What Is Bitcoin and How Does It Work?

The following statements do not constitute investment advice or any other advice on financial services, financial instruments, financial products, or digital assets. They are intended to provide general information. The following statements do not constitute an offer to conclude a contract for the purchase or sale of financial instruments and financial products or an invitation to submit such an offer and to buy or sell any particular digital asset. Cryptocurrencies are subject to high fluctuations in value. A decline in value or a complete loss are possible at any time. The loss of access to data and passwords can also lead to a complete loss.

Bitcoin is a type of digital token that can be sent electronically through a decentralized digital payment network. Bitcoins can be sent from person to person, anywhere in the world; indeed, Bitcoin was initially intended to be used as a secure electronic cash and payment system.

Bitcoin is built on blockchain technology. A blockchain is a type of digital ledger that records information (such as transactions) in a way that makes it nearly impossible to edit or alter that information. This way of recording information is inherently secure, but Bitcoin takes it a step further by specifically employing a decentralized blockchain, which depends on a peer-to-peer network to verify transactions.

All of this may sound a bit complicated right now, but we’ll break it down for you in this guide. Perhaps the most important thing to know is that Bitcoin proposes an alternate approach to finance than the one offered by traditional banks and governments—and many people see it as part of the world’s financial future.

With that in mind, let’s take a look at how Bitcoin started, how it works, and how it’s used in day-to-day transactions.

Bitcoin started as a concept rather than a coin. 

In 2008, a writer going by the pseudonym of Satoshi Nakamoto published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” In this paper, Nakamoto shared a vision of a “purely peer-to-peer version of electronic cash” that would allow people to send money to each other without going through a third-party financial institution, like a bank.

Why is it so important to avoid these financial institutions? Nakamoto saw “inherent weaknesses” in the trust-based model that has traditionally defined the financial sector. If you make a purchase online, you’re relying on the trustworthiness of a third-party financial institution to ensure that your transaction is secure and successful. This dependence on a third party comes with costs—transaction costs, sure, but also the costs of fraud and mediation for disputed transactions. What if there was a better way?

Bitcoin attempts to show exactly what that better way looks like. Rather than relying on trusted third parties, Bitcoin offers “an electronic payment system based on cryptographic proof.” Using a peer-to-peer network to verify time-stamped transactions on a blockchain, Bitcoin creates an altogether new type of currency—along with an immutable record of transactions to allow truly secure online payments in that currency.

Bitcoin itself debuted in early 2009, marking the start of the crypto revolution. Since those early days, the value of an individual Bitcoin has sky-rocketed, hitting its most recent all-time high of $68,521 on November 5, 2021.

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We still don’t know who the true author of Bitcoin’s visionary white paper is. Satoshi Nakamoto might not even be a single person, but rather a group of people. 

Plenty of potential identities have been put forward for this enigmatic figure, but the mystery remains unsolved. Whoever Satoshi Nakamoto is, they have certainly left a mark on the world of finance that may continue to grow for years to come.

Nakamoto defined an electronic coin (i.e., a Bitcoin) as “a chain of digital signatures.” That may sound a bit confusing, but it’s actually a good way to wrap your head around how Bitcoin works. 

When the owner of a Bitcoin transfers it to another owner, information about the transaction is recorded on the blockchain. This information includes the “public key” of the recipient. Public keys work in a similar way to bank account numbers—they can be shared with a third party for verification without compromising your security.

This sounds relatively straightforward, but there’s another problem Bitcoin has to solve. How can the person paying for the coin be sure that the owner hasn’t already spent it? This is a problem unique to digital tokens, and it’s referred to as the “double-spending” problem.  

If you spend a euro at one store, you can’t go to another store and spend that same euro there. In other words, you can’t “double spend” that euro. 

While double-spending isn’t a problem with traditional fiat currency, like a euro or a dollar, it is a potential issue with Bitcoin and other cryptocurrencies. With Bitcoin and these other cryptos, there needs to be some new mechanism in place to ensure that a coin isn’t “double-spent.”

Bitcoin uses a decentralized network of high-speed computers to verify transactions and continually validate the accuracy of the blockchain. The members in this network don’t have to trust (or even know) each other, and each of them gets an identical copy of the same blockchain ledger. 

