How Does Bitcoin Work? - June 2018
All You Need to Know About the Cryptocurrency Bitcoin
In this guide, you will learn everything you need to know about Bitcoin. We will describe how everything works in the Bitcoin Network and explain complicated things in an easy way. Before you read about how Bitcoin works, you should have a good understanding of what Bitcoin is. Therefore we recommend reading this guide first: What is Bitcoin?
Bitcoin is basically a digital file where all transactions are collected in a ledger. People transfer money to each other by updating the public ledger. The Bitcoin Network is a decentralized system because the common ledger is shared with computers throughout the network. No central authority can control Bitcoin because it is based on a peer-to-peer network.
In short, the Bitcoin Network works by Bitcoin Miners competing to solve a cryptographic and mathematical problem and find the next hash in something called the Blockchain. We will explain in detail how this works.
However, you don’t need to know how the technology works to use Bitcoin. Does everyone using the Internet know how it works? You don’t have to worry about the Bitcoin system as it is proven safe and secure. Bitcoin has never been hacked since Satoshi Nakamoto introduced the peer-to-peer network in 2009. Every since then, a new block of transactions has been created every 10 minutes.
That is the heart that keeps beating in the Bitcoin Network, and nobody can control or turn off the network.
How Does the Bitcoin Network Work?
If we want to understand how Bitcoin works, we should start with the Bitcoin Network. It is a global network where people share a common ledger. The system is based on Blockchain technology through the distributed ledger.
The public ledger is updated every time someone solves a cryptographic and mathematical problem. This is called Bitcoin Mining. If you solve the problem, you may create the next block of transactions in the chain. You are then rewarded with Bitcoins and receive transaction fees.
All Bitcoins are linked to a public key, and the owner of it has a private key. The public key consists of an alphanumeric code between 27-34 characters. For extra security, a hash function is used to generate a new line of code. This works as your account number or address. The private key acts as your password by proving that you are the owner of the public key.
It is common to use a QR code generated by your Bitcoin address (here you can create your own QR codes: www.bitaddress.org). Otherwise, your Bitcoin address could look like this: 31Uw6L6RiIcdQgPqBkvIofH6CQ7wnMjxC
Nobody owns the Bitcoin Network in the same way that nobody owns the Internet. No state, bank or company can control the digital currency Bitcoin.
What Is a Distributed Ledger?
The Bitcoin Network is based on Blockchain while the distributed ledger is Blockchain technology. Because the ledger is shared on multiple computers, you don’t need to trust any third party.
Everyone in the Bitcoin network shares a common ledger with each other. In this distributed ledger is all Bitcoin transactions that have ever been done. This means that the Bitcoin network is transparent, but at the same time, it is anonymous. You can not connect an individual to ownership of Bitcoins.
The computers in the network communicate with each other to ensure that they use the same version of the ledger. Through this decentralized system, Bitcoin solved the problem with double-spending. All previous cryptocurrencies had this issue.
Since the ledger is public, anyone can download it and verify transactions. The first Bitcoin Wallet that was created is called the core wallet and contains the entire ledger.
Today that wallet requires about 100 GB of storage space, making it not suitable for all devices. However, you don’t need to download the ledger to use Bitcoin.
How Does Bitcoin and Blockchain Work?
Blockchain uses a cryptographic hash function that is constantly evolving based on previous blocks in the chain. Bitcoin which relies on Blockchain uses a hash function called SHA-256. It stands for “Secure Hash Algorithm” and was developed by the NSA in the United States. In other words, it is safe.
To create a new block of transactions, you need to solve this cryptographic hash function. It’s not as complicated as it sounds. The function has input data that is converted to output data. After the output data is generated, it is difficult to recreate the input data. Therefore, a large amount of computer power is required to solve the mathematical hash function.
There is no simple solution to this math problem. Computers generate random numbers until the results meet certain criteria. For example, we know that 1 + 2 + 3 + 4 = 10. We can easily see that 1 + 2 + 3 + 4 generates the number 10. But there are a variety of other combinations that can also generate the number 10.
You simply need to test input for input to see if the data generates the right result. The difficulty of the problem is also increasing based on the number of computers involved. Therefore the Bitcoin Network is self-regulatory.
All rules in the network are in the Bitcoin protocol, and a consensus is required to update the protocol.
How Does Bitcoin Mining Work?
Bitcoin Mining is trying to solve the cryptographic and mathematical problem we described. When a Bitcoin Miner solves the math problem, it may create the next block of transactions in the chain. That’s why it’s called Blockchain.
Bitcoin Miners is rewarded with Bitcoins and transaction fees from users if they create a new block. Once the block is created, everyone in the network will be notified to update their version of the ledger.
Because it takes time to solve the problem, it works like a proof-of-work system. This creates an open network because it requires a consensus in the network. As said, the difficulty also increases when the number of computers increases. Meaning that no individual can overtake the Bitcoin network.
If Bitcoin Miners creates a block of transactions at the same time, two versions of the Blockchain will occur in the network. If this happens, the Bitcoin Network will select the longest chain of blocks. All transactions in the shorter chain will then be included in the next block.
Even though Bitcoin is anonymous, it is possible to track all transactions since it came from the Blockchain. All Bitcoins come from the Blockchain. If you follow the transaction history of a Bitcoin, you will sooner or later end up in the Blockchain. Bitcoins can only be created by Bitcoin Mining.
