According to its anonymous creator, Satoshi Nakamoto, Bitcoin (BTC) is an “… entirely peer-to-peer version of electronic cash.” It emerged from the financial crisis of 2008 with the aim of creating “a peer-to-peer electronic cash system” and, through a combination of ingenuity and determination, it has succeeded far beyond what many expected in achieving this goal.

Importantly, Bitcoin’s software is open-source, meaning its source code is freely available for anyone to review, use, and modify. This promotes transparency and development, with innovation driven by the community.

Interestingly, while it continues to grow in popularity and is becoming increasingly widespread globally, the inner workings of the Bitcoin network and its approach to creating a healthy financial network remain relatively obscure. So, let’s take a closer look at the world’s most popular digital asset and how it has become the force it is today.

What Problem Does Bitcoin (BTC) Solve?

Before diving into how the network operates, it’s important to understand the issues it was designed to address.

Bitcoin did not enter the market by chance; it was created to function as the currency of the internet and to counter the increasingly flawed financial policies of governments worldwide. In fact, a fundamental message exists in the network’s genesis block, ensuring that its original purpose is recorded for all to remember.

“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” – Satoshi Nakamoto

The message references a headline in The Times, underscoring Satoshi Nakamoto’s belief that current fiscal policies would lead the world into disaster. Without a doubt, this belief fueled the development of the network, enabling it to become what it is today. Looking deeper, here are the specific problems the network was designed to solve.

Inflation

Bitcoin’s approach to solving inflation is fundamentally different from that of fiat currencies. Its decentralized nature, fixed supply, and integrated halving events help mitigate the impact of inflation by ensuring its value isn’t eroded over time due to overissuance. While Bitcoin’s volatility and relatively short history mean it’s not risk-free, its fundamentals make a compelling case for its use as an inflation hedge.

Decentralized Control: Unlike fiat currencies issued by central governments and subject to their monetary policies, Bitcoin operates on a decentralized network. This means that no single organization or government can control its issuance or influence its value through policy changes. Bitcoin’s decentralization eliminates the risk of inflation caused by policy decisions, such as printing more money, which can devalue a currency.

Fixed Supply / Store of Value: One of Bitcoin’s most important features in addressing inflation is its fixed supply. The total number of Bitcoin that can ever exist is capped at 21 million. This scarcity is encoded into Bitcoin’s protocol and cannot be altered. In contrast, fiat currencies do not have a fixed supply, and central banks can increase the money supply at will, leading to inflation.

Due to its fixed supply and global acceptance, Bitcoin is increasingly seen as a store of value and an inflation hedge. Many compare it to gold in this regard. Just as gold has historically been a safe haven during times of economic instability and inflation, Bitcoin is viewed by many as “digital gold,” providing a modern alternative for preserving wealth over time.

Halving Events: Bitcoin has a unique feature called “halving,” in which the reward for mining new blocks is halved approximately every four years. This design reduces the rate at which new Bitcoins are created and mimics the impact of natural resource scarcity, much like gold. Halving events slow the flow of new Bitcoin into circulation, making Bitcoin inherently deflationary, as opposed to fiat currencies, which can experience inflation when more money is printed.

Global Market: Bitcoin operates on a global scale, independent of the health of any individual economy. While the value of fiat currencies may fluctuate based on national economic conditions, inflation rates, and monetary policy decisions, Bitcoin’s value is determined by global supply and demand dynamics. This global presence allows Bitcoin to act as a hedge against inflation or the devaluation of local currencies.

Censorship

Similar to its approach to inflation, Bitcoin addresses censorship in various ways. Unfortunately, we live in a world where many voices are silenced if they do not align with the prevailing viewpoints. This has increased exposure to filtered content and led to the potential for manipulation by the majority.

Bitcoin’s design as a decentralized, borderless, and censorship-resistant currency provides a powerful tool to bypass traditional financial control and censorship. While not without challenges, such as potential privacy concerns and regulatory oversight, Bitcoin offers an unprecedented level of freedom in managing and transferring assets. Here are some ways Bitcoin achieves this:

Decentralization: Unlike traditional financial systems, where transactions can be censored or blocked by governments, banks, or financial institutions, Bitcoin operates on a peer-to-peer network without a central authority. This means no entity has the power to control, block, or censor transactions. As long as you have internet access, you can send and receive Bitcoin.

