How does Bitcoin work?

Bitcoin it's a bit like money ... and it's a bit like a financial bubble. It's Bitcoin, and it may be giving us a glimpse of the future of money.

Bitcoin is a type of virtual currency brought to life by the internet, very powerful computers and the willingness of lot of people looking to embrace new forms of monetary exchange.

Bitcoin shares some similarities with real-world currencies, particularly its growing acceptance as a form of payment with more and more merchants, retailers and individuals, both online and offline. You can buy Microsoft products with Bitcoin, buy airline tickets through Expedia, or buy gift cards to superstores like Walmart.

Yet Bitcoin is also very different from traditional currencies. Unlike dollars or pounds, Bitcoin isn't backed by any government. It's a completely decentralized form of money. Bitcoin isn't linked to any sort of central banking system or issuing authority, and that's a big part of its appeal — instead of being swallowed into a system that's often sullied by human greed and manipulation, this currency exists in an online world driven by mathematics and clever encryption protocols.

You can use Bitcoin for all sorts of real transactions. To do so, you first buy bitcoins however you like, either through your credit card, a bank account or even anonymously with cash. Then your bitcoins are transferred directly into your Bitcoin wallet, and you can send and receive payments directly to a buyer or seller without the need for a typical go-between, such as a bank or credit card company.

By skipping the middleman in the transaction, you pay far less in associated fees. Each party in the deal can also maintain a much higher level of anonymity, which has both pros and cons for everyone involved. Think of Bitcoin as a digital equivalent of a cash transaction. If you're so inclined, it's a nearly untraceable way to do business.

Spending or receiving Bitcoin is as easy as sending an e-mail, and you can use your computer or your smartphone. That simplicity belies the fact that there's a whole lot of complicated math protecting all of these transactions to maintain their legitimacy and security.

Bitcoin's Backstory

The genesis of Bitcoin is the stuff of internet legend. In 2008, a person (or persons) working under the pseudonym Satoshi Nakamoto published a document outlining the feasibility of the Bitcoin concept. Nakamoto mentioned the 2008 financial crisis — as well as the failures of government-backed currencies and corruption of existing banking systems — as a motivating factor for inventing a new currency.

Bitcoin would be, according to its creators, a purer form of money, working for regular citizens of the world instead of being leveraged against them by the powers that be.

In 2009, Nakamoto released the first Bitcoin application, and also "mined" the first bitcoins for circulation. Then it was just a matter of spreading the word about this new currency.

To use Bitcoin, you need a Bitcoin wallet, which encrypts and maintains your bitcoin balance on your computer, smartphone or in the cloud. Then you can fill your wallet with bitcoins by using your bank account, credit card or other form of payment.

After that, it's just a matter of finding a vendor that will accept Bitcoin as payment. Although pickings were slim when Bitcoin first launched, these days there are many merchants that accept these newfangled coins. That includes restaurants, clothing stores, dentists and many others. Some people even use Bitcoin for property rental and vehicle purchases. The gift card website Gyft accepts payment in Bitcoin, letting you turn Bitcoin into store credit that can be spent at every major retailer and restaurant in America.

If you follow financial news at all, you already know that Bitcoin isn't just used for goods and services. A lot of the hype around Bitcoin has centered around speculation. That is, people are using online currency exchanges like Coinbase to invest their real-world dollars and yen in Bitcoin hoping that the latter will appreciate in value. Already, fortunes have been made (and surrendered) as the value of Bitcoin has careened all over the charts.

But how does this invisible, virtual currency wield so much financial power? How can a brand-new type of money be a workable concept? Well, it's complicated. Keep reading and you'll see how Bitcoin comes to life.

One of the main features of Bitcoin — and all virtual currencies — is that the decentralized network shares an open ledger (called the blockchain) of all Bitcoin transactions. The blockchain provides a trustworthy and redundant way of maintaining the number of bitcoins in circulation.

