What is bitcoin and how does it work?

Is Bitcoin Money

There are full books, courses and documentaries on Bitcoin. This is a blog post/article. Keeping that distinction in mind, I will explain Bitcoin succinctly here.

Bitcoin is a number of different things whose whole is greater than the sum of its parts. So what is bitcoin and how does it work? Let’s dive right in!

Bitcoin is a trustless, peer-to-peer, decentralized protocol used to store and transfer value, with money/currency being the first application. It is based on an immutable record/ledger known as “the blockchain”. Bitcoin is not a company, it is not owned by anyone, it does not need the approval of any government or corporation. It exists on its own. In fact, it is much like the internet in that it is a protocol that exists for anyone to use and improve upon.

what is bitcoin and how does it work

The unit of measure is “a bitcoin” and there is a set limit of 21,000,000 BTC (twenty-one million bitcoin), although not all 21,000,000 exist yet. Each individual bitcoin is divisible into 100 millionth of a bitcoin, that’s 0.00000001 BTC, also termed “one satoshi”. Much like how one dollar is divisible in one hundred parts, denoted as a penny or one cent. A person is able to send and receive bitcoin from another individual (or institution/organization for that matter) over the bitcoin network without having to divulge personal or financial information, much like how cash is exchanged.

The big breakthrough here is that if I give someone $100 dollars in cash, I no longer have those $100 dollars (obviously). However, if I send information to someone online, for example, a word document, then that person has a copy of that word document, and I also have that very same word document. If I were to email that word document to 54 people then there are now 55 copies of the same document (the 54 I sent plus my copy). With money, it is very important that I no longer have the dollars that I supposedly send to someone. Today if I send my friend $50 in an email transfer, the bank is the intermediary and my bank communicates with my friend’s bank and information on both myself and my friend is shared between the institutions (unbeknownst to us) and the transaction occurs. The Bitcoin technology removes the necessity of verifying personal information, thus helping to maintain privacy, and truly behave like digital cash.

This is accomplished through the public, distributed/decentralized ledger/blockchain, proof-of-work, and encryption (public-private key pairs). The blockchain is useless without the proof-of-work, encryption and decentralized components.

This is all a very generic description. What is bitcoin made of and how does it work?

  1. Blockchain
  2. Consensus Rules
  3. Proof-of-work
  4. Incentive
  5. Decentralization
  6. Public-Private Key Pairs and Wallets
  7. Immutability
  8. Limited Supply
  9. Divisibility
  10. Pseudo-anonymity

Each of the above topics deserve their own post, but a simply approach/summary is completed below for your eager reading, enjoy! 🙂

1. Blockchain

What exactly is the blockchain and how is it related to Bitcoin? Essentially the blockchain is a method to keep track of transactions. It is a “live ledger” so to speak. A ledger at its very basics is simply a sheet used to keep track of where your money went. Almost like a budget, but not quite. A ledger is an accounting tool that accountants have used for thousands of years. Someone would record money coming into your bank account (and also possibly where it came from) and when money would leave your bank account (and where it would go). This was originally done on paper, then when computers came on scene in the mid-20th century excel sheets were used. And thats where it stopped. Sure excel sheets were shared on banks’ intranet, but good-god they were not shared publicly.

So if someone transferred $10,000 from one of their accounts in Bank ABC to an account in a different bank (Bank MNO) then Bank ABC would write into the ledger that you withdrew $10,000. It may note that it was sent to Bank MNO. And then Bank MNO would update their ledger that you deposited $10,000 into your account (and possibly note that it was from Bank ABC). But the information stops there. If you then took $2,000 and bought a TV, Bank ABC would not be able to verify that. They would have no idea. Bank MNO would know that you took out $2,000. The ledgers between the banks are private and not public. There is no way for the public to verify transactions. I’m sure during an investigation perhaps lawyers can dig up a paper trail perhaps, but it would be tedious and inaccurate depending on the complexity of the situation. At first glance you may like the idea of this – you may not want everyone to know where, when or how much money you move. Remember 2008? No one knew what the banks were up to… yeah…

The Bitcoin blockchain is a live public ledger that provides a timestamped record of transactions. It is decentralized (more on that below). Approximately every 10 minutes all the transactions completed within that time block are verified (via proof-of-work, more on that below) and a snap-shot of the ledger is published on the public blockchain. Then the next time block is verified and that snapshot is published. These time blocks of the state of the public ledger and chained together, like a story. You can “follow the bitcoin” (or other cryptos) on this ledger, the blockchain.

Below (figure 1) I’ve created a rudimentary, basic depiction of what a proof-of-work blockchain looks like.

Blockchain Illustration, what is bitcoin and how does it work
Figure 1.: An example of 4 blocks with the details of each block above. As the blocks progress the link/chain between the older blocks is denoted as thicker because it becomes progressively more difficult to alter the older blocks. The most recent block is being “mined”/produced as denoted by the dotted line and the input of computational power/energy.

