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June 25, 2017

What Is Bitcoin and How Does It Work?

When people first hear about a Bitcoin, they are usually puzzled because they have never heard of anything like it before. In fact, they often wonder if it’s legitimate form of currency. However, it became officially accepted in November, 2013, when the Senate Committee on Homeland Security and Government Affairs reviewed it. On the day Bitcoin passed the scrutiny of the Congressional hearing, the currency hit an all-time high.

How Does Bitcoin Work?

Bitcoin.org provides the following description of a Bitcoin transaction: “A transaction is a transfer of value between Bitcoin wallets that gets included in the block chain.Bitcoin wallets keep a secret piece of data called a private key or seed, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet.”

If you’re a little confused by this description, you’re not alone. This is how most people feel when Bitcoin and its usage are first explained to them. The reason the definition is hard to grasp is because Bitcoin, like any technical field, has evolved its own vocabulary. In plain English, a Bitcoin is a currency that fits into a global monetary system. However, unlike most currency that you’ve become accustomed to using, it’s not made up of notes and coins. Instead it is entirely digital, and unlike a mint, it is created by individual miners or developers like Genesis Mining.

The Bitcoin Foundation

Bitcoin was invented by the mysterious Satoshi Nakamoto on 31 October 2008 when he sent a research paper, "Bitcoin: A Peer-to-Peer Electronic Cash System," to a cryptography mailing list. Shortly after publication of this ground-breaking document, Nakamoto disappeared from public view. Since millions of bitcoins were made in the first two years, if he ever did show up again, he would be a multimillionaire. This is because he likely owns hundreds of thousands of bitcoins. However, before he disappeared, he put Gavin Andressen in charge, making him the lead developer of the project. Today, Andressen is the public face of the Bitcoin Foundation.

Security via Cryptography

Similar to doing a credit or debit card transaction online, you can get or send money via the Internet. However, unlike the use of a plastic card-based transaction, the exchange does not rely on a person’s identity for security. For instance, you can’t buy something from a website using someone else’s credit card. For the transaction to be legal, the credit card has to be linked to your name via your credit card account.

Instead of an identity-based security, Bitcoin’s security is based on the mathematics of cryptography. For this reason, you’ll often hear of bitcoin referred to as a cryptocurrency.

What Is A Cryptocurrency?

A cryptocurrency is a currency that has been encrypted. It’s a decentralized currency, only available in a digital form, which is transferred between peers. A public ledger through mining confirms the transfer. Bitcoin miners process transaction and secure the network. They use special hardware to generate bitcoins because mining is resource-intensive.

At this point, you’re probably wondering how miners are paid for their work. Bitcoin Mining explains: “Miners provide an important service: network security. A large network hash rate keeps Bitcoin safe from attacks by bad actors. Miners need an incentive to pay for electricity and hardware costs. ASIC mining hardware keeps Bitcoin secure through proof of work. Right now, miners are paid through a combination of Bitcoin’s block reward and transaction fees.”

Buying and Using Bitcoins

If you don't want to earn bitcoins from mining, you can buy them. They are available on exchanges and from sellers at marketplaces.Depending on the seller, you can pay for them with cash, debit cards, credit cards, or another form of cryptocurrency.

Bitcoin can be used for trading or as a form of payment. Thousands of online merchants accept bitcoins with the same ease with which they would accept a mastercard or visa payment. You can buy a wide range of things, anything from an IPad to a wedding ring. If you want to spend bitcoins in person, you would need to use a bitcoin mobile app. When you go to a store that accepts bitcoins, you will be shown a QR code that represents the bitcoin-based transaction. After you scan the code with your smartphone, the number of bitcoins required to make the purchase will be transferred to the store.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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