Lesson

How Bitcoin Works

A lot of what makes Bitcoin new and interesting is that for the first time, it lets two people securely exchange value online without a bank, government, company, or any other central authority between them. Here’s a very high-level example of how it works. Let’s say that I want to send you $20 in Bitcoin. The Bitcoin wallet on my computer or phone includes my own Bitcoin address, which is a compressed version of something known in cryptography as a public key. It also contains data needed to sign transactions, known as my private key.

The private key data must be kept hidden because anyone who gets my private key can access and spend my Bitcoins. So, I tap Send, then I enter the amount to pay plus your address, usually by pasting it in or by scanning a QR code. Decide on the amount, in this case $20, and you see that it automatically gets converted into the appropriate amount of Bitcoin. The wallet uses my private key to sign the transaction and adds a little of my Bitcoin as a processing fee.

The wallet then publishes a signed copy of the transaction to the entire internet. The balance in my wallet immediately goes down by the equivalent of $20 in Bitcoin, and the balance in yours goes up by the same amount. Out on the Bitcoin network, our transaction gets bundled into a block with other transactions. This block is tied shut with a cryptographic puzzle, which specialized computers called Miners compete to solve. Whichever computer solves it first is entitled to claim any processing fees that were included in the block, along with a block reward of some Bitcoins, this is actually how new Bitcoins are introduced to the world.

The Miner publishes the soft block and it becomes part of the public ledger known as the blockchain. This block solving process takes about 10 minutes. But we’re still not done, your wallet shows that you’ve been paid $10 in Bitcoin but it’s not spendable yet. You see, several Miners might have solved a block at essentially the same time and they’re all competing to have their block be the next official one in the blockchain. The passage of time solves these conflicts. Without getting into the details, every additional block that gets solved confirms which ones should have come before, so it’s best to wait for confirmation of a few more blocks after the one containing your transaction, before treating the money as irreversible and spendable.

This all happens in about an hour. Now at first you might think that’s a lot slower than credit card transactions which seem to only take a few seconds. But in reality, credit card settlements can take days and can be disputed for weeks or months. They only seem to be fast because the credit card company is guaranteeing the transaction in exchange for some pretty high fees. The same is true for checks, which take a few days to be cleared by the bank. By comparison, 60 minutes isn’t so long.

Earlier I said that Bitcoin works without a central authority between the sender and the recipient. What’s replaced it is this worldwide network of Miners where no one person is powerful enough to disrupt the entire network. Now it’s not a foolproof system, but so far, it’s proven remarkably resilient. I skimmed over a lot of details on how Bitcoin works. Really explaining it fully requires sophisticated references to computer networking, automated conflict settlement, cryptography and a host of other specialties.

Fortunately, the source material is all easy to find. First and foremost is the original Bitcoin paper, available at bitcoin.org/bitcoin.pdf. For further less technical information, there’s lots to explore on the rest of the Bitcoin Foundation’s site at bitcoin.org.