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What Is Bitcoin – History, How It Works & Security Features

Bitcoin (BTC) is a virtual currency, or cryptocurrency, that’s controlled by a decentralized network of users and isn’t directly subject to the whims of central banking authorities or national governments. Although there are hundreds of cryptocurrencies in active use today, Bitcoin is by far the most popular and widely used — the closest cryptocurrency equivalent to traditional, state-minted currencies.

Like traditional fiat currencies such as the U.S. dollar, Bitcoin has value relative to other currencies and physical goods. Like all cryptocurrencies, Bitcoin is wildly volatile — far more so than most fiat currencies — but the general value trend has been upward. For example, during the 12-month period ending on May 1, 2021, Bitcoin roughly sextupled in value, rocketing from less than $9,000 to about $57,000 per BTC.

What Is Bitcoin?

Bitcoin is the most versatile cryptocurrency around. It can be used to purchase goods from an ever-growing roster of merchants that accept Bitcoin payments, including recognizable companies like Expedia, Overstock.com, and Tesla. It can be exchanged with other private users as consideration for services performed or to settle outstanding debts. It can be swapped for other currencies, both traditional and virtual, on electronic exchanges that function similar to forex exchanges.

And, unfortunately, it can be used to facilitate illicit activity, such as the purchase of illegal drugs on dark web marketplaces like the infamous (and now-shuttered) Silk Road.

Whole Bitcoin units can be subdivided into decimals representing smaller units of value. Currently, the smallest Bitcoin unit is the satoshi, or 0.00000001 BTC. The satoshi can’t be broken into smaller units. However, Bitcoin’s source code is structured to allow for future subdivisions beyond this level, should the currency’s value appreciate to the point that it’s deemed necessary.

For all its promise, BTC remains a niche digital currency that’s subject to wild value fluctuations. Despite the wild-eyed pronouncements of its boosters, it’s certainly not a standard investment or trading vehicle in the traditional sense of the world, as is the case with stable national currencies like the U.S. dollar and Japanese yen. To the extent that it’s viewed as an investment at all, it’s firmly in the realm of alternative investing — although, as we’ll see, there are plenty of legitimate reasons to hold Bitcoin beyond the prospect of making money.


Origins & History of Bitcoin

Bitcoin’s origins date back to the early 1980s, when the algorithms that support modern cryptocurrency were first developed. Its closest predecessor was Bit Gold, a proto-cryptocurrency developed in the late 1990s by Nick Szabo. Although Bit Gold never gained widespread traction, it shared many features in common with Bitcoin, including ironclad protections against duplication, the blockchain as the ultimate transaction ledger, public keys identifying individual users, and built-in scarcity.

Bitcoin’s Birth and Early Development

The first public record of Bitcoin dates to October 2008, when a pseudonymous person or organization known as Satoshi Nakamoto published a white paper with the technical outlines for a new, decentralized cryptocurrency. Nakamoto’s identity remains unknown, although speculation centers on a handful of U.S.-based individuals (or various groupings thereof) who were active in the cryptocurrency movement of the 1990s and 2000s. Nakamoto released Bitcoin’s open-source code in January 2009, marking the beginning of public mining and trading, and ceased public communication shortly thereafter.

Bitcoin was built on the theoretical and technical foundations of Bit Gold and b-money, a contemporaneous cryptocurrency model that was never developed. Aside from being the first cryptocurrency to gain widespread traction outside the cloistered ultra-libertarian movement, its biggest claim to fame is as the first cryptocurrency marked by totally decentralized control. In the realm of Bitcoin, no user is more influential than any other.

Bitcoin experienced some growing pains in its first few years of life. In 2010, a coding flaw resulted in the creation of huge numbers of un-mined Bitcoin, temporarily crashing the currency’s value. A subsequent fix repaired the blockchain and erased the unauthorized Bitcoin. Something similar occurred in 2013, although the effects were less drastic. Bitcoin’s open source code has been modified to make such systemic flaws less likely in the future.

Acceptance as a Mainstream Currency

For the first three years of its life, Bitcoin was mainly used as a means of private exchange. Toward the end of 2012, WordPress, an online publishing platform, became the first major company to accept Bitcoin payments. Others, including OkCupid, Baidu, Expedia, and Overstock.com, followed in 2013 and 2014. Baidu later stopped accepting Bitcoin under pressure from the Chinese government, which viewed Bitcoin as a threat to its own fiat currency.

