How Bitcoin Works

How Bitcoin Works

Bitcoin is developed to eliminate the need for a central authority, such as a bank of a government. To do this, It utilizes a peer-to-peer network to confirm any transaction directly between users, and this is achieved through a consensus mechanism known as Proof-of-Work (PoW), where miners solve cryptographic puzzles to validate transactions and get rewarded in the form of BTC tokens.

How does Bitcoin work?

What is Bitcoin?

Bitcoin (BTC) is a form of digital cash, which was specifically developed as a means of eliminating any requirement for a central authority, such as a bank, brokerage, or government, to facilitate or validate transactions. To achieve this, it utilizes a peer-to-peer (P2P) network to truly confirm purchases across different users. 

This is a project that was originally launched in 2009 by an anonymous person or group of people that went by the name of Satoshi Nakamoto. BTC is the native cryptocurrency token that powers the Bitcoin blockchain network and can be mined and is used as a means of incentivizing miners.

What is Bitcoin?

How Does Bitcoin Work? 

Every single Bitcoin (BTC) is essentially a file that gets stored on top of a digital wallet that’s active on a computer or a smartphone.

The Bitcoin blockchain is powered by open-source code, which creates a public history of all of the transactions, which get organized within blocks that are chained together.

A Bitcoin wallet also contains a public key and a private key, both of which work together to allow any owner of BTC to initiate and sign transactions through digital means. 

As an owner of an address, a user can sign messages on behalf of the address. Furthermore, users on the Bitcoin network can verify the transactions through a process that is known as mining, and this process is specifically designed to confirm that new transactions are consistent with other transactions which were completed historically.

What this results in is the fact that nobody can spend a BTC token that they do not have or one that was previously spent, also known as “double spending.” 

This also enables a full, transparent history of all of the transactions which have occurred throughout the blockchain network.

How Does Bitcoin Work?

Due to the frequent questions about the inability to send payments “although there are assets on the balance”, we decided to describe the principle of operation of the Bitcoin network (and similar Litecoin, Dash, Dogecoin, etc.) in a clear way. Even if you already have an idea of “how it works”, we strongly recommend you to read this article and to “refresh” your knowledge. Perhaps you will learn something new for yourself or “sort out” what you have already known.

First, some maths (simplified)… If you take any (generate) a very large number (let’s call it a “private key”), then, using a certain (publicly-known) algorithm, you can find a very large number corresponding to it (the”public key”). There is no reverse algorithm. You can’t get a private key from a public key! The private key must always be known only to the owner. The public key is shared with everyone. The peculiarity of this pair of numbers is that if the message (data set) is “signed” (calculate the signature) with a private key, then this signature can be easily verified. by the single public key. It proves that the message has been created by the owner of this key pair. The Bitcoin address (simplified) is the public key.

Key point: as the owner of the address, you can sign messages “on behalf of the address”.

When you create a new address in the app, a private key is actually generated for you, and the public key and address are generated from it. It is very unlikely (almost impossible) that you will come across a pair of keys that have already been issued to someone before. Deleting an app or damaging its files usually leads to the loss of the private key, which means that the assets which are located at this address are lost.

Like any network, the Bitcoin blockchain network consists of connected devices running special software. Each such device (a part of the blockchain network) is usually called a “node”. All nodes are equal in rights. Very powerful nodes can “mine” (see below).

Each node stores a copy of the network database (ledger). The ledger consists of entries. You can add new entries to this ledger only. You cannot edit or delete existing records. Each entry is data about “sending” and/or “receiving” assets from an address to an address.

Key point: the ledger doesn’t store the address balance. The ledger stores all deposits (“outputs”) and all debits (“inputs”) addresses.

For example: Address A: received X1, received X2, sent Y1, received X3, sent Y2..

Key point: the current address balance is the sum of all outputs minus the sum of all inputs (see above).

For example: x came to address A (for all the time), and y left. This means that the address balance is equal to X – Y.

When you send assets, the app generates a message – “transaction”, which contains outputs in the format “address, output” for withdrawal (spending) and inputs in the format “address, amount” for receiving.
Note that the transaction sum must not be more than or equal to the received sum. The difference between the withdrawn and the deposited is called ” transaction fee “and it goes to the” miners ” (see below). Theoretically, you can create a transaction with fee = 0, and this will not be an error. If the transaction fee is higher than the desired sum, the unspent (“change”) is taken back by adding an entry to the list of inputs. The transaction has a size. More items in the lists means more data and longer transactions.

For example: Address A: exit X1 for the sum of “1”, exit X2 for the sum of”2″. Balance A = 1 + 2 = 3. You need to transfer the sum “2”to address B. Output X1 is not enough, we need the sum of output X2.