2. Consensus Rules

There is some misinformation out there… Consensus is often confused with Proof-of-Work (below). Proof-of-Work (PoW) is NOT a consensus mechanism. Consensus on the bitcoin blockchain is simply the concept that all of the bitcoin nodes agree on the “state” of the blockchain. The correct state is the “longest chain” or the chain with the “greatest difficulty”. And by definition the most difficult chain is the longest chain because the most work (energy) was input to create it (this will make more sense when you read the next section on PoW).

3. Proof-of-Work

What is bitcoin and how does it work

Proof of work, put simply, is the concept or process that in order for a block to be added to the blockchain a computer solves an arbitrary mathematical problem/puzzle that requires a certain amount of computational power (and the corresponding energy/power/electricity). Once the arbitrary computer problem/puzzle is solved, it is broadcast to the bitcoin network and all the other nodes verify that it is the correct answer to the puzzle. Once the other nodes verify the answer the new block is confirmed and all transactions that occurred on this block will become part of the recorded blockchain. Other nodes may propose alternate blocks, but if they have not solved the puzzle correctly then it is regected. In my figure above the concept of proof-of-work is denoted by the lightning bolt in the circle.

In the early days of bitcoin, an ordinary laptop or desktop computer was powerful enough to compute the mathematical problem-solving process to confirm the next block in the blockchain. However, today in order to confirm the next block on the blockchain you would need the computational power (and corresponding energy supply) of literally a warehouse of computers to solve the arbitrary mathematical problem. The overall difficulty of solving the bitcoin block reward problem is called the “hashrate”. Hashrate will deserve its own post. Essentially the higher the hashrate the more difficult it is to solve the arbitrary problem. This means that more computational power or more energy will be required to solve the problem. Many mining companies are trying to source cheap electricity to help make themselves more competitive.

PoW helps to prevent Sybil attacks and prevent malicious attempts to change the blockchain record or to double spend bitcoin. Because of the large amount of power required to validate each block, a malicious actor would have huge resources (large computer mining equipment, and access to vast amount of electricity and its associated cost) in order to propose its own version of the next block, and it would have to do this repeatedly to create the longest chain (the consensus mechanism, the longest chain, not PoW) – this requires MASSIVE resources and is known as a 51% attack.

But why would anyone invest resources in this? Read on to “Incentive and Decentralization” to find out.

4. and 5. Incentive and Decentralization

In Satoshi Nakamoto’s design of Bitcoin he wanted it decentralized. There was a purpose for this. Everyone running a bitcoin node would have the same copy of the blockchain. By ensuring everyone had the same copy of a live blockchain was part of how he solved the Byzantine General’s problem. Also with many, many nodes running live, of the same information, worldwide, it becomes impossible to shut down the Bitcoin network.

Incentive… why would anyone want to set up a bitcoin node and spend money on electricity for your computer to solve an increasingly difficult and energy-intensive mathematical problem? For a reward of course. Everytime a set of computers in a node solves the arbitrary mathematical proof-of-work problem, then they receive a pre-determined amount of bitcoin. Initially, in 2008 it was 50 bitcoin per block. Back then bitcoin was almost worthless, less than a penny. Every 210,000 blocks (~4 years with an average 10 minute block time) the reward for bitcoin is dropped by half. The first halving occurred November 28th 2012, and for 4 years the block reward was 25 Bitcoin, by this point Bitcoin was worth substantially more. Now, each bitcoin is around $3200 USD (16 December 2018) and there are 12.5 bitcoins being mined per block (~$40,000 USD), since the second halving on July 18th 2016.

what is bitcoin and how does it work

Today there are companies that came into existence with the sole purpose of mining bitcoin, and they use specialized computer hardware known as ASIC chips. They are specially designed to solve the mathematical bitcoin problems and act as bitcoin nodes. The incentive for the value of bitcoin means many people and/or organizations will open and operate bitcoin nodes/mines and contribute to the stability of the network. Their business model is literally to mine and sell bitcoin. Simple and straightforward. They can also make money by charging small transaction fees which did not exist in the early bitcoin days. The more nodes operating, and using greater hasrates, the more secure the bitcoin network is.

6. Public-Private Key Pairs and Wallets

Public-Private Key pairs… So this is where we address the issue of privacy and what the heck an actual bitcoin is. A “key” is simply a unique alphanumeric identification that is assigned to a denomination of bitcoin. Each Bitcoin (or portion of bitcoin) is associated with two keys: a public key and a private key. Your public key is what is visible to the blockchain network. All the nodes and software designed to read the public blockchain ledger see the public keys. Your private key is kept on a wallet.

What is bitcoin and how does it work

Wallets… forget your definition and idea of a traditional physical wallet. A Bitcoin (or cryptocurrency wallet) is like a hybrid of a bank account and an email account. Your wallet has an address on it (currently addresses are denoted in alphanumeric fashion). Every bitcoin is associated with a wallet address. Like your email, it doesn’t matter who knows your wallet address. No one can steal bitcoin from your wallet any more than they can send email from your email account. Inside your wallet is your private key. Like your email can get hacked, so can your wallet. When you send bitcoin to another wallet address (this constitutes a transaction) you send your private key (which is then altered to a new private key in the recipient’s wallet address). No one can send bitcoin without the private key of the bitcoin. Owning the bitcoin is owning the private key. If you do not hold the private keys of your bitcoin, then you do not own your bitcoin. Do not let anyone else tell you otherwise.

