How does Bitcoin work?

As we outlined in part one of our Bitcoin Basics series, Bitcoin is a radical new form of currency – called a cryptocurrency or digital currency – designed to serve as a global money system.

Bitcoin and blockchain

Bitcoin relies on fundamentally new technology, cryptography, the use of incredibly powerful computers, and the internet to function.

As no single administrator is responsible for the maintenance or backing of Bitcoin, transactions issued in Bitcoin are verified and recorded in a public distributed ledger that is called a Blockchain.

Whereas, for example, one’s bank of choice might hold a copy of the ledger that represents the flow of financial transactions through one’s account, the Blockchain is a form of ledger that – rather than being kept by a bank – is instead shared between Bitcoin ‘miners’ and ‘nodes’ around the world.

What is blockchain technology?

The Blockchain draws its name from its underlying data structure that consists of 1-megabyte files called ‘Blocks’, which are essentially ledgers themselves. Blocks are ‘Chained’ together through a complex mathematical proof.

The Blockchain is a shared public ledger that the entire Bitcoin network relies on. All network nodes (computers running Bitcoin software) have the potential to access the Blockchain and view authenticated transactions. Transacting parties are, to some degree, anonymous as the Blockchain does not illustrate the names of parties but instead provides an alphanumeric designation.

Whereas one might rely on the trustworthiness of a bank to authenticate the integrity of a ledger, the Blockchain instead relies on cryptography (the art of writing or solving codes) as its proof.

Bitcoin wallets

When transacting in Bitcoin, parties leverage what is called a “Bitcoin Wallet” to exchange denominations in Bitcoin (BTC). Bitcoin Wallets provide their users with both a Public Key (the address from which one sends, or from which one receives Bitcoin) as well as a Private Key.

The term ‘Wallet’ can actually be described as a poor term to use; a more accurate name might be a ‘Keychain’, where users can copy both of their keys rather than simply have access to one.

A Bitcoin Private Key

A Private Key is an incredibly important ‘signature’ for Bitcoin users, which is used to confirm pending transactions by giving a mathematical proof that they originated from the owner of the wallet in question.

When a user wishes to transact in Bitcoin, their intention is signalled on the Blockchain by submitting a transaction signed with the user’s private key. The bitcoin network then validates the transaction by checking that the to and from addresses are valid, that the private key is valid and that it has access to enough funds to perform the transaction. The transaction usually confirmed on the network within the following ten minutes.

Bitcoin Mining

The process of authenticating pending transactions and collecting them into a block to include in the Blockchain is called Mining. “Miners” are computer users with incredibly powerful hardware that solve complex mathematical problems to cryptographically sign a block of transactions and connect them to all previous transactions in the Bitcoin network.

Miners serve the Bitcoin community by securing the network. The process of solving the cryptographic proof for a block is extremely resource-intensive. By winning the race to mine 1-megabyte ‘blocks’ of transactions, Miners receive a ‘bounty’ or ‘reward’ in Bitcoin.

A malicious transaction requires so much computation (and thus electricity) that in almost all cases it is more profitable to use that same compute power to secure the network instead and collect the block reward. This is what prevents bad actors from attacking the network and preserves the Blockchain from recording malicious or fraudulent entries.

Mining draws its name from the metaphor that Miners receive Bitcoin as a reward in a similar fashion to how rare commodities, such as gold, are mined from the ground.

What do I need to know about using Bitcoin?

While Bitcoin is a fascinating technology and perhaps both an exciting store of value and means of exchange, the Bitcoin network is fundamentally different from the traditional banking system and bears some notable differences.

While Bitcoin itself is unhackable in the sense that the Bitcoin network relies on complex mathematical proof as its foundation – and to even hack one transaction would immense resources – Bitcoin Wallets share the same vulnerabilities as conventional wallets in the sense of that they are only as secure as their user leaves them.

As Bitcoin can be transferred anywhere around the world with ease, Bitcoin Wallets are an easy target for computer hackers seeking a fast way to steal digital currency. One should take care in selecting a trusted Wallet service and always secure their Wallet.

Bitcoin storage

Other popular means of storage are custodial services or exchanges which usually either participate in the holding or transaction of cryptocurrency, respectively. Given that these entities usually hold vast amounts of bitcoin and other digital currencies, they are attractive targets for internet hackers and care must be taken when using them.

Bitcoin is further easy to steal thanks to the facts that payments made in Bitcoin are irreversible without the assistance of the party which incorrectly received the funds in question.

Though the Bitcoin network can detect typos and will not allow users to send Bitcoin to an invalid address, confirmed transactions (thanks to the fact that they are secured by cryptography) must be treated as final. Therefore, transacting parties must be able to trust one another when exchanging Bitcoin.

Bitcoin is transparent

Lastly, Bitcoin is not a fully anonymous system. Whereas one might rely on a bank to secure the privacy of one’s bank account (a private ledger), all computers on the Bitcoin network have the potential to view the Blockchain and can usually see each Wallet’s balance. All transactions are further visible on the network. Even though the names of transacting parties are not disclosed on the network when exchanging Bitcoin, sophisticated analysis of the blockchain could allow third parties to trace how bitcoin flows through the network.

In part three of our Bitcoin Basics series, we’ll be exploring how Bitcoin mining works in greater detail.