What is Bitcoin and How does it Work? Ultimate Guide(2021)

Let’s look at crypto. Now, you’ve probably heard the word Bitcoin floating around. You might have seen the Bitcoin price has been skyrocketing recently.

You might’ve seen that Tesla has bought $1.5 billion worth of Bitcoin and is going to start accepting it as payment. And you might have heard of Dogecoin which is apparently going to the moon.

This blog post is my personal guide to the world of Bitcoin and cryptocurrencies in general. It’s the introduction that I wish I would have had when I started investing in crypto.

In this blog post, we are going to look at what Bitcoin is, how cryptocurrencies in general work, and why they’re legit.

Secondly, I’ll share my hot takes about Bitcoin and why crypto is very controversial.

Thirdly, we’ll look at why I do invest in Bitcoin and crypto and I will share my portfolio allocation and the reasons behind that.

And fourthly, we’ll look at how you can get started investing in crypto. If that’s the sort of thing you want to do with lots and lots of caveats and cautionary tales along the way.

As always a table of content below, so you can jump around if you feel like it.

I think more people should learn about money and investing and finance and how it works and be open about that sort of stuff.

Anyway, let’s dive in.

What is Bitcoin?

bitcoin

All right, so let’s take things back to basics to try and build up our understanding of Bitcoin from the ground up. Bitcoin is a cryptocurrency. There are hundreds of other cryptocurrencies out there but Bitcoin is like the original, the OG.

And it’s by far the biggest cryptocurrency around, which makes the question, what is a cryptocurrency?

Here’s my definition of a cryptocurrency based on four central concepts.  A cryptocurrency (or “crypto”) is a digital currency that can be used to buy goods and services, it is encrypted and decentralized. 

Now, what is a currency? A currency is just a medium of exchange. It’s what replaces the old-school bartering system we used to have.

The bartering system is quite inefficient because you have to store a lot of stuff that other people want and that’s just a bit of a pain. This led to the invention of currency in the form of coins usually, as a system that everyone recognized to be able to exchange stuff without having the physical goods.

Back in the day currency itself was tied to metals like gold, silver, and copper, which had different values.

The actual metal of the coins was worth something because everyone agreed that these metals were precious. Then we transitioned to paper notes as our currency in modern days. This means we stopped trusting the precious metals and we started trusting someone and that is the government. 

The value of paper money is stated by the government and everyone agrees that it is worth the stated amount.

For example, If I take $10 almost anywhere in the world most people will recognize that $10 is worth $10 and I’d be able to buy $10  worth of goods or services from it.

If hypothetically the whole world were to tomorrow decide that the US dollar is a meaningless currency and they’re not gonna accept it for anything at all, then the US dollar would be worthless.

Currency is kind of just an abstract way that we’ve all agreed to value things in a certain way. It doesn’t mean anything real.

The main problem with paper money is double-spending. 

Coming back to Bitcoin, Bitcoin is a virtual currency. It is a digital form of currency, i.e. a digital form of paying for goods and services and exchanging money over the internet.

In October 2008 a document was published online by a guy calling himself Satoshi Nakamoto. The document also called a whitepaper, suggested a way of creating a system for a decentralized currency called Bitcoin.

This system claimed to create digital money that solves the double-spend problem without the need for a central authority.

At its core Bitcoin is a transparent ledger without a central authority, but what does this confusing phrase even really mean?

Well, let’s compare Bitcoin to the bank. Since most money today is already digital, the bank basically manages its ledger of balances and transactions.

However, the bank’s ledger is not transparent and it is stored on the bank’s main computer. You can’t sneak a peek into the bank’s ledger, and only the bank has complete control over it.

Bitcoin on the other hand is a transparent ledger. At any point in time, you can sneak a peek into the ledger and see all of the transactions and balances that are taking place.

blockchain

The only thing you can’t figure out is who owns these balances and who is behind each transaction. This means Bitcoin is pseudo-anonymous; everything is open, transparent, and trackable, but you still can’t tell who is sending what to whom.