Initially, the transaction looks like this: outputs: “Address A, X2″, inputs:”Address B, 2”. Debited “2”, deposited “2”. This transaction has a fee = “2 – 2” = “0”. Miners are not likely to appreciate this. Let’s add a fee = “0.001”. Output X2 is fully used, so we use another output X1.

Initially, the transaction looks like this: outputs: “Address A, X2″, inputs:”Address B, 2”. Debited “3”, deposited “2”. This transaction has a fee = “3 – 2” = “1”. This is more than needed. Let’s return the change = “1 – 0.001” = “0.999”.

Initially, the transaction looks like this: outputs: “Address A, X2″, inputs:”Address B, 2”. Debited “3”, deposited “2”. This transaction has a fee = “3 – 2.999” = “0.001”. Now that’s all right! Let’s note that, although the deposited sum is “2.999”, it includes our “0.999” change, which will be returned to us and will not be spent actually.

Key point: transactions spend the entire output. You can not spend a part of the output, but you can return the “overspent” through the change.

Key point: you cannot create more transactions than there are outputs. The maximum: one output = one transaction. But you can have one output = multiple inputs (recipients).

Key point: the solution is any transfer (arrival) of assets, including the change.

A transaction generated and signed with “private keys” can be sent via any node. The node checks whether the signature is valid, whether it is formed correctly, and whether outputs are available. Then, the transaction is placed in the” mempool ” – the storage of new (unprocessed) transactions. Transactions located in mempool are visible to all nodes. From this point on, all outputs used in this transaction are considered used or “spent” and cannot be used in other transactions.

Adding new entries to the ledger occurs in batches (blocks) of several thousand at once. Blocks are formed by nodes – “miners”. Blocks have a size limit. You can’t create a block larger than the maximum size. A few (thousands) transactions from the mempool are combined into one unit, then the “mining” starts. Mining is the search for a specific block hash using a matching method. The first one to “mine” the block gives it to the other nodes for verification. Each node compares the block entries with previous entries in its ledger. They should not conflict. If the block passes verification, it is added entirely to the ledger of this node. Each node only works with its own ledger.

Key point: each node works independently with its own ledger.

If a block is not accepted on some nodes, then there is some discrepancy in ledgers or a “separate version of the blockchain”. In this case, the nodes are synchronized, and the most common version “wins”. Due to the possibility of desynchronization, to make sure that the block and all transactions in it are included in the correct version of the blockchain, the final confirmation requires several more blocks after the current one 

Key point: transactions are confirmed when new blocks appear after their block.

Key point: you can use the outputs from the confirmed transactions only. 

For the correct block, the miner receives a fixed fee, plus the sum of all fees for all transactions in this block. It makes sense that the most profitable way is to form a block of transactions with the maximum fee, so the reward will be bigger. But you also need to remember: the block size is fixed, so you also need to look at the transaction length. In fact, it is most profitable to include transactions in which the “density fee ” (fee per unit of information) is higher. This indicator was called “sat/B” (Satoshi per byte). It is equal to “fee in Satoshi “divided by “transaction length”.

Key point: nobody knows how the miner selects transactions from the mempool. There is no way to force the miner to select your transaction. But for the miner it is more profitable to primarily take transactions that have a higher sat/B score.

Key point: if you want your transactions to get into the block more quickly (i.e., be confirmed), set a fee that makes your transaction’s sat/B score higher than the average for the mempool.

If everyone simultaneously wants their transactions to go faster (for example, because of a great rise in value), then everyone will increase the sat/b value. This means it may vary depending on the network load. This is a difficult choice between the speed and the transaction fee.

The Best Example

·         You have the address A. There are no exits on it. Its balance = 0 BTC.

·         1 btc is sent to your address A (this means that the transaction for this sum is confirmed). Now it has one output per 1 BTC Its balance = 1 BTC.

·         0.2 BTC is sent to your address A. Now it has outputs: 1 BTC and 0.2 BTC. Its balance = 1.2 BTC.

·         You make a transfer from address A to address B in the sum of 0.3 BTC. To make it simple, the fee = 0.

·         Understandably, the output of 0.2 BTC is not enough, so we use 1 BTC.

·         This means that the transaction will have an output of “1 BTC” and inputs “address B, 0.3 BTC”, “address A(unspent), 0.7 BTC”.

·         Immediately after sending and placing it in the mempool, only one output to 0.2 BTC will remain on your address, because the output to 1 BTC has been just used (spent) in the transaction. From now on, the “available” balance of your address = 0.2 BTC.

·        The unspent of 0.7 will not be returned until the confirmation of the transaction. This means this sum cannot be used.

·        In theory, you have 0.2 + 0.7 = 0.9 BTC, but in practice you can’t use these 0.7 BTC.

