For those of you just starting out with bitcoin, this will break down the basics for you in a straightforward manner. To begin our how bitcoin works guide, we’d like to share a quote directly from the bitcoin website:

Bitcoin uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network. Bitcoin is open-source; its design is public, nobody owns or controls Bitcoin and everyone can take part. Through many of its unique properties, Bitcoin allows exciting uses that could not be covered by any previous payment system.”

As a new user of the Bitcoin Protocol, you can easily get started without fully understanding the technical details. As soon as you have installed a bitcoin wallet onto your computer or mobile device, it will automatically produce your first bitcoin address. You are then able to create more whenever you are in need of one.

Sharing your address

You can share your addresses to your peers so that they are given the ability to pay you or vice versa. This enables direct, or peer to peer, payment capability. As a matter of fact, this works similarly to how emails function. The key exception is, in order to maintain optimal financial security and privacy, each bitcoin address should only be used once.

When it comes to transactions, it is the basic transfer of value between bitcoin wallets that ends up on the blockchain. This is the shared public ledger where all confirmed transactions are placed. Bitcoin wallets possess a secret piece of data called a ‘private key’ (sometimes referred to as ‘seed’). This is primarily used as a way to sign transactions, providing mathematical proof that they were derived from the owner of the wallet.

Additionally, the ‘signature’ also prevents transactions from being corrupted or altered by anybody once it has officially been issued. All of the transactions are distributed to the network. Typically, each transaction completes the confirmation process within 10-20 minutes through a process known as ‘mining.’

The processing stage

This is otherwise known as the processing stage, but it is officially referred to as mining. It’s essentially a distributed system of consensus that is utilized to confirm pending transactions. It does so by way of including them into the blockchain. By administering a chronological order in the blockchain, this form of consensus protects the overall neutrality of the network. It also permits different computers to come to an agreement on the general state of the system.

In order to be confirmed, transactions must be packed in a block that is able to fit very strict cryptographic rules that will be validated by the network. These rules prevent previous blocks from being modified in any way. To do so would effectively invalidate all of the subsequent blocks.

Moreover, mining additionally creates the equivalent of a competitive lottery. It halts any individual from potentially adding new blocks consecutively to the blockchain. With this particular function, no group or individual can control what exactly is included in the blockchain. Neither can they replace parts of the blockchain in order to roll back their own spends.

All that has been explained is arguably a more technical definition of how Bitcoin works. It is considerably straightforward, but to a certain extent, you have to be familiar with the terminology. For the sake of making sure that the procedure pertaining to how this popular platform works is 100% clear, we will break it down in a more simplistic manner.

A more simplified explanation

Let’s set up a hypothetical scenario. You are sitting on a park bench with your friend and you have a single apple. You decide to give it to your friend, so you hand it over to them. Your friend now has one apple and you are left with zero apples.

Sounds pretty simple, doesn’t it? Let’s dig a little deeper into this system. We’ll need to take a closer look at what just occurred between you and your friend.

Your apple was physically placed into your friend’s hand, that much is obvious. There was absolutely no need for the participation of a third person in order to make the apple transfer successful. There was no need for a middleman to get involved. Also, there was no need for confirmation from this third person that the transfer had been accomplished because you and your friend both saw it.

Control of assets

Furthermore, the apple is now in possession of your friend and you cannot give them another apple because you do not have another one. You no longer have control over what becomes of that apple. But now your friend does. If they want to give it to someone else, they can. If that person wants to hand it over to someone else, then they can, because now they are in control of the apple.

In person exchanges

In essence, this is what an in-person exchange looks like. Whether you are giving your friend an apple, a pencil, or a dollar bill, the process remains exactly the same.

Now let’s assume that your friend has a digital apple and they decide to give it to you. This is where things start to get interesting in the way of the transfer.

How can you be absolutely sure that the digital apple that used to belong to your friend is now in your possession and your possession alone? When you take a moment to think about the minute details of it all, you will come to the realization that it is actually pretty complicated.

There really is no sure-fire way to tell if your friend did not actually send that apple to somebody else as an email attachment first. Why if they already sent to their uncle or sibling or another friend of theirs? For all you know, your friend might have made a couple of other copies of that digital apple on their computer. Perhaps they might have gone so far as to put it up on the Internet and over a million people have downloaded it already!