In 2013, Bitcoin’s market value exceeded $10 billion for the first time. That year, the first Bitcoin-dispensing “ATM” — more accurately, an automated currency exchange machine — appeared in Vancouver, British Columbia, and their numbers exploded in the subsequent years. Genesis, the leading Bitcoin ATM manufacturer, makes two types of machines: a one-way device that allows users to insert paper fiat money for conversion to Bitcoin units, which are then deposited into their digital wallets; and a two-way device that permits Bitcoin-fiat conversions as well.

2014 saw the first major Bitcoin crime scandals. In January, prominent U.S. Bitcoin proponent Charlie Shrem was arrested after a money laundering investigation found he’d illegally procured Bitcoin for use in black market transactions, according to CoinDesk. In February, Mt. Gox filed for bankruptcy after the extent of its breach became clear.

In 2015, Barclays became the first major bank to process Bitcoin transactions, although its embrace was initially limited to charitable contributions.

The “mainstreaming” of Bitcoin continued through the late 2010s and early 2020s. Day traders, hedge funds, and even professional money managers piled into the space, spurring a wave of speculation. Bitcoin’s value increased tenfold in 2017, skyrocketing from about $1,000 at the start of the year to around $10,000 at the close.

Another sustained leg up occurred in 2020 and 2021. Bitcoin more than sextupled in value during the 18 months that ended in May 2021, and formerly reluctant multinational banks like Citibank and JPMorgan Chase signaled openness to accepting the currency.

Pro tip: If you’re planning to invest in Bitcoin, sign up for an account with Coinbase. You’ll earn $5 when you sign up for an account and up to another $25 when to learn how certain cryptocurrencies work.


How Bitcoin Works: Features and Capabilities

Bitcoin is a cryptocurrency, meaning it’s supported by a source code that uses highly complex algorithms to prevent unauthorized duplication or creation of Bitcoin units. The code’s underlying principles, known as cryptography, are based on advanced mathematical and computer engineering principles. It’s virtually impossible to break Bitcoin’s source code and manipulate the currency’s supply.

Although it was preceded by other virtual currencies, Bitcoin is known as the first modern cryptocurrency. That’s because Bitcoin is the first to blend certain key features shared by most subsequently created cryptocurrencies:

  • User Anonymity. Bitcoin users are identified by public keys, or numerical codes that identify them to other users, and sometimes pseudonymous handles or usernames. Additional protections allow users to further conceal the source and flow of Bitcoin. For instance, special computer programs available to all Bitcoin users called mixing services or tumblers privately swap a specific Bitcoin unit for another Bitcoin unit of identical value, and thereby obscure the source of the owner’s holdings.
  • Cryptocurrency Exchanges. Bitcoin exchanges allow users to exchange Bitcoin units for fiat currencies, such as the U.S. dollar and euro, at variable exchange rates. Many Bitcoin exchanges also exchange Bitcoin units for other cryptocurrencies, including less popular alternative coins that can’t directly be exchanged for fiat currencies. Most Bitcoin exchanges take a cut of each transaction’s value, typically less than 1%. Due to its popularity, Bitcoin is more liquid than most other cryptocurrencies on these exchanges.
  • Blockchain Technology. The blockchain is a distributed public ledger of all prior Bitcoin transactions, which are stored by all machines in the Bitcoin network in groups known as blocks. It is also the sole arbiter of Bitcoin ownership; no complete record exists anywhere else. Because new Bitcoin transactions constantly occur, the Bitcoin blockchain grows over time. As long as miners continue their work and record recent transactions, the Bitcoin blockchain will always be a work in progress.
  • Facilitation of Bitcoin Transactions. A Bitcoin transaction hasn’t technically occurred until it’s added to the blockchain, at which point it becomes irreversible — unlike traditional payment processors, Bitcoin doesn’t have any standardized facility for chargebacks or refunds. During the window between the transaction itself and the moment it’s added to the blockchain, the relevant Bitcoin units are essentially held in escrow — they can’t be used by either party to the transaction. This prevents duplicate transactions, known as double-spending, and protects the system’s integrity.
  • Two-Key System. Bitcoin uses a “two-key” system in which every user has at least one private and public key. A private key — basically, a password — is required to send Bitcoin; a public key is required to receive it. Keys can be stored online (either in private cloud storage or on public Bitcoin exchanges); on physical storage media (such as thumb drives); or on paper, and only entered online during transactions. Secure storage is critical because Bitcoin essentially derives its value from user keys. If a key is permanently lost, the corresponding holdings move into a sort of permanent limbo and can’t be recovered.
  • Cryptocurrency Wallets. Actual Bitcoin units are stored in “wallets,” or secure cloud storage locations with special information confirming their owners (Bitcoin users) as the guardians of the Bitcoin units contained within. Although wallets like Coinbase theoretically protect against the theft of Bitcoin units that aren’t currently being used, they’re vulnerable to hacking. Indeed, hackers often target public wallets that store users’ private keys, enabling them to spend the stolen BTC. Ars Technica has a good rundown of Bitcoin hacks large and small.