Let’s explain this with an example. The first Bitcoin transaction was made in May of 2010. It was worth 10,000 Bitcoins and it was used to buy 2 pizzas by a guy named Laszlo.

Laszlo published a post back in 2010 asking for someone to sell him 2 pizzas in exchange for 10,000 Bitcoins.  Well, someone did, and now the price of these two Pizzas is worth well over 100 million dollars today.

Bitcoin is also decentralized; no one computer holds the ledger. With Bitcoin, every computer that participates in the system. It is also keeping a copy of the ledger, also known as the Blockchain.

If you want to take down the system or hack the ledger, you’ll have to take down thousands of computers that are keeping a copy and constantly updating it.

Like most money today, Bitcoin is also digital. This means there’s nothing physical that you can touch in Bitcoin. There are no actual coins, there are only rows of transactions and balances.

When you “own” Bitcoin it means that you own the right to access a specific Bitcoin address record in the ledger and send funds from it to a different address.

What does all of this mean?

Why is Bitcoin such big news?

Well, for the first time since digital money came into existence we now have an alternative to the current system. Bitcoin is a form of money that no government or bank can control.

For example, think about the time before the Internet, how centralized the flow of information was. Basically, if you wanted information you could get it from a few major players like The Washington Post, the New York Times, and others like them.

Today, thanks to the Internet, information is decentralized and you can communicate and consume knowledge from around the world with the click of a button.

Bitcoin is the Internet of money and it’s offering a decentralized solution to money.

Bitcoin has several advantages over the current system.

  • First, it gives you complete control over your money. With Bitcoin, you and you alone can access your funds.
  • No government or bank can decide to freeze your account or confiscate your holdings.
  • unlike fiat currencies, Bitcoin was designed to be digital by nature, this means you can add additional layers of programming on top of it and turn it into “smart money”.
  • Also, Bitcoin cuts a lot of the middlemen from the process of transferring money. This means that in many cases Bitcoin is cheaper to use than traditional wire transfers or money orders. 
  • Finally, Bitcoin opens up digital commerce to 2.5 billion people around the world who don’t have access to the current banking system. These people are unbanked or underbanked because of where they leave and the reality that they have been born into.

However, today, with a mobile phone and a click of a button they can start trading using Bitcoin, with no permission needed.

Today there are several retailers online and offline that accept Bitcoin. You can order food or book a hotel with Bitcoin if you like.

There are even Bitcoin debit cards that allow you to pay at almost any store with your Bitcoin balance. However, the road toward acceptance by the majority of the public is still a long one.

The revolution of money began in 2009 and these days we are seeing it change money as we know it.

Most people didn’t believe that Bitcoin would be a viable form of currency, but over the last decade-plus, as Bitcoin has become more and more popular, people are starting to say that maybe Bitcoin could be the currency of the future.

Maybe in the future, maybe a few years, a few decades from now, we’ll be paying for goods and services using Bitcoin over the internet, rather than by using these old-school, old-fashioned centralized banking and government institutions to exchange US dollars and our actual local currencies.

That was the currency part of it. We can think of Bitcoin or crypto as “Internet Money”.

Let’s now talk about the ledger system that holds it all together. The thing to understand here

is that Bitcoin is effectively one giant huge spreadsheet. This spreadsheet is called a ledger as mentioned earlier and in the spreadsheet, we’ve got a record of every single Bitcoin transaction that has ever happened since when Bitcoin was, was first invented.

For example, let’s say you’re going on shopping with a group of friends and you don’t want to keep on splitting the bill and handing over cash because that’s a total nightmare.

Therefore, someone makes a spreadsheet to keep track of who owes who and what. The idea is that as our shopping goes on, you would keep on adding stuff to our spreadsheet or a ledger.

At the end of the holiday, you would all settle up and then actual money would exchange hands. Assuming you trust your friends, to be honest, this spreadsheet works reasonably well.

You can treat this whole spreadsheet as virtual money. Now that’s fine for a group of a few people on a shopping day.

But imagine hypothetically, if the whole world were to run on a similar spreadsheet, where instead of money ever exchanging hands it would just be a line item in the spreadsheet.

