Bitcoin is the world’s first and most popular cryptocurrency.
After slowly gaining mainstream attention over the last decade, the bull run of 2020 got everyone talking about Bitcoin.
While many people know what Bitcoin is, not many people understand how the cryptocurrency actually works. Behind the scenes, a complex ecosystem enables the decentralized peer-to-peer cryptocurrency.
How Does Bitcoin Work?
Bitcoin is complex and can be overwhelming to those who are new to the space.
To learn how Bitcoin works, you’ll need to understand three concepts; blockchain, mining, and the difference between private and public keys.
First, you’ll need to understand what a ‘blockchain’ is.
Blockchain is a confusing term – it might help to think of a blockchain as an open, transparent, and unchangeable ledger of transactions.
Every 10 minutes, new transactions on the network are grouped into something called a ‘block’. These blocks are then ‘chained’ together to create a permanent ledger of every transaction since the network started.
Anyone can view every transaction on the ledger. Once a transaction has been added to the ledger, nobody can alter or remove it.
The blockchain isn’t stored on a centralized server; instead, it’s distributed across various computers on the Bitcoin network. This means that the Bitcoin blockchain is ‘decentralized’, or not controlled by a single entity.
This means that the Bitcoin network cannot be stopped, shut down, or censored by any third party.
While some people think bitcoins can be generated at the click of a button, that isn’t the case.
To create new bitcoin, they must be created through a process called ‘mining’.
Bitcoin mining is the process of using software to validate transactions on the network and create new blocks on the blockchain.
Bitcoin mining requires the use of high-performance computers or dedicated machines known as Application Specific Integrated Circuits (ASIC).
Miners across the globe compete to be the first to validate each block. Whoever successfully validates the block first receives a bit of newly created bitcoin, called the ‘block reward’.
This process is called a ‘Proof-of-Work’ mechanism, meaning computational power is required to validate transactions on the network.
As more miners compete for these block rewards, the difficulty of solving the block hash increases. Algorithms on the Bitcoin network automatically adjust the difficulty to maintain a rate of one block mined every 10 minutes.
While mining used to be possible using just your home PC, there are now massive mining operations with multi-million dollar data centers competing against you. Today, the average number of attempts to solve a block hash is somewhere in the tens of trillions.
Private Keys and Public Keys:
When people think of holding their bitcoin in a wallet, they often assume their computer or a hardware wallet is storing their funds. However, that’s not how it works.
The blockchain stores all the information about account balances and transactions. Anybody can view all of the balances and transactions on the network at any time, as it’s all public.
Think of it as a wall of bank safe deposit boxes, but the door of each box is see-through. Anyone can look at what is inside every box, but only the person with the private key can open the door.
To understand the difference between public and private keys:
1. Public keys:
Public keys are similar to a username or an email address. Every wallet on the network has a unique public key that is used to identify the wallet. Public keys can safely be shared with others in order to receive funds.
In our previous analogy, your public key is your safe deposit box number.
2. Private keys:
Private keys should NEVER be shared with ANYBODY. Your private keys are used to approve transactions from your Bitcoin address. If someone else has access to your private key, they can move bitcoins and other assets out of your wallet without your permission.
In our safe deposit box example, your private key unlocks the door to the box you own.
A wallet is software that enables you to view your bitcoin balance on the network.
You’ll often hear about two types of wallets: custodial wallets and non-custodial wallets.
1. Custodial wallets:
Custodial wallets are wallets where the private keys are held by a third-party entity, typically a centralized exchange.
When choosing a custodial wallet, it’s crucial to choose a reputable, trustworthy company. If the company holding your keys goes out of business, your funds are likely lost forever.
2. Non-custodial wallets:
Non-custodial wallets allow the user to store their own private key. Typically, these wallets take the form of a mobile application or web browser extension. These types of wallets are also called ‘hot storage’, referring to the fact that your private keys are stored on a device connected to the internet.
Another term you’re likely to hear is ‘cold storage’. Cold storage is when you store private keys on a device that is completely disconnected from the internet. Cold storage is generally considered the safest way to store your private keys. Most people choose to use dedicated devices called hardware wallets to store their private keys securely offline.