What is Bitcoin and how does it work?

07 Aug 2018

What is Bitcoin and how does it work?

Surely yes, you must have heard about it. The first and most famous cryptocurrency has been in the headlines due to a vertiginous increase in its value, breaking the threshold of $ 1,000 for the first time on January 1, 2017, exceeding $19,000 in December of that year and then losing approximately 50 percent of its value during the first part of 2018.

But the history of Bitcoin is much more extensive and is not limited to headlines in newspapers talking about the fluctuation of its price. It incorporates technology, currency, mathematics, economics and social dynamics. It is multifaceted, highly technical and continues to evolve very fast. But because it is completely digital and does not necessarily correspond to any existing fiduciary currency, it is not easy for new users to understand. This guide is intended to clarify some of the fundamental concepts and provide answers to some basic questions about bitcoin.

But First, a Quick Story
Bitcoin was invented in 2009 by a person (or group) who called himself Satoshi Nakamoto. Its declared objective was to create "a new electronic cash system" that was "completely decentralized without a server or central authority". After cultivating the concept and technology, in 2011, Nakamoto handed over the source code and domains to other members of the bitcoin community, and subsequently disappeared.

What is Bitcoin?

Bitcoin is a digital currency. It is a concept that could be more complex than you think: it is not simply an assigned value of money stored in a digital account, such as your bank account or line of credit. Bitcoin does not have a corresponding physical element, such as coins or paper bills.

How Does Bitcoin Differ from Traditional Currencies?

Bitcoin can be used to pay electronically, if both parties so wish. In that sense, it is equal to dollars, euros or yen, which are also traded digitally.

But it differs from digital fiat currencies in a few important ways:

1. Decentralization

The most important feature of Bitcoin is that its system is decentralized. No institution controls the bitcoin network. It is maintained by a group of voluntary coders and is managed by an open network of specialized computers distributed throughout the world. This attracts individuals and groups who are uncomfortable with the control that banks or government institutions have over their money.

Bitcoin solves the "double spending problem" of electronic currencies (in which digital assets can easily be copied and reused) through an ingenious combination of cryptography and economic incentives. In electronic fiduciary currencies, this function is fulfilled by banks, which allows them to control the traditional system. With Bitcoin, the integrity of transactions is maintained through a distributed and open network that is not owned by anyone.

2. Limited Supply

Fiat currencies, such as the dollar, euro, yen, etc.) have an unlimited supply: central banks can have the volume they want and can try to manipulate the value of one currency in relation to others. The owners of the currency (and especially the citizens with little alternative) pay the cost.

With Bitcoin, on the other hand, the supply is tightly controlled by the underlying algorithm. A small number of new bitcoins is created every hour, and will continue to be so at a decreasing rate until a maximum of 21 million is reached. This makes Bitcoin more attractive as an asset: in theory, if the demand grows and the supply remains the same, the value will increase.

3. Anonymity

Although the senders of traditional electronic payments are usually identified (for verification purposes, and to comply with anti-money laundering legislation, etc.), Bitcoin users theoretically operate in semi-anonymity. Since there is no central "validator", users do not need to identify themselves when they send bitcoin to another user. When a transaction request is sent, the protocol verifies all previous transactions to confirm that the sender has the necessary amount of Bitcoins and the authority to send them. The system does not need to know your identity.

In practice, each user is identified by the address of his "wallet" (or electronic wallet). Transactions can, with some effort, be traced in this way. In addition, the police have developed methods to identify users if necessary.

The law requires that most exchanges perform identity checks on their clients before they are allowed to buy or sell Bitcoins, which facilitates another way of tracking their use. As the network is transparent, the progress of a particular transaction is visible to all.

This makes bitcoin not an ideal currency for criminals, terrorists or money launderers.

4. Immutability

Bitcoin transactions can not be reversed, unlike electronic transactions with fiat money.

This is because there is no central "regulator" that can say "ok, the money has to be returned". If a transaction is registered in the network, and if more than one hour has passed, it is impossible to modify it.

While this point may disturb some, this means that you can not alter any transaction in the Bitcoin network.

5. Severability

The smallest unit of a Bitcoin is called satoshi. It is one hundred millionth of a bitcoin (0.00000001), at today's prices, about one hundredth of a cent. This could facilitate microtransactions that traditional electronic money does not allow.

How Are Bitcoin Transactions Monitored?

Bitcoins use a very simple data log file called blockchain. Each blockchain is unique to each individual user and their personal Bitcoin wallet. All Bitcoin transactions are recorded and made available in a public ledger, which helps guarantee their authenticity and prevent fraud. This process helps to avoid duplicate transactions and people copying bitcoins.

