How Does Bitcoin Work Behind The Scene?
The word pseudonymous cryptocurrency Bitcoin drew the attention of the financial world for the past few years. Massive amount of profit and loss have been made from cryptocurrency. Now, Bitcoin is considered as one of the most accepted digital currencies that are used across numerous online platforms. The word “Bitcoin” is no longer sounds unknown to any of us. However, the word “Bitcoin” and “blockchain” are used interchangeably due to the lack of understanding of the fundamental concepts of blockchain technology. Bitcoin is regarded as one of the top assets worth investing in, and blockchain technology is considered as one of the greatest innovations since the invention of the Internet. To understand how blockchain technology works, and how Bitcoin works under the hood, first, we need to explore some history of digital currencies.
History On Digital Currencies
The concept of decentralized digital currency has been around for decades. In the 1980s and the 1990s, anonymous e-cash protocol has been introduced with a high degree of privacy. However, e-cash has failed to gain traction due to its reliance on centralized systems massively. Nevertheless, in 1998, Wei Dai has proposed b-money, which was the first who created the concept of generating money through computational puzzles as well as decentralized consensus. Yet, b-money has failed due to the difficulty in implementing the consensus mechanism. Later, in 2005, Hal Finney introduced the concept of “reusable proof of work.” Hal used many ideas from b-money to achieve the concept for cryptocurrency, but once again, it has failed due to relying on centralized computing. Years after proposing and failing, in 2008, Satoshi Nakamoto introduced Bitcoin in his paper titled, “Bitcoin: A Peer-to-Peer Electronic Cash System.” In his article, Nakamoto proposed a purely decentralized version of electronic cash that would allow online payments to be sent directly from one entity to another without passing through a third financial party such as banks.
The Basic of Bitcoin
The most well-known cryptocurrency out there is Bitcoin, which is used to exchange products and services like our traditional currencies. The unit of Bitcoin is BTC. Like any conventional currencies, Bitcoin has no value without the mass adoption in the market. The value of Bitcoin comes from trading goods and services to bring the price of the Bitcoin under our control.
The blockchain network uses a public ledger to keep tracking all the Bitcoin transactions to identify the available balance of an account.
The public ledger is distributed across the world through a decentralized network, which is composed of many computers or nodes that are participating in the ledger distribution. For instance, if Bob wants to send 2 BTC to Alice, Bob would broadcast a message to the decentralized network asking to send 2 BTC from his account to Alice. Each computer or node in the network would receive Bob’s transaction. The transaction would be added to every copy of the distributed ledger across the world. The updated ledger would look like Figure 2.
You may think of blockchain as a group of computers that are responsible for updating the distributed public ledger. A bitcoin wallet is needed to perform any transactions. Each Bitcoin wallet is secured by a cryptographic method that uses public key and private key. For instance, when Bob sends 2 BTC to Alice, Bob first encrypts the transaction with his private key. Once the transaction is encrypted, then the transaction would be broadcasted to the Bitcoin network. The encrypted transaction only can be decrypted with Bob’s public key. Bob does not need to reveal his private key. Therefore, a public key and private key work in conjunction. If you encrypt with the private key, then you need the public key to decrypt, and vice versa is also true. Note that this cryptographic mechanism makes it secure when a transaction is broadcasted in the network. Once a transaction is digitally signed, it would be impossible to be decrypted if any malicious change occurs during the transaction verification in Bitcoin decentralized network.
To send Bitcoin, you need to prove that you own the private key of a wallet because you encrypt your transaction request message. You only need to encrypt the transaction once with the private key. Then, you will not need to reveal your private key with the transaction. The receiver would use the sender’s public key to decrypt the transaction and verify the transaction.
Tracking Bitcoin Balance
Blockchain network does not keep track of account balance at all. It only keeps the records of each transaction that has been confirmed successfully. Unlike traditional banks, the distributed ledger does not keep track of the available balance of each account. However, it keeps track of every transaction broadcasted within the Bitcoin network. In order to check the available balance of an account, the Bitcoin wallet needs to verify and analyze all the transactions that ever took place on that account.
The balance would be performed based on links to previous transactions. In order to send 2 BTC from Alice to Bob, Alice needs to create a transaction request that includes links to previous incoming transactions that add up at least 2 BTC. These links are called “inputs.” Computers or nodes in the network verify the amount and ensure that these inputs have not been spent yet. This mechanism would prevent double-spending, meaning that sending an amount of Bitcoin to two entities at the same time.
Owning Bitcoin means that there are transactions written in the ledger that point to your wallet address and the transaction have not been used as inputs yet. Transactions in the Bitcoin network are public to anyone meaning that anyone with an Internet connection can see who sent and received Bitcoin.