All of this works thanks to Bitcoin's ingenious open-source (that is, viewable to everyone) code. Open-source software is commonly used by programmers who are opposed to corporate profiteering and control. Any skilled programmer can see how Bitcoin's programming works, and that's OK — it's not the code that protects transactions. Instead, it's the shared blockchain ledger that verifies the legitimacy of each transfer.

Bitcoin's Extralegal Activities

If Bitcoin seems a bit anarchist, well, that's because it is. Bitcoin dodges the traditional paradigm in which government regulators control and manipulate the money supply.

With Bitcoin, people all over the world can engage in online gambling, which the U.S. federal government seriously disapproves of. Bitcoin was also infamously and irrevocably linked to Silk Road, a black market website where people could anonymously purchase about anything, including illegal drugs. The original Silk Road was shut down in 2013 and its founder sentenced to life in prison, but plenty of Silk Road-style marketplaces have since popped up on the dark web [source: Greenberg].

Bitcoin's reputation was soiled by these early associations with Silk Road and other criminal networks. Media reports frequently highlighted the role of Bitcoin on the dark web. Need a kidnapper or hired gun? How about some compromising pictures of your political enemy? With enough Bitcoin and some investigative work, you could potentially find the right person for any job [source: Buterin].

But as more cryptocurrencies have entered the market, criminals are relying less on Bitcoin. In fact, Bitcoin's much-heralded anonymity can be compromised by law enforcement, pushing more cybercriminals to switch to fully encrypted currencies like monero and dash [source: Cheng].

The relative anonymity of Bitcoin and other cryptocurrencies is also a boon for tax evasion. Traditionally, hiding your assets in some offshore account takes some real legwork. With Bitcoin, though, you can potentially stash millions of dollars in your digital wallet safely out of view of all tax collectors, and you could complete this process in just an afternoon.

Governments and concerned citizens obviously take issue with these sorts of underhanded internet shenanigans. Governments don't want citizens skimping on taxes, and their drug-enforcement agencies understandably aren't happy about people finding high-tech ways to skirt their laws.

In spite of these sort of legal or ethical concerns, and even though their value is crazily unpredictable, Bitcoin has endured. That leaves a lot of economists and consumers wondering just what's in store for the future of currency.

Bitcoin is Just the Beginning

The sharp peaks and valleys in Bitcoin's value are clear warning signs that this new cryptocurrency is anything but stable. Until more people actually use the currency to buy things, as opposed to speculating in the currency itself, it's difficult to say what role Bitcoin will play in the future economy.

Is the world really ready to ditch our centuries-old paper and coin, government-backed monetary systems for a purely digital currency? Or will the blockchain technology behind Bitcoin prove more revolutionary than the currency itself?

Bitcoin's success as a speculative commodity has opened the floodgates to hundreds of new cryptocurrencies, each competing for a niche in the market. As we mentioned earlier, some differentiate themselves by their deep encryption and anonymity. Others boast faster transaction processing speeds. But the most promising Bitcoin alternative to date is something called Ethereum.

Ethereum is less of a pure currency than a full-service financial platform. Unlike Bitcoin, you can't use Ethereum's currency (called ether) to buy stuff in the real world. The real power of Ethereum comes from its next-generation blockchain technology and robust programming language. Economists are excited about the potential for Ethereum to usher in an era of "programmable money" and "smart contracts" that run on cryptocurrencies. Again, the underlying blockchain technology may be the game-changer, not the currencies themselves.

Whether it's Bitcoin, monero, dollars or euros, our global economy requires all of us to trust a system of currency that makes sense. Perhaps the future of money is going to be a lot more fluid, with electronic transactions processed on a secure, decentralized blockchain in every currency imaginable.

But before that happens, Bitcoin and other cryptocurrencies will need to address their energy problem. All of the computing power required to mine and verify Bitcoin leaves a huge carbon footprint. Environmental watchdogs calculate that a single Bitcoin transaction consumes as much energy as nine US homes burn through in a full day [source: Digiconomist].

Source:https://money.howstuffworks.com/bitcoin.htm