How does Bitcoin work?

 

At a high level, Bitcoin is a philosophy of money, governance and systems that has been successfully digitised.  It emerged after the Global Financial Crisis from an anonymous source called ‘Satoshi Nakamoto’ (there is fierce debate whether or not ‘Satoshi’ is a single entity or collective). Satoshi outlined several concepts that work together in an open system to create a viable digital currency.

Bitcoin derives its value from security and decentralisation. The actual mechanism of how it does that is revolutionary in perceiving the essence of money accurately. The simplest explanation is that difficult cryptographic puzzles are solved by a network of computers (who do not necessarily have “trust” in one another) to maintain the integrity of the system and that this ‘work’ creates value that is locked into the transactions and the tokens. This ‘work’ concept is commonly referred to as ‘proof of work’ or POW.  That value, baked into digital tokens, is then traded amongst users.

Blockchain (aka DLT – distributed ledger technology) has existed for several decades, however, the advent of Bitcoin has catapulted the idea into the modern lexicon.

The Bitcoin blockchain is a ledger that contains the full transactional history of each bitcoin. A Bitcoin is traded by announcing transactions to the ledger and the transaction is checked by a de-centralised network of computers who ‘agree’ on the event and confirm it to the blockchain, eventually gaining consensus through multiple confirmations. The most recent transactions are grouped together in a ‘block’, held in a chain of transactions held in blocks, or, the blockchain.

It is the immutability (i.e. permanence) of the transactions on the ledger, and the length of the blockchain that are the basis of the integrity of the system.  The Bitcoin system validates a transaction with the greatest amount of supporting evidence that it is the ‘right’ blockchain. This is the transaction with the longest ‘blockchain’ history – a history going back to that Bitcoin’s origin or, its ‘Genesis block’.

Older non-cryptographic currencies relied on a centralised authority to validate transactions, whereas the Bitcoin protocol uses a de-centralised network of computing power to perform the transaction. This de-centralised network is idealised as incorruptible by Bitcoin enthusiasts, where 51% of the computing network must act in concert to corrupt the system. The network checks Bitcoin transactions against the blockchain to perform transactions, removing the risk of ‘double-spend’, where digital currency could be spent twice.

Previously, a central, trusted authority was required to register and validate a transaction to avoid this problem. In the Bitcoin Protocol. The digital asset requires no trusted third party, making it a “trust-less” transaction.

Computers on the network, called Bitcoin ‘miners’ are rewarded in Bitcoin for performing calculations. The “hash” power (i.e. the computing power dedicated to ‘mining’ Bitcoin) recently reached another record high and shows no sign of abating. The system is open but maintains its integrity through game-theory. It is fair to say that this has been overwhelmingly successful.

Bitcoin exists at an address on the blockchain as the last recipient in a series of transactions that go back to the Bitcoin’s origin, its Genesis Block.  The chain of transactions that it has been involved in is recorded in blocks, creating a chain of transactions, permanently recorded in digital blocks of data.  They are processed by a de-centralised computing network, avoiding the need to trust an authority or institution to register the transactions.

The authority of Bitcoin is the Bitcoin Protocol, the concepts it is testing, and the execution of those concepts. It has been 10 years since Bitcoin’s conception and it stands as a revolution in the concept of money, in how the real world interacts with the digital world and with the financial system.

And that anonymous source of the Bitcoin whitepaper? The elusive Satoshi Nakamoto is estimated to have $10 billion dollars’ worth of Bitcoin that has never been accessed, presumably to maintain the integrity of the entire system.

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