Borderless Transactions: Bitcoin transactions can be made across borders without interference from any government or organization. This global reach ensures that individuals in countries with strict capital controls or where certain transactions are censored can still transfer value worldwide.

Immutability: Once a Bitcoin transaction is confirmed, it is recorded on the blockchain, a distributed ledger that maintains a permanent and unchangeable history of all transactions. This immutability prevents post-transaction censorship because no one can alter or delete a transaction once it’s included in a block.

This also means the network is resistant to fraud. With the decentralized nature of the blockchain, to censor or alter a transaction, an attacker would need to control most of the network’s hashing power (computational power). Today, such a feat is unrealistic and prohibitively expensive due to Bitcoin’s proof-of-work consensus mechanism, making it nearly impossible.

Transparency and Pseudonymity: The blockchain is a public ledger, meaning anyone can view transactions. While this transparency may seem counter to privacy, it contributes to Bitcoin’s censorship-resistant nature by allowing anyone to independently verify transactions.

At the same time, Bitcoin offers a certain level of pseudonymity, as transactions do not require real-world identity. While the transaction history of a Bitcoin address is public, the identity of the address owner may remain unknown. This pseudonymity protects users from being targeted for censorship based on their identity, although it’s worth noting that advanced analysis techniques can sometimes de-anonymize transactions.

How Bitcoin (BTC) Works

So, we know that Bitcoin operates as a decentralized global network, built on sound monetary principles, allowing the transfer of value without manipulation. But how exactly does it achieve this?

Blockchain Technology

At its core, Bitcoin operates on a technology called blockchain, a decentralized ledger of all transactions on the network. This ledger consists of blocks, each containing a list of transactions.

The blockchain is maintained by a network of nodes (computers), which gives it the ability to resist centralized control or censorship.

Each transaction on the blockchain is encrypted and linked to the previous transaction, creating a secure and immutable chain. This ensures that once a transaction is recorded, it cannot be altered or deleted, providing a reliable and transparent history of all transactions.

What is BTC?

Bitcoin is based on ‘BTC’ – the native token of the network. This digital currency serves several essential functions:

1. Transaction fees: BTC is used to pay transaction fees within the network, compensating miners for processing transactions and securing the blockchain.
2. Incentive for mining: BTC rewards miners as part of the consensus mechanism, where miners compete to solve cryptographic puzzles using the Proof of Work (PoW) algorithm to earn newly minted BTC as a reward.
3. Medium of exchange: BTC allows holders to buy, sell, or trade goods and services, functioning as a decentralized digital currency independent of traditional banking systems.

Notably, BTC mining not only secures the network by validating transactions and adding them to the blockchain but also provides a mechanism for miners to earn rewards. This encourages participation and investment in the security and growth of the network, ensuring the integrity and continuous operation of the network.

Network Mining

Mining is both the process of creating new Bitcoins (BTC) and an essential component of maintaining and growing the blockchain ledger. It involves several key steps:

1. Transaction verification: Miners collect transactions from the memory pool or ‘mempool’ (all unconfirmed transactions waiting to be processed) and verify their validity. The validity of a transaction includes checking whether the digital signature is correct and whether the sender has sufficient funds to complete the transaction.
2. Forming a block: After verifying the transactions, miners group them into a block. Each block also contains the hash of the previous block, linking the blocks together into a chain—hence the name ‘blockchain’. This ensures the integrity of the blockchain’s history.
3. Solving the puzzle: To add a block to the blockchain, miners must solve a cryptographic puzzle called Proof of Work (PoW). This puzzle requires miners to find a number called a nonce, which, when combined with the block’s data and passed through a hash function, produces a hash that meets certain criteria (e.g., a specific number of leading zeros). The difficulty of this puzzle adjusts approximately every two weeks to maintain the target block time of 10 minutes.
4. The race for the nonce: Miners across the network compete to be the first to find a valid nonce. This process requires significant computational power because the solution is found through brute force trial and error.
5. Adding the block and rewards: The first miner to solve the puzzle submits the new block to the network for verification, while other miners check the nonce and the transactions in the block. If the majority agrees everything is correct, the block is added to the blockchain. The successful miner receives the block reward (newly minted BTC) and transaction fees from the transactions in the block. This reward acts as an incentive to contribute computational resources to the network.