Note: While each bitcoin records the digital address of each wallet it touches, the bitcoin system does NOT record the names of people who own wallets. In practical terms, this means that each transaction is digitally confirmed but is completely anonymous at the same time.

So, although people cannot easily see their personal identity, they can see the history of their Bitcoin wallet. This is good, since a public history adds transparency and security and prevents people from using Bitcoins for dubious or illegal purposes.

How Does Bitcoin Work

Compare it to Torrent, the P2P network you definitely never used to download lots of music in the early 2000s. Except that instead of moving files from one place to another, the Bitcoin network generates and verifies the blocks of information that they are expressed in the form of a virtual currency.

Bitcoin and its many derivatives are known as cryptocurrencies. The system uses cryptography (extremely advanced cryptography called blockchain) to generate new currencies and verify those that are transferred from one user to another. Cryptographic sequences serve several purposes: to make transactions virtually impossible to counterfeit, to make banks or wallets of currencies easily transferrable as data, and to authenticate a transfer of Bitcoin value from one person to another.

Before a Bitcoin can be spent, it has to be generated by the system, or mined. While a conventional currency needs to be minted or printed by a government, the mining aspect of Bitcoin is designed to make the system self-sufficient: people mine Bitcoins by providing processing power from their computers to the distributed network, which generates new data blocks that contain the distributed global record of all transactions. The coding and decoding process for these blocks requires a huge amount of processing power, and the user who successfully generates a new block (or more accurately, the user whose system generated the random number that the system accepts as a new block) is rewarded with a number of Bitcoins, or with a portion of the transaction fees.

In this way, the same process of moving Bitcoins from one user to another creates the demand for more processing power donated to the network on an equal footing, which generates new Bitcoins that can then be spent. It is a system of self-replication that generates wealth ... or at least generates cryptographic representations of value that correspond to wealth.

What Is Bitcoin Mining?

Bitcoin mining refers to the process through which new Bitcoins are created due to the computers that help maintain the network. The computers involved in Bitcoin mining are in a kind of computational race to process the new transactions that enter the network. The winner, usually the person with the fastest computers, receives a portion of new Bitcoins. There is usually a new winner every 10 minutes. Similarly, we have already mentioned that there will be a total number of up to 21 million Bitcoins in the world. After this number no new Bitcoins will be created. It is expected that this limit will be reached in 2140. So far, around 16 million Bitcoin have been distributed. Each existing Bitcoin was created through this method and was initially granted to a computer that helped maintain these records. Anyone can set up their computer to extract Bitcoin, but these days only people with specialized hardware manage to win the race.

Is It Worth Investing in Bitcoin Mining?

The Bitcoin mining industry has grown at a rapid pace. Mining, which at one time could be done in a common home computer, is now only done profitably in specialized data centers. These data centers are warehouses full of computers called ASICs created with the sole purpose of mining Bitcoin. Today it costs millions of dollars to even start a profitable mining operation.

Bitcoin mining is no longer a profitable investment for new users.

If you want to venture into this activity, go ahead. But do not try a mining operation at home as an investment nor do you expect to profit from it.

What Can I Do with My Bitcoins?

Once you have Bitcoins these behave like physical gold coins: they have value and trade as if they were gold nuggets in your pocket. You can use Bitcoin as an investment, buying the cryptocurrency in an attempt to obtain a profit from the fluctuation of its price. You can also see it simply as a new way to spend money. The amount of places where you can spend your Bitcoins is growing every day.

How to Invest in Bitcoins?

It is not surprising that Bitcoin, a safe, global and digital currency, has gained the interest of investors. Bitcoin is open to all and offers an excellent opportunity to bet on a completely new asset class.

Do you plan to invest in Bitcoin? The following information will describe some things you NEED to know before buying.

What Makes Bitcoins Valuable?

Let's look at gold as an example coin. There is a limited amount of gold on earth. As new gold is extracted, there is always less gold left and it becomes harder and more expensive to find and extract. The same is true with Bitcoin. There are only 21 million Bitcoin and, as time passes, they become more and more difficult to extract.

Bitcoin Price

Bitcoin has no official price. The price of Bitcoin is established according to what people are willing to pay.

The price of Bitcoin is usually shown as the cost of an entire bitcoin. However, exchanges will allow you to buy any amount, and you can buy less than one bitcoin. The Libertex price index is a good resource to view Bitcoin price in real time.

When is the right moment to buy?

As in any market, nothing is certain. Throughout its history, Bitcoin has generally increased its value at a very fast rate, followed by a slow and steady decline until it stabilizes. Use tools such as the Libertex price index to analyze charts and understand the history of Bitcoin pricet.

