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How Does Bitcoin Work - Step By Step Guideline For Beginners

Bitcoin, the world’s first peer-to-peer decentralized digital currency, took the world by storm when its value peaked just under$20,000. Nearly 6 million people use bitcoin and they have a good reason to.

If you are not aware of bitcoin and how it works, you have come to the right place. In this article, we will layout everything you need to know about its functionality. In order to understand how bitcoin works, you need to first understand what exactly bitcoin is.

What Is Bitcoin?

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Bitcoin is a decentralized cryptocurrency. Bitcoin is made up of two words, Bit and Coin. The bit indicates 0’s and 1’s as it is computer software. It is digitally stored in the computer and does not have a physical form.

Bitcoin was developed by Satoshi Nakamoto, in 2008. You can read the entire history of bitcoin in our article What is bitcoin: definition and history. It is based on blockchain technology. The blockchain is a digital ledger containing a network of nodes connected.

This digital ledger is public and is used to record and verify the transactions of cryptocurrencies such as bitcoin. The transactional information is visible to everyone in the blockchain. We have covered more on the bitcoin blockchain later in the article.

On the other hand, bitcoin is a decentralized currency in the sense no central authority, governs, and dictate the transactions on the bitcoin blockchain. The transactions happen within minutes. You can carry out transactions from and to anywhere in the globe.

Bitcoin has achieved mass adoption from countries, organizations, and the general masses. It is used primarily as a payment method. But it also used for trading, store of value, collateral for other assets, governance etc.

But why do we need bitcoin and when there is a myriad of existing payment methods and assets? What makes bitcoin so different? Why was bitcoin invented? 

It is crucial to know the answers to these questions before we understand how it works.

Why Was Bitcoin Created?

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The idea of Bitcoin didn’t just come out of thin air. Bitcoin’s creator Satoshi Nakamoto felt the existing money system on which the world operates had severe shortcomings and exploitations. He wanted to create a digital currency that would solve these problems.

He wasn’t the first person to realize this issue. There have been others who envisioned the same but failed to convert their concept to reality.

Thus there are two main reasons as to why Satoshi Nakamoto created Bitcoin; improve upon the failed attempts to create a reliable digital currency, and to solve the loopholes in the existing financial system.

We will first take a look at how Satoshi drew inspiration from the failed attempts to create a decentralized currency.

Turning B-money And Bit Gold’s Concept To Reality

In his whitepaper, Satoshi Nakamoto listed a variety of reasons why he proposed the idea of bitcoin and the blockchain on which it operates.

Even before Bitcoin was created in 2008, there have been attempts to create a decentralized digital currency. Two of the most significant contributions have been made by Wei Dai (B-money) and Nick Szabo (Bit Gold).

They laid down similar characteristics such as a decentralized token, verification of transfers, security, the anonymity of transactions, computational work to facilitate the digital currency, and rewarding of the verifiers on the network.

The area where they failed to make their concept the reality was, the issue of double-spending. Bit Gold proposed the processing of the solved cryptographic puzzle through a Byzantine peer-to-peer network. But the problem with this was the Byzantine method relied on a group of network addresses rather than hash power.

Inevitably, it was subjected to Sybil attacks and it failed to solve the double-spending problem. Bitcoin proposed to solve these problems through its proof-of-work algorithm and having to spend energy to receive bitcoins.

The current blockchain network is reliable but it’s not unhackable. As new vulnerabilities are found, they are being patched and the network remains largely secure.

We will now look at the primary reasons why the need for Bitcoin, a decentralized digital token, arose in the first place.

Problems With The Existing Financial System

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Here are the major issues with the traditional financial system:

• The Issue Of Banks:

Banks operate solely based on trust. The clients dealing with the bank must rely on the banks to keep their money safe, and the banks must trust the clients to repay any loan they have taken.

With bitcoin, it operates on a system where you don’t to rely on trust to make it work. All the information is stored on the blockchain and available publicly

• Security:

We all know banks are vulnerable to theft and fraud. According to a study undertaken by Lexis Nexis, just in the U.S, merchants lose $190 billion/year to credit card fraud.

Moreover, the money you deposit in the bank isn’t stored in their vault. Banks use it to finance other ventures for larger returns. Legally, they are required to store only 10% of your money.

Bitcoin rises above these issues. You can store your crypto securely in your wallet without worrying about the safety of your funds.

• Fees:

We are all tired of paying exorbitant fees that are incurred when we use traditional payment systems, such as banks, PayPal, or other online transfer systems. Banks act as a middleman when the money transfer takes place between the two countries. The processing fees are too high, which demotivates many to send money abroad.

