Yes, your assumption is partially correct. Encryption is one of the uses of Passkey.
Bluetooth pairing is necessary whenever two Bluetooth devices connect to each other to share resources. A trusted relationship is established between the devices using a numerical password, commonly referred to as a passkey. Depending on how often one Bluetooth device connects to another, the user might opt to have the passkey saved for future connection attempts or prompt to enter the passkey each time the devices request communication with each other.
This is already explained on Stack Overflow please check- How does Bluetooth pairing work?
In the below answer, I will try to explain what is not mentioned in the above link or answers.
In Pairing process, when the initiating device sends a ‘Pairing Request” to the other device. The two devices then exchange I/O capabilities, authentication requirements, maximum link key size, and bonding requirements. Basically, all this phase consists of, is the two devices exchanging their capabilities and determining how they are going to go about setting up a secure connection. It is also important to note that all data being exchanged during this phase is unencrypted.
Now the question is why this Phase is needed?
As mentioned- “two devices exchanging their capabilities.” The pairing should happen between compatible device there is no point in Pairing you Mouse with a Headphone as Mouse capabilities are different than Headphone.
One more use of Pairing is – “determining how they are going to go about setting up a secure connection.” Here the frequency hopping pattern is determined for two reasons-
- To avoid Middle Man Attack.
- To avoid Collision
Bluetooth uses 79 radio frequency channels in the band starting at 2402 MHz and continuing every 1 MHz. It is these frequency channels that Bluetooth technology is "hopping" over. The signal switches carrier channels rapidly, at a rate of 1600 hops per second, over a determined pattern of channels. The hopping pattern is determined well during the pairing process so that no other device will know in which band of the frequency the data is being transferred at an instance. Its rare case that frequency hopping pattern can be the same for a couple of devices communicating hence collision is avoided.
Note: If any third device is able to capture the passkey then it can replicate the whole communication pattern and capture the data being transferred. This is how the BT Sniffers work.
I am not able to cover all the details as per SIG specs. I hope the above answers give you a clearer picture of the need for the Pairing process. Feel free to point out, if you want me to explain any specific point in detail.
Below are the reference Links for more information-
http://large.stanford.edu/courses/2012/ph250/roth1/
https://www.bluetooth.com/blog/bluetooth-pairing-part-1-pairing-feature-exchange/