How Bitcoin Works For Beginners, Explained in Plain English, but Not at the Expense of Accuracy:
Everything the Average Person Needs to Know About Bitcoin… and a Few Extra Details
Bitcoins can be sent between public Bitcoin addresses using a unique password that relates to each address called a “private key.” Public addresses (or public keys) and private keys are generally stored in digital Bitcoin wallets. Wallets are software designed to store addresses and keys and to facilitate sending Bitcoin to other addresses.
That is a bit to take in, but it essentially is the gist of how Bitcoin works. Wallets contain addresses which relate back to transactions, private keys are used to send transactions from one address to another using wallet software, and that is all recorded on a digital public ledger that keeps track of which addresses have which amounts of Bitcoin.
In other words, the transaction data encrypted on the digital ledger (blockchain) is “what Bitcoin is,” and the encrypted passwords that let you access amounts of Bitcoin associated with a specific address on the ledger is “having Bitcoin.”
The ledger says X address owns Y Bitcoins, thus if you have the password (private key) to X address, you can send those Y Bitcoins (or any fraction of those Y Bitcoins) to any other address by paying a transaction fee in Bitcoin.
Its a bit like how your bank keeps a ledger of transactions and balances and you can use an online banking platform to access your accounts, and thus access your funds (which are represented digitally as numbers in your bank account). Anyone who knows your account number can send you funds, but only you can move funds around or send them to other accounts using your PIN / Password / Signature.
Meanwhile, the value of Bitcoin is determined by the price a Bitcoin trades for on online cryptocurrency exchanges (which are like stock exchanges, but for cryptocurrencies). Thus, Bitcoin’s value is determined much the same way any other commodity or currency is, via exchange on the market (but influenced by factors like supply and demand).
KEEPING IT SIMPLE: A Bitcoin user doesn’t need to understand Bitcoin to invest in it (and only really needs to understand sending and receiving Bitcoin to use it). The reality is, you can use a broker/storage service like Coinbase to buy, sell, and store Bitcoin with almost zero knowledge of how Bitcoin works. To get started, all you need to do is sign up for Coinbase, add your bank account or credit card info, and click the buy and sell buttons. We cover other methods for buying, selling, storing, and using Bitcoin here.
A Summary of How Bitcoin Works
The following points will help give a basic overview of how Bitcoin works, going over the basics again in more detail will hopefully help the concept solidify in your mind:
- Bitcoin is software. Almost every aspect of the software is based on encryption AKA cryptography.
- Bitcoin is a store of value and medium of exchange like gold or the dollar. You can’t pay taxes with it, it’s not legal tender, but otherwise you can use it as either currency or investment.
- The key components of Bitcoin are 1. a digital ledger of transactions called a blockchain, 2. digital tokens which represent entries on the ledger (each transaction is a “token” in that it is represented by a unique string of data that relates to other data, for example a public address), and 3. digital wallets which are software that contain public addresses that relate back to transactions on the ledger, private keys that allow you to access the balance of an address, and facilitate sending Bitcoin to other addresses.
- Bitcoins can be sent to any public address from any public address with a non-zero balance using passwords called “private keys.” Each public address has a matching private key that let’s the balance of that address (where the balance is the sum of all transactions done by that address).
- Sending a transaction requires paying a fee in Bitcoin, so you must have enough Bitcoin left over to pay the fee when making a transaction.
- Bitcoins aren’t physical objects any more than bank credit is a physical object. Instead, both bank credit and Bitcoins are simply digital representations of balances on a ledger associated with account numbers and based on past transactions.
- Like with banking accounts, only people who own the accounts can send from them, but anyone who knows the account number can send to them.
In summary, Bitcoin is essentially just a software digital ledger, hosted on computers across the globe, where numbers that represent Bitcoins are moved around using passwords, and everything is secured by and based on encryption. People refer to Bitcoins has “coins” or “tokens” but really “having Bitcoin” really just means having the ownership of passwords (public and private keys) which represent the right to move numbers around on the ledger.
When you enter an email address into a website to join a mailing list, you’re often asked to check your email and click on a link.
The link looks something like this: //www.website.com/confirm_email?token=4bdebebc-135b-4748-b7ab-25b31a285df8
In this case, the ‘token’ is this string of characters which was sent to you. It’s a unique string of characters, which, when you click on it, tells the server that “yep, the guy definitely got the email, so the email account is definitely his.”.
Cryptocurrency tokens don’t exist as a string like we saw above (if they did, they would be easy to copy), but rather they exist conceptually as entries on a ledger (a blockchain). You own these ‘tokens’ because you have a key that lets you create a new entry on the ledger, re-assigning the ownership to someone else. You don’t store tokens on your computer, you store the keys that let you reassign the quantity. I prefer to think of these ‘tokens’ as specific amounts of digital resources which you control, and you can reassign control to someone else.
Email and Online Banking as Metaphors
Another way to think about how Bitcoin works is by comparing it to online banking and email.
As email: A public address is like an email address (people can send to it). A private key is like an email password (it allows you to send). A wallet is like a mail platform where you can manage all your email addresses and emails at once. The Ledger is like your email server, were you don’t really need to know how it works, but it hosts the emails. Meanwhile, its all software and not a physical object despite us saying things like “you’ve got mail.”
