What is bitcoin and how does it work?

Bitcoin (BTC) was first mentioned on a niche cryptography mailing list in 2008 but over the last ten years has grown to be a household name – albeit one that remains poorly understood by most. Find out more about the cryptocurrency with our in-depth guide to what it is and how it works – including explanations of how it’s priced, how it’s used, mining and forks.

What is bitcoin?

Bitcoin is a cryptographically secured digital currency that operates outside of the mandate of a central authority. It was launched in 2009 by the pseudonymous Satoshi Nakamoto, and originally conceived as a method of payment that wouldn’t be subject to government oversight, transaction fees or transfer delay – unlike traditional ‘fiat’ currency.

Bitcoin has proven to be a particularly volatile asset with frequent swings. Its price rose in spurts between 2010 and 2017 from around 0.003 cents to nearly $20,000, before falling dramatically in 2018 to hit lows under $6000 (as of 21 August 2018). In that time, hundreds more cryptocurrencies have emerged, all with unique features and applications. Few of these have any significant value, but bitcoin does have its rivals in the form of ether and bitcoin cash, and – to a lesser extent – litecoin, ripple, stellar, EOS, and NEO.

Bitcoin was initially devised as a method of payment, and in certain cases functions as exactly that. But it both lacks widespread adoption and is currently far too volatile to provide a real alternative to fiat currency: vendors need to revise their prices constantly in response to its swings in value. It therefore has little in common with traditional currencies.

As a result, bitcoin and other cryptocurrencies should really be thought of as a separate asset class – one that is primarily used for speculative trading and is somewhat immune to the factors that affect traditional assets’ prices.

Learn more about what moves bitcoin's price

How does bitcoin work?

Bitcoin needs two underlying mechanisms to function: the blockchain and the mining process.

The blockchain is a shared digital ledger composed of all the bitcoin transactions that have taken place up to that point. These transactions are grouped together in ‘blocks’, which are cryptographically secured during mining and linked to one another.

The blockchain is accessible to everyone at any given time, and can only be altered with the will and computing power of the majority of the network. This means it is almost impossible to be retroactively amended, won’t fall victim to human error and lacks a single point of failure.

Read more about blockchain technology

What is mining?

Mining is the process required to secure each of these blocks and, in doing so, releases new units of the cryptocurrency. These units are known as the ‘block reward’. In bitcoin’s case, the block reward is currently 12.5 bitcoins, though this halves every four years or so.

The miner’s role is to carry out this process by solving complex algorithms – an ongoing task which can be made easier or more difficult. By altering the complexity of the algorithms, miners can ensure they keep the processing time of blocks roughly constant. Because of their crucial role in the network, miners exert significant control over bitcoin, especially as mining has now become big business.

Once these tokens are in circulation, they can be freely exchanged via an exchange, and stored in a digital wallet. When you trade bitcoin with IG, you never actually own the underlying asset, so you won’t need a wallet or an exchange account.

What is a bitcoin fork?

A fork occurs when one blockchain splits into two, creating two separate records of data. It is up to the network of bitcoin miners to agree which one of these to continue using, and which should be discarded.

Forks are the result of a misalignment of the community’s mining programs, and enable the blockchain to undergo essential software updates. The two main types are soft forks and hard forks.

  • Soft forks: the upgraded blockchain is now responsible for validating all transactions (blocks), but the existing blockchain will still recognise and record these transactions. Keep in mind that this only works one way: the upgraded blockchain will not recognise any blocks mined via programs using the existing blockchain.
  • Hard forks: the upgraded blockchain is now responsible for validating all transactions, but the existing blockchain no longer recognises these blocks as valid, nor records them. This means all users of outdated programs must update to access the upgraded blockchain.

Generally, forking is resolved with little to no disruption. But differences of opinion in how a cryptocurrency should scale or function have proven insurmountable in the past. The most high-profile example of this is bitcoin cash, which came about when bitcoin hard forked and divided bitcoin miners along with it. This ultimately resulted in two distinct cryptocurrencies, bitcoin and bitcoin cash, albeit ones with the same transactional history up until July 2017.

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Frequently asked questions about bitcoin

Is bitcoin regulated?

No, bitcoin is currently mostly unregulated by both governments and central banks. One of the key concerns about the future of bitcoin is how the regulatory landscape will change over the next few years.

US regulators have taken the lead in regulating bitcoin and bitcoin exchanges, although many disagreements still exist. For example, the US Treasury classifies bitcoin as a virtual currency, the CFTC classifies bitcoin as a commodity and IRS considers bitcoin property for tax purposes.

Is bitcoin legal everywhere?

Bitcoin is illegal in several countries, including Algeria, Egypt, Morocco and the United Arab Emirates. There are also steps being made in others – such as in China, where bitcoin exchanges and initial coin offerings (ICOs) have been banned – to curb interest in and use of the cryptocurrency. However, such bans are very difficult to enforce as bitcoin is designed to exist outside of centralised control.

Is bitcoin taxed?

It depends on your location, but in the UK, yes – any profits made when bitcoin moves from one party to another are subject to capital gains tax.

Spread betting on bitcoin is tax free, however, as you won’t have to pay any capital gains tax or stamp duty on your profits.*

Is bitcoin risky?

Trading on any market comes with risk, but bitcoin has a few key pitfalls to bear in mind:

  1. It is volatile: sharp and sudden moves in price could see bitcoin lose hundreds, if not thousands, of dollars’ worth of value in next to no time
  2. It is niche: while bitcoin’s popularity may have skyrocketed recently, most businesses and consumers are still some way from adopting it in earnest
  3. Transfers aren’t foolproof: there’s no perfect way to prevent human error or technical glitches – and there’s no system in place to reimburse you for losses
  4. The future is uncertain: cryptocurrencies will be under a microscope from governments and central banks over the next few years, and new regulations could erode the benefits that set it apart from fiat currency

How many bitcoins have been lost?

There’s no way of knowing for sure how many bitcoins have been lost, but it’s estimated that – of the 16-plus million bitcoins to have been mined so far – as many as 25% have been lost for good. This is because there is no way to recover those that have been lost through carelessness, death, issues with hardware or the multiple other reasons for their disappearance.

Bitcoin trading

You don’t need to own cryptocurrencies to trade
on them.

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*Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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