What Bitcoin Is and How It Works
What is the best way to categorize? Bitcoin is a contentious topic. Is it a currency, a store of value, a payment network, or a class of assets?
Fortunately, defining what Bitcoin is is a lot easier. It’s a set of protocols and processes—software and a fully digital phenomena.
It’s also the most successful of hundreds of attempts to utilize cryptography to produce virtual money. Hundreds of imitators have followed in Bitcoin’s footsteps, but it remains the largest cryptocurrency by market capitalization, a position it has held for more than a decade.
Bitcoin, like traditional currency, is created and has systems and safeguards in place to avoid fraud and ensure that its value increases. Blockchain, mining, hashes, halving, keys, and wallets are the fundamental components of Bitcoin. They’re covered in depth farther down.
(A general note: The word “Bitcoin” is capitalized when referring to the cryptocurrency as a whole, and “bitcoin” when referring to a quantity of the currency or the units themselves, according to the Bitcoin Foundation.) BTC is another abbreviation for Bitcoin. We’ll switch between these usages throughout the article.)
Important Points to Remember
- Bitcoin is a decentralized digital currency that keeps track of transactions in a distributed ledger known as a blockchain.
- Bitcoin miners use high-powered computers to solve difficult riddles in order to confirm blocks of transactions. These blocks are added to the blockchain record if they are successful, and the miners are paid with a tiny amount of bitcoins.
- Other Bitcoin market participants can buy or sell tokens through cryptocurrency exchanges or peer-to-peer transactions.
- A trustless mechanism protects the Bitcoin ledger from fraud, and Bitcoin exchanges attempt to safeguard themselves from potential theft, albeit high-profile thefts have occurred.
Blockchain is a distributed ledger technology.
Bitcoin is a network that is based on the blockchain protocol. A 2008 publication by a person or people calling himself Satoshi Nakamoto originally suggested the use of a chain of blocks to validate transactions and build confidence in a network, albeit it did not use the term blockchain.
Since then, the blockchain has grown into its own concept, with many of blockchains established using similar encryption approaches. The nomenclature can become muddled as a result of this history. The term “blockchain” is frequently used to refer to the original Bitcoin blockchain. At other occasions, it refers to blockchain technology in general or a specific blockchain, such as the Ethereum blockchain.
A blockchain is made up of a single chain of chronologically ordered discrete pieces of data. Emails, contracts, land titles, marriage certificates, and bond trades are all examples of this type of data. In theory, a blockchain can be used to construct any type of contract between two parties as long as both parties agree to it. This eliminates the requirement for a third party to be engaged in any transaction, opening up a world of possibilities, such as peer-to-peer financial products like loans or decentralized savings and checking accounts, where banks or any intermediary are irrelevant.
Governments and private organizations have taken notice of blockchain’s versatility; in fact, some analysts believe that blockchain technology will be the most impactful component of the bitcoin frenzy.
The information on the blockchain in the case of Bitcoin is largely transactions. Bitcoin is essentially a list. Person A sent X bitcoins to B, who then sent Y bitcoins to C, and so on. Everyone may see where individual users stand by totaling these transactions. It’s vital to realize that these transactions don’t have to be carried out by humans.
The blockchain network behind Bitcoin opens up a world of possibilities for the Internet of Things. We may see systems in the future where self-driving taxis and Uber vehicles have their own blockchain wallets. The passenger would transmit bitcoin to the vehicle, which would remain stationary until the funds were received. The car would be able to determine when it needs to be refueled and use its wallet to make the process easier.
A “distributed ledger” is another name for a blockchain, emphasizing the major distinction between this technology and a well-kept Word document. The blockchain of Bitcoin is distributed, which means it is open to the public. Anyone can download it in its entirety or parse it on any of a number of websites. This means that the record is public, but it also means that changing the blockchain ledger is complex. Because there is no central authority to keep track of all Bitcoin transactions, participants must create and validate “blocks” of transaction data themselves. For more information, see the mining section below.
On sites, you can check the status of blocks and the transactions related with them. Such sites display the transacting parties’ address identifiers, dates, the transaction’s date, and the transaction’s time.
The long strings of numbers and letters are addresses, and if you’re in law enforcement or merely well-informed, you can probably find out who controls them. Although certain safeguards can make it very difficult to trace individuals to transactions, there is a common fallacy that Bitcoin’s network is completely anonymous.
Despite, or perhaps because of, its complete openness, Bitcoin is extraordinarily resistant to tampering. You can’t lock a bitcoin in a safe or bury it in the woods because it has no physical presence. In theory, a criminal would only need to write a line to the ledger that reads “you paid me all you had” to take it from you.