For transferring even as little as $1000 incurs fees over $50. If you transfer the same amount in bitcoin, it would cost you a few cents.

• Privacy:

When you open a bank account, you need to submit a lot of documents for verification. Banks store this private data. At the same time, many banks have been vulnerable to hacks and attacks that expose the private data of their clients.

Even though the blockchain is transparent where the transactional data is publicly available, privacy is a primal feature of bitcoin. It is pseudonymous in the sense the information can be tracked to a public address, but the identity of the address owner is unknown.

• Central Authority And Middleman Problem:

As discussed above, banks act as a middleman in money transfers. Banks need to be paid to administer these transactions. This makes bank powerful as they can exercise a lot of power over their clients.

Banks have the authority to block or freeze your account, as per their whims and wish. You sign an agreement with the bank respecting their policies so they can exercise their control over you.

There is also the issue of the central authority of banks. Along with the government, banks have the power to control the supply of currencies as per their needs.

Bitcoin is free from any central authority and governance.  It does not require a middleman. It operates on a peer-to-peer network. On the other hand, the supply and demand are not influenced by any single authority and empowers individuals rather than facilitating financial institutions.

How Bitcoin manages to accomplish these will understand once we take a look at how bitcoin works.

How Does Bitcoin Work?

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To reinstate, bitcoin is a decentralized digital currency that is powered by a public digital ledger, known as the blockchain.

Understanding how bitcoin works require you to understand certain concepts such as the blockchain, trust-less system, mining, verification of transactions, hashes, confirmation, difficulty, bitcoin keys, wallets, cryptography, decentralization, and supply and demand.

These concepts are interrelated to one another. We will try to explain these easily and sequentially to make it easy for you to understand.

The Blockchain – Public And Decentralized Distributed Ledger

Blockchain is the technology, comprised of a network of nodes that is decentralized in nature. These nodes are users and they are all interconnected to each other.

Every node contains transactional information. This information is sequentially passed between them. Therefore, all the information contained in the blockchain is visible to all the peers in the network.

The information stored is permanent. So any modification by one single entity is impossible without altering other nodes in the network. This makes the blockchain immutable and decentralized.

Each block in the network is connected to the next one using cryptography. A cryptographic hash of the preceding block is stored in the current block along with the transaction data.

Bitcoin thus operates on a trust-less system where no third party is required to oversee and verify the data. Every node on the network contains the same transactional information and is protected using cryptography.

Cryptography

Cryptography is not a new concept that originated with Bitcoin. It dates back to the world war era, where radio messages were encrypted so even if the enemy could intercept the messages, they couldn’t decipher it.

It is beautifully depicted in the movie “The Imitation Game” starring Benedict Cumberbatch.

On the other hand, Cryptography is the technique of protecting information via codes so that only those for whom the information is intended can decrypt and access it. It is a means of protecting sensitive data to prevent unauthorized access and modification of information.

Cryptography is employed in the bitcoin blockchain. The transactional information is encrypted using computational power. Miners solve complex cryptographic puzzles using the power of their mining rigs and hash the information on the network.

Mining – Verifying Transactions

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Mining is the process of verifying transactions on the blockchain by solving complex mathematical problems on the network. This work is done by miners, who use powerful and dedicated mining rigs to solve these problems that cannot be solved by hand.

For their effort, miners are rewarded with bitcoin. Thus Bitcoin mining can be defined as the process of acquiring and creating new bitcoins by solving complex cryptographic puzzles to verify and add new transactions into the blockchain network.

Mining reward halves after every 210,000 blocks are mined. The current mining reward is 25 BTC and it will halve on 15th May 2020 to 12.5 BTC.

Difficulty And Hashes

This represents the difficulty level involved in bitcoin mining. What miners do is use their powerful mining rigs to solve complex mathematical problems. The problem involves guessing or coming up with a 64 digit hexadecimal number, which is called the hash.

This hash value must be less than the target hash. The mining difficulty is adjusted every 2016 blocks or every two weeks if we consider it takes 10 minutes to solve a block.

The current mining difficulty stands at 11.9 Trillion. That means the probability of the mining rig to produce a hash below the target hash is 1 in 11.9 trillion. Mining rigs have come a long way to keep up with the difficulty. A single mining rig is able to generate as high as 15 TH/s these days.

Confirmations

As we have seen, a new block is created roughly every 10 minutes. It is the work of bitcoin miners to verify and confirm new transactions into the blockchain.

Once done, the transactions are confirmed into the blockchain network.

