How Does Bitcoin Work? Definition and How to Invest

What Is Bitcoin?

Bitcoin is a decentralized digital payment system and currency. It was created by a person or group, going by the username Satoshi Nakamoto, who posted a whitepaper on a discussion board.

Bitcoin operates without a financial system or government authorities and doesn't require the involvement of financial institutions. It can be used as an alternative to fiat currencies or as an investment through crypto exchanges, utilizing peer-to-peer transfers on a digital network that records and secures all transactions. This network is powered by a blockchain, an open-source program that chains transaction histories to prevent manipulation.

Bitcoin makes money for investors through appreciation, the increase of an asset's market value. There's a lot going on behind the scenes in the Bitcoin network, so here's a detailed primer designed to help you further your understanding of this digital phenomenon.

The Bitcoin Blockchain

The Bitcoin blockchain is a database of transactions secured by encryption and validated by peers—here's how it works. The blockchain is not stored in one place; it is distributed across multiple computers and systems within the network. These systems are called nodes. Every node has a copy of the blockchain, and every copy is updated whenever there is a validated change to the blockchain.

The blockchain consists of files (called blocks), which store data regarding transactions, previous blocks, addresses, and the code that executes the transactions and runs the blockchain. So, to understand the blockchain, it's important first to understand blocks.

Blocks

When a block on the blockchain is opened, the blockchain creates the block hash, a 256-bit number that encodes the following information:

• The current software version: The Bitcoin client version
• The previous block's hash: The hash of the block before the current one
• The coinbase transaction: The first transaction in the block, where the bitcoin reward for opening the block was issued
• The block height number: How far away numerically the block is from the first block
• Merkelroot: A 256-bit number that stores information regarding the transactions in the block
• Timestamp: The time and date the block was opened
• The target in bits: The network target
• The nonce: A 32-bit number that is added to the block hash

Queued transactions are entered into the block, the block is closed, and the blockchain creates the hash. Each block contains information from the previous blocks, so the blockchain cannot be altered because each block is "chained" to the one before. Blocks are validated and opened by a process called mining.

Bitcoin Mining

Mining is the process of validating transactions and creating a new block on the blockchain. Mining is conducted by software applications that run on computers or machines designed specifically for mining called Application Specific Integrated Circuits.

The hash is the focus of the mining programs and machines. A hash is the result of sending block data through a hashing algorithm, which outputs a fixed-length sequence of numbers and letters no matter the size of the data sent through it. These hashes are in hexadecimal format, which means they can be converted to a numerical value.

The programs repeatedly generate hashes to try and create a number equal to or less than the numerical value of the network target, adjusting a variable called the nonce with each guess. The nonce begins at a value of one and is increased by a value of one every time a guess is made. The number of hashes a miner can produce per second is its hash rate.

Mining programs across the network generate these hashes, competing to see which one will solve the hash first—the one that does receives the bitcoin reward, a new block is created, and the process repeats for the next group of transactions.

Bitcoin's mining difficulty adjustments will require a longer or shorter string of zeroes, depending on the number of miners on the network. The difficulty is adjusted every 2,016 blocks to hit a rate of about one new block every 10 minutes. The difficulty—or the average number of tries per second to solve the cryptographic puzzle—has been increasing since Bitcoin was introduced, reaching tens of trillions of average attempts to solve the hash.

Mining is intensive, requiring expensive equipment and a lot of electricity to power it all. There's no telling what nonce will work, so the goal is to plow through them as quickly as possible with as many machines working on the hash as possible to get the reward. This is why mining farms and mining pools were created.

Halving

Halving is an important concept in Bitcoin mining. At first, the mining reward was 50 BTC for solving the hash. About every four years, or 210,000 blocks, the reward is cut in half. So, rewards were cut to 25 BTC in 2012, 12.5 in 2016, and 6.25 in 2020. The last halving occurred on April 19, 2024, reducing the reward to 3.125. The next halving will happen in 2028, further reducing it to 1.5625.

It's often stated that the last bitcoin will be mined somewhere around 2140. However, this is somewhat misleading because the last block reward of 1 BTC or more will be awarded sometime in 2032—right before the rewards are cut to 0.7813 BTC. From that point on, block rewards will be handed out in satoshis, as the following table shows (assuming no changes to the blockchain's halving schedule are made in the future):

There are 100 million satoshi per bitcoin (eight places after the decimal point), so in mid-2032 the block reward will change to 781.3 million satoshi, and will decrease every halving until reaching 1 satoshi (0.00000001 BTC). From there, the reward cannot be halved any further, so it will remain 1 satoshi until some point when the last satoshi will be awarded, increasing the total amount of bitcoin in circulation to 21 million. Then, there will be no more mining, only fees paid to the network participants—that used to mine—for validating transactions and proposing new blocks. So, it's more accurate to state that the last halving will occur in 2136, and the last satoshi will be awarded sometime afterward.

Bitcoin Keys and Wallets

A common question from those new to Bitcoin is, "I've purchased a bitcoin, now where is it?" The easiest way to understand this is to think about the Bitcoin blockchain as a community bank that stores everyone's funds. You view your balance using Bitcoin wallets, which are like your bank's mobile application.

If you're like many people today, you don't use cash very often and never physically see the money in your checking account. Instead, you use credit and debit cards with security numbers, which act as tools to access and use your money. You access your bitcoin using a wallet and the keys you're given when you receive it.

Keys

A bitcoin, at its core, is a token representing value. The token is digital (or virtual), and your public key is used to assign it to you. Ownership is transferred when transactions are made to another person's public key. You use your wallet, the mobile application, to send or receive bitcoin.