Now imagine a world in which everyone trusted the spreadsheet and everyone was being honest and good and only adding legitimate things to the spreadsheet that everyone agreed on. That’s basically what Bitcoin is.

But this will only remain as imagination because there are very few trustworthy people these days. A lot of people will try to game the system by adding illegal transactions to the spreadsheet. And that is where Bitcoin mining comes in.

What the heck is bitcoin mining?

Bitcoin mining

Bitcoin mining is the process of creating new bitcoins by solving a computational puzzle. It is performed by high-powered computers that solve complex computational math problems; these problems are so complex that they cannot be solved by hand and are complicated enough to tax even incredibly powerful computers.

In plain English, mining is the process of confirming if the transactions are legit or not.

Moving on, it’s this giant spreadsheet that keeps track of absolutely every single transaction that’s ever happened regarding Bitcoin since the start of Bitcoin.

This means that this spreadsheet has a record of everyone in the world who has ever bought and sold Bitcoin and it tells you how much Bitcoin each address bought and sold.

For example, let’s say you have three Bitcoins in your account which is quite a lot of money these days. And you were to give one Bitcoin to a friend, this transaction is to this spreadsheet.

Because it’s all in one spreadsheet, the spreadsheet knows that your Bitcoin account has now two Bitcoin and your friend’s Bitcoin account now has one Bitcoin in it as well.

Fundamentally, this is all Bitcoin is. A giant spreadsheet. But it’s got some other fancy features that make it a potential candidate for the currency of the future.

See, the problem with our ledger system that is in the bank’s main computer is that if it’s on a spreadsheet usually it’s one person who’s maintaining the spreadsheet, and hence there is no transparency.

Every bank, financial institution, and government in the world is a centralized authority that handles money. The US dollar is tied to the federal reserve and the US government, the UK pound is tied to the bank of England and then to the international monetary fund.

Essentially it’s the governments and banks that manage the financial system for every country in the world.

The third part of our definition of a cryptocurrency is that it needs to be decentralized. The way that Bitcoin and all these other cryptocurrencies work is that there is no central person in charge of them. Instead, what happens is that every single person in the world can have a copy of that master spreadsheet if they want.

With Bitcoin, for example, there are millions of people around the world on their computers who each have a copy of the master spreadsheet.

And each of those computers is running software that’s constantly checking to make sure that the master spreadsheet is legit. It’s the same as every other copy of the master spreadsheet on the network.

This means that if you wanna hack a Bitcoin it’s quite hard to do because there are millions of people all around the world who are helping to maintain it from their computers.

Now we get to the final part of our definition which is that this whole system is built and secured using cryptography.

Cryptography is a branch of maths and computer science that’s associated with code-making and code-breaking. Cryptography is also how all of our communications are encrypted.

For example, when you send a WhatsApp message there is no way that WhatsApp or Facebook can read the message because it’s encrypted by cryptography on either end.

Only the sender and the recipient can see what the message is. No one in the middle can see what the messages are, it’s become encrypted, it’s just a bunch of numbers that no one can interpret.

Cryptocurrencies such as Bitcoin use cryptography to solve the problem of trust and to solve the problem of centralization.

The problem of trust is that, from the previous example, when you went shopping with your friends, you all trust each other and you know that no one’s gonna screw anyone over, but in real life, that doesn’t necessarily happen. So your system needs to be secure enough so as not to rely on trusting individuals.

And secondly, the problem of centralization, the ledger cannot be owned by a certain company or government. It needs to be truly decentralized in a way that everyone maintains and manages the system.

Essentially, cryptography is based around the use of one-way functions called hash functions.

The idea behind these is that you can put any message or anything through a hash function and it will spit out a totally random combination of letters and numbers on the other end in such a way that you can then reverse the function.

If we were to take your name and put it through a hash function called SHA-256 which is the one that Bitcoin uses it will come out with a random string of letters and numbers.

If you were to just look at that random string of letters and numbers, there is no way you can reverse the chain to go back to what the original message was.

Bitcoin uses these hash functions to solve both those problems. It solves the problem of trust by using digital signatures based around secret keys and public keys in this thing called “Public Key Cryptography”.

