How Bitcoin works: Everything you need to know about cryptocurrency and the blockchain

In 2017, many of us use online banking to sort out our finances but there’s an all-digital currency soaring in popularity, and it’s called bitcoin. To add to the confusion, the “coins” are known as bitcoins but there is also a form of the currency called Bitcoin. Earlier this month, a bitcoin fork generated a new form of cryptocurrency called Bitcoin Cash. Still with us? 

Unlike other currencies, bitcoin only exists on the internet and not in physical form – despite what stock images will have you believe. Bitcoin works a little differently, so instead of a central authority, it uses an encrypted peer-to-peer network to store your balance and confirm and verify any transactions or purchases. This platform is called the blockchain, and it can also be thought of as a huge list of every bitcoin transaction that has ever taken place.

It’s stored on every computer (or “node”) in the bitcoin network, and lists the sender, receiver, value and approximate time of every Bitcoin transfer, all verified and anonymised. So what is the blockchain exactly, and how does Bitcoin work? Here’s all you need to know.

What is Bitcoin? 

Bitcoin is known as a “peer-to-peer electronic cash system” or “cryptocurrency”. Its beauty and appeal lie in the fact it isn’t controlled by a single authority or country, and that it allows money to be sent anonymously (this is also seen as one of its biggest downsides, and critics claim it encourages illegal behaviour). Bitcoin as an idea was first officially proposed by a programmer called Satoshi Nakamoto in a paper in 2008. The system and network were built a year later. Due to its complex nature, it remained a reserve of more tech-savvy users for years, but more recently (due to an increase in knowledge as well as computing power), it has soared in popularity. 

The prevalence of Bitcoin in the global zeitgeist is becoming increasingly entrenched; Google’s 2018 Year in Search has revealed that “What is Bitcoin?” was the most searched query of the year. The question came in at number one, followed by “What is GDPR?” and, intriguingly, “What is an ibex?”

How Bitcoin works

The best way to understand how the bitcoin register blockchain works is to follow how it’s added to step-by-step, starting with transactions. When a user wants to send bitcoins to someone else, they broadcast the details of the transaction – their public key, the recipient’s public key, and the bitcoin amount transferred – to a network of interlinked nodes.

This transfer information is independently verified by other computers in the network, analogous to having witnesses present when signing a contract. These other nodes use a “digital signature” to authenticate a transaction.

This long, complex string of letters and numbers is generated from a combination of a user’s private and public keys, along with the transaction message itself. The alphanumeric pattern is unique to every transfer and can’t be used twice, to further guard against fraud.

Once it’s been confirmed that the transaction message is genuine, the transaction data itself must be added to the blockchain to be considered “confirmed”. Nodes periodically collect “unconfirmed transactions” – those that have been verified genuine but not yet added to the blockchain – into sets, and broadcast them to the network as a new potential block.

These blocks are comprised of a group of transactions that have all been judged to take place at roughly the same time. Each new block that joins the chain must reference the preceding block, and in this manner, the blockchain establishes a traceable chronology that runs all the way back to the first bitcoin transfer.

The blockchain: Mining

Bitcoin’s mining software can be installed by anyone and uses a computer’s processing power to carry out the calculations needed for the transactions. The ultimate aim of mining bitcoin is to identify a sequence of data known as a “block”. This generates a pattern when the Bitcoin “hash” algorithm is applied to the data and whoever’s computer does this first will “win” bitcoins. There is a cap on the number or bitcoins that will be produced, which is 21 million, and a pre-defined schedule of how quickly they are released up until 2040.

The strength of the blockchain relies on group verification. Every node in the network has a copy of the blockchain, and if a node submits data that doesn’t match the rest of the network’s blockchain data, that information will be rejected.

Therefore, it’s important that all network nodes operate from identical blockchain information. In order to prevent clashes deriving from two different blocks being proposed by separate nodes at the same time, before a submitted block is accepted into the chain, nodes must first solve an incredibly complex cryptographic puzzle.

Involving highly complex mathematics and algorithms, the puzzle essentially boils down to each node guessing random numbers. The best comparison would be trying to guess the code to a combination lock, or the weight of a cake at a church fair.

Statistically speaking, a lone computer would take years to arrive at the right solution. Multiple computers on the network guessing simultaneously, however, average a solution time of about ten minutes. The first node to solve the puzzle gets their block suggestion added to the chain.

Nodes that perform this function are known as miners, and each node that successfully solves a block puzzle is rewarded with bitcoins, as an incentive to keep the blockchain going, and keep the system operational.

However, there is a finite number of bitcoins in existence, and every four years, the amount of coins generated per solved block is halved, in order to stave off the currency’s deflation. Some experts have stated that in spite of this, Bitcoin is unsustainable in the long term due to the gradual and irrecoverable loss of private keys.

The blockchain: Privacy

One of the key benefits of Bitcoin over traditional monetary systems is its anonymity. What designates Bitcoin as a “crypto-currency” is that Bitcoin, and the transfers thereof, can’t be traced back to individual users.

How the system achieves this is linked to the methods in which transactions are managed. Although the network has a public and open record of every transaction, the blockchain keeps no details of users’ individual balances.

Instead, the blockchain uses a reference system to ensure that users have enough funds to cover any bitcoin transfers. When sending money to another user, this transaction (known as an output) must be validated by referencing the information stored in the blockchain of one or more payments you received in the past (also called inputs).

To prevent users referencing the same input in more than one transaction – doublespending – each input can only be referenced once before it is considered “spent” by the system. For every transfer, the network checks these references against their copy of the existing blockchain data.

This is another aspect of the authentication system blockchain uses, in concert with the digital signature mentioned earlier. The signature ensures that the transfer is authorised by the account holder, while the input references make sure that they have sufficient bitcoins to send.

Another factor in Bitcoin’s anonymity, and the thing that makes it so attractive to criminal enterprises on the dark web, is that it’s possible to maintain complete separation between bitcoin transfers and your real identity.

Privacy-conscious users can use anonymising services such as TOR for extra identity protection, but this isn’t really necessary. The public keys that bitcoin holders use to receive payments are randomly generated sequences that can be generated at will by your wallet software, with almost limitless combinations.

The blockchain: Other uses

The beauty of the blockchain system is that it can be used as a model for other peer-to-peer authentication networks. This technique can be applied to access codes to secure clouds, encrypted file transfers and communication logs.

While the blockchain is almost always associated with bitcoins right now, it looks set to be an important part of the technological network throughout this century.