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Bitcoins- What are They and How do They Work? Bitcoins- What are They and How do They Work?

Bitcoins- What are They and How do They Work?

How do bitcoins work?

Tech Updated 30th January, 2018 by Stacy Clark

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Bitcoin is a digital currency and a worldwide payment system. Bitcoins are not physical currency such as Dollars or Sterling, but lines of encrypted code that can be transferred from person to person. But just like cash or gold, Bitcoins can be used for purchasing things, can be traded for other cryptocurrencies, dollars or Euros, and can be stored and traded later when their value inflates. 

Bitcoin value changes daily and you can see their latest rate at websites like CoinDesk. But this value is not accepted everywhere. Just like when you go to exchange or sell gold ornaments or foreign exchange, the broker or seller determines his own rate, Bitcoin exchanges or brokers also fix their own rates. But this is where similarity between Bitcoins and cash or gold etc end.

Who made the first Bitcoin?

There are a few theories about who invented the first Bitcoins. Many say a 64-year old Japanese-American developer, Satoshi Nakamoto, from California made the first Bitcoins. Recently, CNBC revealed that Australian entrepreneur, Craig Wright, declared that he invented Bitcoins. But the mystery remains unsolved as Satoshi has since vanished and left a huge Bitcoin fortune behind him. The Bitcoin technology became open-source in 2009.

 

Satoshi Nakamoto

How can Bitcoins be produced?

Anybody, including you, can produce new Bitcoins. You just have to have a super powerful computer that will work round the clock to solve complex “proof of work” (computational) problems, and extraordinary mathematical and encryption skills. These intensive problems will have a 64-digit solution and will take around 2 or 3 days, for a computer working non-stop, to solve. In return for solving problems, you earn Bitcoins as reward. This process is called mining and the people who dedicate their time and brainpower to the process are called “miners”. Miners can choose to process whichever transaction pays them a higher fee. Miners’ fee depends on the storage size needed for storing the inputs for a transaction. The larger the transaction, the bigger the miner’s fee.

Miners are the auditors of the Bitcoin system. Each mining pool has a couple of miners who are computer and math wizards. They devote a lot of time to verify each transaction that passes their node (computer) and maintain the public ledger system. They are rewarded by Bitcoins. Seems simple, but there’s a catch! The Bitcoin system is so programmed that at a time there can only exist some 21 million Bitcoins in the world. Out of these around 11 million coins are alreadin circulation. This means that generating Bitcoins is going to be harder every successive day.

If you think becoming a miner is super cool, think again. A small time miner running a personal computer non-stop for mining Bitcoins, can earn about 50 to 75 cents per day minus his electricity costs. Big-ticket miners can earn almost $500 a day if they run 36 supercomputers non-stop. This is a financially unviable business model and the top reason that constraints Bitcoin production.

How Bitcoins Work?

Here is a simple example explaining how Bitcoins work and the terminology associated with it:

 

Some Bitcoin terminology:

Blockchain: a distributed database that records all transactions. The blockchain is maintained by communicating nodes, manned by miners. It’s a public ledger with its copies available to all users worldwide. There’s a limit to the number of blocks that can be added and Bitcoins created.

Mining: A record-keeping service where each transaction is verified and added to a block. This process involves using computer’s processing powers.

Miners: Ledger keepers and auditors of the network.

Wallets: Similar to PayTM and PayPal but used to store Bitcoins instead of cash. Can be online or offline.

Cryptoexchanges: Places where you can purchase or sell Bitcoins for cash.


Is there any fee for transacting Bitcoins?

Bitcoin transaction fee is nominal as compared to bank transfers. Typically, Bitcoin users will have to pay three types of fee:

Fee to owners of all nodes that pass Bitcoins.  Every time money passes a node, a small fee will be charged by its owner.

Fee charged by crypto exchanges for converting your Bitcoins into dollars and vice versa.

Fee for joining a mining pool. This will be either a donation or a flat fee.

How can you start buying Bitcoins?

You will have to buy Bitcoins and store them in a wallet. Thereafter, Bitcoins will be tracked using their digital footprint that they leave on every wallet they touch.

 

How to Buy Bitcoins

There are a number of ways by which you can buy Bitcoins:

By purchasing Bitcoins directly from a classified seller

By exchanging your cash for Bitcoins from an exchange or broker

By using a bitcoin ATM

Read the detailed step-by-step buying process in our blog- Bitcoin Buying Guide For Beginners.

Why are bitcoins so popular?

By now, you might have gathered that Bitcoin transactions have the following advantages that have made Bitcoins a favorite among investors and traders:

Pseudonomous : Each Bitcoin is registered to a unique Bitcoin address, not a real-world identity. Each wallet that the Bitcoin touches shows the address in its history. While wallet histories are public knowledge, the real identity of Bitcoin or wallet holder is not possible to trace. In a latest development, some exchanges and wallets have asked new users to register with their photo identification. This is a good move to prevent misuse of Bitcoins for illegal purposes.

Un-collateral : Unlike traditional coin currencies, Bitcoins have no metal value attached to them. The value of a Bitcoin is the digital code hidden inside it, that’s all.

 

 

Bitcoins are extremely popular among millennial generation

 

Transparent

All transactions are recorded in a distributed ledger that is available to everybody. Whenever a verified transaction block is added to another blockchain, all past wallet transactions are checked and all users are notified. This develops an inherent transparency in the system, essential for preventing fraud and duplication of Bitcoins.

Secure

Computing the private key from a Bitcoin address and then finding a valid coin-key match that has funds, is mathematically impossible, so you can share your bitcoin address without harming your private key. But if you lose your private key, the bitcoins are essentially unusable. This is because miners will not be able to recognize your ownership. That is why users are advised to take periodic backups of all their private keys and wallets. A .dat file will be created which will get automatically updated whenever you receive or send any Bitcoins from the wallet.

Profitable

This is no news. Bitcoin values are skyrocketing faster than stock, property or gold. Skeptics would view this as a bubble, but smart investors can cash out in time and make a bundle in the process. Besides their volatility, Bitcoins have limited tax liability and are hard to track by governments. They can be effective inflation hedges.

How can I keep my Bitcoins safe?

As explained before, take backups of your wallets. It’s advisable to not share your private keys with too many people. Another recommendation is to use offline wallets (removable hard drive or flash drive) rather than online wallets (hosted in cloud). Although not failsafe, cold storage (using hardware wallets) can prevent hacking of your wallet data from internet hackers.

What is Bitcoin Cash and Bitcoin Gold? What is their market acceptance?

In August, 2017, following a debate on the profitability of existing blockchain, Bitcoin forked into another blockchain- Bitcoin Cash (BCH). It had a larger blockchain limit and used the same proof-of-work algorithm as mainline bitcoins. Presently, users can migrate between the two blockchains. Most leading crypto exchanges such as CoinBase and BitStamp have adopted BCH. Some crypto wallets also accept BCH.

Bitcoin Gold (BTG) is a fork from the original bitcoins and uses a different algorithm for mining coins. The new blockchainreceived 100,000 new coins, created after rapid mining. Controversy surrounds this offshoot since it was revealed that an online BTG wallet was storing and decoding users private keys using Google Analytics cookies.

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