Double-spending is a related concern. If a bad actor was able to spend bitcoin and then spend it again, trust in the currency’s worth would soon erode. To perform a double-spend, the bad actor would need to control 51 percent of Bitcoin’s mining power. As the Bitcoin network grows, this becomes less feasible since the computer power required would be huge and prohibitively expensive.
You’ll need trust to prevent either from happening. In this scenario, the usual answer would be to conduct business through a central, neutral arbiter, such as a bank. However, Bitcoin has rendered this obsolete. (It’s likely no coincidence that Nakamoto’s initial explanation was published in October 2008, when bank trust was at an all-time low.) The Bitcoin network is decentralized, rather than having a centralized body to maintain the ledger and oversee the network. Everyone keeps a close eye on each other.
For the system to work properly, no one needs to know or trust anyone in particular. The cryptographic protocols ensure that each block of transactions is fastened onto the last in a long, transparent, and immutable chain, assuming everything is working as it should.
Mining is the process of keeping this trustless public ledger up to date. A network of miners underpins the network of Bitcoin users who trade the cryptocurrency among themselves, recording the transactions on the blockchain.
A modern computer can easily record a series of transactions, but mining is tough because Bitcoin’s software makes the operation artificially time-consuming. People could spoof transactions to enrich themselves or bankrupt others without the added complexity. They might log a false transaction in the blockchain and then pile on so many insignificant transactions on top of it that tracing the fraud becomes hard.
Similarly, it would be simple to inject false transactions into previous blocks. Bitcoin would be worthless as the network devolved into a huge, spammy jumble of rival ledgers.
Nakamoto’s breakthrough was combining “proof of work” with other cryptographic approaches. Bitcoin’s software adjusts the difficulty miners confront every 10 minutes to keep the network limited to a new 1-megabyte block of transactions. The volume of transactions will be more manageable this way. The network has enough time to review the new block and the ledger that preceded it, and everyone can agree on the current state of affairs. Miners don’t just work to verify transactions by adding blocks to the distributed ledger because they want the Bitcoin network to run smoothly; they get paid for it. Below, we’ll look into mining compensation in more detail.
Miners are rewarded with Bitcoin for verifying blocks of transactions, as previously stated. Every 210,000 blocks mined, or roughly every four years, the payout is lowered in half. The halving, or “halvening,” is the name given to this occurrence. For the rate at which new Bitcoin is released into circulation, the system is designed to be deflationary.
This system is set up so that Bitcoin mining rewards will continue until around 2140. When every Bitcoin has been mined from the code and all halvings have been completed, miners will be compensated by fees charged to network users. Healthy competition, it is hoped, will keep rates affordable.
This system reduces Bitcoin’s inflation and raises its stock-to-flow ratio until it reaches zero. The reward for each block mined increased to 6.25 bitcoins after the third halving on May 11, 2020.
This is a more technical explanation of how mining works. The latest batch of transaction data is sent to the network of miners, who are spread throughout the globe and are not connected by personal or professional relationships. They put the information through a cryptographic process that generates a “hash”—a string of numbers and letters that confirms the correctness of the data but does not expose it. (In actuality, with industrial-scale mining farms and large mining pools developing an oligopoly, this ideal notion of decentralized mining is no longer accurate.) (More on this later.)
You can’t tell what transactions are in the relevant block (#480504) based on the hash 000000000000000000c2c4d562265f272bd55d64f1a7c22ffeb66e15e826ca30. You can, however, take a bunch of data that claims to be block #480504 and verify that it hasn’t been tampered with. The data would generate a completely different hash if one number was out of place, no matter how minor. If you ran the Declaration of Independence through a hash calculator, you’d receive 839f561caa4b466c84e2b4809afe116c76a465ce5da68c3370f5c36bd3f67350 as a result. However, if you remove the period following “submitted to a candid world,” you get 800790e4fd445ca4c5e3092f9884cdcd4cf536f735ca958b93f60f82f23f97c4. Even though you just altered one character in the original text, this is a whole different hash.
A hash enables the Bitcoin network to check the validity of a block in real time. It would take an inordinate amount of time to go over the entire ledger to ensure that the individual mining the most recent batch of transactions didn’t try anything unusual. Instead, the hash from the preceding block appears within the current block. That hash would change if the tiniest information in the previous block was changed. Even if the change occurred 20,000 blocks earlier in the chain, the hash of that block would trigger a cascade of new hashes and alert the network.
