What Is Bitcoin And How Does It Actually Work?

The term Crypto refers to encryption algorithms and techniques like public key/ private key pairs. These technologies were combined with hash functions to develop the first well-known (and currently most popular) cryptocurrency called Bitcoin that was launched in 2008–09 by an individual/corporation under the pseudonym “Satoshi Nakamoto.” Bitcoin was released as virtual money or token with an intent to disrupt the financial markets and as an alternative to paper- based currency. It leverages a collection of cryptographic concepts and blockchain technology to store and transmit value among users.

Bitcoin’s modus operandi is a combination of the following key components:

  • Proof-of-Work (PoW) consensus algorithm that serves as a decentralized peer-to-peer network.
  • Blockchain technology that is used as a transaction ledger.
  • A decentralized and mathematically bound mining and token issuance method.
  • A verification method used with the help of transaction scripts.

Bitcoin allows people to send money (or value in the form of tokens) in a way that is similar to sharing information via an email or text—that is, online! To understand how a transaction takes place within the Bitcoin network, let’s consider an example. User A wants to transfer 5 bitcoins to User B.

Following are the steps that need to be followed to settle the transaction:

Step 1: User A and User B need to create their wallets. Thus, each user will have their own unique public and private key pair (also called addresses).

Step 2: User A (sender) requests the public key/address of User B (receiver) and sends bitcoins (or any other cryptocurrency).

Step 3: The transaction is confirmed and recorded within the blockchain ledger.

These transactions are recorded using a large distributed set of computers over the Internet. This network is neither closed nor under the control of one party. As soon as User A (from the preceding example) initiates the transfer of bitcoins to User B, a transaction message is generated and sent across the blockchain network. The transaction message contains the time, date, participants’ unique wallet addresses, and the amount. This message is encrypted using the sender’s unique private key known only to the sender. When the new transaction is sent to the network, each node verifies the transaction using a complicated state-of-the-art technology, which is based on mathematics. Each node of the blockchain tests the signature by trying to decrypt it. If successful, they know that the true account owner created the signature. The mathematical principle also ensures that nodes automatically and continuously reach consensus about the current state of the ledger and every transaction in it.

The nodes are distributed all across the globe, and each node contains a copy of the exact same ledger. The maintainers of these nodes are called miners. Thus, when a new message with a valid signature is sent, each miner updates their personal ledger with the transaction information. Since these ledgers are distributed, traffic delays lead to differences in the ledger. Thus, for the world to decide which version of the ledger to use, a kind of voting system is followed. But unlike traditional voting, which involves ballot boxes, blockchain technology relies on mathematical puzzles that each miner has to solve. The first miner to solve the puzzle broadcasts the solution and everybody updates to that solution, making the vote a mathematical race.

The private keys serve like signatures on a cheque book. But instead of relying on handwriting, it relies on mathematics to ensure the integrity of the blockchain. Thus, if someone tries to send an unauthorized transaction, the nodes will not reach consensus, refusing to incorporate the concerned transaction into the blockchain. This way every node of the blockchain contains the entire copy of the ledger right from the genesis block (which is the first block ever mined) to the most recent block. Thus, everyone has access to a shared single source of truth called blockchain, which we can trust with the authenticity of all the transactions ever made.

Bitcoin is not similar to traditional banking or payment systems. In the traditional transaction method, a centralized authority keeps track of money, but in the Bitcoin system, there is no issuance authority. Instead, all tracking and settlement are achieved by cryptographic concepts and blockchain technology over a network maintained by the participants themselves.

If you want know about Blockchain, then check out our book "Blockchain for Business with Hyperledger Fabric". The book starts with a brief introduction to the world of blockchain. The book will cover all aspects of fabric ranging from network setup, to use case deployment and testing. Several examples have been covered in this book which will provide you a hands-on understanding of the subject. 

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