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Gomoon's Guide to How Bitcoin Works



Bitcoin is a revolutionary new type of money, but very few people really understand its power and potential. Even fewer understand how it works, which is a crucial aspect of why it is so incredible. In this article we will explain the essentials behind how Bitcoin transactions are processed and how new bitcoin enters the supply, allowing you to peek behind the curtain at this groundbreaking self-sustaining system.


The Importance of Decentralization


Bitcoin processes transactions using something called a ‘proof-of-work’ consensus mechanism. This may sound complicated, but the theory behind it is very simple, and we’ll explain it more in a moment. Before we go into that though, we need to explain one of the founding principles of Bitcoin - decentralization.


As we explained in our introductory piece Gomoon's Guide to Bitcoin, Bitcoin was created to be free from the oversight of governments and central banks. It was not, contrary to popular belief, created to be a way for criminals to launder the proceeds of their crimes without being caught. Rather, it was created to be a complete financial system that could operate outside the fiat currency model, where users were responsible for their own money and couldn’t have it arbitrarily seized. This negated the need to rely on third parties to use or store it - Bitcoin lets you be your own bank.


Where a financial system relies on itself to operate, it must have robust methods of confirming that transactions are genuine and no one is trying to game the system. This is where Bitcoin’s decentralization comes in. Bitcoin transactions are verified by ‘nodes’ - tens of thousands of regular people around the world who run the Bitcoin software on a regular computer, allowing it to verify transactions taking place on the network and rejecting those that the majority does not agree on. This decentralization makes the Bitcoin blockchain theoretically unhackable.


The Importance of Bitcoin Mining


If the nodes verify transactions, how do they get there in the first place? Bitcoin transactions are submitted to the network all the time by people wanting to send it and spend it, and every 10 minutes those transactions are bundled up and sent for processing. This processing is carried out by Bitcoin miners, a term you may have come across before. Bitcoin miners are not individuals in the same way that nodes are (although they used to be, back in Bitcoin’s early days), but are instead companies that own warehouses filled with Bitcoin mining machines whose job is to process those bundles of transactions and send them onto the nodes.


Bitcoin’s popularity has grown so much that Bitcoin mining is now a multi billion dollar industry - hence why regular people can’t be miners anymore, at least not profitably. The money and energy that goes into running these Bitcoin mining machines is the ‘work’ that proof-of-work refers to. The explosion in Bitcoin mining has led to complaints that the energy used in the process and the CO2 produced is damaging the environment, but the fact is that Bitcoin mining produces less than 1% of the world’s CO2 and Bitcoin mining is in many respects leading the way in green tech innovation.


One important thing to note is that these Bitcoin mining machines are not working together to process transactions. Instead, they are competing with each other. Only one machine is chosen to process the last 10 minutes’ worth of transactions, with that machine being rewarded with the transaction fees that the sender has to pay. This isn’t all, however - the successful machine also attracts a subsidy in the form of newly minted bitcoin. This is the only way that new bitcoin can be created.


Bitcoin mining is also crucial in protecting the network from hackers - the security of a proof-of-work network is directly proportional to how decentralized the mining pool is and how much mining there is going on. If one entity controls over 51% of the total mining power (called the ‘hashrate’) then it has the power to attack the blockchain, invalidating transactions and stealing coins. Today, it would cost an attacker over $43 million per day to try and do that to the Bitcoin blockchain, not to mention the billions of dollars in infrastructure and energy costs.


Anatomy of a Bitcoin Transaction


Once a transaction is submitted to the Bitcoin network, a miner is chosen from the worldwide pool to process it. Once processed, the transactions are broadcast to the nodes who confirm with each other that they are legitimate, with any found to be illegitimate rejected.

Once the transactions in the bundle have been approved and rejected as appropriate, the entire block is added to the blockchain - the public transaction ledger that anyone can view, going back to the very first Bitcoin transaction - and the bitcoin is sent on its way. Transactors are identified on the blockchain only by their addresses, a string of 26-35 alphanumeric characters to which the bitcoin is sent. This is why the Bitcoin system is classed as pseudonymous rather than anonymous.


The entire transaction process can take up to an hour, although this can be reduced if the sender increases the transaction fee - the higher the transaction fee, the quicker it will be processed. Other systems, such as Bitcoin’s Lightning Network, have been created to make Bitcoin transactions faster and cheaper.


The Halving and Mining Difficulty


There are some other factors involving Bitcoin’s transaction process that are worth knowing about if you want to get a full understanding of how Bitcoin works.


First, the halving. As we mentioned earlier, miners are awarded a subsidy of newly minted bitcoin when they process a block of transactions. This amount is halved every four years, starting with 50 bitcoin back in 2008 - a time when Bitcoin mining could be done on a laptop - with the event called the ‘halving’. Bitcoin halvings will continue to take place every four years until, theoretically at least, the last bitcoin is mined in 2140.


The reason for the halving is simple, but also very clever. Bitcoin’s creator, the never identified Satoshi Nakamoto, knew that mining power would increase over time as more people got involved and machines got more powerful, and he didn’t want the Bitcoin supply schedule to be impacted by this growth - he wanted it to be fixed and released over decades. History has proved him right on that front, and the halving event ensures that the amount of new bitcoin entering the supply is strictly controlled and spread out over time, no matter how much mining power it aimed at it.


Another way in which Satoshi Nakamoto ensured that Bitcoin mining couldn’t run rampant with more powerful machines was with something called the ‘mining difficulty’. This relates to the hashrate that we mentioned earlier, which is simply the cumulative amount of power going into Bitcoin mining around the world. A growing hashrate indicates a growing amount of power aimed at mining Bitcoin which, if left unchecked, could again lead to bitcoin being mined quicker than planned.


The antidote to this is the ‘mining difficulty’ level which acts like a proportional handicap for the network, reducing the impact of a growing hashrate and ensuring that no single mining entity can come along with super powerful computers and dominate the Bitcoin mining for themselves.


Conclusion


This has been a very brief overview of how Bitcoin mining works, how Bitcoin transactions are processed, and how the supply of bitcoin is controlled. As can be expected, there is a wealth of information out there for those who want to really dig into the technicals of Bitcoin mining, but we hope this has given the average reader a useful introduction into the nuts and bolts of the Bitcoin system.


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