Creating a hash, on the other hand, isn’t actually effort. Because the procedure is so rapid and simple, unscrupulous actors could still spam the network and possibly pass off bogus transactions a few blocks back in the chain if they had enough computer power. As a result, the Bitcoin protocol necessitates proof of work.
It does so by throwing a curveball at miners: their hash must fall below a specific threshold. That’s why the hash of block #480504 begins with a long string of zeros. It’s quite small. Because each string of data generates only one hash, finding one that is compact enough requires adding nonces (“numbers used only once”) to the end of the data. As a result, [thedata] will be mined. She will attempt again if the hash is too large. [thedata] 1. The size is still too large. [thedata] 2. Finally, [thedata]93452 generates a hash for her that starts with the required amount of zeroes.
The mined block will be broadcast to the network for confirmation, which will take another hour or so to process, but it may take considerably longer in some cases. (Again, this is a simplified description.) Blocks are not hashed in their entirety, but rather in Merkle trees, which are more efficient structures.)
Bitcoin’s algorithm will demand a longer or shorter string of zeroes depending on the type of traffic the network is receiving, adjusting the difficulty to hit a rate of one new block every 10 minutes. The current difficulty is roughly 22.465 trillion as of November 2021, up from 1 in 2009. As this indicates, mining Bitcoin has become substantially more difficult since the cryptocurrency’s introduction a decade ago.
Mining is a labor-intensive process that necessitates the use of large, expensive rigs and a lot of electricity to keep them running. It’s also competitive. Because it’s impossible to predict which nonce will work, the idea is to get through them as soon as possible.
Early on, miners realized that forming mining pools, sharing computer power, and dividing the rewards among themselves may boost their chances of success. Even when these incentives are distributed across numerous miners, there is still a strong motivation to seek them. The successful miner receives a bundle of newly minted bitcoins every time a new block is mined. It was 50 at first, but then it was cut in half to 25, and then it was reduced to 12.5. On May 11, 2020, bitcoin’s reward was halved for the fourth time in its existence, and it is now set at $6.25.
The reward will halve every 210,000 blocks, or around four years, until it reaches zero. All 21 million bitcoins will have been mined by then, and miners will rely exclusively on fees to keep the network running. When Bitcoin was first introduced, the entire supply of the cryptocurrency was expected to be 21 million tokens.
Some people are concerned about the fact that miners have formed pools. If a pool’s mining power exceeds 50% of the network’s, its members may be able to spend coins, reverse the transactions, and spend them again. They could also obstruct the transactions of others. Simply said, because of its majority power, this group of miners would be able to overcome the decentralised structure of the system, confirming bogus transactions.
That may mark the end of Bitcoin, although even a so-called 51 percent attack would be unlikely to allow bad actors to undo previous transactions because to the proof of work requirement’s time-consuming nature. To change the blockchain in the past, a pool would have to control such a huge portion of the network that it would be worthless. Who can you trade with when you own the entire currency?
From the perspective of the miners, a 51 percent attack would be financially disastrous. When the mining pool GHash.io reached 51 percent of the network’s computing power in 2014, it voluntarily agreed not to exceed 39.99 percent of the Bitcoin hash rate in order to retain trust in the cryptocurrency’s value. However, other parties, such as governments, may find the prospect of such an attack appealing. However, even for a world power, the sheer magnitude of Bitcoin’s network would make this prohibitively expensive.
Another source of concern for miners is their practical propensity to cluster in places with inexpensive electricity, such as China or, following a Chinese crackdown in early 2018, Quebec. Bitcoin mining uses a lot of electricity, which has led several governments to restrict access to power or charge Bitcoin miners special rates. This, combined with the Chinese government’s repeated attempts to shut down mining infrastructure in the nation, has resulted in a global dispersion of miners. The United States had surpassed China to become the world’s largest worldwide hub for Bitcoin mining as of October 2021.
Transactions in Bitcoin
The ins and outs of the blockchain, hash rates, and mining are not especially relevant to most Bitcoin network participants. Bitcoin owners who aren’t part of the mining community usually buy their bitcoin from a Bitcoin exchange. These are internet platforms that facilitate Bitcoin and other digital currency transactions.
On June 9, 2021, El Salvador made Bitcoin legal tender. This is the first time a country has done so. Any firm that accepts cryptocurrency can use it for any transaction. El Salvador’s major currency is still the US dollar.
