Ever Wonder How Bitcoin Works?

It is safe to say that most of the free world has at least heard of Bitcoin. Given its status as one of the most volatile yet valuable commodities out there, you would have a hard time finding someone who had never heard of it before.

But have you ever wondered how Bitcoin works? What makes it such a valuable commodity in the first place and where is this whole thing going? Here are the basics behind how Bitcoin works.

The Concept

The concept of Bitcoin is a relatively simple one: to create a peer-to-peer network for financial transactions. Prior to its creation, most financial transactions had to be done through a centralized entity such as a bank.

But the creation of Bitcoin back in late 2008 created a new method. With it came a digital currency in a decentralized system. All of the transactions could be recorded and then stored on a distributed ledger known as a blockchain.

Further, Bitcoin would be finite. It would be possible to “mine” Bitcoin by solving a series of complex math problems. But unlike our current system, Bitcoin would be finite. That would instead drive up the value of the single bitcoin rather than simply creating more.

The Blockchain

Bitcoin runs on a protocol known as the blockchain. The blockchain is a concept and has since spawned thousands of other blockchains separate from the original that was created by Bitcoin’s mysterious creator, Satoshi Nakamoto.

Blockchain technology is pretty straightforward. Any blockchain will consist of a chain of blocks of information that have been organized chronologically. The information can include contracts, emails, marriage certificates, and more.

The contract between the two parties can be established on the blockchain so long as the two parties agree. That removes the need for a third party to be involved. It also opens up a massive world of potential for peer-to-peer financial products. That includes decentralized checking and savings accounts where banks or any other type of intermediary would be irrelevant.

Post-Trust

Despite the fact that Bitcoin is quite public, it is actually extremely difficult to actually tamper with. It doesn’t have a physical presence, so there is no need to hide it in a safe or bury it in your yard. There are questions about the trustworthiness of the chain because of how simple it is.

To combat this, it created a system where basically everyone watches everyone else. Instead of the centralized entity, such as a bank, the network is totally decentralized. The great thing is that, for the system to operate effectively, no one needs to know or even trust anyone in particular.

Mining

The public ledger that compromises the blockchain is known as mining. Beneath the network of users out there who buy, sell, and trade cryptocurrency among themselves are the miners. These are the ones who record those transactions within the blockchain.

Mining is difficult despite the computing power that we have available today. That’s because Bitcoin’s software was meant to make the entire process artificially time-consuming. Without that added difficulty, people could eventually spoof transactions to either help themselves, hurt others, or both.

The software works by adjusting the difficulty that miners face to limit the network to just a single new 1-megabyte block of transactions that occurs every 10 minutes. In this way, the volume of all transactions becomes digestible.

The network is then given the time that it needs to vet the new blocks and the ledger that came before it. This way, there can be a consensus about the validity of the block. Miners don’t work to verify transactions through adding blocks simply because they want to see the network run smoothly. Miners are compensated for that work, which is perhaps the most important part.

Halving

Miners, as mentioned at the end of the last section, get rewarded when they verify transaction blocks. The reward is cut in half for every 210,000 blocks that are mined. That equates to about four years of time. The event is known as halving and the system is meant to be a deflationary one.

The process of mining Bitcoin is meant to continue until about 2140. When all the Bitcoin has been mined from the code and each of the halvings are done, then miners will continue to be incentivized by the fees that they charge network users. The thought is that there will be healthy competition, keeping the fees low.

The system is constructed in a way that is meant to lower inflation and drive up the stock-to-flow rate of Bitcoin. As of May 11, 2020, the reward for each block that has been mined is now up to 6.25 bitcoins.

There is far more to it than that, but that is for another time.