What exactly is Bitcoin & how does it work?

11 min readFeb 19, 2021

In layman’s terms …

Thanks for stopping by — following is intended for a non-technical audience, with just enough tech to make it spicy! None of the following is investment advice — just sharing info!

Bitcoin is 2 main things:

A store of value in the form of a digital asset.
A software Platform connecting a network of Nodes, Miners & Users — all explained below.

We will refer to the asset as “bitcoin” and the overall Platform as “Bitcoin”.

Bitcoin was introduced by Satoshi Nakamoto in 2008. It remains unclear to this day whether Satoshi is a man, woman or group of people. The original whitepaper is here, but the following breaks it down in simpler terms.

A core aim of the Bitcoin platform was to create a “separation of Money and State”, i.e. free and clear of politics & corruption. After the financial collapse of 2008, and the resulting bailout of financial institutions (that caused the collapse), it seems “Satoshi” wanted to even the scales between the money-elites (Wall Street/Central Banks) and the man-on-the-street.

The result is tamper-resistant electronic money (using cryptography) that cannot be continually devalued through money printing and general financial mis-management. The monetary policy of bitcoin is hard-coded.

What makes it compelling?

Scarcity — Only 21 Million bitcoin will ever be mined (created). So far, over 19.5 Million already exist.
Non-sovereign — Not controlled by any government or corporation.
Transactable — Essentially a payment network, running 24x7x365
Store of value — has been dubbed “digital gold”, where at a minimum its value is not ravaged by inflation.
Accessible — Available to anyone globally. Bitcoin is divisible down to 1/100,000,000 of a bitcoin, called a “Satoshi” (or “Sat” for short). Yes you can buy a fraction of a bitcoin!

Quick word about “Money”

Money, as we know it, is issued by governments and generally referred to as “Fiat Money”. This means it is backed by nothing more than the full faith & credit of the issuer, i.e. not by gold, bourbon or anything of tangible value.

If enough people go along with that, then things generally work. It comes down to trust, credibility, rule of law protections and general buy-in.

What if the issuers cannot be trusted anymore? What if the (mis)handling of the issuance and distribution of money decays broad economic opportunity & stability.

All fiat currencies steadily devalue (debase) over time as a result of governments creating more money out of thin air (“printing money”) to cover their excess spending. This is understandable in times of crisis, but is financially ruinous as the norm. More $ in circulation = less purchasing power per $.

Hold that thought as you consider whether Bitcoin has value or a future …

OK, so how does some bitcoin come into being?

First some concepts to understand.

Control of the Bitcoin platform is de-centralized, meaning no single party, person, entity actually controls it.
That means it requires consensus between the majority of the 10,000's of Nodes & Miners to ensure the integrity of Bitcoin. The more Nodes, the more stable & unbreakable, and there are now > 10,000 Nodes spread around the world: https://bitnodes.io/

A key underlying technology is Blockchain. Think of it as a specialized database which is simply a linked list of information (Blocks). A new Block includes a set of transactions + some brand new bitcoin.

When consensus is reached that a Block is valid, it is added to the Bitcoin Blockchain by linking it to the previous Block, aka. Blocks chained together. NOTE: Blockchain is NOT unique to Bitcoin. Many other products also use the Blockchain approach.

Above Alice -> Bob transaction could be: “Alice transferred 0.25 bitcoin to Bob”

Block (& bitcoin) creation factoids

Blocks are created by Miners. Miners are essentially powerful computers running some Bitcoin-related software.
A Block is created approximately every 10 minutes. Currently, 6.25 new bitcoin are created in each new Block.
If the Miners create Blocks too quickly or too slowly, the mining degree of difficulty is adjusted to bring the creation window back to an average of 10 minutes.
This degree of difficulty is adjusted after each 2,016 blocks are created, which occurs about every 2 weeks.
The degree of difficulty is controlled by making the Miners solve a cryptographically hard problem (defined below).
Every four years, there is an important “halving” event, where the number of bitcoin created in each new Block is halved. Therefore, on approx May 29, 2024 the number of bitcoin created every 10 minutes will be 3.125.
The last halving event was May 11, 2020. There is typically a sharp price runup for the 12–17 months after a halving.

The 3 core groups of Participants in the Bitcoin ecosystem are Nodes, Miners & Users. Nodes & Miners are just computers running Bitcoin-related software. Users are people like you and I (Alice & Bob above) buying and selling bitcoin, i.e. creating transactions.

NOTE: There are literally 1000’s of full copies of the Blockchain spread around the world — there is no 1 dominant copy. When a Block is added by a Miner to one of the Nodes, the remaining Nodes are notified and either accept or reject it. It’s been working this way for 15+ years without incident.

