This is intended to be a high level overview of how the Bitcoin network works. The components are broken down into different levels of detail that build on each other to help explain the key concepts in a progressive way.
To truly understand what Bitcoin is, the explanation of how it works must be used in conjunction with the economic and monetary principles it aims to solve.
Level 1:
- Wallets create a transaction to send Bitcoin from one address to another.
- Transactions are confirmed by a series of computers competing to be the first to do so.
- Validated transactions are appended onto a global universal ledger called the blockchain.
Level 2:
- While not identical, wallets are similar in function to a “bank account” that have a “balance” and are composed of two major components:
- Public Key: Used to receive incoming transactions
- Private Key: A digital password used to create a transaction to send Bitcoin to another public address
- Transaction messages are broadcasted to the network and grouped together into “blocks”. Computers validate the strict requirements of a transaction and solve a puzzle which requires computing power. If a computer is the first to validate the requirements and solve the puzzle, it is rewarded with new Bitcoin. This process is called “Mining”.
- Solved blocks from the mining process are appended onto an ever-growing string of blocks called the “Blockchain”. The blockchain is a collection of all transactions ever recorded on the network. A copy or summary of the data in the blockchain is called a “Node”. Like cents to the dollar, a Satoshi is the smallest unit of a Bitcoin. There are 100,000,000 Satoshis to a full Bitcoin.
Level 3:
- A wallet is a type of computer program that is designed to contain and manage the public and private keys of a Bitcoin address. Wallets come in a variety of types with different features, but they all must obey the strict rules of the Bitcoin network when sending and receiving transactions.
- Hot Wallet: A wallet that is somehow connected to the internet. Examples would be a wallet that exists on your cell phone, computer, or other network enabled device. Considered convenient, but not secure.
- Cold or Hardware Wallet: A physical device that holds the keys which is NOT connected to the internet. Considered to be the most secure.
- Exchange Wallet: This is a wallet that exists on an online website hosted by a specific company or trading host. An “Exchange” is a web based platform typically used for purchasing and selling Bitcoin in the market. An exchange is only as secure as the trust in the company that provides this service.
- Miners are a network of computers that are constantly trying to verify transactions, solve the puzzle, and hopefully win the reward from the blocks. The mining Bitcoin reward consists of two parts:
- Newly introduced Bitcoin. There is a fixed rate at which new Bitcoin enters into the ecosystem.
- Transaction Fee. Each transaction also requires a small fee to further incentivize the reward that miners get by validating transactions.
- Blocks are constructed in a way that the previous block becomes a digital segment of the following block. This enables them to link together and ensure the chain will only grow forward. Changes to historical transactions cannot happen since that would immediately disrupt the continuity of the linked blocks. Forward transactions only.
Level 4
- Wallets and private keys are generated by a series of seed words. The unique combination of these words work as a way to generate the keys using a form of mathematical and digital cryptography. If a wallet becomes lost or damaged, the seed words can be used to regenerate the digital password to reactivate access to the key. The seed words (and therefore the private key) are the most crucial point of security since they are the required mechanism to send a transaction from the address. Having personal ownership of the seed words and private key is known as “Self-Custody”. Online and custodial wallets are considered risky since the private key is not controlled by yourself. A wallet itself does NOT contain Bitcoin. It is merely the mechanism that controls the private key which creates a transaction message.
- The mining process functions much like a lottery in the sense that the puzzle is only solved by guessing random numbers by using sheer computing power. Many miners work together in a group or ‘pool’ to share rewards. The mining process contains three critical components that are among the true innovations and foundational pillars of the network:
- “Halving”: Every 210,000 blocks (approximately 4 years), the reward of new Bitcoin granted to miners is reduced by half. This effectively decreases the amount of new coins entering into the ecosystem and forces a diminishing new supply. This helps to enforce scarcity and contributes to the increasing value of Bitcoin over time.
- “Difficulty Adjustment”: The network constantly monitors how quickly blocks are being added onto the chain. They are kept at a constant rate of about 10 minutes per block. About every two weeks, this rate is controlled by changing the difficulty of the puzzle that needs to be solved by the mining process. This ensures a steady and predictable rate of transactions and Bitcoin entering the chain no matter the amount of computing power.
- “Hashing Power”: This is a cumulative measurement of how much computing power is active throughout the mining network. If more computers or more powerful processors enter the network, blocks will be solved too quickly and will require an increase in the difficulty adjustment. Decreasing hash power means that miners and processing power are leaving the network and the difficulty adjustment will need to be reduced to sustain the 10 minute average.
- “Proof of Work”: The only mechanism for solving a block is the use of raw power to validate the blocks and transactions. Computing power can ONLY be supplied by electricity which MUST be generated in the physical world. The use of mechanical physics in the real world can not be hacked, coded around, or bypassed creating the most effective strategy for long term security. This requirement helps to ensure that the underlying principles of securing the network cannot be cheated by any software code or dominant owners and must be enforced by a physical constraint.
- Nodes that contain the entire blockchain are distributed around the world and provide transparent and universal visibility to every participant in the network. Nodes can be hosted by anyone and are in constant communication with each other. As new blocks are published, the nodes stay in sync and provide global transparency of all balances and transactions. This visibility provides an unprecedented ability for public security and verification.
- “Decentralized”: The code that governs the Bitcoin network is universally distributed across all participants. There is no central server, CEO, I.T. department, board members, or fallible human intervention. Like dimples on a golf ball, there is no starting or ending point that can be controlled or stopped from a single location.
- “Censorship Resistant”: The Bitcoin network exists completely outside the current financial network that we currently use and commonly know. With no governing authority, transactions are made directly peer-to-peer to other users on the network. The network exists without any 3rd party (company, bank, or government) to censor, block, or prevent the transfer of Bitcoin from one user to another.
- “Open Source”: The Bitcoin code is publicly visible for all to see. Nothing is hidden or unknown about how it works, what the rules are, or what it is doing. Visibility ensures that all participants are fully aware of the rules and agree to cooperate within them.
- “Consensus”: The law of Consensus requires that the majority of users must agree on the rules to be used within their network. Changes in the core code are often proposed and even encouraged, but will not be adopted unless everyone on the network agrees to implement the same rules. Any significant change in the rules creates a new network with different properties called a “fork”. The market majority will always evaluate and decide which set of rules it chooses to uphold.