THE.BITCOIN.FUNDAMENTALS

Published in

Coinmonks

8 min readFeb 13, 2022

In the previous article, we summarized the history of digital decentralized currencies, and we tried to answer the question: why does bitcoin exist? So, the next question should give us more insights about the underlying network fundamentals: how does the bitcoin network operate, and what are its key mechanics?

The network

First things first, the bitcoin network operates through decentralized ledger technology (DLT), or to be more specific blockchain technology, which is a derivative of DLT. The main takeaway of blockchain technology is the decentralized approach to data storage. This is still a rather vague definition, so we will go over some examples of centralized networks we use daily, and how they differ compared to decentralized networks.[4]

Our online banking system, the videos we stream on Netflix, or the Medium website you are currently reading this article on, can all be considered centralized platforms. This is because all data is stored and accessed via central data centres (or servers), as indicated in the figure below. So, the host (your bank, Netflix, and Medium) acts as intermediary connecting the service or product with the user, and therefore, holds control over the network. Essentially, they decide who can operate within the network. For example, your bank can easily restrict your transactions or lock your bank account, and thereby, seizing control over your finances. Or Medium can easily ban certain accounts or articles that don’t align with their terms and conditions. Thus, in general, centralized networks create the rules and decide who can access and participate in the network.[4]

So, how do centralized networks differ compared to decentralized networks, and what is the advantage of a decentralized infrastructure? First, instead of a single point of access, decentralized networks spread data via p2p-networks over different ‘nodes’, which each hold a copy of the network’s transaction history, called a ledger (see the figure below). Second, most networks (e.g., bitcoin) are open-source, and therefore, everyone can contribute to the networks’ code. Third, the network is immutable, meaning that the data stored on the network cannot be altered. Each block in the chain holds data and is sealed via a unique block header. Hereby, no transaction can be undone, and due to its p2p and open-source infrastructure everyone is able to participate in the network. It isn’t easy to compress the main selling points of blockchain technology in one paragraph, but the main aspect you need to understand is: (i) there is no single entity controlling the network, (ii) transactions are immutable on truly decentralized networks (e.g., bitcoin), meaning that everyone is able to transact and maintain the network, by verifying transactions (mining).[4] [5]

If we go back to the example of the bank that can block transactions, we see how decentralized networks like bitcoin offer more sovereignty. Due to the open-source and p2p nature of the bitcoin network, no single entity has control over the network, and therefore, transactions don’t require permission by a centralized actor. In short, transactions cannot be blocked on the network, and can be sent 24/7.[4]

The supply

In comparison to our fiat-driven economy, the bitcoin network maintains a different approach regarding scarcity. Instead of an infinite supply, the bitcoin supply is finite and hard-capped to 21 million bitcoins. The hard-capped supply is coded into the original code of the network, and those who use and maintain the network understand and accept this decision. A finite supply will ensure that the value of the network cannot be debased by printing (mining) more coins. Besides the hard-capped supply, Satoshi made sure that the supply would be steadily brought into circulation. The slow release of new bitcoins, would give people a fair chance to accumulate the digital asset, and would create an economic incentive for people to maintain the network, which is called mining and ensures that transactions are verified.[2]

The network consensus mechanism / mining

So, we arrived at the point where we should discuss how new bitcoins are created but first, we need some context. Bitcoin operates via the proof-of-work (PoW) consensus protocol, meaning that those who maintain the network need to leverage their computing power to verify transactions. Therefore, in order to conduct transactions on the bitcoin network, we require people willing to use their computing power to verify transactions. Below, we will give a brief overview of how transactions are handled on the network. [4]

(i) Person-A issues a transaction, and will pay a fee to send his/her transaction.

(ii) The transaction will be picked-up by the mempool, where each transaction will be checked by the network, to ensure that all transactions are valid.

(iii) Each miner works on the same block number that should be added to the chain, but each miner will develop a personal block composed of different (valid) transactions, from the mempool.

(iv) Once there is consensus about the candidate blocks, the miners will compete to verify their (personal) block, by solving a mathematical equation (solving the hash). The winning miner will then receive both the block rewards and the fees linked to the block.

(v) Once the block is mined by one of the miners, the block will be linked to the chain.

(vi) Person-B will receive the funds from person-A.