Bitcoin Consensus Mechanism (BTC) – Proof of Work (PoW)

The consensus mechanism is the process by which the network agrees on the state of the blockchain, ensuring all participants have a consistent view of the transaction history. Bitcoin uses Proof of Work (PoW) as its consensus mechanism, providing several essential features:

1. Security: PoW secures the network by making the process of adding blocks computationally expensive, preventing malicious actors from altering the blockchain. To change the blockchain, an attacker would need to control over 50% of the network’s computational power, known as a 51% attack, which is highly impractical due to the costs and resources involved.
2. Decentralization: By allowing anyone with sufficient computational resources to participate in mining, PoW supports the decentralized nature of the Bitcoin network. This prevents any single entity from gaining control over the blockchain.

Behind the scenes, PoW uses SHA-256, which stands for Secure Hash Algorithm 256-bit. This cryptographic hash function generates a fixed 256-bit (32-byte) hash. It is part of the SHA-2 family of hash algorithms designed by the National Security Agency (NSA) and published by the National Institute of Standards and Technology (NIST) in 2001 as a U.S. Federal Information Processing Standard.

SHA-256 is widely used in various security applications and protocols, including SSL/TLS and digital signatures, as well as in blockchain technology and Bitcoin. In the context of Bitcoin, SHA-256 is used in mining and generating Bitcoin wallet addresses. The strength of the algorithm lies in its ability to generate a unique hash for every input, making it nearly impossible to predict the input from the output (pre-image resistance), find two different inputs that produce the same output (collision resistance), and ensure that any modification to the input will change the output (avalanche effect). These properties are crucial to maintaining the integrity and security of data on the Bitcoin blockchain.

Together, the mining and consensus mechanisms form the foundation of Bitcoin’s design, providing a secure, decentralized way to process transactions and agree on the state of the blockchain without the need for a trusted central authority. While alternative consensus mechanisms, such as the popular Proof of Stake (PoS), exist, each mechanism sacrifices some level of security, reliability, or decentralization to create the Bitcoin we know today.

Bitcoin Network Updates (BTC)

For newcomers, Bitcoin (BTC) today is not the same as when it was first launched. Over the years, the network has undergone several upgrades, improving functionality, security, and performance.

Segregated Witness (SegWit) – 2017
How it works: SegWit is a protocol upgrade implemented as a soft fork. It addresses several issues, including transaction flexibility and scalability. SegWit works by separating the witness data (signatures) from the transaction data. This separation allows for more transactions to fit into a single block, effectively increasing block capacity without changing its size limit.

Implementation: As a soft fork, SegWit is compatible with the existing blockchain, requiring only the majority of miners to upgrade their software to enforce the new rules. Once activated, it enables users and services to opt into using SegWit addresses and transactions.

Taproot – 2021
How it works: Taproot is a significant upgrade that enhances privacy and efficiency for Bitcoin. It introduces Schnorr signatures, replacing the previously used ECDSA signatures. This change allows more complex Bitcoin transactions to appear like standard transactions on the blockchain, improving privacy. Taproot also makes smart contracts more space-efficient and private on the Bitcoin network.

Implementation: Taproot was activated through a soft fork using a Speedy Trial activation method, requiring miners to signal their readiness within a specific window. The upgrade received broad support, bringing new capabilities for smart contracts and enhancing privacy in transactions.

How Updates are Implemented
These updates are made through soft forks, which differ significantly from hard forks.

• Soft Forks: These are backward-compatible upgrades that tighten or add new rules to the blockchain protocol. Only the majority of miners need to upgrade to enforce the new rules, while non-upgraded nodes can still participate in the network.
• Hard Forks: These are not backward-compatible and create a permanent divergence from the previous version of the blockchain. Hard forks require all nodes to upgrade to the new protocol to continue participating in the network.

Updates like SegWit and Taproot, as soft forks, allow for smoother transitions and wider adoption within the community without splitting the network.

Bitcoin (BTC) Layer 2 Solutions
For Bitcoin (BTC) to scale and function as a true currency, not just a store of value, many believe the answer lies in Layer 2 solutions. The Lightning Network is currently the leading candidate for facilitating this role.