Mining: How New Bitcoin Is Minted

Bitcoin miners play a vital role in the currency’s ecosystem. As keepers of the blockchain, they keep the entire Bitcoin community honest and indirectly support the coin’s value.

Miners are individuals or cooperative organizations with access to powerful computers, often stored at remote, privately owned “farms.” They perform incredibly complex mathematical tasks in an effort to mint new Bitcoin, which they then keep or exchange for fiat currency.

In an elegant twist, Bitcoin’s source code harnesses this computing power to collect, record, and organize previously unverified transactions, adding a new block to the blockchain about every 10 minutes. This work also verifies the accuracy and completeness of all previously existing blocks, preventing double-spending and ensuring that the Bitcoin system remains accurate and complete.

Each time a new block is created, a predetermined number of fresh Bitcoin are minted. Miners are “rewarded” these Bitcoin for their effort and often also receive transaction fees paid by buyers.

As Bitcoin grows more valuable — albeit amid gut-wrenching market volatility — and more commonly accepted, so too does the business of mining Bitcoin. But the required processing power comes at a notable cost: the consumption of vast amounts of electricity, often powered by non-renewable sources.

According to the Bitcoin Energy Consumption Index, Bitcoin mining consumed approximately 51 trillion terawatts of electricity per year as of February 2018. That figure has risen steadily and inexorably over time, irrespective of day-to-day market movements, prompting policymakers to take a closer look at Bitcoin’s carbon footprint.

Bitcoin’s Inherently Finite Supply

Bitcoin’s own source code places a strict limit on the number of Bitcoin units that can ever exist: 21 million. This is achieved by slowing, over time, the rate at which the creation of new blockchain copies produces new Bitcoin. Every four years or so, this rate halves.

The last Bitcoin is projected to spring into being sometime around 2140 — that is, if the currency still exists and people still care enough to mine it. After that, miners’ sole compensation will be Bitcoin transaction fees.

This enforced scarcity is a key point of distinction between Bitcoin and traditional fiat currencies, which central banks produce by decree, and supply of which is theoretically unlimited. In this regard, Bitcoin has more in common with gold than the U.S. dollar.


Bitcoin Security Issues & Risk of Theft

Taken together, the security risks around Bitcoin are the currency’s single greatest drawback, and are worthy of special consideration for anyone considering converting U.S. dollars into Bitcoin.

The fact that Bitcoin units are virtually impossible to duplicate does not mean that Bitcoin users are immune to theft or fraud. The Bitcoin system has some imperfections and weak points that can be exploited by sophisticated hackers looking to steal Bitcoin for their own use. The Mt. Gox incident, in which hackers stole $460 million worth of Bitcoin from the popular exchange, as well as a host of smaller, less publicized incidents, underscore that Bitcoin exchanges are particularly vulnerable to theft by hacking.

Two of Bitcoin’s perceived strengths — its independence from any central authority and strong anonymity protections — actually make it more attractive to thieves and fraudsters.

In many jurisdictions, Bitcoin occupies a legal gray area, meaning local law enforcement authorities view theft prevention as a relatively low priority. Moreover, it’s often difficult for the authorities to prosecute those responsible for Bitcoin heists, many of which originate in politically unstable or unfriendly nations and affect a global population of Bitcoin holders.

Those who use Bitcoin for illicit purposes face additional risks. Dark web marketplaces — online, international black markets whose users buy and sell illicit substances, stolen goods, and prohibited services — are frequent heist targets. Bitcoin users who participate in the dark web are likely already breaking the law, and thus have limited recourse in the event of a hack or theft. After all, they can’t very well contact local authorities and say that the funds they received for selling illegal drugs were stolen.

Common Modes of Bitcoin Theft

It usually takes more technical skill to steal Bitcoin than physical cash. Most Bitcoin heists involve sophisticated hack attacks by highly accomplished outsiders or rogue exchange employees.