·        This means that you will not be able to transfer even 0.20000001 BTC immediately after sending it.

·        Your 0.7 BTC will be “frozen” before the confirmation of your transaction.

What is Bitcoin Node?

A Bitcoin node is essentially a machine that is responsible for the process of executing the Bitcoin Core Software. It has additional functionality, such as processing transactions and adding blocks. Every single Bitcoin node can send and receive transactions and can verify their authenticity alongside other nodes throughout the network.

What is Bitcoin Node?

How to run a Bitcoin Node?

If you want to run a Bitcoin Node, here is a step-by-step guide on everything that you need to do in order to fulfill this goal. Prior to beginning, remember that you need to have a hardware device, such as a computer that runs a specific operating system. Within this guide, we will use Windows as an operating system. However, the process can be executed on Linux as well.

  • Step 1: Download and install the Software

To begin, you will need to navigate to the Bitcoin Core download page, after which you can verify that you have made a secure connection to the server.

Download and install the Software

Then you need to click on the “Download Bitcoin Core” Button to download the installer to your desktop.

After you have downloaded the file, you can run it by double-clicking on the icon. Note that Windows will ask you to confirm that you want to run in, and in this case, you will need to click on Yes.

Then, press the Windows key and type “Bitcoin,” after which the Bitcoin core icon will appear.

  • Step 2: Set up the Bitcoin Core Software

You will now be prompted to pick a directory to store the Bitcoin blockchain and your wallet. Click Ok if you want to use the default path or set a custom data directory.

Note that your firewall might initially block Bitcoin Core from making outbound connections. It is safe for you to allow Bitcoin Core to use all networks. 

  • Step 3: Enable Firewall Access

At this point, Bitcoin Core GUI will begin to download the blockchain. This could take several days or much more, depending on the internet connection you have. During this process, Bitcoin Core will utilize a significant portion of your connection bandwidth but can be stopped at any time. 

Once the download process is complete, you can use Bitcoin Core as your wallet or let it run to support the Bitcoin network.

Note that if you do not want to manually set up a Bitcoin Core, you can utilize a blockchain-as-a-service provider such as NOWNodes to simply connect to a Bitcoin wallet and get all of the information you need that way.

full nodes

In this case, all you have to do is navigate to the official NOWNodes website, after which you can enter your email address and click on “GET FREE API KEY.”

Conclusion

How to make everything “run like clockwork” without problems?

·         Have more outputs. This means you should either send multiple transactions to your address, or have more addresses.

·         Use fewer outputs. This means you should make fewer transactions, but with more recipients in a single transaction.

·       Make actions to get your exchange faster. In other words, set a fee so that the sat/B indicator will be currently competitive in the mempool.

Frequently Asked Questions (FAQs)

⬛️ How Does Bitcoin Make Money?

We first need to go over why cryptocurrencies have value. Cryptocurrencies such as the Bitcoin (BTC) coin have value due to the fact that they can function as a store of value and a unit of exchange.

It can also demonstrate the six key attributes to enable its use within an economy. While Bitcoin demonstrates the attributes of a currency, it has a source of value due to the fact that it has a restricted supply and an increased level of demand.

Bitcoin is capped at 21 million coins, which means that once that maximum supply of the cryptocurrency has been mined, no more Bitcoin can ever be mined, and this level of scarcity is expected to lead to its overall increase in value.

Furthermore, the main way through which new Bitcoins get added into circulation is through the process of cryptocurrency miners solving complex cryptographic puzzles through a competition, where the miner that does indeed solve the issue gets to validate the transaction and record a new block of confirmed data on top of the blockchain network.

In return for contributing the computing power and energy to confirm the transaction, they receive a reward through a newly created BTC cryptocurrency, and this is how Bitcoin makes money.

⬛️ Is Bitcoin Mining Legal?

If you are curious if mining Bitcoin is legal, the answer is yes in most cases. However, there might be cases where this is not the case.

Specifically, there might be countries on a global scale where mining cryptocurrencies is illegal. Before diving deep into the process of cryptocurrency mining, or even making the first investment in cryptocurrency mining gear such as a GPU farm or ASICs devices, it is recommended that you take the time to do your research and look into the local regulations where you live in regards to cryptocurrency mining and Bitcoin (BTC) mining.

For the time being, Bitcoin mining is legal in the United States as well as most other countries on a global scale, but there will always be some exceptions to this rule.

Financial watchdogs, such as the Securities and Exchange Commission(SEC) and the Commodity Futures Trading Commission (CFTC), have issued guidelines, warnings, and rules when it comes to mining cryptocurrencies, and it is likely that this is also the case for mining cryptocurrencies in other parts of the world.

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