What is Bitcoin? Many people just finding out about the digital currency are justifiably confused, as most Bitcoin news stories only provide a cursory explanation.

And many of them have made matters worse by using photos of "bitcoins," when in fact bitcoins have no physical existence. They exist only as digital code on the Internet.

Just one year ago very few people had even heard of Bitcoin, even though it was created in 2009. But last year's sudden spike in the value of Bitcoin, from less than $20 in January to (briefly) $266, caught the attention of the mainstream media.

Since then, news about people investing in Bitcoin, merchants accepting Bitcoin, and problems affecting Bitcoin has flooded financial news channels and websites.

The truth is, Bitcoin is a major development and will only grow in importance.

Here's an overview of what Bitcoin is and why it matters…

What Is Bitcoin? Something Totally New

At its most basic, Bitcoin is a digital form of money, much as e-mail is a digital form of paper mail. It's also a method of payment, which as we'll see is key to what makes Bitcoin so special.

Bitcoin is a form of money built on the foundation of the Internet itself. It uses the global network both to create the bitcoins themselves as well as to record and verify every transaction.

And the Internet is the means by which bitcoins are transferred from one person to another, which means transactions can easily cross international borders.

Bitcoin is not controlled by any person, group, company, or government. Instead, the system is managed by a software algorithm – essentially an extremely sophisticated computer program.

That's why Bitcoin has attracted so much interest. Because it is decentralized, no one can manipulate it, as central banks manipulate fiat currencies.

And because the bitcoins can be transferred directly from one entity to another (say, a customer and a retailer), there are virtually no fees such as those charged by banks for the use of credit cards.

The software algorithm also controls how quickly bitcoins are created and has safeguards built in to prevent anyone else creating them, or executing fraudulent transactions.

Now let's take a closer look at how bitcoin works.

How Bitcoin Works

Bitcoins are created by "mining," which is a colorful way to describe a technical process. People using powerful computers all work to solve a very difficult math problem. Right now, the computer that solves the problem first is awarded a block of 25 bitcoins. This "block reward" started at 50 bitcoins and is programmed to be cut in half about every four years. The transaction fees users pay to move Bitcoin are expected to rise with higher adoption, partly offsetting the shrinking block rewards.

In most cases, the miners work in groups called "pools" to increase their chances of winning a block. Any bitcoins a pool wins are divided amongst the member miners.

So far, miners have created nearly 12.4 million bitcoins, and new ones are created at the rate of about 150 to 175 an hour. But the rate of bitcoin creation is programmed to slow over time, and is set to stop at 21 million in approximately the year 2140.

Again, that differs dramatically from fiat currency, where central banks are constantly printing new money that lowers the value of existing money.

The miners, once they have earned some bitcoins, can then spend or sell them to others, which puts them into general circulation.

Anyone can buy, sell, or spend Bitcoin, but they first need a "digital wallet." The Bitcoin wallet, like a real-life wallet, is where you keep your bitcoins. It also is the tool you use to send bitcoins to others and to receive bitcoins sent to you by others.

Some third parties offer online digital wallets for Bitcoin in the cloud, but you can also download one of several Bitcoin wallets if you want to store the digital currency on your own home computer or mobile device.

Once you have your wallet, you can buy bitcoins from an online exchange, from another individual, or from a website that provides online Bitcoin wallets like Coinbase.

A Bitcoin transaction involves using wallet software to send a set amount of the digital currency to another wallet "address," a long string of letters and numbers unique to that user. In addition, an electronic signature is added.

Once the transaction is sent, the miners on the network verify the transaction, and it is added to the "blockchain," a digital record of every Bitcoin transaction ever made.

That's right. Part of the security of Bitcoin requires that the network verify every transaction, and then store in permanently. Each Bitcoin wallet maintains an up-to-date copy of the blockchain (which is why creating a new Bitcoin wallet on your computer can take many hours to "sync" with the network).

If all this seems a bit overwhelming, don't worry. It is a lot to take in. But it's worth taking the time to figure it out, because Bitcoin has such amazing potential.

That's why Money Morning has created a comprehensive Bitcoin guide that provides complete details on how to set up a Bitcoin wallet, how to trade bitcoins, how to mine bitcoins and, best of all, three ways you can profit from Bitcoin.