Again… like all the sub-sections in this post, they all deserve their own long detailed posts.

7. Immutability

The concept of immutability is a relative one… and a complicated one. Nothing in life is 100% certain. Like I was explaining earlier, in order to approve/confirm each block on the blockchain an arbitrary, difficult mathematical problem must be solved by highly specialized computer hardware and software. The difficulty level is measured by the hashrate. In order to change the previous 2-5 blocks on the bitcoin blockchain a bitcoin miner would have to direct his/her computers/ASIC chips to input all the same energy that was required to “build”/compute the previous blocks AND keep the next blocks mined on time in order to keep the “longest chain”. Today, this would be an astronomical undertaking costing billions of dollars to simply change the history of the Bitcoin blockchain from today and/or this week… let alone trying to falsify or cover up transactions from 3, 6 or 12 months ago… or 2-3 years ago… good luck.

Essentially, the massive amounts of computational power and actual energy put into mining bitcoin are progressively making older blocks more and more secure as the blockchain progresses in length (number of blocks mined). By secure, I mean immutable. Bitcoin is the most secure and immutable blockchain in existence today.

In figure 1 I made the lines between the blocks progressively thicker as the blocks are older to illustrate that it becomes more difficult to edit/alter the blockchain as more blocks are added. A clever trait. It is commonly said “wait for 6 blocks” before a transaction is considered “secure”. This is because it would take an exceedingly large amount of resources to alter the bitcoin network 6 blocks back. Six blocks in only approximately one hour. Imagine trying to alter something from 6 months ago?

8. Limited Supply: 21,000,000

There is a limited supply of bitcoin: 21,000,000 BTC to be exact. It is being mined every 10 minutes, with a decreasing supply released per mining block every 210,000 blocks (~ every 4 years). Currently, there are 12.5 BTC mined per block. There are currently a total of 17, 426, 650 bitcoin mined, which is ~ 82.98%. However, it will take ~140 years for all of the bitcoin to be mined (starting from 2008). That is exponential power working in reverse, it becomes exponentially slower to mine as the halvings occur every 4 years.

Keep in mind that the real supply of Bitcoin is actually significantly lower than 17, 426, 650. Satoshi Nakamoto has ~1,000,000 bitcoin in his wallet, but no one knows who he/she/they are, or even if they are still alive. Moreover, many people who had mined bitcoin on their laptops in the early days have lost their private keys, either because the laptop was lost or destroyed or the infrastructure of the wallets was so rudimentary that they lost them (not recognizing the importance of keeping them). Those bitcoins are lost forever. There is no way to recover those lost bitcoins. Such is the nature of cryptocurrency. It is just like losing cash or gold coins.

what is bitcoin and how does it work

9. Divisibility

But… if there are only to be 21,000,000 bitcoin how will people transact… it just doesn’t seem like enough to be used worldwide by everyone. Great question! Bitcoin is divisible into 100 million parts. Therefore, in every bitcoin there are 100,000,000 satoshi. So really there are 2,100,000,000,000,000 satoshis (2 Quintillion 100 trillion satoshis)… if I did my math correctly (21 million multiplied by 100 million). When Bitcoin becomes significantly more valuable it will not be feasible to denote things in bitcoin and in my opinion satoshi will be more common. If and when each bitcoin is worth $1,000,000 USD each satoshi would be worth $0.01 USD (1 penny). If/when BTC is $10 million then each satoshi would be ten cents. If/when each BTC is worth $100 million then each satoshi will be worth $1 USD.

10. Pseudo-anonymity

I say pseudo-anonymity because technically every single bitcoin transaction is traceable via the decentralized blockchain. However, anyone can have any number of alphanumeric wallets and your identity does not have to be associated with the wallets. The use of bitcoin and wallets is anonymous in that your ID is NOT required to use it. However, technically, bitcoin transactions are exceptionally visible and traceable. The anonymity comes with the difficulty of associating a wallet address with a person. It is possible and it has been done (during the Silkroad website debacle).

Markshire Crypto Conclusion on What is Bitcoin

Anyway… if you made it all the way to the bottom of this post then congrats! You’re definitely interested in Crypto and Bitcoin and I cannot wait to write more original content for your consumption.

Go back to What is Cryptocurrency to learn more on cryptocurrency.

If you enjoyed this article or have any questions, comments to contribute, please let me know, I would love to hear from you!

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Author: Markshire Crypto

Millennial cryptocurrency investor, writer and marketplace researcher. Founder of Markshire Crypto. Mark has been involved in the cryptocurrency industry since 2017, following the industry daily and creating content.

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