Remember there is no customer service to call, nor anyone can help to solve any issue regarding sending Bitcoin to a wrong address or recovering wallet password. Therefore, it is essential to use it carefully. Keeping the private key of your wallet in a safe place and making sure from the value and the recipient address is correct.
Bitcoin Wallets
Any Bitcoin owner can send and receive Bitcoin transactions anonymously revealing nothing other than public key. However, if Alice keeps using one Bitcoin address for every transaction that she makes, there would be a chance to connect all the transactions that Alice made. For instance, let’s suppose that Alice uses a single address for every transaction that she makes. When Alice makes her first transaction, the recipient would have her Bitcoin address. Therefore, the recipient could see all the transactions that Alice ever made since Alice uses one Bitcoin address for every transaction. It is important to preserve the anonymity of the user. The Bitcoin network allows you to generate addresses as many as you like, each with its own private and public keys. It would allow users to receive payments on different wallets. Therefore, there would be no way for anyone to know that you own all the addresses unless the user sends all the received Bitcoins to a single wallet.
The total number of possible Bitcoin addresses is
1461501637330902918203684832716283019655932542976
This would protect the network from possible attacks. Meanwhile, it allows users to own as many as Bitcoin addresses.
Bitcoin Transactions
The main advantage of the blockchain system is the lack of central authority to verify transactions for validity. However, a transaction in the blockchain network occurs in a peer-to-peer network. In other words, transactions are done in a decentralized manner. As we have mentioned, a shared public ledger is open to every participant in the blockchain system is eligible to carry out a validation of every Bitcoin transaction. Transactions need to go through a complex mathematical computation to be confirmed and accepted as a new transaction.
The Following Steps Are Required When A User Transmits A Bitcoin Transaction
All incoming transactions are queued in a pool of unconfirmed Bitcoin transactions.
The blockchain network is supported by a group of nodes that are called miners. Miners are responsible for carrying out transactions of the unconfirmed transactions.
The miner would determine whether the new transaction is valid or invalid. The verification process goes through many steps in Bitcoin blockchain, a complex process called Proof of Work (PoW).
After the validation process, the miner creates a new block that contains a group of confirmed transactions.
Each block has the following attributes
o A sequential ID or nonce
o A Hash of the previous block
o Transactions
There is a consensus protocol that is required to perform a complex mathematical problem and sing the new block before it is broadcasted into the blockchain network.
Other miners in the blockchain network must validate the new computed block. The latest block is only accepted to the blockchain network if the block is evaluated as a valid block.
Mining Bitcoin
In order to send Bitcoins, a reference to the user’s wallet is needed. This is required for every transaction across the network.
Where Do Bitcoins Come From In The First Place?
It is crucial to balance the deflationary nature of Bitcoin. A reward is given to those who solve the mathematical problem of each block. The activity of running the Bitcoin blockchain software to obtain these Bitcoin rewards is called “mining.” These rewards are given as an incentive to users due to their contribution to supporting the network with their computing power to process transactions and stabilize the blockchain network.
However, the blockchain requires an enormous amount of computing power to process transactions. Therefore, a typical computer might need a very long time, sometimes a year, to mine one Bitcoin. Therefore, working as groups speeds up the process of guessing the right number and getting the reward, which shared among the participants. These groups are called mining pools.
Since the overall network computing power increases rapidly, the blockchain system readjusts its mining difficulty of solving the next block to target 10 minutes on average for the entire network. This would enhance network security and network performance.
Moreover, the Bitcoin network has the tendency of reducing the mining reward by halving the amount of reward every four years. This process is called “Bitcoin halving.” Therefore, to encourage miners to participate in proving computing power to the network, a small reward fee can be dedicated to verify and add each transaction to the block. Therefore, transactions associated with a higher reward are usually processed faster than low reward. For instance, if you want to proceed your transaction more quickly than other transactions, you need to provide a higher transaction fee, so that your transaction gets prioritized to be selected.
Blockchain Benefits
The user has complete control of their Bitcoins. There is no central authority that holds or limits your Bitcoins.
There is no restriction in sending transactions anywhere in the world, and the transaction fee is very low compared to traditional bank transfer.
Bitcoin transactions are quite fast compared to traditional bank systems. It might take minutes to transfer Bitcoin from one user to another.
The transactions are available to the public, resulting in complete transparency.
Blockchain technology can be leveraged to build decentralized applications.
Blockchain Challenges
Transactions are sent and received anonymously. This would provide privacy to users. However, anonymity could be used to allow illegal activity on the network.
Many exchange platforms enable users to buy and sell cryptocurrencies. However, Bitcoin is not traded easily for goods and services.
Bitcoin is considered as extremely volatile, which makes it difficult for users to depend on Bitcoin for daily transactions.
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