How Bitcoin Works?

Cryptography and Economics

Bitcoin participants may have sometimes conflicting interests, but they all share the same ultimate goal - that Bitcoin succeeds. And the more parties are invested in Bitcoin, the more everyone has to lose if it “breaks” - this creates a symbiotic relationship, one where all parties benefit.

Design Of Bitcoin

Bitcoin is a peer-to-peer network of computers all following a set of rules and instructions for validating transactions and issuing new coins. Any computer running any software that respects these rules can participate in the Bitcoin network. These are called Bitcoin Nodes.

Bitcoin has a ledger of all the transactions, called the Blockchain. Transactions are recorded in blocks, which are created at set intervals and connect to the previous block to create a chain. There is the mechanism for adding blocks to the Blockchain and reaching agreement that the transactions are valid, and the whole chain accurate. This is called Mining.

Blockchain

Instead of a single ledger kept locked away by a central authority, Bitcoin ensures anyone can have a copy of the ledger containing all transactions that ever happened. Everyone can mathematically verify that every transaction in it is legitimate. Transactions that don’t respect the rules are automatically rejected by the software.

Bitcoin transactions are batched approximately every 10 minutes into a block, which is then added to a long chain of blocks containing all previous transactions (hence the term blockchain). This process of adding the new blocks into this shared ledger is called mining.

How Bitcoin Mining Works?

Mining involves a competition for solving a complex mathematical problem, which takes on average 10 minutes and is adjusted every two weeks to account for current computing power. The winner gets to add the current block of transactions and receives a reward for their efforts.

The catch is, everyone can easily verify that the solution is right. If a miner cheats, all other participants will simply discard the block. A cheater would lose not just the reward, but also all the money spent in energy to mine that block. This combined loss far outweighs any expected profits.

Although in theory anyone can participate in mining, the mathematical problem is so hard, and the competition so fierce that you’d need hundreds of specialised computers to even stand a chance today - which is quite an investment.

Money Supply And Inflation

Mining is also the way by which new bitcoin are released into the system. Transaction fees are the sum of fees paid for all transactions included in that block, which vary according to demand. These are bitcoin already in circulation.

The current reward is set at 6.25 bitcoin per block until 2024. This process will continue until all 21 million BTC are out there, at which point miners will only receive transaction fees.

There’s no way that anyone can arbitrarily create new bitcoin or mess with the issuance rate unless everyone of the network agrees to change the protocol. Bitcoin satisfies the properties of sound money with no one in charge.

It is durable. The architecture of the blockchain makes it incredibly robust. Since every node has a copy of the ledger, destroying the Bitcoin network would require that all 50,000 distributed around the world would need to be destroyed at the same time, along with however many backups there are. That’s very unlikely.

It is divisible. Bitcoin’s smallest unit, called a Satoshi, is 1/100,000,000 of one coin. In today’s values, that’s orders of magnitude more precise than even the smallest microtransactions would require. However, due to network fees, that level of precision isn’t currently practical - we’ll discuss this below.

It is fungible. All bitcoin are created equal and have equal value - just like one gram of gold is equal to any other gram of gold.

It is portable. Bitcoin is entirely digital and incredibly portable. It can be stored on a computer, mobile phone, and on paper. It can be instantly transferred anywhere in the world with just an internet connection - and even without one.

Limitations Of Bitcoin

The main limitation is the trilemma between security, scalability, and decentralisation. This means that there are trade-offs when designing a network, and you can’t have all three. Fiat money, for example, is very scalable and reasonably secure. On the flip side, it’s completely centralised, and controlled by very few people.

Bitcoin, on the other hand, is designed to focus on decentralisation and it’s incredibly secure. This comes at the price of scalability. Currently, Bitcoin’s maximum speed hovers at around 5 transactions per second (a fraction of Visa’s purported 50,000+).

This makes Bitcoin impractical for use at scale and explains why right now it is popular as a Store of Value and less so as a Medium of Exchange.