Besides, the number of confirmations depends on the transaction amount. One block added to the blockchain represents one confirmation. For amounts less than $1000, one confirmation is enough.

Keep in mind that at least one confirmation is compulsory or else the transaction can be reversed. For amounts ranging from $1000-$10000, 3 confirmations are needed.

For large payments ($10000-$1,000,000), 6 confirmations is the norm. It takes up to1 hour to process. For extreme amounts upwards of 10 of millions of dollars, 10+ confirmations are used.

Wallets (Public & Private Keys)

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Since bitcoin is digital, it has no physical form. Therefore it must be stored in software or a program. Simply bitcoin wallet is a program where you can send and receive bitcoins. Bitcoin wallets are of two types: cold storage and hot storage.

Cold storage refers to hardware wallets and paper wallets. Hot storage consists of desktop wallets, mobile wallets, and web wallets. Moreover, cold storage is considered safer and more secure than the hot storage wallets. Besides, web and desktop wallets can be hacked and you could lose your investment.

Every bitcoin wallet contains a public and a private key. We have to understand that bitcoins are not stored on wallets. Wallets store your private and public keys, which can be used to access your owned bitcoins. Therefore, you need to keep your wallet safe at all times.

You need to share your public key to send and receive bitcoins. When someone sends you bitcoin, they are indicating the ownership of those bitcoins to your public address. The public address is derived from your private address.

Therefore, our private key has to match with the public key for accessing those received bitcoins. If it matches your wallet balance increases.

How Do Supply And Demand Affect The Bitcoin Price?

At the beginning of the article, we mentioned that there are a total of 21 million bitcoin in existence, hence the supply of bitcoin is limited. At the time of writing this article, 18,207,950 BTC have been mined.

This number changes every 10 minutes as every new block is added to the blockchain. Each new block adds 12.5 BTC. It used to be 50 BTC at the beginning, and 25 BTC from 2012 to 2016. On May 2020, the block reward will be halved to 6.25 BTC.

As the block reward continues to decrease, fewer miners will continue mining as the cost of mining won’t decrease with the block reward. As such, the supply of new bitcoin will decrease, but the demand won’t.

More and more people are investing in bitcoin as it gains mass adoption. The simple theory of economics states that as supply decreases, price increases. Thus the value of bitcoin will rise with the decrease in block reward.

Understanding How Bitcoin Works With An Example

Let us illustrate what we have learned so far through an example. Consider two friends Dave and Andrew. Dave decides to send 1.5 BTC to Andrew. He gets Andrew’s public key to send the selected amount to his wallet.

Dave has to log in to his wallet first. From there, he selects the send button and enters his desired amount. After double-checking both Andrew’s public address and the amount to send, he clicks on the send button.

The transaction is now stored in the blockchain. Andrew will receive this amount, once his transaction has been verified by miners in the blockchain.

Andrew needs to match his private key with the public key. After that, the amount will be added to his wallet balance.

What if Dave tries to be sneaky and tries sending the same BTC to another address?

In this case, the computers on the blockchain check the last block that this bitcoin was used in. The last block contains information on Andrew’s public key. The current block doesn’t contain Andrew’s public key and hence the transaction will not be validated and rejected.

Thus double spending is avoided on the bitcoin blockchain and sneaky as you maybe you can’t mess with it. If you tried changing the data on the blockchain, only the block will be unaffected. Additionally, the rest will remain the same.

You actually won’t affect the blockchain at all. Unless you owned the majority of the blockchain, you had access to 51% of the computers in the blockchain, then you could run a 51% attack.

But the bitcoin blockchain is so massive that even if you owned more than half the computers in the network, adding new blocks must require verification. The verification must be done via mining and the cost of mining would be far higher than the amount of bitcoin earned, so it is not worth the effort at all.

Conclusion

Understanding how bitcoin works are just the tip of the iceberg. Bitcoin is the first cryptocurrency that started with humble beginnings. Currently, there are more than 2500 cryptocurrencies with different use-cases.

Now cryptocurrencies in the market are faster, offer more privacy, incurs less transfer fee, and more. But we have to remember it, all started with Bitcoin and there is a good reason why it remains the number one cryptocurrency in terms of volume, adoption, market cap, and transaction volume.

Bitcoin was created to replace the authoritarian structure of banks. It was created to offer users a secure, private, fast, and reliable system of financing and money. That day won’t be far when it completely replaces banks and becomes the preferred choice of the majority of users.

In this article, we explained how bitcoin works by explaining the blockchain structure and how transactions are processed in the blockchain. We also discussed the role of miners in addition to new bitcoins and the block reward structure.