The Nodes are constantly communicating with each other (“gossiping”) maintaining the integrity of the Blockchain and facilitating transaction requests from Users.

Mining process

Miners gather up new transactions (submitted by Users) waiting to be added to the Blockchain. Queued up transactions are pulled from a waiting area called the “MemPool”.
They then perform a “Proof of Work” which is solving that cryptographically hard problem (defined below)
If the Miner is successful, that Block is added to their copy of the Blockchain, broadcast out to the Nodes, accepted by the other Miners & Nodes, and the winning Miner reaps rewards (transaction fees + new bitcoin).
The Miner then optionally sells some or all of their new bitcoin.

What is the cryptographically hard problem?

The key concept to understand here is Hashing. Don’t worry, this is not difficult. Let’s jump in with a concrete example:

Input Text: Hello
Hashed Output
185f8db32271fe25f561a6fc938b2e264306ec304eda518007d1764826381969Input Text: Hello!
Hashed Output
334d016f755cd6dc58c53a86e183882f8ec14f52fb05345887c8a5edd42c87b7

Notice that even changing just a single character (adding the !) completely changes the output. This is a feature of Hashing and why it makes the Proof of Work so difficult.

Try it yourself: Hash Generator

Click “Generate SHA-256 Hash” after inputting your string.

A feature of hashing is that the same input always produces the same Hash value — critical to the verification process.

How does Hashing relate to Bitcoin Proof of Work ?

There is a Hash Target Value that must be beaten by the Miners, in order to meet the Proof of Work requirements.

Remember our hashed value above:
334d016f755cd6dc58c53a86e183882f8ec14f52fb05345887c8a5edd42c87b7

Well, the Bitcoin degree of difficulty may require that the winning hash value look something like the following:

Degree of Difficulty:
0000000000000000003a86e183882f8ec14f52fb05345887c8a5edd42c87b7

The key point being that the Platform adjusts the number of zeros that must appear in the leftmost part of the hash. More zeros = more difficult. The non-zero portion to the right is also significant (the Target Value), but the # zeros required paints the picture of how difficult this is, given that hash outputs are very unpredictable, as we have seen.

OK Miners, create some bitcoin …

Miner suits up, gets their game face on, and does the following:

Gathers up 2500 (or so) transactions from the MemPool
Inserts a special transaction (called the “coinbase”) as the 1st transaction. This includes the pre-determined # of bitcoin the miner is entitled to for (potentially) solving this Block
Grabs the identifier from the previously confirmed Block, to which this Block will link
Sets a few other fields, like timestamp.
Takes all of the above and hashes it.

You guessed it, there is virtually zero chance the resulting hash meets the Target Value criteria set by the Bitcoin Platform.

Enter the Nonce

A Nonce is a unique (number used once) number added to the set of data to be hashed, in order to provide variation in the input (along with the existing transactions, timestamp etc.). Hopefully, incorporating the Nonce tips the scales and magically meets the number of zeros requirement.

The Nonce is an Integer value & can provide 4,294,967,296 possible unique values to try.

This seems like a lot, but on state-of-the-art mining computers, that number of hashes (4+ Billion) can be performed in 1 millisecond (1/1000th of a second). Whoa!

So what’s a miner to do, if that doesn’t work?

To increase variability in the input, options include:

Adding and/or removing some transactions from the list being considered.
There is also room for variability in a couple of the input fields, such as the coinbase transaction, to set some bits without affecting the nature of the transaction.

Yeah, it’s a hard problem. How hard?

On Feb 16, 2021 the average number of hashes required to solve this was:

21,434,395,961,349 (21.43 TRILLION Hashes).

Daaang that’s some busy work!

However, ~10 minutes later … Success!

After all this feverish hashing, a Miner lands on the magic hash value that beats the target value. Now what?

Miner adds the Block to the end of their copy of the Blockchain.
All other Miners & Nodes are notified of the presence of this new Block.
They now verify the winning Miner is telling the truth by rehashing all the same inputs the Miner used.

Key Point:
It is extremely hard to find the hash, but super easy to verify it.

If there is consensus, the Nodes & Miners quickly accept the new Block and … onto the next Block, no rest for the Miners!

GO CHECK IT OUT!

Go take a peek at blocks created and all the cool stats — hashing difficulty, nonce, winning hash value, how long it took etc. Now you know what most of it means!

Completed Blocks: https://www.blockchain.com/explorer

Realtime Visualizer: https://txstreet.com/v/btc

Let’s look at a real block

PARTIAL LIST OF BLOCK DETAILS ...Block #: 671445Hash Value (from Proof of Work):
0000000000000000000297dde22ecc9e962f9c51fe168bcab8e355b0ee020ae9Timestamp
2021-02-20 09:25# Transactions: 3,087Block Size: 1,184,029 bytesNonce: 3,778,307,493Difficulty: 21,724,134,900,047 Hashes

How do you buy bitcoin ?

