How Bitcoin Works: A Simple Guide to Bitcoin and the Technology Behind It

Michelle Heath

Bitcoin Series:

The Brilliance | The Dilemma | Tax Havens

How Bitcoin Works

Bitcoin is a cryptocurrency, money that is completely virtual.  Understanding how bitcoin works is not as complicated as it may seem. It is not tangible like cash that you can touch but rather a balance on a decentralized public ledger called a blockchain that is transparent to anyone accessing it. 

Cryptocurrencies have three main components:

  1. A protocol or set of rules as to how participants can transact;
  2. A ledger that stores the history of transactions; and
  3. A decentralized network of participants that update and store the ledger of transactions according to protocol.

Who Invented Bitcoin?

Bitcoin was designed by Satoshi Nakamoto, a pseudonym for the mysterious person or group of people that released the original Bitcoin white paper in 2008, which proposed the introduction of a digital currency called bitcoin and a peer-to-peer method of transacting bitcoins without a centralized control. 

On January 3, 2009, Satoshi Nakamoto mined the ‘genesis block’ (block 0) with a reward of 50 bitcoins.  In total, there are only 21 million bitcoins (BTC) available to be mined and the amount available is cut in half every 4 years as is the block reward until there are no more block rewards.

There are 18.6 million bitcoins in existence with 2.4 million left to be mined, and new blocks being mined about every 10 minutes.  Each new block currently adds 6.25 bitcoins into circulation. 

The smallest bitcoin unit is called a Satoshi, after the founder.  There are 100 million Satoshis to one bitcoin.

The Bitcoin System and Its Blockchain

Bitcoin is created, distributed, traded and stored using a system called a blockchain, a shared public ledger that can be envisioned as a collection of blocks with each block like a page on the ledger, listing a collection of permanently recorded bitcoin transactions.

The Bitcoin system is maintained by miners and nodes.  The miners are the owners of the computers dedicated to the Bitcoin system, which validate the transactions that are broadcast to them by Bitcoin users.  A node is a server or storage device, which stores the entire Blockchain and runs a Bitcoin client software that scrutinizes all transaction data to check if they conform to Bitcoin protocol.

According to Bitnodes, 10,135 reachable nodes existed on February 25, 2021.

A Bitcoin Transaction Overview

A bitcoin transaction is a transfer of value between bitcoin wallets.  Each transaction involves a sender, the transaction information, and a receiver.  Bitcoin processes 4.6 transactions per second, close to 400,000 transactions a day.

To buy and sell bitcoins you need a wallet to store your virtual coins.   Your wallet, which has a unique alphanumeric address generated by an elliptical curve digital signature algorithm, is a collection of private keys and a record of transactions relating to them.  Each private key has a corresponding public key.  The public key, which can be shared, becomes your wallets address (like your bank account number); whereas, the private key (similar to your ATM PIN number), which should be kept to yourself, is your way of proving that you are the owner of the wallet and can spend any of the coins inside of it. 

How the Bitcoin Blockchain Works

Blockchain building, as outlined by the Journal of Internet Banking and Commerce, involves five major steps:

(1) Transaction Defined:  The bitcoin sender creates a transaction that contains the public-address of the recipient, the transaction value, and a cryptographic digital signature that verifies the transaction validity and credibility.

(2) Transaction Authenticated:  The network nodes receive the transaction and confirm the message by decrypting the digital signature.

(3) Block Building:  One of the nodes in the network updates the ledger or block using the pending transactions and transmits it to the other network nodes waiting for validation.

(4) Block Validation:  Once a request for validation of the updated block is received by the nodes responsible for network validation, each node undertakes an iterative process that requires the approval of other nodes to authenticate the new block.

(5) Block Chaining:  Once the new block is approved, it is added or “chained” to the previous block in the current chain.

How Bitcoin works is complicated. Underlying the Bitcoin system is the need for validation, transparency, and ensuring that the blockchain remains credible and legitimate.  It is the miners that the Bitcoin system relies on to ensure this occurs.