As an online bank account: A public address is like an account number (people can send to it). A private key is like your PIN / online banking password (it allows you to send). A wallet is like your online banking platform where you can manage your different accounts. A bitcoin is like the dollars you can send and receive via your accounts. Your balance is the sum of all dollars sent and received from a given account. Blockchain is like your bank’s ledger (where withdrawals and deposits are tallied to arrive at a balance).
The Other Aspects of Bitcoin
Above we covered the basics of Bitcoin from a user’s perspective, however to fully get the picture we need to cover a few details.
Blockchain: The Key to Bitcoin
Remember how we said all Bitcoin transactions are recorded on a digital public ledger called a blockchain? Well, that blockchain is the main thing going on with Bitcoin. So, let’s take a closer look at what that means.
Notice how there is one or more addresses sending to one or more address? Those are the transactions that will be verified and added to the public ledger in sequential “blocks” by “miners” (miners are people running software to crack cryptographic puzzles that let them play digital accountant for a chance at getting freshly minted Bitcoin are a reward).
All confirmed transactions represent all ownership of all Bitcoins in circulation and provide an accountant of very transaction ever made using Bitcoin!
In other words, the Bitcoin blockchain is a digital public ledger of transactions between Bitcoin wallets, and if you have a Bitcoin address that relates back to one of those transactions, then you have Bitcoin.
FACT: The sequential blocks of transactions added by miners across the world is what secures Bitcoin and creates new Bitcoins. The software controls the algorithm, but otherwise miners are the ones playing banker!
Private Keys / Public Keys
If you use a third party product like Coinbase, you don’t need to know about private keys (as entities like Coinbase handle that part of the deal for you).
However, if you use a wallet where you control your “private keys” (the passwords to the addresses in your wallets), then you also need to understand how private keys work.
Whoever has the password (private key) to a Bitcoin address, essentially has the rights to the balances associated with that wallet.
This private key allows people to send Bitcoin (so its like having the keys to a safe or password to a bank account). As you can imagine, private keys should never be shared with anyone.
Meanwhile, public addresses allow people to receive Bitcoin. Like an email address, this can generally be shared with anyone.
All platforms that store cryptocurrency contain public addresses, third party platform generally don’t require using private keys (as third parties are custodians of your Bitcoin and your Bitcoin addresses).
What Does it Mean to Have Bitcoin?
“Having Bitcoin” means having a digital wallet that contains one or more “public addresses” with non-zero balances (and importantly, having the private keys to access those balances).
Each address relates back to one or more transactions recorded on the ledger (the “blockchain”).
The balance of a public address is the sum of all transactions sent to a from that address as recorded on the ledger (ex. 1 Bitcoin sent, 3 Bitcoin received, balance is 2 Bitcoin).
The balance of a wallet is the sum of all balances on all public addresses contained in that wallet.
A person’s total Bitcoin owned is the sum of all Bitcoin stored in all public addresses in all Bitcoin wallets they own (there is nothing stopping you from having many Bitcoin wallets, each with many addresses).
TIP: Sending Bitcoin between addresses involves paying a fee. This is true even if you send between your own addresses. It makes very little sense to send small transactions between addresses, thus most people will need only one Bitcoin address and one Bitcoin wallet (unless they use multiple platforms). Some third party platforms where you don’t control your private keys get around this rule for coins that shifted around internally.
How Do I Access My Bitcoins?
If you have a wallet where you are in control of your “private keys,” then you need to use your private key to “send” bitcoin from your public address to another public address.
Private keys provide a signature, kind of like a pin number at an ATM or signing a check.
In this respect, and as noted above, this is all like online banking. There is an account number money can be sent to, the password is like a PIN number to access the funds, and the blockchain is like the bank’s ledger.
Here are a few extra details to help you move one step past absolute Bitcoin beginner:
- Many transactions are recorded together in a block of transactions on the block chain. Transaction blocks are added to the chain sequentially. This is why its called “blockchain.”
- Everything noted on this page (almost without exception) is secured with cryptography (it is “encrypted”). The public address is actually an encrypted version of the actual address. The private key is a cryptographic code that relates back to the encrypted version of the public address that relates back to the public address people see. The blockchain is a somewhat complex cryptographic system that uses “consensus” (derived from more than one entity trying to add transactions to the block chain at once) and “hashes” (like little cryptographic puzzles). Mining is essentially the solving of cryptographic puzzles contained in public and private keys. Etc. Actually explaining the details of all this would not be beginner level.
- Mining is the process of using software to add transactions to the ledger (new coins are created as a reward for miners). With so many miners distributed across the world trying to add the same data to the blockchain, it helps prevent against fraud and ensures accuracy through “consensus.”
- Bitcoins aren’t physical objects, they are cryptographic tokens that relate back to transactions between addresses stored on the blockchain. It’s not too different from digital numbers in a digital bank account where the only thing really happening is the bank is keeping a ledger of the ownership of dollars based on transactions between accounts.
- Private keys are used to provide a unique signature every time a transaction is made. For a transaction to send from a wallet, the signature needs to match the address.
FACT: A Satoshi is the smallest fraction of a Bitcoin that can currently be sent: 0.00000001 BTC. When buying, investing, or trading Bitcoin, you can send or receive as little as one satoshi (although, with fees this would be nonsensical). Satoshis are sometimes called Sats for short.
- How does Bitcoin work? Bitcoin.Org
- What’s the difference between a wallet and an address? StackExchange.com.
- Bitcoin Basics. NYTimes.com
"Bitcoin Basics and Beyond" contains information about the following Cryptocurrencies: