What is bitcoin and how does it work?


Back in 2009, the pseudonymous Satoshi Nakamoto introduced bitcoin to the world in a white paper, and the financial world hasn’t been quite the same since. These days, when it comes to investing, it’s not just about the top picks on Wall Street. Now, you can also decide to invest in, buy and sell bitcoin.  

However, just because bitcoin and other cryptocurrencies have broadened the playing field doesn’t mean they’re mainstream. There are several sticking points surrounding bitcoin, chief amongst them the fact that few people really understand what it is and how it works.

Let’s get to the following commonly asked questions:

  • What is bitcoin?
  • How does bitcoin work?
  • What is bitcoin mining?
  • What are the benefits of bitcoin?
  • What are some of the disadvantages of bitcoin?
  • How is bitcoin primarily being used?
  • Should I invest in bitcoin?  
  • Where to buy bitcoin?  

Q1. What is bitcoin?

Bitcoin is one of a number of virtual currencies shaking up the financial sector. It is different to a so-called fiat currency (like dollars or pounds) in that this digital currency is a payment system that doesn’t require central authorities, third party involvement, or transaction fees. And, you can think of it instead as peer to peer electronic cash, which is managed collectively by its network of end users in a public ledger.

Bitcoins value is derived from its creation process, known as bitcoin mining. This process, which we’ll talk more about in a bit, is basically the means by which individual units of bitcoin (known as ‘blocks’) are cryptographically secured by bitcoin miners using bitcoins software.

The value of bitcoin is real and recognised across the world. Contrary to what some people think, it is not an illegal Ponzi scheme or a scam. In fact, there are even some banks that accept bitcoin and more that are moving in that direction. It is, however, unlikely that bitcoin will enjoy widespread adoption.

Important: When you consider traditional currencies vs bitcoin, there is notable volatility in the latter. So, it’s not ideal as a means for budgeting and paying bills or managing your personal finance. Whether it will be in the future remains to be seen.

Q2. How does bitcoin work?

We’ve already touched on the two major components that keep bitcoin ticking: the public or distributed ledger, and the mining process. So, let’s dive a little deeper into both of these concepts before taking a closer look at some of the pros and cons of bitcoin.  

All bitcoin transactions are recorded on a digital ledger called the blockchain. It is so called because each transaction, known as a ‘block,’ is ‘chained’ to all the blocks that came before it, by way of an open-source code.

This helps to create a permanent record of every bitcoin transaction, meaning that, in many ways, they are more secure than traditional money transfers. And, for an additional layer of security, blockchain technology can only be altered if agreed upon by a majority in the bitcoins network. It is, in other words, not under the centralised control of one person or party.

Note: Anyone trading bitcoin will have a virtual bitcoin wallet that contains public keys and a private key. This digital wallet is similar to physical wallets in that it allows owners to initiate transactions. However, they differ in the fact that the keys they contain provide a proof of authorisation that is permanent and accessible to all through the blockchain.

Q3. What is bitcoin mining?

Mining is the process by which new units of bitcoin are created and stored. Bitcoin miners, who sometimes work in groups called mining pools, generate bitcoin by solving complex algorithms, for which the miner will earn a block reward. In earning this reward, miners release new units of the cryptocurrency.

Q4. What are the benefits of bitcoin?

Bitcoin brings with it a number of advantages. For one thing, while bitcoin's price does tend to swing fairly substantially, the cryptocurrency can make people a substantial amount of money.

Those trading in bitcoin also have a choice in how they manage their money. For example, investors can choose to store their bitcoins either in hot wallets or cold wallets, the former of which stores currency in the cloud. In the case of the latter, users download their funds into an external drive, which offers them additional security.

Note: From a security stance, bitcoin is considered by many to be a safe investment. This is because transactions don’t contain any personal information and no one person has the power to alter them.

Q5. What are some of the disadvantages of bitcoin?

While some investors hold bitcoin in high regard, there are plenty who remain wary. For one thing, as mentioned above, the bitcoin market is volatile. This means it is unlikely to be stable enough for use alongside conventional currency.

Plus, while it is considered secure in some ways, bitcoin hot wallets are prime targets for hackers. The Bitfinex hack of 2016 is a prime example. This trading platform was targeted by hackers who stole several million bitcoin from the cryptocurrency exchange. Today, the bitcoin stolen would be worth almost a billion dollars.

Bitcoin is also not covered by financial insurance policies like standard currency is. As such, if online brokers go bust or have their funds stolen, they will not be protected by the FDIC or SIPC.

Important: A final downside comes in the sheer processing power bitcoin uses. On the whole, bitcoin currently consumes around 110 Terawatt Hours every year, which is roughly equivalent to the annual energy consumption of a small country like Sweden. So, not only are there concerns surrounding its security and stability, but also about its sustainability.

Q6. How is bitcoin primarily being used?

Now we know what bitcoin is, but how exactly is it used, and by whom? Well, bitcoin can be viewed primarily as an investment opportunity. Given that the value of bitcoin changes in response to surrounding markets and other external factors, it is in many ways similar to the stock market.

While relatively few financial institutions have embraced bitcoin thus far, more and more are accepting bitcoin, while increasing numbers of businesses are accepting bitcoin payments. In Australia in particular, bitcoin is becoming popular as a payment method. Nowadays, people can pay for food and drink and buy physical products with their bitcoin funds.

However, by nature of the bitcoin system, partners, vendors and more would need to constantly revise their prices if they were to adopt bitcoin on a larger scale. Additionally, as with other monetary systems, there is a darker side to bitcoin and how it is used.

Note: For example, there are online operations that take advantage of the system and use it for money laundering purposes. While the number of organisations that do so are relatively small, they are capable of laundering substantial sums of money.

Q7. Should I invest in bitcoin?

Investing in bitcoin can be risky, more so than investing in stocks and real estate. Even a slight change in the market often sends bitcoin either plummeting or sky-rocketing. Still, while high risk, bitcoin investments can certainly be high reward. Bitcoin users have been known to amass millions of dollars’ worth of bitcoins as a result of their investments.

And, bitcoin's future looks to be getting brighter and brighter. While it seems unlikely that it will be adopted into the mainstream or accepted by central banks anytime soon, more and more institutions are starting to accept the currency. Who knows what big players will be in the game and buying and selling bitcoins further down the line!

When it comes down to it, though, working out whether to invest in bitcoin vs stocks, mutual funds, and other, more traditional investments, the main consideration you’ll need to take into account is your personal finance.

Important: One thing to always note is that you should never take out a personal loan or dip into your emergency savings account to invest in an asset class as risky as bitcoin. If you don’t have the money to invest to start with, then borrowing is not the answer. But, if you do have the funds and you’re still feeling unsure, it might be worth approaching a financial advisor.

Q8. Where to buy bitcoin?

Once you’ve made the decision to buy bitcoin, it’s time to decide which bitcoin exchange to buy from. And, the good news is that there are plenty of reputable Australian crypto exchanges for you to choose from including:

  • CoinSpot
  • Independent Reserve
  • Swyftx

Do some research and decide which exchange you want to go with, and then use either your credit card, bank account, or checking accounts to make your initial investment. Plus, be sure to check whether the crypto exchange has a ISO 27001 certification; which is a high-grade security audit that has been undertaken by SCI Qual International (an accredited JAS-ANZ certification body).  

No matter the amount of bitcoin you decide to invest in, it is recommended that you devote less than 10% of your investment portfolio to it, given its volatility and associated risks.

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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation.

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