or later, all governments will bring regulation to the crypto space and let it flourish under controlled supervision. At this time, the likes of Bitcoin would grow further since normies (someone who does not invest in Bitcoin) will get onboarded.

Conclusion

Bitcoin is a technological marvel, an economic reinvention, and a financial disruption. It is one of the finest inventions of the last 15 years and has opened the door for so much more. Will Bitcoin stand against the test of time? Most likely. Regardless, watching all this pan out in front of our eyes would be interesting.

FAQs

1. Why is Bitcoin so volatile?

The volatility of Bitcoin has reduced over the past 3-4 years. All new asset class undergoes extreme bouts of volatility to discover their perceived price in the eyes of the masses. Bitcoin is no different. Being relatively new, it is comparatively more volatile than stock markets which are centuries old.

2. What is the main purpose of Bitcoin?

The main purpose of Bitcoin is to be used as a medium of exchange. It is a fast, cheap, private, and transparent way of sharing value from one place to another. Besides, Bitcoin is also being used as a store of value due to its fixed supply.

3. Can you turn Bitcoin into cash?

Yes. You can simply sell your Bitcoin for native currency on a centralized exchange to convert it into cash. However, proponents of Bitcoin believe that if you hold Bitcoin for long enough, you wouldn’t need to sell it. This is because they envision the adoption to the extent where you’d buy everything you need using BTC.

4. What is the minimum amount to invest in Bitcoin?

Depending on the exchange you are on, the minimum amount varies. For most Indian exchanges, you can invest in Bitcoin for as low as INR 100. The smallest unit of a Bitcoin that can be bought is one Satoshi which is 0.00000001 BTC

5. Who owns the most Bitcoin?

Since Bitcoin is a public ledger, anyone can see the holdings of any address. Currently, the address belonging to Satoshi Nakamoto has roughly 1.1 Million Bitcoin. This has never been touched throughout the lifetime of Bitcoin, which leads to various theories around the death of Satoshi.

In publicly listed companies, Michael Saylor’s Microstrategy owns roughly 129,218 BTC.

6. When you buy Bitcoin, where does the money go?

When you buy Bitcoin on a centralized exchange, the money goes to the exchange itself. They buy it from the seller and transfer it to you on your behalf. If you purchase it directly from a friend, it goes to that friend instead.