This means that you as an individual can have a secret key, a password that no one else knows, but then you have a public key which is sort of related to your password which other people do know, but that’s fine because they can never find out your true password.

And as long as you use your true password to sign your messages, it’s 100%, guaranteed that those messages are legit. This solves the trust problem.

We solve the decentralization problem by using this concept called “Proof of Work” where all of the different people on the Bitcoin network who are maintaining the system, are called “Bitcoin Miners”.

What these guys try and do is they essentially try and solve a “Hash Puzzle”, which just requires lots and lots of computing power. It effectively involves guessing multiple numbers, multiple times.

If you are the lucky person, who’s plucked the random number out of thin air that solves the “Hash Puzzle”, then your spreadsheet gets saved permanently, and then you get rewarded with some Bitcoin for giving up your computing power to help kind of maintain the whole thing.

I’m using a lot of jargon and this is very hard to break down easily.

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Let’s now move on to topic number two.

Read: Websites That Will Pay You DAILY!

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Why is Bitcoin and crypto controversial?

There are broadly four reasons why crypto is controversial.

  1. the speculation bubble, 
  2. the threat of illegal activity, 
  3. security issues, and 
  4. the environmental impact.

Firstly, a lot of people say that Bitcoin is a speculative bubble. The price of Bitcoin is volatile and is not based on anything.

Any intrinsic value behind Bitcoin is in fact based on people like you and me thinking, that Bitcoin’s a big deal. Therefore we buy it and hence the demand increases leading to the price going up.

And yes there is an extent to which Bitcoin is a speculative bubble.

For example, when Elon Musk tweets that he’s about to buy a Bitcoin suddenly the price sores high. That is not the sign of how a market would respond to an underlying value increase. It is in fact how the market would respond to speculation.

Elon Musk is buying Bitcoin therefore, everyone in the world would like to buy therefore the price goes up.

Bitcoin has fundamentally changed because of Elon Musk’s tweet. It’s just that people are speculating at it which is why it’s this sort of speculative bubble.

Secondly, Bitcoin is sometimes used as a form of payment for illegal activities.

Let’s say you wanna buy drugs or you wanna buy something on the dark web, you can pay in Bitcoin because nobody is going to know who made that transaction.

Theoretically, your Bitcoin username is a random string of letters and numbers that are not directly tied to you as an individual. And therefore Bitcoin is a way that unscrupulous people across the internet can facilitate payments without needing to verify their identity with anyone.

In fairness, people can also do illegal things with US dollars and every other form of currency in the world.

Some people would say Bitcoin is bad because it’s fundamentally anonymous. And therefore, you never know who the actual person is on the other end unless you kind of trust them initially.

I don’t buy that argument personally. I mean the internet itself can be a good or bad thing depending on the context in which it’s used.

I think Bitcoin could be the future and it is broadly a good thing, but of course, it could be a bad thing depending on how it’s used.

Thirdly, Bitcoin is controversial because people are sometimes worried about security issues.

In practice, there are these companies called “Crypto Exchanges“. These are big companies that are sort of like the London stock exchange and the New York stock exchange in the stock market.

These exchanges connect buyers to sellers. A lot of people who have accounts on these exchanges also use the exchange to store their crypto which is not a good idea. 

I have a few of my Bitcoin at Binance. If Binance were to get hacked for whatever reason then I might lose my Bitcoin.

There’ve been quite a few high-profile hacking instances where the exchange has been targeted and users have lost their crypto.

In practice, this is something that should be worried about. To prevent this from happening to you, you need to store your crypto in a hardware wallet.

Trezor

Reason number four is the fact that Bitcoin is controversial because of the energy consumption and alleged environmental impact of the technology.

While there’s been a lot of criticism regarding the energy consumption that Bitcoin mining employs worldwide there are various arguments against this claim as well.

For starters, you could say that Bitcoin mining ultimately requires fewer resources than the current banking system.

If you take into account banks, servers, ATMs, credit card companies, and all other components of the current monetary system, you’ll find out that it is much more wasteful than Bitcoin mining.

