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February 11, 2022

How Does Bitcoin Work?

 While bitcoin has made headline after headline over the last decade, its underlying concepts and function are simpler than you might think. Let’s take a look at the basics of how bitcoin works.

The basics of Bitcoin

Bitcoin at its core is a software protocol, based on the blockchain, that has a value based on what others are willing to pay for it - or simply, based on the concept of supply and demand. When it first came out a bitcoin was worth $0.0008, but as more people bought into the idea, the price has now climbed to over 65,000 USD. 

Bitcoin is a digital currency, based on a decentralized system that records each transaction on a ledger, known as a blockchain. This essentially means that the Bitcoin network isn’t run from some guys basement on the other side of the world, rather it’s run on thousands of computers across the world simultaneously, without one centralized controller. 

While many people just buy bitcoin, the digital tokens themselves are actually created by Bitcoin miners, which use high-powered computer rigs to solve complex math problems, confirming transactions on the decentralized blockchain. After a block of transactions is confirmed, the miners are rewarded with a small amount of bitcoins. Bitcoin mining is ultimately how Bitcoin works. Miners lend their computing power to the blockchain and get rewarded with the digital currency.  On 3 January 2009, Satoshi Nakamoto mined the first block, called the genesis block, and was rewarded 50 bitcoins. This brought Bitcoin into existence.

How the Blockchain Works

But let’s learn a little bit more about blockchain. Blockchain isn’t Bitcoin as much as Bitcoin isn’t the blockchain. Blockchain is actually a software protocol that can be used in less exciting applications, like manufacturing, software compliance, banking, and many other software applications. 

The first blockchain was described by Satoshi Nakamoto in 2008, the creator of Bitcoin. Initially, the two terms were always used together, but blockchain diverged into an even bigger software and technology phenomenon.

Blockchains are simple in theory. It’s a digital chain of blocks, each block being a group of information. The blocks are arranged in order, chronologically, and cannot be unordered. It’s like a timeline of digital events that are independently verified and securely held through a decentralized network. You could agree to pay a friend $20 through a blockchain and that agreement would forever be on the blockchain, ensuring you pay.

It’s this secure software protocol that stands as the basis for Bitcoin. By having a secure transaction network in the blockchain, Bitcoin tokens can be transferred from person to person, securely tracked through blocks of information, all decentralized and anonymous.

Because blockchains are distributed ledgers, the entire bitcoin blockchain is public. By making such a complex amount of information public, it can be ensured that no changes are made to it over time. No central authority oversees bitcoin transactions, rather the miners work together to validate them

Bitcoin users will have a wallet address, like a string of letters and numbers: 24N3yGu3UFHeyUNdzER5sS3aRTRzu5Ae7EZ

This address serves as a unique identifier on the blockchain. Anytime bitcoin is sent or received to or from this address, it’s logged in the chain.

What gives Bitcoin value?

But what makes Blockchain worth anything? Well… nothing, other than what people are willing to pay for it. Well, that and there can never be more than 21 million bitcoin in existence. The only way bitcoin is made is through mining, or as rewards to miners for validating transactions. The amount of bitcoin a miner gets for processing a block slowly decreases over time in a process called halving. The reward for mining is cut in half for every 210,000 blocks mined. This process will continue until 2140, when all of the bitcoins are mined. After this, miners will get paid fees to continue processing transactions on the blockchains. This also means that mining can get less profitable - unless the price per bitcoin goes up. 

The limited supply of Bitcoin also means there’s a supply and demand issue. If more people wanted to buy bitcoins, due to there being a limited supply, the price would need to go up. That’s why we’ve seen such a meteoric rise in Bitcoin’s price. If the lowest owner of bitcoin doesn’t want to sell for anything less than 50K, then Bitcoin is valued at 50K. This is a little oversimplified, but essentially, bitcoin is worth what people are willing to pay for it. It doesn’t have any intrinsic value.

All of this serves as a very basic overview to bitcoins and blockchain though. We haven’t really gone into hashed data, different risks to bitcoin’s network like a 51% attack, or event the cryptography that goes into making the blockchain and blockchain wallets secure. However, to the casual or beginning Bitcoin owner or buyer, that info can overwhelm and confuse and warrants its own research.

Understand your bitcoin

In summary, Bitcoin is a digital token, validated by a secure decentralized software network that runs off of computers all around the world called miners. These miners ensure people can buy and sell bitcoin, and for their trouble, the miners get rewarded with a small amount of bitcoin. There can only ever be 21 million bitcoin in existence, and due to a limited supply, as more people want to buy bitcoin, the price goes up and up until more people are willing to sell it at a given price - supply and demand. 

No one really knows what’s going to happen to bitcoin or its price, but one thing is for sure, fortunes have been made and lost on the cryptocurrency, but it’s likely here to stay. 

If you have bought bitcoin, or any cryptocurrency, you’re going to need to file income tax on your earnings or risk being audited by the IRS. One of the simplest ways to do that s by using Ledgible. Our tax software allows you to quickly create tax documents for your cryptocurrency activity for the tax year, analyze your gains and portfolio value throughout the year, and be able to maximize your tax savings at year-end by making smart, informed moves. You can learn more about Ledgible and use it to file your taxes by clicking here

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