There is also a limit of 21 million Bitcoins that can be mined. The last Bitcoin will be created approximately in the year 2140.
Is Bitcoin safe?
Overall, there are two things that make the Bitcoin Network secure. The first is that people download the core wallet, which means that the ledger is shared on multiple computers. This wallet is called QT clients and contains the entire public ledger.
In addition to containing all transactions, it also acts as a Full Node. This means that it communicates the rules to all other clients and Bitcoin Miners. The Bitcoin Core wallet works on Windows, Linux, and Mac
The other thing that secures the network is all Bitcoin Miners that verifies transactions by solving mathematical problems. Bitcoin Mining ensures that all transactions are verified and sorted in the correct order. If we do not know the order of the transactions, people can spend their money several times.
In order to sort the transactions, we need something called time. That’s why a cryptographic and mathematical problem is used. Solving the problem takes time. In that way, the Bitcoin network has a proof-of-work system that creates time stamps on all transactions.
Bitcoin is secure and safe because there are thousands and thousands of Bitcoin Miners and Nodes around the world.
How Can Bitcoin Be Used?
Today Bitcoin is primarily used as a payment method. No middleman or third party is required to transfer money. You are your own bank. However, using Bitcoin as money is just one of several applications in the network.
Because the Bitcoin protocol includes smart contracts, there are a variety of uses for Bitcoin. Businesses have started building applications within private messages, data storage, finance, smart payment solutions and much more.
For example, it has become popular to use Bitcoin in crowdfunding. Not only because it’s easy, fast and cheap to pay but because cryptocurrency enables smart contracting. This makes it easy to collect money for a project. Can you image more opportunities?
You can create contracts with specific requirements which need to be achieved by the project. In other words, they can’t run away with your money.
Another example is Bitcoin services that eliminate spam. Applications that require a small amount of money for each mail sent. It doesn’t have to be more expensive than 1 penny. For you, it costs almost nothing, but if someone wants to send 100,000 spam emails, it costs money.
There are great opportunities with hundreds of cryptocurrencies that are good at different things.
What Are the Problems and Limitations with Bitcoin?
Bitcoin is not flawless and has problems and limitations like all other currencies. The good thing is that problems and constraints can be solved by updating the Bitcoin protocol. However, this requires users to agree in the Bitcoin Network.
Let’s look at technical limitations that exist and what it means. First of all, you need a broadband connection to use the Bitcoin network. It is necessary to communicate with each other to update the ledger continuously.
Therefore, it is difficult to use Bitcoin in geographic areas where there is no Internet. However, this will be solved in the future when everyone has access to the Internet. Another drawback is that the core wallet requires around 100GB of storage space today. At the same time, Moore’s Law exists which means that processor power doubles approximately every two years.
Another important point is that you don’t have any protection with Bitcoin. If something goes wrong, there is no customer support that you can call. With freedom comes responsibility.
There are many other things discussed in the world of Bitcoin. Such as the size per block, the time it takes to verify a transaction, and how to make Bitcoin more user-friendly.
How Does a Bitcoin Transaction Work?
When a transaction is completed, it is shared together with its message in the Bitcoin network. But how do you know that the transaction is not fake?
This is solved by using a digital signature. If you want to transfer Bitcoin from one address to another, you need to use a digital signature. As a regular signature, you verify ownership of Bitcoins. Each transaction has a unique digital signature which means that they can not be restored.
To create a digital signature, the private key together with your message is used in a mathematical algorithm. That way, you can prove that you are the owner by holding the private key. At the same time, you don’t need to show your private key thanks to the mathematical algorithm.
Your transaction is collected in a block that a Bitcoin Miner verifies by linking it with the rest of the Blockchain. This gives your transaction 1 confirmation, and for each new block that is created, another confirmation is added.
With small amounts of money, you don’t have to worry about confirmations. However, if you’re sending a large sum of money, you should wait for more than 1 confirmations. It is recommended to wait for at least 6 confirmations to be 99.9% sure that your transaction will not be canceled.
This takes about 1 hour. Everything is relative, but it’s nothing compared to bank transfers.
At present, a Bitcoin can be divided into one hundredth of a million (0.00000001), also known as a satoshi.
Bitcoin Will Change the World
Bitcoin is revolutionizing the financial industry. You can transfer money fast, easy and cheap. There are neither geographical restrictions nor closing hours. You can transfer money 24/7 to anyone on earth for extremely low fees.
How the future will look in a couple of decades is impossible to predict. However, finance is just the first sector that Bitcoin and Blockchain will change forever.
Today, we are 7.5 billion people on earth, with 2-4 billion that are entirely excluded from the financial world. Almost 5-6 billion are cut out from international trade. Bitcoin removes barriers and opens the financial world to everyone. This change will happen faster than anyone can imagine.
If you want to learn more about how Bitcoin works, we have several guides available. For those who are interested in details, we recommend the original white paper from Satoshi Nakamoto. You can read it here: bitcoin.org/bitcoin.pdf.
The easiest way to get started with Bitcoin is to buy Bitcoin. However, many marketplaces are not safe. We only recommend buying Bitcoin at well-known marketplaces.
Below we have listed three of the best marketplaces where you can buy Bitcoin. These sites are both safe and reliable.
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