Bitcoin exchanges like Coinbase bring buyers and sellers from all around the world together to buy and sell cryptocurrency. These exchanges have become increasingly popular (along with Bitcoin’s popularity) while also being laden with regulatory, legal, and security issues. The legislation governing the purchasing and selling of bitcoins are complex and constantly altering, as governments throughout the world regard cryptocurrencies in a variety of ways—as currency, an asset class, or any number of other classifications.
The prospect of theft and other criminal activities is perhaps even more important for Bitcoin exchange participants than the threat of shifting regulatory control. Individual exchanges are not always secure, even though the Bitcoin network has been relatively secure throughout its lifetime. Many high-profile cryptocurrency exchanges have been targeted for thefts, resulting in the loss of millions of dollars worth of tokens.
Mt. Gox, which dominated the Bitcoin transaction area until 2014, is likely to be the most well-known exchange robbery. Early that year, the network disclosed the possible theft of approximately 850,000 BTC, which at the time was worth around $450 million. Mt. Gox declared bankruptcy and closed its doors; the majority of the stolen money (worth an estimated $8 billion) has yet to be retrieved.
Wallets and keys
As a result, it’s reasonable that Bitcoin traders and owners would want to take any security precautions they can to safeguard their investments. They achieve this by using keys and wallets.
A public key and a private key are the only two numbers that determine who owns Bitcoin. A username (public key) and a password are a rough equivalent (private key). The one displayed on the blockchain is a hash of the public key called an address. Using the hash adds another degree of protection.
It is sufficient for the sender to know your address in order to receive bitcoins. The private key, which is required to send bitcoins to another address, is derived from the public key. Receiving money is simple, but sending it requires identification verification.
A wallet, which is a collection of keys, is used to access bitcoins. These can take a variety of forms, ranging from third-party web applications that offer insurance and debit cards to QR codes printed on paper. The most crucial contrast is between “hot” wallets, which are connected to the internet and thus vulnerable to hacking, and “cold” wallets, which are not connected to the internet and hence not vulnerable to hacking.
The majority of the BTC stolen in the Mt. Gox case is thought to have come from a hot wallet. Despite this, many users give their private keys to cryptocurrency exchanges, which is effectively a wager that the exchanges’ defenses against theft will be stronger than those of the user’s own computer.
Bitcoin is a digital currency and payment network that is made up of a set of protocols and operations. The blockchain, which is made up of a series of digital blocks linked together as a list and keeps track of all transactions in its network, is Bitcoin’s most important component. Bitcoin can work as a decentralized system without the need for a neutral central organization to confirm and process transactions thanks to the use of a blockchain.
Mining operations, which confirm and process transactions, are the backbone of the Bitcoin network. Miners are rewarded with bitcoin in exchange for their efforts, and the number of bitcoin awarded to miners is halved every four years in a process known as halving.
Cryptocurrency exchanges are also critical to the success of Bitcoin because they allow ordinary people to buy and sell bitcoins, boosting the number of transactions on the network. Finally, in order to access and store bitcoin, cryptographic keys and wallets are required.
What is Bitcoin’s mechanism?
The blockchain—a sequence of connected blocks that preserve a record of all transactions completed in Bitcoin’s network—is the most critical component in making it work. Other major aspects of Bitcoin include cryptographic keys and wallets, which are required for access to the cryptocurrency, as well as procedures such as halving, which cause inflation in the Bitcoin network by limiting the number of bitcoin in circulation.
How does the blockchain render Bitcoin untrustworthy?
The blockchain of Bitcoin is a distributed ledger, consisting of a series of linked blocks holding transaction data, that is supported by complex mining operations that assure transaction integrity. The blockchain is open to the public, which means that anyone can see the transactions that are taking place on it. In this way, everyone on the Bitcoin blockchain keeps an eye on everyone else, making fraud extremely difficult to perpetrate unless there is widespread agreement among transacting parties.
How does hashing ensure that a block is valid?
By checking for the previous block’s hash in a new block, the Bitcoin network can rapidly determine the legitimacy of a block. Bad actors will find it difficult and time-consuming to spam the network and pass off bogus transactions a few blocks down the chain if the hash falls below a particular threshold.
In Bitcoin, how are keys and wallets used?
In Bitcoin, there are two sorts of keys. A public key is similar to a username in that it is used to identify an address on a blockchain. A private key is similar to a password in that it is used to access your bitcoin and must not be shared with anybody. A wallet is a collection of keys that can take several forms, including QR codes. Wallets are divided into two categories. A hot wallet is one that is linked to the internet, whereas a cold wallet is one that is not.