How Bitcoin Works
Bitcoin has long now been one of the most fascinating concepts everyone wants to understand and be a part of. We hear about it on TV, we watch it on the morning stock exchange report, and we see more and more people making real gains on this novel asset.
But what Bitcoin actually is and how it works is something that eludes popular discourse. While this technology is admittedly very complex it is possible to get a well-grounded understanding of what it does and why. Not only can this help you conceptualize this technology, but also it can help better inform your investment decisions and get to know the cryptocurrency and blockchain space a little more.
That's why we've created this easy-to-follow guide to explain what Bitcoin is and how it works.
What Is Bitcoin?
Bitcoin was created in 2009 shortly after the 2008 economic recession. The seismic events of 2008 had revealed a new concern for centralized financial systems and out of this grew the first truly decentralized peer-2-peer cash system: Bitcoin. This network was supposed to be able to simply send financial transactions and the value they hold to one another without the need for any centralized authority. The Bitcoin network would inherit its infrastructure from the community of miners that ran and verified its transaction, and get its security from cryptographic means.
It was this cryptographic element that also interested some users to see Bitcoin as a store of value, as a comparable virtual gold. Today this is how we know Bitcoin; it now sets the bar and trends for the entire cryptocurrency market with a total market capitalization of over $840 trillion. Bitcoin also famously has no leader, instead, it is a mysterious figure known as Sitoshi Nakomoto, a riddle yet to be solved by the community. You can find the Bitcoin white paper online written by Satoshi that sets out the core principle of how this technology works.
What Is the Bitcoin Network?
You can imagine the Bitcoin network as a big order book full of transactions, or a ledger. Users can send amounts of Bitcoin to other users on this ledger by using a specific address, just like with a traditional bank transaction. But where a bank transaction is sent to the centralized network of that bank to be verified, Bitcoin is sent to the decentralized Bitcoin ledger. This is how funds are sent to users.
Miners make up an additional important part of this decentralized network as they provide the physical infrastructure for this platform to run on. Once they have verified the transactions and sorted them into blocks, users know that the funds they are sending and receiving are secure, and this is what creates a functioning financial network. These miners then receive rewards for completing this process in BTC which results in more BTC being added to the overall supply.
Bitcoin is famous for being the antagonist to the modern-day inflationary financial system. Although it originally sought to act as a per-2-peer cash system it now seems to be more of an investment than a tool to send money to one another without the need of a centralized authority. Many now perceive Bitcoin’s primary function as a hedge on inflation in traditional economies for example, with some others seeing it as simply a long-term investment.
Some now even dub Bitcoin as the digital gold, meaning it acts as a stable and capped store of value that can act as a combatant to poor market performance or inflationary events.
How Does Bitcoin Work?
Here we will cover some of the core concepts to help conceptualize how Bitcoin works. We will look at the consensus mechanisms that underpin the entire network, how it nurtures its ecosystem, and how it remains a deflationary asset.
The blockchain consensus mechanism for Bitcoin requires miners to solve complex mathematical problems with extensive levels of computing power to verify transactions on the network and in turn, earns miners rewards.
Very energy consuming
Requires specialist hardware
Mining is ongoing and indefinite in order to solve problems and verify blocks
There are two core concepts to understand about the nature and functions of Bitcoin mining that both hold incredible value to the wider system.
These two facets are:
The process of new Bitcoin entering the overall supply via rewards for work.
The process in which transactions become confirmed.
Supply and Rewards
When users send transactions to one another they are entered into an unconfirmed transactions pool to be sorted and verified by the network’s miners. This verification process is called mining and essentially consists of computers solving complex mathematical equations. You need a lot of computer power to complete these problems so miners are required to have special hardware to do so. But it's the utility within this complex problem-solving process that holds the key to Bitcoin’s success.
Essentially, once a problem is solved it means a block has been created. A block represents a collection of verified and confirmed transactions that give the network security of trade. Miners all work on these problems to create verified blocks, and once connected into a chain they form the Bitcoin ledger and its blockchain network.
Once a miner successfully creates a block they are rewarded with Bitcoin and the overall market supply is slightly increased. These rewards are halved every four years as a deflationary measure to ensure the integrity and value of the Bitcoin supply. It is designed in this way to be a direct antagonist to the current financial system - but more on this later.
Bitcoin confirmations are one of the core pillars providing security to the financial ecosystem. When a user signifies that they want to make a payment in Bitcoin this is sent to an unconfirmed transaction pool and miners undergo the verification process. Once this verification process is complete the block is constructed - we can describe this as one confirmation. Once this group of transactions is confirmed and grouped into a block miners then begin working on the next block. Blocks are constructed, or chained, on top of one another so every time a new block is added to the chain it becomes harder to manipulate or change an old transaction. If a new block is built on top of an older block then the community can have faith that the transactions they are built on are valid and verified.
The degree of security you enjoy depends on how many Bitcoin confirmations there have been. Also, another influencing factor can be the value the transaction represents. Manipulating blocks requires an extreme amount of computing power, much more than just mining which is already energy-intensive, so it is unlikely to be undertaken for a small amount for example.
Halving is the deflationary element of the Bitcoin ecosystem. It is an inbuilt function within the network that means around every four years, or every 210,000 blocks mined, the rewards miners receive for mining blocks will be cut in half. Of course, this is not ideal for miners but in terms of tokenomics, it helps to reduce the supply of new coins. This essentially increases the value of those BTC that can be mined as now there are half as many available; this can also have a direct impact on the market price of the coin as speculators can see that there is no dilution of value. Essentially, it's a control on the supply.
It is fair to say that how Bitcoin works is a complex process to understand. Here we have covered all of the main elements that make up this novel decentralized technology.
Bitcoin is a ledger, designed originally as a P2P system that then evolved into a store of value and relies on miners and Bitcoin confirmations. You can think of it as one of the more conservative types of blockchain technologies out there, so if you wish to really dive into the technical side of cryptography and blockchain networks there is plenty of literature. Some of the more technical concepts to explore are things like hash functions (SHA-256) which are the real nuts and bolts of this network. You can find everything you need to know in the Bitcoin white paper by Satoshi Nakomoto.
But it is possible to have a grounded idea about how Bitcoin works and why it works that way. This can help inform you more generally on the wider cryptocurrency and blockchain space, and in doing so you can even begin to better inform your investment and trading decisions.