How Bitcoin Works

In our previous content, we talked about “Introduction to Bitcoin”, where we gave a brief but detailed explanation on what bitcoin actually is. We detailed how Bitcoin came about and the terminologies associated with it. You’ll come across most of the mentioned terminologies here, so if you haven’t read the introduction already, you can read it [here]. 

Now that we’re up to speed, in this content, we will be taking a look at a brief history of Bitcoin and how it works. It’s great you now know what bitcoin is and how it came about. But how exactly does it work? Continue reading to find answers for yourself. There’s so much to learn.

Brief History of Bitcoin

Bitcoin was invented in 2008 by Satoshi Nakamoto with the publication of a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. Satoshi Nakamoto combined several prior inventions such as b-money and HashCash to create a completely decentralized electronic cash system that does not rely on a central authority for currency issuance or settlement and validation of transactions. The key innovation was to use a distributed computation system (called a “Proof-Of-Work” algorithm) to conduct a global “elec‐tion” every 10 minutes, allowing the decentralized network to arrive at consensus about the state of transactions. This elegantly solves the issue of double-spend where a single currency unit can be spent twice. Previously, the double-spend problem was a weakness of digital currency and was addressed by clearing all transactions through a central clearinghouse. Satoshi who created the Bitcoin system is totally anonymous to the entire world.

Bitcoins are completely virtual coins designed to be self-contained for their value, with no need for banks to move and store the money. Once bitcoins are owned by a person, they behave like physical gold coins. They possess value and trade just as if they were nuggets of gold. Bitcoins can be used to purchase goods and services online with businesses that accept them or can be tucked away in the hope that their value increases over time.

How are bitcoins generated?

Bitcoins are generated by bitcoin miners. Miners secure the Bitcoin network and process transactions. Without miners, Bitcoin would be vulnerable to attack and become worth nothing. In return for their security and processing services, miners are rewarded with new bitcoins (and transaction fees). 

Each time a miner successfully solves Bitcoin’s proof of work algorithm, that miner mined a “block”. The miner or mining pool that mines a block is rewarded through the block reward, a set amount of bitcoins agreed upon by the network. The bitcoins included in the block reward are all new bitcoins. This is the only way that new bitcoins are created.

How many bitcoins are generated?

The block reward started at 50 bitcoins per block, and halves every 210,000 blocks. This means that each block up until block 210,000 will reward 50 bitcoins, but block 210,001 will reward just 25. The Bitcoin difficulty makes sure that blocks are found on average every 10 minutes. With an average of 10 minutes per block, a block halving occurs every four years.

This means new bitcoins are generated every 10 minutes. Anyone can publically verify the creation of new bitcoins using a block explorer. Eventually the block reward halves many times and becomes so small that no new bitcoins can be created.

Can counterfeit bitcoin be generated?

Only bitcoins awarded to miners can be spent. It is impossible for a single user to bring new bitcoins into supply. This is because Bitcoin uses cryptography to verify all transactions. Only the correct digital signature will allow bitcoins to be spent.  Miners verify and process this data while they try to solve the proof of work. This prevents people from spending bitcoins they do not own or creating bitcoins that were not issued by the network. Someone could create their own fork of Bitcoin that gave themselves new bitcoins. Since this would create a fork, the new bitcoins would only be valid on the new fork of the network. The main Bitcoin chain would see the new coins as invalid and unspendable.

How are bitcoins stored?

Bitcoins are stored on computers as a set of access keys called a bitcoin wallet. This set of secret keys allows you access any bitcoins sent to your wallet. Creating copies of this wallet will duplicate access to the same coins (since they’re both using the same secret keys). There are several different strategies that one can use to store your secret keys. We will see them in our next content when we will be talking about bitcoin wallets in detail.

How are bitcoins transferred/spent?

Bitcoins are transferred and or spent through a process called “Bitcoin Transaction”. A Bitcoin transaction is a message, like email, which is digitally signed using cryptography and sent to the entire Bitcoin network for verification. Transaction information is public and can be found on the digital ledger known as the ‘blockchain.’ The history of each and every Bitcoin transaction leads back to the point where the bitcoins were first produced or ‘mined’. We will talk more on bitcoin transactions in our subsequent contents. In our next article, we will be talking about Bitcoin wallets and its types, how to set up a Bitcoin wallet and how to know the right Bitcoin wallet to choose. Did you learn just enough to know Bitcoin actually works? Comment below.