This huge amount of distributed copies—as opposed to a single “master” copy—not only eliminates the need for a trusted centralized authority, but it also protects the blockchain from hacking or double-spending.  

Once an initial transaction is verified by the network and added to the blockchain, it can’t be changed. If a hacker tries to alter or edit the blockchain in any way, they would only be altering their own copy. The altered copy would not match the copies stored on the network’s other computers, so there could be no majority consensus on its validity. 

In Bitcoin’s case, at least 51% of the computers in the network would have to validate the erroneous copy of the blockchain in order for it to be considered valid. Given the cost and computing power required to influence that many computers in a decentralized network, it’s super, super difficult to successfully introduce an error into the blockchain. 

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Bitcoin mining is the process by which Bitcoin transactions are validated. It’s also the process by which new Bitcoins enter circulation. Allow us to explain.

We just mentioned that Bitcoin’s consensus model requires a ton of computing power to function. This consensus model is called “proof-of-work,” and it’s integral to an understanding not only of how Bitcoin transactions are verified, but also of how new Bitcoins are created.

Bitcoin’s “proof-of-work” model requires miners on the Bitcoin network to solve highly complex math problems to validate transactions. In return, these miners are rewarded with newly created Bitcoins. The fact that so many computers are spending so much power to validate transactions means that it’s essentially impossible to get at least 51% of those computers to validate an inaccurate version of the ledger.

Though it was originally conceived of as a cash payment system, Bitcoin has grown into a number of different uses. Here are a few:

• You can use Bitcoin to buy things. From glamorous luxury cars to everyday insurance, you can use Bitcoin to buy all kinds of things. And with Bitcoin debit cards, which are loaded with cryptocurrency but are also capable of completing day-to-day transactions in fiat currency, you can “use” Bitcoin anywhere that accepts plastic.
• You can consider Bitcoin as a store of value. Though it’s a far cry from typical investments, Bitcoin is also considered by many as an appealing store of value. Its volatile, whiplash pricing means that Bitcoin is a highly risky asset, but that hasn’t stopped many speculators from piling in. The total number of Bitcoins is capped, which encourages some to see it as “digital gold.” 
• You can buy, sell, and trade Bitcoin. Due to their volatile and unpredictable pricing on the open market, Bitcoin and other cryptocurrencies have become popular with day traders and investors alike. Keep in mind, though, that any investment in cryptocurrency carries with it serious risks.

Bitcoin’s value comes from open-market bidding. It essentially follows the rules of supply and demand: the higher the demand, the higher the value.

Because of this—and because it’s still such a new thing—the value of a single Bitcoin fluctuates constantly. Unlike traditional fiat currencies, Bitcoin has seen enormous price swings in recent times, dropping $12,000 in value over the course of a single weekend in early December 2021. Its highest price to date—$68,521 on November 5, 2021—may prove to be durable or short-lived. At this point, it’s hard to say!

The total number of Bitcoins was capped at 21 million by the coin’s founder. 

With that said, the number of Bitcoins currently in circulation is constantly changing. It was pegged at around 18.86 million in November 2021, but new Bitcoins are constantly being mined—adding to the growing amount of Bitcoins available. 

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As we’ve seen, the price of Bitcoin can swing wildly in both directions. There are further upsides and downsides to consider, as well. 

• Bitcoin is by its very nature secure, with little risk of false or double-spending transactions being verified by the network.
• Bitcoin is a highly transparent financial vehicle, with every transaction recorded in the blockchain for all to see.
• Bitcoin offers potential for major returns thanks to its high price volatility—though this also comes with significant risk

• Bitcoin’s volatility can also be seen as one of its chief disadvantages, especially if you plan to use it as a store of value.
• Bitcoin isn’t yet ready to replace cash for day-to-day needs.
• Bitcoin mining is an energy-intensive process that requires expensive equipment. This makes Bitcoin less appealing to environmentalists and those concerned about climate change.

If you’re still a bit baffled by Bitcoin, don’t worry. It can take some time to wrap your head around the financial concepts that underpin cryptocurrency, and one article is really only a start. For a more comprehensive rundown, check out our beginner’s guide to cryptocurrency.

The most important thing to remember is that, like everything, cryptocurrencies have both advantages and disadvantages. N26 is here to help you navigate this emerging space, so you can make informed decisions when it comes to buying and selling cryptocurrency.