Double spending

In hindsight, this particular type of digital exchange poses a problem. It is apparent that sending out digital apples does, in fact, seem the same as with physical apples, yet there’s a risk. A name has been given to this sort of problem and that name is ‘double-spending pattern’. This is the risk that a person could concurrently send out a single unit of currency to two separate sources.

There is a lot that can be said about this specific problem. But for the sake of keeping this article on track and comprehensive, we’ll move on to discussing the solution in the form of a ledger.

Ledgers

A good resolution for double-spending would be to track the digital apples on a ledger. Basically, this is log that gives users the ability to track all of the transactions. Simply put, it is an accounting book.

Because the ledger is digital, it needs to function in its own world. But it also needs someone in charge of it. To better illustrate this, think of the popular online game, World of Warcraft. Blizzard designed it to have a digital ledger of all the rare flaming fire swords that exist within their system. This way, someone in a similar position can keep track of the digital apples that you and your peers are exchanging.

Problems

Right off the bat, it’s easy to view this as the ideal solution. However, there is a bit of a problem that comes from this:

  1. What if someone working at Blizzard created more apples? Couldn’t they just add a few more digital apples to their balance whenever they want to?
  2. It is not entirely the same as the aforementioned scenario in the park bench. There, it was just you and your friend. Going through Blizzard is a lot like pulling in a third party to involve them in all of your park bench transactions. How exactly can you or your friend just hand over the digital apple in the usual way?

So, is there any possible way to closely replicate the park bench transaction through a digital format? That is actually rather tough to answer.

A solution

Now, what if we gave this ledger to everybody? Rather than have it live on a Blizzard computer, it instead lives in everybody’s computers. All transactions that have ever been carried out, in digital apples, will inevitably be recorded on it.

You are unable to cheat it and you cannot send out digital apples that you do not possess because it wouldn’t sync up with everybody else in the system. It would pretty much be a tough system to beat. This is especially true if it gets really big.

Moreover, no one person controls it. So it’s a given that there’s no one that can simply decide to give themselves more digital applies. The rules associated with the system were already defined at the very beginning. The code and the rules, sort of like the software that is used in a mobile phone or like Wikipedia, exist so that people familiar with the technology can maintain, secure, improve, and check it.

Network participation

You can participate in this network as well. You may do so by updating the ledger and making sure that it all checks out. For your support and engagement in the system, you could receive 25 digital apples as a reward. As a matter of fact, that is the sole way to produce more digital apples for the system.

Everything that has been said concerning digital apples is an analogy for what is commonly referred to as the ‘Bitcoin Protocol’. These digital apples are the bitcoin currency within the system.

More on the ledger

Before we bring this comprehensive guide on how bitcoin works to a close, we should take a good look at what exactly the public ledger enables:

  1. It is an open-source system. The total number of apples was outlined in the public ledger at the very beginning. We are aware of the precise amount that exists within the system.
  2. When one makes an exchange, they know that the digital apple has officially left their possession and is now under the control of whoever it was sold to. Additionally, it will be updated and verified by the public ledger.
  3. Because it is a public ledger, you do not need a third party entity to make absolutely certain that you did not cheat, make extra copies for yourself, or send apples more than once.

The action of exchanging a digital apple is now very similar to the exchange of an actual apple. It is now just as good – not to mention beneficial. That’s because you’re seeing a physical apple leave your hand and being given directly to someone else. Much like in the park bench scenario, the exchange is carried out by only two individuals. Peer to peer, you and your friend, and no third person.

Similarities to a physical object

Strictly speaking, how bitcoin works is very much like a physical object. However, the best part of it all is that it is entirely digital. You are now able to deal with 1,000 apples, over a million apples, or even 0.001 of an apple. So you can easily send the apple(s) away with just the click of a button. Also, you can just as easily drop it into the digital wallet of your friend in Budapest, all while you sit on a park bench in Toronto. This peer to peer transaction happens quickly and costs very little.

You can even make other digital components work alongside the digital apples. For instance, you can attach some text onto them (i.e. a digital note). Or you can attach some more crucial things, like a contract, stock certificates, and maybe even an ID card.

Conclusion

In the end, how should we treat and value these digital apples? There is honestly no definitive answer and it has been a subject of debate by numerous groups. These include – but are not limited to – politicians, programmers, entrepreneurs and everyone in between.

Regardless of this debate, we hope this guide has set you on your way to understanding how bitcoin works. Join us on Twitter to receive notifications when we publish crypto news stories, development updates, and more helpful tutorials.

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