Ask CryptoVantage: What Do I Get When I Buy Bitcoin?

What is Bitcoin?

Bitcoin is a self-contained digital currency that uses cryptography to verify and secure its transactions as well as control the creation and distribution of new units. It operates as a worldwide peer-to-peer transaction system without a central authority or middleman such as a government, bank, or financial institution.

Therefore, without a centralized entity controlling its distribution and security, the network itself has a built-in security and distribution mechanism using blockchain technology.

At its core, each bitcoin is simply an entry in a distributed ledger that is blockchain technology. These entries are a list of transactions that have occurred since the beginning of bitcoin.

For example, when you purchase bitcoins from an exchange, the blockchain’s ledger is updated to show that the exchange’s wallet is debited and your wallet is credited with new bitcoins.

How Bitcoin Transactions Work

A transaction on the blockchain is simply a transfer of value between Bitcoin wallets. The blockchain acts as a notary service that informs other members of the update in the ledger.

To ensure that the transaction is valid, miners use a series of specialized algorithms called hashing functions.

Miners run transactions through a hash function which produces a shorter 32-bit alphanumeric string, referred to as a hash value or address. This process cannot be reversed and each block’s information can only be accessed using its respective hash value. The irreversibility or immutability of publishing a block of transactional information gives bitcoins its security.

It’s important to note that Bitcoin doesn’t really “move” in the traditional sense. It remains on the blockchain for everyone to see. The only difference is that you now own the private key, which is your claim on that particular Bitcoin.

Each Bitcoin wallet uses an encrypted private key to act as a digital signature that only allows the owner of the private key to access the wallet.

How Bitcoin Wallets Work

To understand how Bitcoin wallets work, think of each wallet as a safe where the private key is the lock.

Any Bitcoin sent to your wallet is in effect deposited into your safe. When you want to spend bitcoins, you open the safe using the key and take out what you need. The transaction functionality tracks who owns how much Bitcoin by storing information in each member’s safe which makes up the public blockchain. However, when you need to receive Bitcoin to your wallet, the only way the sender will know that they are sending it to your wallet and not another person’s wallet is through your public key.

You can give your public key or public address to anyone looking to send you some bitcoin but your private key or address is your secret as it allows you to have access to your wallet.

What Are Private And Public Keys?

A private key essentially functions as the password to your safe. Just like you would not give out your bank account’s password to just anyone, you should never share your private keys with others.

Both the private and public keys are created using a sophisticated cryptographic algorithm that is difficult to decode. Therefore, each private key must match its public key (wallet address). As long as you own the public and private keys to your bitcoin wallet, you are guaranteed absolute control over the bitcoin contents in that wallet, plus you can send and receive bitcoin and act as your bank. However, if you lose the private key to your wallet, you will also permanently lose the bitcoin contents of that wallet address.

Private Key Ownership And Non-ownership

Now that you understand the basics of how bitcoin wallets work, let’s explore how owning private keys works.

When you purchase Bitcoin from an exchange, the exchange acts as a custodian to your corresponding private key. This gives the exchange absolute control over the bitcoin you just bought. While your account on the exchange might show your bitcoin balance, you don’t own them as the exchange owns the private key to the wallet address they are stored on.

The exchange might prohibit you from sending your bitcoin to a third-party wallet as is the case with Robo-advisor platforms such as Robinhood. However, for those who do not want to risk losing their private keys, custodial platforms and crypto exchanges are a decent alternative.

For non-custodial ownership, you will need to download a bitcoin wallet that gives you absolute control over your private key. You can choose to create an offline paper wallet or store the private key on an encrypted device such as Trezor. Once the wallet is downloaded, you will need to back up your seed recovery phrase and make sure it has all of your funds saved before sending them somewhere else.

Bitcoins And Robo-Advisor Platforms

Although some Robo-advisors invest bitcoins on your behalf, such as SoFi or Robinhood, most of these platforms only give you fractional ownership of bitcoin through contracts for difference (CFDs).

Much like how a normal brokerage account allows you to buy fractional shares of a stock without actually owning those stocks, these platforms allow you to invest in bitcoin through their platform using cash or debit cards but you don’t get to own your bitcoin’s private keys. It’s more of an IOU for Bitcoin.

Conclusion: Decide What Kind of Ownership You Want

It’s important to know which type of ownership you’re getting before investing your own money into the purchase of Bitcoin. While non-custodial wallets offer real ownership, it also features significant levels of risks especially when there is no secure storage of private keys.

Custodial wallets, which are available through exchanges, allow you to retain your assets without the risk of losing them if you don’t remember your password. The downside is you don’t get full control over your coins and if anything happens to the exchange than your coins are at risk.