When bitcoin is assigned to an owner via a transaction on the blockchain, that owner receives their private key. Your wallet has a public address—called your public key—that is used when someone sends you a bitcoin, similar to the way they enter your email address in an email.

Wallets

A wallet is a software application used to view your balance and send or receive bitcoin. The wallet interfaces with the blockchain network and locates your bitcoin for you. The blockchain is a ledger with portions of bitcoin stored on it. Because bitcoins are data inputs and outputs, they are scattered all over the blockchain in pieces because they have been used in previous transactions. Your wallet application finds them all, totals the amount and displays it.

There are two types of Bitcoin wallets: custodial and noncustodial. A custodial wallet is one where a trusted entity, like an exchange, holds your keys for you. For example, when you sign up for a Coinbase exchange account, you can elect to have them store your keys for you as custodians.

Noncustodial wallets are Bitcoin wallets where the user takes responsibility for securing the keys, such as in your wallet application on your mobile phone. Storing keys in an application connected to the internet is called hot storage. Hot storage is the vulnerability most often exploited by hackers and thieves.

To remedy this, the cryptocurrency community has developed methods for storing your keys offline. Most commonly, you'll hear about hot storage, cold storage, and deep cold storage. Hot storage is any wallet that stores your keys and has an active connection to the internet; this is the most vulnerable method. An example of a hot wallet is the wallet application on your mobile device.

Cold storage is any method that is not connected to the internet. This could be a removable USB drive or a piece of paper with your keys written on it (this is called a paper wallet). Deep cold storage is any cold storage method that is secured somewhere that requires additional steps to access the keys beyond removing a USB drive from your desk drawer and plugging it in. Examples might be a personal safe or storage deposit box—anything that takes extra effort to retrieve your keys.

Bitcoin Transactions

A bitcoin transaction occurs when you send or receive a bitcoin. To send a coin, you enter the recipient's address in your wallet application, enter your private key, and agree to the transaction fee. Then, press whichever button corresponds to "send." The receiver must wait for the transaction to be verified by the mining network, which can take some time (occasionally several hours) because transactions wait in a mining queue called the mempool.

The mempool is where transactions waiting to be verified go. The network, on average, confirms a block of transactions about every ten minutes, but not all new transactions go into the new block that is created. This is because blocks only hold a certain amount of information, and each transaction comes with a mining fee.

Transactions must meet the minimum transaction fee threshold to be processed, and the transactions with the highest fees are processed first. This is why you may hear about the problem of rising fees. Bitcoin is so popular that demand for transactions has increased, allowing (or requiring) miners to charge higher fees.

Once the fee is met, the transaction is transferred to a block, where it is processed. Then, the transaction information within the block is validated by miners, the block is closed, and all receivers collect their bitcoin. Both wallets display their appropriate balances, and the next transactions are processed.

Bitcoin Security

The Bitcoin blockchain and network have many parts, but it is not necessary to understand them all to use this new currency technology. You only need to know that you use a wallet to send, receive, and store your Bitcoin keys; you also should use a cold storage method for security because wallets are software, and software can be hacked.

Exchanges that store customers' keys can also be hacked, but many who offer this service take measures to reduce the chances of hackers getting into the storage systems. Most are turning to the enterprise-level cold storage techniques businesses use to store essential data for extended timeframes.

For good reason, many people are concerned about Bitcoin's level of security, especially since it involves exchanging money for encrypted data ownership. However, it's important to note that the Bitcoin blockchain has never been hacked because of the community consensus mechanisms used.

Wallets are the weak spot, so if you're looking to get involved in Bitcoin, it's essential to understand how to utilize cold storage methods and keep your keys out of your hot wallet.

Pros and Cons of Investing in Bitcoin

While there are many reasons Bitcoin is popular with investors, there are just as many reasons why it shouldn't be. Here's what you should be aware of when considering investing in Bitcoin.

Pros Explained

• Bitcoin has experienced exponential growth since its early days, creating vast amounts of wealth for many individuals and businesses.
• Bitcoin's market cap on Oct. 11, 2024, was more than $1.2 trillion, and its 24-hour trading volume was more than $32 billion, which provides plenty of liquidity for the market.
  
• Many investors use Bitcoin as a hedge against inflation because its market value has outpaced it in the past.
• Bitcoin exchange-traded products have made investing in Bitcoin easier for retail investors and offer protection from losses if brokers or crypto custodians collapse.

Cons Explained

• While Bitcoin's price has continued to grow since it was introduced, it experiences a large amount of volatility, sometimes thousands of dollars change in price per day. This is not ideal for short-term investing strategies.
  
• Bitcoin trading can become expensive. Transaction fees average less than $1, with occasional spikes of up to $100 or more.
• For ESG-conscious investors, mining is a concern because miners are essentially converting energy into a virtual investment only the wealthy can afford.
• While many see Bitcoin as a hedge against inflation, it only remains this way as long as it outpaces it. Unlike securities designed to hedge inflation, there are no guarantees your money will grow faster than inflation in the future.
• If you purchase Bitcoin yourself and custody the keys on an exchange or in your wallet, there is no protection from losses if you lose your Bitcoin keys or they are stolen. The exchange might have insurance if their systems fail to secure your keys, but in general, Bitcoin losses due to wallet hacks and stolen keys are not covered.

The Bottom Line

Bitcoin is a digital currency that can be used instead of fiat currencies or physical cash. It uses a blockchain to secure transaction information out of the reach of centralized third parties who traditionally facilitate and regulate transactions.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our warranty and liability disclaimer for more info. As of the date this article was written, the author does not own bitcoin.