This material may seem complex because we just introduced new terminology without any context. Yet, this is merely a simplistic representation of how the network operates, but this should be a good starting point to grasp how transactions are sent over the network. Yet, we didn’t mention the most important part: how are new bitcoins minted?

Cycles

Besides the fees, miners compete to verify blocks to receive block rewards, paid out in bitcoin. So, each block mined by the network will release new bitcoins, paid out to the miner, who verified the block. Approximately, every 10 minutes a new block is mined by the network, and the current cycle rewards 6.25 bitcoin per block. Thus, on average, 900 bitcoins are released into circulation daily. Again, we encounter some new terminology, and the bitcoin rabbit hole keeps unfolding new mechanics. But, we will try to easily explain what we mean with cycles (both halving and cycle are interchangeable).[1] [2]

Satoshi invented a clever way to slowly release new coins into circulation, by first creating the incentive for others to verify transactions in exchange for bitcoin, paid out in block rewards and transaction fees. Second, he introduced the four-year-cycle, which cuts the block rewards in half every four years. So, back in 2009 the mining reward for each block was 50 bitcoins, leading to 7,200 bitcoins being mined daily. Then the first halving occurred in 2013, slicing the block rewards in half to just 25 bitcoins per block. The second halving happened in 2016, where we went from 25 bitcoin to 12.5 bitcoin per block. Currently, we find ourselves in the third cycle, which started in 2020, again slicing the rewards in half, and the fourth cycle will occur in 2024 when each block reward will be equal to 3.125 bitcoin.[1] [2]

Little technical detour…

In the previous sections, we tried to cover numerous network activities, and each step of the transaction process can be easily a standalone article. Yet, one thing we didn’t discuss due to its complexity is: how the miners compete to verify blocks by solving mathematical equations. I find it hard to explain this topic in an understandable manner, even more in an article like this, where I try to give a brief overview. But I’ll give it a shot!

Every verified block can be considered as sealed by a block header, meaning that transactions stored in the block cannot be altered, if someone would succeed to alter a single transaction, the network would grind to a halt, and a parallel chain would occur. To this day this never happened, and due to the network’s resilience, and the enormous amount of computing power required to alter sealed blocks, it is impossible to change transactions.[3] [5]

But how is a block sealed? Each block is sealed via a hash shaped into a block header. The header holds information about the transactions nested in the block, it generates a time stamp, and is linked to the previous block. In general, miners compete to guess the hash of the candidate block; those who first come up with the hash, will receive the block rewards and its transaction fees. Yet, this is a merely simple take on the process, and it skips important parts. But the main takeaway is that miners will create blocks with valid and unconfirmed transactions, and try to guess the hash, which will link the block to the chain.[3] [5]

Conclusion

We covered the underlying mechanics, but it is normal if it’s overwhelming. I told myself to easily explain the fundamentals, but it seems that I broke my own rule. Still, this article will give you a brief understanding of the bitcoin network mechanics, and other proof-of-work protocols. If you still have trouble understanding certain terms or mechanics, don’t worry. Others, and I, were also confused when we tried to grasp the fundamentals. Therefore, for more information, please check the footnotes for the sources and interesting links to other articles. Or use Google and get lost in the rabbit hole.

Sources

[1] Conway, Luke, Erika Rasure, and Skylar Clarine. “Bitcoin Halving.” Investopedia (blog), November 29, 2021. https://www.investopedia.com/bitcoin-halving-4843769.

[2] Floyd, David, Julius Mansa, and Pete Rathburn. “How Bitcoin Works.” Investopedia (blog), November 29, 2021. https://www.investopedia.com/news/how-bitcoin-works/.

[3] Hayes, Adam, and Erika Rasure. “Target Hash.” Investopedia (blog), August 29, 2021. https://www.investopedia.com/terms/t/target-hash.asp.

[4] Rauchs, Michel, Andrew Glidden, Brian Gordon, Gina C. Pieters, Martino Recanatini, François Rostand, Kathryn Vagneur, and Bryan Zheng Zhang. “Distributed Ledger Technology Systems: A Conceptual Framework.” SSRN Electronic Journal, 2018. https://doi.org/10.2139/ssrn.3230013.

[5] Tasca, Paolo, and Claudio J. Tessone. “A Taxonomy of Blockchain Technologies: Principles of Identification and Classification,” 2019. https://doi.org/10.5195/ledger.2019.140.

Join Coinmonks Telegram Channel and Youtube Channel learn about crypto trading and investing