Especially if you think about all of the paper used for printing money and pollution caused by these institutions.

Also, you could say Bitcoin mining is actually optimizing power consumption around the world.

Many companies are moving their mining operations to countries that have an excess of electricity.

This means that the use of electricity worldwide is actually becoming more efficient.

This is because it is kind of decentralized and run by millions of computers, millions of nodes, all around the world people would say that those nodes use lots and lots of computing power, therefore lots of electricity is used to solve the hash puzzles that the whole Bitcoin system is based around.

The environmentalists would say that this use of energy is bad for the environment and it’s causing a lot of carbon to go into the atmosphere just to maintain a system.

Whereas the pro-Bitcoin people would say, yeah, that’s true but we need to use energy to maintain any system and the actual banking industry uses far more energy than Bitcoin does.

Ultimately, I don’t know what the answer is, there are pros and cons. Everything kind of uses energy.

That is just one of the reasons why people think Bitcoin is a bit controversial.

That brings us onto section three, having said all of that about the potential issues with Bitcoin.

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Why do I personally invest in it?

Again, let’s break this down into three parts.

  1. Number one is diversification, 
  2. number three, FOMO, and 
  3. number four, fun.

Firstly, I’ve got to be honest. The primary reason I invest in crypto is because I want to diversify my portfolio.

If I do think of it as an investment, I’ve got some percentage of my portfolio in crypto and that theoretically helps me diversify my portfolio which is otherwise mostly in stocks and shares.

I first heard about Bitcoin in 2011 as everyone else did. And then I’m thinking damn, if only had bought Bitcoin in 2011 I’d be a multi-millionaire by now. And I’d never have to work a day in my life.

Secondly, Every few years I’d hear about Bitcoin and be like, Bitcoin’s now $100, but you know if only I had invested two years ago… but I can’t possibly get it now because it’s way too expensive.

It’s the sense of fear of missing out which is why I do invest in crypto.

And Thirdly, it’s just kind of fun. It’s fun to be a part of the future, it’s fun to keep up with the news about Bitcoin, it’s fun to look at the portfolio occasionally and be like, Oh, are we up?, Are we down?, How are things going?

I feel like part of this like revolution.

And I genuinely do think that Bitcoin could be the future of money and I want to be a part of that and that just feels kind of fun.

What is my strategy for investing in crypto?

Well, these days I have about 2% of my overall investment portfolio in crypto in a combination of Bitcoin and Ethereum. Mostly Ethereum because I actually bought loads of Ethereum like four years ago and just held onto it.

I think my allocation is about 80% Ethereum, 20% Bitcoin.

The main thing with any investment is that you only want to put in money that you can 100% afford to lose because it’s quite a high-risk speculative venture.

If tomorrow I lost that 2%, I wouldn’t care in the slightest. I like to think it wouldn’t affect my mental wellbeing at all.

And I know this because when I lost 35,000 pounds in 2017,

Therefore I’ve sort of put my arbitrary risk profile that I’m happy with to be 2% of my portfolios in crypto. The other 98% of my portfolio is in stocks and shares.

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How to get started with investing in crypto?

If you do want to get started, firstly, you wanna understand how to safely buy crypto step by step.

Secondly, there are two things you need you. a wallet to store your cryptocurrency that can be a hardware wallet or a mobile wallet and you also need a cryptocurrency exchange company where you can buy and sell cryptocurrencies.

Now, most big exchanges will also let you store currency on the platform, but this is not recommended.

I use Binance for everything. That is buying and selling cryptocurrency. Please don’t try and hack my Binance account. In securing my crypto I use Trezor and Ledger Nano X as my best hardware wallets.

Binance is the biggest crypto exchange in the world. It’s very nice and easy. 

In practice, you do wanna secure your account. On my Binance account, I have two-factor authentication enabled.

And if you really care about security, you can invest in a hardware wallet that stores your Bitcoin offline. It is a much more secure way of storing your Bitcoin rather than having it stored on the internet in an exchange like Binance.

That was my beginner’s introduction to crypto. Hope you found this article useful and please share it.

Read: Best Crypto Exchanges

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