The Lightning Network

How it works: The Lightning Network is a Layer 2 payment protocol built on top of the Bitcoin blockchain. It enables instant microtransactions at scale by allowing users to create payment channels between two parties on this additional layer. These channels can exist for any duration, and transactions within them are not broadcast to the blockchain until the channel is closed. This setup significantly reduces the load on the main Bitcoin network, enabling faster transactions with lower fees.

Implementation: The Lightning Network is built using smart contracts on the Bitcoin blockchain. Users need to lock up a certain amount of Bitcoin in a payment channel, after which they can transact almost instantly. When the channel is closed, the final state of the balance is recorded on the Bitcoin blockchain. The Lightning Network operates independently from the main blockchain, with users running Lightning nodes alongside traditional Bitcoin nodes.

The development of the Bitcoin network through updates like SegWit and Taproot, along with the growth of Layer 2 solutions like the Lightning Network, showcases the community’s commitment to improving Bitcoin’s scalability, privacy, and functionality over the years. These updates are carefully tested and deployed to ensure compatibility and security, with the goal of making Bitcoin a more flexible and efficient digital currency.

How to Buy Bitcoin (BTC)
Depending on your region, you may want to explore guides for Australia, Canada, Singapore, or the UK. The exchanges listed below are some of the best globally.

• Uphold – One of the leading exchanges for US & UK residents offering a variety of cryptocurrencies. Restricted in Germany and the Netherlands.

Uphold Disclaimer: Terms apply. Cryptocurrency assets are highly volatile. Your capital is at risk. Do not invest unless you are prepared to lose all the money you invest. This is a high-risk investment, and you should not expect protection if things go wrong.

• Coinbase – A publicly listed exchange on NASDAQ. Coinbase accepts residents from over 100 countries, including Australia, Canada, France, Germany, Netherlands, Singapore, the UK, and the US (excluding Hawaii).
• Kraken – Founded in 2011, Kraken is one of the most reliable names in the industry and offers trading access to over 190 countries, including Australia, Canada, Europe, and the US (excluding Maine, New York, and Washington state).

How to Store Bitcoin (BTC)
As the world’s largest digital asset, almost every service supports storing Bitcoin (BTC), from exchanges to non-custodial hardware and software wallets.

The phrase “Not your keys, not your coins” is often emphasized for those who prioritize security for their assets, meaning if you don’t control your private keys, you’re trusting someone else to protect your assets. This highlights the importance of choosing a hardware wallet—or at least a non-custodial software variant—to maintain control over your private keys. Additionally, it’s always crucial to set up good password habits.

For more insights on why Bitcoin cannot be replaced by one of its many potential competitors, visit our look at the network’s fundamentals and how they will enable its longevity.

Looking Ahead for Bitcoin (BTC) – Concerns and Predictions
Investing in Bitcoin comes with unique considerations that potential investors must carefully weigh.

Although the price of Bitcoin (BTC) has risen significantly throughout its existence, historically, it has also been quite volatile. This means it can experience sharp fluctuations in value due to changes in market sentiment, regulatory announcements, and broader economic factors. This volatility highlights the importance of a cautious investment approach, ideally as part of a diversified portfolio.

Legally, Bitcoin (BTC) has gained more clarity than any other digital asset. It is viewed as a commodity in the US and is now accessible through traditional investment products like ETFs. However, the landscape is still evolving, with different countries taking varying views on cryptocurrency, ranging from widespread acceptance to strict restrictions. On a broader scale, these regulations can affect the accessibility, use, and overall momentum of the Bitcoin market.

Environmental concerns also play a significant role in discussions surrounding Bitcoin, particularly regarding the energy-intensive nature of mining. Critics point to the significant carbon emissions from mining activities, although there is a growing movement within the community towards more sustainable practices and renewable energy sources. Interestingly, this has led to a shift in perspective, with many now seeing Bitcoin (BTC) as an environmental benefit due to its ability to monetize methane gas flaring and stranded energy.

Despite these challenges, the potential for price appreciation remains a strong and attractive factor for many investors. Driven by factors such as increased adoption, the limited supply capped at 21 million coins, and its growing role as a “digital gold” hedge against inflation, Bitcoin continues to attract significant interest from both institutional and retail investors.

Like any investment, a deep understanding of the risks and an awareness of the changing landscape are essential to navigating the world of Bitcoin investing.