Bitcoin is global and is not affected by the stability or financial situation of any country. For example, speculation about the devaluation of the Chinese yuan has caused greater demand in the past from China, which has also raised the exchange rate in exchanges based in the United States and Europe. Global chaos is generally considered beneficial for the price of Bitcoin, since Bitcoin is apolitical and is beyond the control or influence of any government. When thinking about how the economy and politics will affect the price of Bitcoin, it is important to think on a global scale and not only about what is happening in a single country.

Bitcoin Pros and Cons

Strong Points of Bitcoin

However, that does not mean that Bitcoin does not have its place in the future. Let's talk about some advantages and disadvantages of Bitcoin with respect to the traditional currency.

  • Anonymity and Privacy

    Bitcoin purchases between individual users are completely private: it is possible for two people to exchange Bitcoins or fractions of coins between wallets simply by exchanging HASH functions, without names, e-mail addresses or any other information. And because the P2P network uses a new HASH function for each transaction, it is more or less impossible to link simultaneous purchases to a single user. The nature of the encrypted P2P network also protects it from the outside: nobody can see your purchases or personal receipts without first having access to your wallet.

  • No transaction fees (for now)

    Conventional purchases that are not cash include transaction fees: pay with a Visa credit card, and Visa will charge the merchant a few cents to verify the transaction. And, of course, the cost of that charge is transferred in the form of higher prices for goods and services.

    At the moment, there are no mandatory transaction fees for Bitcoin. Individual users and merchants can send their purchases to the network on an equal basis and simply wait for it to be verified in the next block. However, this process can take time (and it takes more time the more the network is used). Then, to speed up transactions, many merchants and users add a transaction fee to increase the priority of the transaction in the block, rewarding users in the P2P network for completing the verification process more quickly.

    As the global supply of Bitcoins reaches its limit of 21 million coins, transaction fees will become the main method for miners to earn Bitcoins. At this point, presumably most transactions will include a small fee simply as a function of completing the purchase quickly.

  • No central government authority or taxes

    Because Bitcoin is not recognized as an official currency by any country, buying and selling Bitcoins and using them to buy goods and services is not regulated. Therefore, anything you buy with Bitcoins is not subject to a standard sales tax or any other tax that is normally applied to that item or service. This can be a great economic advantage if you are rich enough to do a lot of business exclusively in Bitcoin.

    Without being subject to most currency laws, Bitcoin is effectively a barter system. Imagine your current supply of Bitcoins as a gigantic pile of potatoes: if you exchange ten thousand potatoes for a new television, the government will not request a sales tax in the form of eight hundred potatoes. It simply is not equipped to handle transactions that are not made in its own currency.

    However, you should keep in mind that any conventional income you receive from transactions in Bitcoin will be treated in the usual way. So, if you transfer Bitcoins worth $10,000 to your bank account through a Bitcoin market, you will have to declare it as an income in your tax forms. Trading Bitcoin does not override other standard requirements for taxation: even if you buy a new car through Bitcoin from a private seller, you will still have to register that car with the government and pay taxes based on its market value.

Weak Points of Bitcoin

So, if Bitcoin is so good, why do not everyone use it? Well, obviously, it has some drawbacks too, especially at the present time.

  • Possible government interference

    Every time something new comes up and challenges the status quo, the government gets involved to make sure that things remain as they are supposed to be.

  • No Monetary Sovereignty

    Perhaps the biggest weakness of bitcoin is that it is not a "recognized" sovereign currency, that is, it is not backed by the full faith of any governing body. While this could be seen as a strength, the fact of using Bitcoin as a fiduciary currency is supported only by the perceived value of other bitcoin users that makes it highly vulnerable to destabilization. In short, if one day a large number of merchants who accept bitcoin as a form of payment stop doing so, then the value of bitcoin will drop drastically.

    The high current value of Bitcoin is a function of both the relative scarcity of Bitcoins and their popularity as a means of investment and wealth generation. If confidence in the Bitcoin market is suddenly and drastically reduced, for example, if a major government declares the use of Bitcoin illegal or if one of Bitcoin's major trading platforms is subject to attacks and loses all of its stored value, the Currency value will fall and investors will lose huge amounts of money.

  • Lack of guarantees

    The Bitcoin network does not have built-in protection mechanisms when it comes to accidental loss or theft. For example, if you lose the hard drive where your Bitcoin wallet file is stored (think of a "hack" or an error in a unit without a backup copy), the Bitcoins held in that wallet are lost forever. Interestingly, this is an aspect that further aggravates the limited supply of Bitcoins.

    In addition, if the file in your wallet is stolen or compromised and the Bitcoins contained in it are spent by the thief before the legitimate owner, the double-spending protection mechanism integrated into the network means that the legitimate owner has no alternative. Unlike if, for example, your credit card is stolen, you can call the bank and cancel the card, Bitcoin does not have that authority. The Bitcoin network only knows that the bitcoins in the committed wallet file are valid and process them accordingly.

