What Is Bitcoin, And How Does It Work?

Bitcoin, ethereum, monero — no, these aren’t far-off planets in a sci-fi film. They’re the names of cryptocurrencies you’ve likely seen mentioned in the financial news, or maybe because your Uncle Ted keeps pushing them as the “next hottest thing.”

Even though they’ve sparked the interest of investors around the world, they’re still a head-scratching topic to most of us. That’s because, while you can use them to buy and sell things, they don’t exist in physical form and you can’t keep them in the bank like you can with the dollars in your wallet.

Confused yet? We’ll break it down for you.

WHAT IS BITCOIN AND WHY IS IT ALL OVER THE NEWS?

Bitcoin is a type of cryptocurrency, which is simply digital money that uses advanced encryption technology to complete transactions. But unlike other forms of currency, there’s no physical version of it (that is, you won’t actually get a coin if you buy bitcoin) and it isn’t backed by any particular government or central bank. So unlike the U.S. dollar or euro, it doesn’t “belong” to any particular country or region, nor is it tied to something physical, like silver or gold (a long time ago, money was tied to gold and/or silver).

Rather, its value comes from its trading activity on exchanges, much the way other types of investments are bought and sold on an exchange. And the reason why cryptocurrencies have been dominating the financial headlines lately is because of how quickly their values have soared — and crashed. For instance, bitcoin reached a record high of nearly $20,000 in mid-December (that means one bitcoin cost almost $20,000 U.S. dollars to buy), only to drop to below $10,000 in mid-January. Volatile, much?

HOW WERE CRYPTOCURRENCIES INVENTED?

The beginnings of cryptocurrency are still a bit of a mystery. Bitcoin, the first cryptocurrency, was created in 2008 by Satoshi Nakamoto, believed to be a pseudonym for an unknown person or group of people who wanted to create a peer-to-peer electronic cash system. Initially, bitcoin was a favorite among black-market websites because it offered a level of anonymity that traditional payment systems couldn’t.

However, it began to move into the mainstream as some legitimate businesses started to accept bitcoin as payment, and as other developers began to create their own cryptocurrencies — there are now more than 1,000 different types. Kodak even recently announced that it was creating a digital currency specifically for photographers, and several countries are trying to develop their own government-backed cryptocurrencies.

Although cryptocurrencies can operate differently, most are powered by the same underlying technology as bitcoin, known as blockchain.

If you ever lose the passcodes you need to verify your transactions — or even the hard drive you use to store all that digital cash — you’re probably out of luck.

WHAT IS BLOCKCHAIN?

Blockchain is basically a digital ledger that doesn’t require a central authority to do its record keeping. With traditional money, your local bank keeps track of what’s going in and coming out of your account, while the Federal Reserve acts as the governing body for all of the U.S. money in circulation. With blockchain, you don’t need either of those institutions.

Rather, the vast network of people who own a particular cryptocurrency share the ability to confirm and track transactions. Every time a bitcoin changes hands, for instance, the transaction creates a “block” of data that gets added to the “chain” that records the digital history of that bitcoin. Any computer that has been involved in that bitcoin’s transactions will maintain a full account of its history, and any future transactions must be verified by others in the network before that bitcoin can be spent. High-level encryption means the chain can’t be broken or tampered with.

By the way, blockchain isn’t limited to cryptocurrency use. Companies have started exploring how to use the technology for other systems, too, such as supply-chain management. Because blockchain helps remove the middleman from a transaction, some in the tech industry believe it could make a lot of processes more efficient.

HOW DO PEOPLE GET CRYPTOCURRENCIES?

In order to buy cryptocurrencies, you need to open a digital wallet (using any number of available apps or actual hardware) that let you receive, store or spend your cryptocurrencies. You’ll also likely need to open an account with a cryptocurrency broker or exchange and connect your wallet to it. Well-known exchanges include Coinbase and Kraken.

Some platforms may only enable you to purchase cryptocurrencies using funds directly from your bank account; others may allow you to link a credit card or even a PayPal account. You can trade cryptocurrencies on these exchanges or convert them to traditional currencies. If you want to use your cryptocurrencies to purchase things from a vendor that accepts them, you’ll have to transfer your cryptocurrencies into your digital wallet.

Cryptocurrencies hold promise as a way to revolutionize how we buy and sell things, particularly because of the technology behind them, which makes transactions so secure and transparent. But their relative newness and lack of regulation make them extremely volatile. Plus, when we say cryptocurrencies are secure, we aren’t kidding. If you ever lose the passcodes you need to verify your transactions — or even the hard drive you use to store all that digital cash — you’re probably out of luck. (In other words, don’t expect to see a “reset my password” button on a cryptocurrency account.) That doesn’t mean cryptocurrency exchanges can’t be hacked, however — there have been several instances in which hackers have been able to steal millions through security breaches.

Whether you’re fascinated by them or consider them a fad, there’s one thing you can’t argue with: Cryptocurrencies have created a stir. And whether they stick around or are gone within a few years, they’ve already made an impact with their technology and innovation.