Common modes of Bitcoin theft include the following:

  • Stealing Private Keys. Private keys stored in publicly accessible digital repositories, such as Bitcoin exchanges or personal cloud storage drives, are vulnerable to theft by hacking. The thieves use these private keys to access and transfer the corresponding Bitcoin holdings, relieving their rightful owners of their funds.
  • Exploiting Wallet Vulnerabilities. Some Bitcoin wallets have security flaws that render them vulnerable to attack. As a convenience, some service providers store private keys in the same virtual wallets as Bitcoin funds themselves, allowing hackers to steal the funds and keys in one fell swoop.
  • Operating Fraudulent Exchanges and Investment Funds. Some seemingly legitimate companies dealing in Bitcoin are actually fronts for financial crimes. For instance, a boutique “Bitcoin investment fund” called Bitcoin Savings & Trust made a name for itself in the early 2010s by providing outsize returns to early investors. However, Bitcoin Savings & Trust was actually a run-of-the-mill Ponzi scheme. When it went belly-up, it wiped out about $4.5 million in investor value.
  • Attacking Legitimate Exchanges Directly. Because they attract thousands of users and store millions of dollars in Bitcoin, exchanges are attractive targets. Bitcoin can be stolen from exchanges’ own Bitcoin wallets (which they use to store Bitcoin units taken as exchange fees), from users’ wallets (many users store Bitcoin balances with exchanges for convenience, similar to a brokerage account’s cash balance), or during exchanges and transactions themselves.
  • Attacking Dark Web Marketplaces. The vulnerabilities of dark web marketplaces are similar to those of Bitcoin exchanges. Another huge Bitcoin heist, not as well publicized as the Mt. Gox hack, affected a dark web marketplace called Sheep Marketplace. Losses approached $100 million at then-current exchange rates.

Strategies for Reducing Security Risks

The cybersecurity industry is locked in a constant arms race with hackers and other cybercriminals, whose sophistication and operational scope increase by the week. In this environment, there’s no such thing as a complete guarantee of security — particularly when money is involved.

However, prudent Bitcoin users employ these common-sense strategies to reduce their exposure to theft and general security breaches:

  • Securing Private Keys. Savvy Bitcoin users store copies of their private keys offline, either in physical storage media or even on paper printouts, rather than in online locations that can easily be accessed by hackers. Because you have to provide your private key during a Bitcoin transaction, storing your key offline isn’t completely foolproof — but it’s preferable to leaving it in a static online location all the time.
  • Using Highly Secure Bitcoin Wallets. Even if you’re not an advanced computer programmer capable of evaluating wallet code or technical security protocols directly, do your best to research a particular wallet service’s track record. Speak with current users or read online reviews, if possible. Think twice about using services that have been hacked in the past and have yet to publicly state that they’ve made security enhancements.
  • Researching Bitcoin Exchanges and Other Services. To avoid getting caught up in a Ponzi scheme or simply being robbed blind by a seemingly legitimate Bitcoin exchange, do your own due diligence before transferring or storing Bitcoin units with a new platform. Treat any promises that sound too good to be true, such as rapid or outsize returns on your funds, as red flags — and avoid working with platforms that make them.
  • Avoiding the Dark Web. Like real-world black markets, the dark web is an unsavory and sometimes dangerous place. Avoiding marketplaces like the now-defunct Silk Road and its successors is an easy way to avoid needless exposure to security risks. Additionally, avoid using Bitcoin for “gray market” activity that, while possibly legal in your jurisdiction, might be illegal or frowned upon in others, such as sports betting. It may be impossible to recover your funds after a heist that targets a gray market platform found to be operating illegally, even if you’re not criminally liable.

Final Word

The list of merchants that accept Bitcoin is steadily lengthening. You can now buy plane tickets (Expedia), furniture (Overstock.com), web publishing services (WordPress), and cars (Tesla) with Bitcoin.

However, before you rush out and cash in your dollars for Bitcoin, remember that Bitcoin has a long way to go before it’s a legitimate currency on par with the U.S. dollar, euro, or pound. And despite the seductiveness of cryptocurrency as a means of exchange, there’s no guarantee that Bitcoin — or any other decentralized, virtual currency not controlled or backed by a national bank — will ever be a viable alternative to fiat currencies.

Some experts believe that, in the coming decades, national governments will rework their currencies with state-sanctioned means of exchange that have some cryptocurrency features, like built-in scarcity and virtually impenetrable counterfeiting protections. Others believe that fiat currency and cryptocurrency will continue to exist in parallel, but that cryptocurrencies will fail to expand beyond the niche currently occupied by gold and other precious metals — that of an alternative investment whose primary purpose is to hedge against inflation.

For the time being, treat Bitcoin as you would any speculative asset: Move cautiously, or not at all, and never invest money that you can’t afford to lose.

Brian Martucci
Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.

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