  • Limited concurrent transactions

    The Bitcoin block system requires the connection and confirmation of the P2P network to be verified. Because each block contains a limited record of transactions and an upper limit to the number of new transactions that can be written, there is a limit on how many people can buy and sell with the system at any given time. As more and more sellers and individuals use Bitcoin to do business, the number of transactions per second increases, the P2P network becomes congested, and some operations without transaction fees take hours to complete. While conventional payment systems such as credit cards can simply expand their connections and processing power to speed up processing, Bitcoin's P2P nature does not allow it to be compared with the global financial system.

However, all the previous weaknesses are not that significant if you do not buy them, but Bitcoins are exchanged. As a merchant you are not the owner of Bitcoins, you do not make payments with bitcoins, but you get a reward for a successful investment. So, what is the difference between buying and selling Bitcoins?

What is Buying Bitcoins?

When you buy or sell cryptocurrencies, you buy the asset itself. To buy Bitcoin you need to download a wallet. The Bitcoin wallet looks a bit like the online banking software that most traditional commercial banks use for their customers.

Once you have a Bitcoin wallet, use a traditional payment method, such as a credit card, bank transfer or debit card, to buy Bitcoins on a Bitcoin exchange platform. The Bitcoins are transferred to your wallet. The most important part of any wallet is to keep your passwords (a string of characters) and / or passwords safe. If you lose them, you lose access to the Bitcoins stored there. Once you have Bitcoins in your wallet, you can make payments or exchanges.

Pros

  • You own Bitcoins
  • You can use Bitcoins to pay for various products and services

Cons

  • You need to put all the value of the purchase
  • You have limits for maximum deposits.
  • You must pay the deposit and / or withdrawal fees.
  • Your wallet password is exposed to hacker attacks and you can lose your entire investment.

What Is Bitcoin Trading?

You can sell and buy Bitcoins not only with fiduciary money, such as USD or Euro, but also by exchanging Bitcoin for other cryptocurrencies, generating profits as a result of the difference in your costs. This is a way to get involved in the world of cryptocurrencies without having to undermine them.

Margin and Leverage in Cryptocurrencies

In margin trading, you will borrow buying and selling power in exchange for a portion of your funds being reallocated (the margin). This margin will only be accessible again after an operation in which you return the capital that you borrowed.

Pros

  • You can use the leverage*, so you only have to put a fraction of the total size of your position in advance
  • You will not have to pay income tax
  • You start operating immediately, without the need of an account in a cryptocurrency platform for buying and selling
  • You must not pay deposit or withdrawal fees
  • You can start demo operations and not open a real account

Cons

  • You do not own the Bitcoins
  • You cannot use Bitcoins to pay for goods or services
  • You can easily invest too much and too quickly using leverage*

*Leverage negotiation allows you to negotiate an amount that you do not have. Crypto Trading services usually offer leverage. This means that for every dollar you have, you get $10 of purchasing power. This means taking a higher risk and getting a greater potential reward.

Cryptocurrency CFD’s (Contracts for Difference)

Libertex offers Bitcoin CFD’s that allow you to trade cryptocurrencies without owning them. Crypto CFD’s are contracts between buyers and sellers, in which sellers pay buyers the difference between the current value of the encryption assets and their value when the contract expires.

What Is Bitcoin Cash?

In August of 2017, different sects within the Bitcoin community had a disagreement over the rules governing the mining process, specifically about what constitutes the appropriate size (in megabytes) of a block. After the inability to reach a consensus, two sides were formed; on the one hand the Bitcoin traditionalists and on the other the group that cheered bigger blocks. Finally, the members of the second side separated to create the Bitcoin Cash.

Although they share a common digital ancestor, each has its own individual blockchain with slightly different protocols. (For what it's worth, bitcoin miners are running on 1MB blocks, Bitcoin Cash uses 8MB blocks). The bifurcation is expected to happen again in the future.

Are There Any Other Cryptos?

Yes. More than a thousand, with more outbreaking every day. Apart from Bitcoin, which is the true progenitor of all of them, other known alternative currencies include Ethereum, Ripple and Litecoin.

Conclusion

In summary we can say that Bitcoin and cryptocurrencies are in general one of the most attractive assets of the moment to invest. On the other hand, as we could see, investing directly with Bitcoins involves risks of all kinds. From the issue of volatility to the probability of being scammed.

Investing your money with Libertex is completely safe since through our platform, you just bet on whether the crypto price will go up or down, without buying Bitcoins directly or making transactions with intermediaries.

Invest now with Libertex!

Back