Bitcoin is the world’s first peer-to-peer (P2P) digital payment network, producing a restricted supply of BTC cryptocurrency. Its greatest innovation is the ability to transfer assets — digital tokens — from one party to another without the need of intermediaries such as banks or payment services.
As a result, Bitcoin has changed the understanding of money. Ever since Bitcoin was released in 2009, more than 10,000 cryptocurrencies have hit the market, including Ethereum, the No. 2 network and the cornerstone of decentralized finance.
To fully understand the implications of Bitcoin as decentralized money, we need to understand how it works.
Bitcoin Origin and Purpose
Computer scientist and cryptographer Nicholas Szabo first laid the groundwork for Bitcoin in 1998. He proposed a theoretical construct called Bit Gold. As its name implies, it would be a digital form of gold, secured by a decentralized network. Bit Gold contained key elements we see in Bitcoin and other cryptocurrencies:
- It all starts with users installing a source code on a computer — network node.
- The user’s node must employ its computing power to solve a cryptographic equation.
- Resolved crypto puzzles are sent across the Byzantine Fault Tolerant (BFT) computer network.
- Each resolved solution is assigned with a public key identifying the node.
- Transfer details are stored in a public ledger (database).
With every solution chronologically stamped, the ledger is then generated as a chain, each addition validated as a block dependent on the validity of the previous block. So, to fudge the public ledger, one would have to compromise not just the single transaction, but the entire record.
Because each network node contains the entire record, it then becomes virtually impossible to corrupt all nodes. This is where Byzantine Fault Tolerance (BFT) comes in as the critical cog. BFT is a reference to the Byzantine Generals’ problem, in which ancient generals had to devise a system by which messengers would have to relay orders without distortion.
In blockchain cryptography, BFT is an algorithm that allows some nodes to be corrupted, but still allowing for the network to stay intact. This is why Szabo called this theoretical construct Bit Gold. After all, sound digital money would have to be as non-fungible as gold itself, and BFT provides that redundancy.
Fast forward to 2009, the pseudonymous Satoshi Nakamoto applied these principles to launch the Bitcoin network. He titled the whitepaper “Bitcoin: A Peer-to-Peer Electronic Cash System.”
The timing was ripe, as the world was hit by the Global Financial Crisis. Consequently, the Federal Reserve (central bank) had to bail out commercial banks, using taxpayer money.
For this reason, Nakamoto embedded the following message in Bitcoin’s first block — the Genesis block.
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” was a title copied from the UK’s newspaper The Times, announcing more bank bailouts. By doing this, Satoshi made it clear what Bitcoin is all about — countering the central banking system.
How Does Bitcoin Work?
Satoshi Nakamoto made it clear that the only way digital money can work is if it is “an electronic payment system based on cryptographic proof instead of trust.”
Interestingly, the seeds of this thinking have been planted over a hundred years ago. In Keynes’ Cambridge lectures of 1912–13, dubbed the “Principles of Money I,” it was theorized that measuring the value of money would be supplanted by units of energy.
To answer the question — how Bitcoin works? — is to answer the question — how Bitcoin mining works?
Again, “mining” is a reference to mining gold, because gold has been used as an immutable value for thousands of years. As a rare noble metal, gold is both precious and a cost has to be exerted to mine it. Accordingly, Bitcoin has to mimic this mechanism of limited supply and mining cost.
This is how Bitcoin mining accomplishes this:
- The first prerequisite was defining Bitcoin’s source code: limited to 21M BTC. Additionally, a deflationary mechanism of BTC rewards was set: every four years, BTC mining reward is halved, going to zero by 2140 when all 21M BTC is in circulating supply.
- When this source code was deployed in 2009, reward per block was 50 BTC. In 2022, it is 6.25 BTC, and in 2024 it will be 3.125 BTC.
- Miners install this source code on computer nodes, exerting computational power to process Bitcoin transactions and add them as new data blocks on the chain. This is miners’ Proof of Work in order to receive rewards.
In other words, Bitcoin mining makes it a self-sustaining and self-incentivizing trustless network.
That’s the only way it can exist without needing to have any CEOs, governance board, or customer support.
If one can remember all the seed phrases when opening a new wallet address, it is then feasible for the first time in history to hold unaccountable wealth in one’s mind.
What Does Bitcoin Mining and Transactions Look Like?
Miners’ computational power to solve cryptographic puzzles is measured as hash rate. For instance, a typical ASIC mining machine for Bitcoin, Antminer S19 Pro, has the capacity of 110 TH/s (tera hash per second) at an energy consumption of 3,25kW.
Hash is a mathematical function that generates unique identifiers, formed as a fixed-length alphanumeric code. Hash functions transform any data into unrepeatable character strings. With Bitcoin, miners need their rigs to mine a heavy-duty SHA-256 hash function.
This hash rate power is pitted against the network’s hash rate difficulty. The higher it is, the more difficult it becomes to compromise the network. For miners, hash rate difficulty sets how difficult and time-consuming it is to find the right hash (mine it) for each transaction block.
To maintain the fairness of Bitcoin mining, it is impossible to predict which miner will resolve the hash first. Meaning, they are randomly picked to receive BTC rewards. For this reason, Bitcoin miners form mining pools, bundling up thousands of transactions per block. The value of each transaction is completely irrelevant. Instead, all it matters is its byte size.
Typically, each block holds 1.6MB worth of transactions, generated every ~ 10 minutes. Visualized, they look like this.
Named after Satoshi, “sats” represent one billionth denomination of one BTC, just like the cent is one hundredth denomination of the dollar. This is what BTC senders pay as a fee, going into miners’ pockets. Each mini-block represents individual transactions with their own transaction ID (TxID), a 64-character string that looks like this:
Even if BTC transactions are unconfirmed during the 10min block generation, one can check its TxID, copy it, and send it to the receiver. This way, the BTC recipient knows that the payment was indeed sent.
They would simply use a blockchain explorer like blockchain.info or bitfeed.live to paste the TxID and see that it is in a Bitcoin block, irreversible and immutable. Additionally, because all Bitcoin transactions are chained, they could see its entire input-output history.
Although Bitcoin is an immutable public ledger, it doesn’t mean its source code can’t be tweaked. If all miners agree on the Bitcoin Core upgrade, then the entire network runs on new code.
The first significant upgrade happened in 2017 — Segregated Witness (SegWit). Its goal was to improve the network’s throughput by reducing the weight of transactions per block. Effectively, this increased the number of transactions that could be bundled per block.
Technically, the SegWit upgrade did this by removing the “witness data” that hold transaction signatures.
Lastly, another important upgrade is the Lightning Network. Although it doesn’t tamper with Bitcoin Core software, it serves as a Layer 2 network on top of the Bitcoin network. This scalability solution is similar to Ethereum’s Polygon, Optimism, or Arbitrum.
Lightning Networks works by funding a payment channel, through which BTC is sent. Because LN payment channels can execute multiple transactions, without waiting for them to be mined first, this dramatically expands Bitcoin usability as a daily, near-instantly finalized payment system.
Once the payment channel is closed, all the transactions are bundled up and added to the Bitcoin mainnet. As a reason, the Bitcoin network can not only serve as a decentralized storage of wealth, but as a true electronic cash system. Just like Satoshi Nakamoto originally envisioned.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.