"How does Bitcoin work?"

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This blog post is devoted to providing a high-level, non-technical theoretical overview of Bitcoin's unique architecture. How does the network reach a consensus about the current "account balances"? How exactly are transactions verified in a reliable manner without the need for third party intermediaries between the sender and the receiver? Find out below!

The "blockchain"

In this previous blog posts, we learnt that Bitcoin is a decentralized digital currency operating without the need of a financial system or government authority. It utilizes peer-to-peer transfers on a digital network powered by the blockchain, an open source code that pairs blocks of transaction history to prevent manipulation. This network is a shared public ledger that records all cryptocurrency transactions and eliminates the need for central facilitators like banks and governments to verify currency transfers. Bitcoin is a revolutionary financial system that enables fast, reliable, and secure money transfers across the globe. It is an entire ecosystem at work, and understanding how its mechanism is key to eventually grasping its influence on the world's financial system.

Bitcoin's blockchain is a distributed database of encrypted transactions that is validated by peers. This network is powered by "nodes", which store a copy of the blockchain and update it whenever there is a validated change. The blockchain consists of blocks, which store data about transactions, receiving and sending addresses, and the code that executes the transactions and runs the blockchain. When a block is opened, the blockchain generates a "block hash", a 256-bit number that encodes the block version, the previous block's hash, the timestamp, and other key information. Queued transactions are entered into the block, the block is then closed. Each block contains information from the previous blocks, so the concatenation of blocks, a.k.a. the blockchain, cannot be altered. Blocks are subsequently validated and "opened" through a process called mining. In this way, Bitcoin's blockchain creates a secure and stable network capable of performing virtually instantaneous, extremely cheap and non-censorable transactions.

What is meant by "mining"?

"Mining" is the process of validating transactions and creating a new block on the blockchain. While in its early days Bitcoin mining could be performed by anybody (and, technically, still is), nowadays mining is mostly conducted by reputable businesses, which invest millions of dollars each year in cutting-edge instrumentation such as Application Specific Integrated Circuits (ASICs) (machines that are designed specifically for mining). The miners compete to generate a number that matches the "block hash", and the process is repeated for the subsequent group of transactions. The "strength" of the network is commonly measured in "tera-hashrate per second" (or TH/s), which can be checked here. The miner that "solves" the hash first receives the transaction fees paid by the senders of each transaction included in the block on top of a sizeable reward, known as "block subsidy". This subsidy is cut in half (an event called "the halving") approximately every 4 years, and currently stands at 6.25 Bitcoin per solved block.

Why is "the halving" important?

The halving is an important concept in Bitcoin mining, wherein the mining reward is cut in half every 210,000 blocks (which correspond to approximately every 4 years). The reward was initially set at 50 BTC and has been decreased to 25 BTC in 2012, 12.5 BTC in 2016, and 6.25 BTC in 2020. The next halving is expected to occur in 2024 when the reward will reduce to 3.125 BTC, followed by a reduction to 1.5625 BTC around 2028. All 21 million Bitcoins are expected to be mined by 2140, after which miners will need to rely solely on fees to maintain the network. This mechanism is what confers to Bitcoin its characteristic deflationary property, ensuring that Bitcoin's purchasing power grows in time, rather than diminishing.

Keys and wallets

A common question from those new to Bitcoin is, "I've purchased a Bitcoin, now where is it?". While we will dwell into the details of that question in a future blog post, l'd still like to provide a high level overview of how to store and move funds on the Bitcoin blockchain. To draw an analogy to a system most people are accustomed to, it may be helpful to think of the Bitcoin blockchain as a community bank that stores everyone's funds. Wallets are like a bank account, and are used to view your balance and access your money. Credit and debit cards are used to access and use your money in the same way as wallets and keys are used to access and use your Bitcoin.

"To own a Bitcoin" is in principle equivalent to owning data. Transfers of ownership occur when transactions are made, similar to using a debit card to pay an online retailer, for instance. Your wallet, which could be a desktop or mobile application, is used as an interface to send or receive Bitcoin. When Bitcoin is assigned to an owner, they receive a number known as their private key, which is necessary for to confirm a Bitcoin transaction. Additionally, your wallet has (at least) a public address, i.e. a public key, which is used when someone sends you a Bitcoin, similar to how you would provide an IBAN code to receive a bank transfer. Your wallet is connected to the blockchain network and locates the user's Bitcoin, which are scattered across the blockchain due to previous transactions. Despite these underlying principles are fundamentally true in any situation, there are several different kinds of wallets, with different features, advantages and drawbacks associated with them which we will be reviewing in the next blog post.

Bitcoin's security

Many people are concerned about Bitcoin's security, however the Bitcoin blockchain has never been successfully hacked thanks to the robust consensus mechanisms used and represents by far the most secure network known. While the network is by design extremely secure and sturdy, there is no Bitcoin customer service, nor a Bitcoin account executive or any other professional figure to ask for help in case you lose access to your funds. When you own Bitcoin, you are the sole responsible person for your own money. In other words, you are de facto a self-banked, self-sovereign individual.

In our next blog post, we will be diving deeper into the best practices for acquiring, securing and storing Bitcoin, so if you're looking to get involved, make sure to read our next piece!