What is Bitcoin and How Does it Work?

Nakamoto left the project in 2010 without ever revealing much about who they were. But, the departure of the person or persons behind bitcoin is of little consequence to current developers and coders who remain. According to bitcoin’s website: ‘the identity of bitcoin’s inventor is probably as relevant today as the identity of the person who invented paper’.¹

How does bitcoin work?

Bitcoin works as a decentralised peer-to-peer virtual currency. What does that mean? Well, ‘decentralised’ means that there isn’t an overarching body that regulates bitcoin transactions. Instead, bitcoin operates according to a majority-rules principle, whereby a transaction won’t be considered valid until at least 50% of the machines on the network have verified it.

‘Peer-to-peer’ means that you can send bitcoins to other users on the network without having to go through any middlemen – such as a bank or third-party payment mediator. Instead, you might say that you wanted to buy a pizza using bitcoin, and you’d see who was willing to sell pizza to you while accepting bitcoin as a form of payment.

‘Virtual currency’ means that no physical, tangible bitcoins exist. There are no metal bitcoins out there that you can hold in your hand like you can with US cents or British pound coins, and there likely never will be. Instead, every new bitcoin is created entirely electronically.

Example of how bitcoin works

At a very basic level, bitcoin works in the same way as many other currencies around the world. It can be exchanged for goods and services with vendors who accept it as a form of payment. Bitcoins are stored in digital bitcoin wallets, not entirely dissimilar to the wallet in your pocket.

If you wanted to buy something with bitcoin, you’d go to your bitcoin wallet and choose to send an agreed amount of bitcoins to a vendor. Bitcoin transactions use a ‘private key’ to confirm the exchange of coins between wallets – which helps to increase security.

Once a transaction has been completed, it is lumped together with other completed transactions into a ‘block’, which is then assigned a unique signature – called a ‘hash’. The hash is a very important part of how bitcoin works, and simply put, it is formed using all the transaction data contained in one particular block, condensed down into a readable and easily-distinguishable code.

Once a block has a hash, it is broadcast to the network for verification and if it is determined to be valid, it is added to the ‘blockchain’ for everyone else on the network to see. Now, while these words might seem like jargon, they’re each defined in more detail later in the article.

What is bitcoin mining?

Bitcoin mining is the process of collecting bitcoin transactions into blocks, and then generating a hash for that block. It is performed by ‘miners’, who use computers – known as ‘mining nodes’ – in a race to be the first to generate a hash for a new block of transactions.

Think of a ‘block’ in bitcoin as, quite literally, a collection of transactions that have been grouped together. To create a block, a few things need to happen.

Firstly, a miner will need to verify that a transaction is possible. This is done by checking that the person using bitcoin to buy something on the network has enough funds to complete the transaction. This involves cross-referencing the details of this transaction against the previous transaction history stored in the existing blockchain.

Once they’ve verified that this transaction is possible by establishing that the buyer has enough coins to complete the purchase, the miner will collate a group of legitimate transactions together to form a block.

Next – and this is the tricky bit – a miner will attempt to generate a hash for this new block of legitimate transactions. The hash is unique to this block and its transaction data, so no two hashes are ever the same.

After a hash has been created, there is a cryptographic mathematical proof that the transactions in this block are valid – and once the proof has been verified by 50% of the network, the block is added to the blockchain. As a whole, the network will only generate a new hash once every ten minutes or so, and the hash difficulty is increased as new machines join the system.

How are bitcoins created?

Bitcoins are created as a reward for the first miner to create a hash for a block of transactions. This means there is a race between the miners to be the first to generate a hash and receive this block reward.

The reward halves every four years or so, which is roughly the time it takes to create 210,000 blocks. After the most recent bitcoin halving that took place in May 2020, the reward for bitcoin mining was 6.25 bitcoins per block.

New coins are added to the winning miner’s bitcoin wallet, and they are free to exchange them with other users on the network. This creates more transactions which will need to be collected into blocks and assigned hashes, resulting in more bitcoins being released into the system.

This process will continue until the entire supply of bitcoins is in circulation. Currently, this supply is capped at 21 million, and estimates state that it won’t be until 2140 that the last bitcoin is mined.

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