Even though the price of 1 bitcoin at time of this writing is approx USD $55K, buying bitcoin is accessible to virtually anyone since 1 bitcoin can be divided into 100 million Satoshis (like really small cents). You buy bitcoins (or portions of bitcoin) on exchanges, such as:

Coinbase.com
Gemini.com (Remember the Winklevoss twins)
Others

When purchasing bitcoin on the exchange, you are assigned 2 keys:

Public Key — a public address, like an email address.
Private Key — a secret string, like a PIN or Password.

The Public Key (string of random characters) you can safely give out to receive bitcoin. When you purchase (or sell) bitcoin, this public key will be recorded on the Blockchain in the transaction, i.e. not your name.

The Private Key is kept for you at the exchange. The private key uniquely identifies your claim to the bitcoin on the blockchain. It is required in order to transfer/sell that bitcoin.

You don’t have to, but the only way to access your Private Key directly at this point is to download it into a Wallet — there are Software Wallets (app) and Hardware Wallets (similar to USB Drive).

NOTE: If you download your Private Key into a software or hardware wallet, and lose that, you have just essentially burned your bitcoin. It is no longer accessible. BE VERY CAREFUL WITH WALLETS.

So, for the beginner (and many experienced users as well), leave it on the exchange until you have a strong game plan for safekeeping your own keys.

The word “Custody” is used to describe this process. If you download your keys into your own Wallets, you are “self custodying”.

If you leave your keys on the exchange, the exchange is the Custodian of your keys which are typically backed by insurance (carried by the Exchanges). The main crypto Custodians, as of this writing, who service the exchanges include BitGo, Coinbase and Gemini.

Why buy bitcoin?

The reasons have different significance depending on where you live.

Wealth Preservation: In a country with high inflation, your purchasing power in that local currency rapidly declines. A dozen eggs can increase in price every week, but you don’t receive a commensurate increase in (a) income or (b) interest on your holdings of that currency. Therefore, your purchasing power gets hammered.

Permissionless: Especially in countries with unstable or rogue governments your money can be seized. In any country, transferring money can be rejected since it has to go through a middle-man (financial system).

Bitcoin solves the above with following properties:

There is a fixed & predictable supply of bitcoin — unlike all governments, bitcoin cannot be debased from creating unlimited supply.
If you know a recipient’s bitcoin address, you can send them some bitcoin without anyone’s permission.
If you have bitcoin, and want to move to a new country, all you need are your private keys to transact on the Bitcoin network. No-one can “steal your bitcoin” as you’re crossing a border, for example.

The above explanations are particularly relevant to countries with financial/regime problems. Even though the USA does not (yet) fall into any of these buckets, given the (unsustainable) national debt spiral USA has started down, it is only a matter of time before further debasement of even the US Dollar will accelerate. As the saying goes “slowly then suddenly” which is why it is prudent to have some early exposure to this digital asset.

Keeping $ in cash these days is a losing battle against inflation, so what to do?"We just had the awful realization that we were sitting on top of a $500 million ice cube that’s melting.” - Michael Saylor, CEO MicroStrategy, a prolific Bitcoin investor

A good way to think about bitcoin is as a Savings Account with a great interest rate. As with any form of saved money or asset, you want the value to grow faster than inflation and only spend it when you need/want to.

When to Buy/Sell?

The price of bitcoin has been quite volatile since inception. Then again, many other very valuable assets (e.g. Amazon stock) have gone through similar wild rides as they mature. The idea is to buy and hold for the long haul, but if you want to time those smart buys, following is a chart resource of bitcoin price patterns.

Bitcoin Rainbow Chart — Blockchaincenter

How is it Taxed ?

In the USA (but not everywhere), it is considered Property which means it is taxed like a Stock, and therefore subject to Long/Short Term Capital Gains.

If you Sell bitcoin, Buy something with it or Exchange it for another crypto, it is all considered a Taxable Event. Therefore, think twice about transacting and consider tax implications.

To help keep up with taxes, I’ve heard the following is a useful service: https://www.cointracker.io/

https://www.cointracker.io/blog/crypto-tax-guide

Services I Use

Following are 2 of the more reputable crypto service providers. Never had a problem with either.

Resources

To stay informed, I have found all of the following useful:

What Bitcoin Did — Peter McCormack

Unchained Podcast — Laura Shin

Coin Bureau — Great educational videos on all things crypto

Real Vision Crypto — Raoul Pal

Lyn Alden Investment Strategy — all around sound research & analysis

BitCoin Fundamentals Podcast — Preston Pysh