How Bitcoin Works
The Blockchain
We have already touched on the key components of what a blockchain is. However, we think it is worth going over these ideas again, before we introduce you to the key components of the blockchain. Once we have covered these issues, it should be easier for you to understand how the blockchain enables someone to safely send and receive Bitcoin without any input from a financial organisation.
The blockchain should be thought of as an entirely transparent ledger that is publicly available and can be viewed at any time by anyone. The blockchain records every unique Bitcoin transaction, regardless of how or when it is sent. It is important to note that Bitcoin has its own blockchain. The immediate implication of this is that alternative cryptocurrencies, such as Ethereum, cannot be sent and received using the Bitcoin blockchain.
As you know, the blockchain is decentralised. This is because the computers (or nodes) that are used to verify each transaction are spread across the world. Anyone can run their own node in order to bolster the Bitcoin network, and more importantly to assist in the ongoing verification of Bitcoin transactions. A key first step in running a node is to download the entire Bitcoin blockchain. By downloading each transaction that has already taken place, that node will add to the security of the Bitcoin blockchain. Once downloaded, the node will begin to verify the latest Bitcoin transactions.
What you need to Node
The Recap
The Bitcoin blockchain is propped up by computers, called nodes, that run the Bitcoin software;
The nodes are connected to one another, via the Bitcoin blockchain;
Through this connection, nodes are able to communicate transactions with one another. This connection enables users to send Bitcoins to others; and
Nodes hold a complete record of all Bitcoin transactions, in the chronological order that the transactions occurred.
Putting the Block in Blockchain
If nodes are used to validate Bitcoin transactions, then why is it called the blockchain? Well, this is because nodes don’t validate transactions on an individual basis. For example, when Alice pays Bob 1 Bitcoin, the nodes on the network do not verify just that transaction. If they did, then the network would run the risk of repeatedly verifying the same transactions, if different nodes became aware of Alice’s payment to Bob at different times.
Instead, the nodes will verify multiple transactions at once. When groups of transactions are grouped together, these groups are called blocks. It is these blocks that make up the block in blockchain. For example, Alice’s payment to Bob will be part of a block that includes multiple other transactions made on the Bitcoin blockchain.
This ensures that nodes do not need to agree on the order of individual transactions. Instead, nodes only need to confirm the order of blocks of transactions. Once a node has verified a block of transactions it communicates this out to the other nodes.
Blocks + Chains = Blockchains
This is all well and good, but understanding what makes up a block is half the battle. Currently, our blocks are not chained together. Without a chain, or chains, to link each block together, the blockchain cannot exist. Luckily, these chains do exist. They are called a “hash”. A word of warning - this is where things become a little complicated.
Each Block has its own hash. A hash is a string of random letters and numbers, and it looks a little something like this:
000000000019d6689c085ae165831e934ff763ae46a2a6c172b
Each hash is specific to the block it is assigned to and it is always unique, just like a passport number. Therefore, a specific hash refers to just the transactions in the block that it references. If an attempt is made to change any data within a block, for example by amending Alice’s transaction to suggest that she sent 2 Bitcoins to Bob instead of just 1, then that block’s hash will change. Accordingly, hashes are crucial in determining whether a change has been made to a block.
So, how does a hash create a chain between the blocks? Well, each block on the blockchain references the previous block’s hash. This creates a chronological order that the blocks need to follow. For example, if you have two blocks, block 2 and block 3, and block 2’s hash is ABC123, then block 3 will need to reference that same hash, as well as its own unique hash. If both blocks reference ABC123 in their hash, then you know that they are in the correct chronological order on the blockchain. If, however, the transactions in block 2 are changed, this will cause the hash for that block to change. This will then make all subsequent blocks invalid because blocks 2 and 3 will no longer share the same hash.
This is the chain that chains the blockchain together.
Mining Bitcoin
Up until now, we have focussed almost exclusively on the role of “Full Nodes” on the Bitcoin blockchain. These are nodes that download the entire blockchain, before then validating blocks of transactions, once the transactions in the blocks have been confirmed.
There is another type of node, called a Miner, and they play a pivotal role in the creation of new Bitcoins.
This is important because, as you already know, the total supply of Bitcoins is capped at 21 million. However, not all of these coins are currently in circulation. Unlike traditional currencies like the US Dollar, there is no central body associated with Bitcoin that can create more Bitcoins. This is where Miners come in.
Whenever a block of transactions is confirmed, and that block is added to the blockchain, a reward is issued to the first Miner that is able to verify the transactions contained within the block. That reward is, you guessed it, newly created Bitcoins. Once that block is added to the blockchain, the Miner communicates this with all other nodes (both Full Nodes and Miners), ensuring the block of transactions becomes validated. The process then starts all over again and the Miners race to be the first to verify the next block of transactions.
This is very much a simplified explanation and it should be noted that the Bitcoin mining process is very technical.
The Halving
So, Miners receive a reward for confirming blocks of transactions, before then communicating them out to the network. But how are the rewards monitored, and who decides the value of the rewards?
Rather unsurprisingly, the reward that Miners receive for adding blocks to the blockchain was determined by Satoshi Nakamoto. However, there is a twist. Typically, every four years, the reward that Miners receive is halved in an automated process called the Halving.
In 2009 a Miner’s reward was 50 bitcoin per block verified. In November 2012, this number was halved to 25 Bitcoins per block. In July 2016, the reward was reduced again to 12.5 Bitcoins per confirmed block. Since May 2020, the reward for each mined block has been 6.25 Bitcoins. It is expected that the next Halving will occur in 2024. Whenever it occurs, the mining reward will halve again, to 3.125 Bitcoin per block mined.
You might be looking at this and thinking, what a strange system. We wouldn’t blame you for thinking this - it is a quality not shared with any other currency on Earth. The Halving is an attempt, by Satoshi, to ease inflationary pressure on Bitcoin. This quality is appealing to those who resent their governments for printing more money and causing inflation.