How does Bitcoin work?

How does Bitcoin work? 1
How does Bitcoin work?

As we described in the first part of our Bitcoin Basics series, Bitcoin is a radically new form of currency – called a Cryptocurrency or digital currency – designed to serve as a global monetary system.

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Bitcoin and Blockchain

Bitcoin relies on radically new technology, cryptography, the use of incredibly powerful computers, and the internet to function.

With no single administrator responsible for maintaining or securing Bitcoin, transactions issued in Bitcoin are verified and recorded in a public distributed ledger known as a blockchain.

For example, while the bank of choice might keep a copy of the ledger, which depicts the flow of financial transactions through one’s account, the blockchain is is a form of ledger that – instead of being run by a bank – is instead shared between Bitcoin miners and “nodes” around the world.

What is blockchain technology?

The blockchain derives its name from its underlying data structure, which is made up of 1 megabyte files called “blocks,” which are essentially ledgers themselves. Blocks are ‘concatenated’ through a complex mathematical proof.

The blockchain is a common public ledger that the entire Bitcoin network relies on. All network nodes (computers running Bitcoin software) have the potential to access the blockchain and display authenticated transactions. The acting parties are anonymous to a certain extent, as the blockchain does not represent the names of the parties, but instead offers an alphanumeric designation.

While one could rely on the trustworthiness of a bank to authenticate the integrity of a ledger, the blockchain instead relies on cryptography (the art of writing or solving code) as evidence.

Bitcoin wallets

For transactions in Bitcoin, the parties use a so-called “Bitcoin Wallet” to exchange denominations in Bitcoin (BTC). Bitcoin wallets provide their users with both a public key (the address from which one sends or receives Bitcoin) and a private key.

The term “wallet” can actually be described as a bad term; a more specific name might be a “keyring” where users can copy both keys instead of accessing just one.

A private bitcoin key

A private key is an incredibly important “signature” for Bitcoin users that is used to confirm pending transactions by providing mathematical proof that they came from the owner of the wallet in question.

When a user wants to make a transaction in Bitcoin, their intention is signaled on the blockchain by submitting a transaction signed with the user’s private key. That bitcoin The network then validates the transaction by verifying that the incoming and outgoing addresses are valid, the private key is valid, and that it has access to enough money to complete the transaction. The transaction is usually confirmed on the network within the next ten minutes.

Bitcoin mining

The process of authenticating outstanding transactions and collecting them in a block for inclusion in the blockchain is known as mining. “Miners” are computer users with incredibly powerful hardware who solve complex mathematical problems in order to cryptographically sign a transaction block and link it to all previous transactions on the Bitcoin network.

Miners serve the Bitcoin community by securing the network. The process of solving the cryptographic evidence for a block is extremely resource intensive. By winning the race to mine 1 megabyte transaction blocks, miners receive a “bounty” or “reward” in Bitcoin.

A malicious transaction requires so much processing power (and therefore electricity) that in almost all cases it is more profitable to use the same processing power instead to secure the network and collect the block reward. This prevents malicious actors from attacking the network and prevents the blockchain from recording malicious or fraudulent entries.

Mining takes its name from the metaphor that miners receive Bitcoin as a reward, similar to how rare commodities like gold are extracted from the ground.

What do I need to know about using Bitcoin?

While Bitcoin is a fascinating technology, and perhaps both an exciting store of value and a medium of exchange, the Bitcoin network is fundamentally different from the traditional banking system and has some notable differences.

While Bitcoin itself is unhackable in the sense that the Bitcoin network relies on complex mathematical evidence as a basis – and even hacking a transaction would mean immense resources – Bitcoin wallets have the same weaknesses as conventional wallets in the sense that they only are as safe as their user leaves them.

Since Bitcoin can be transferred easily anywhere in the world, Bitcoin wallets are an easy target for computer hackers looking for a quick way to steal digital currencies. One should be careful when choosing a trustworthy wallet service and always secure his wallet.

Bitcoin storage

Other popular storage means are custody services or exchanges, which usually take part in either the holding or the transaction of cryptocurrencies. As these companies usually sell large amounts of bitcoin and other digital currencies, they are attractive targets for Internet hackers and caution should be exercised when using them.

Bitcoin is also easy to steal as payments in Bitcoin are irreversible without the help of the party who mistakenly received the funds in question.

Although the Bitcoin network can detect typos and doesn’t allow users to send Bitcoin to an invalid address, confirmed transactions (thanks to the fact that they are secured by cryptography) must be treated as final. Therefore, the parties involved must be able to trust each other when exchanging Bitcoin.

Bitcoin is transparent

After all, Bitcoin is not a completely anonymous system. While a bank can be relied on to protect the privacy of their bank account (a private ledger), all computers on the Bitcoin network have the potential to view the blockchain and can usually see the balance of each wallet. All transactions are still visible in the network. Even if the names of the parties involved in the Bitcoin exchange are not disclosed in the network, a sophisticated analysis of the blockchain could enable third parties to understand how bitcoin flows through the network.

In part three of our Bitcoin Fundamentals series, we’ll take a closer look at how Bitcoin mining works.

How does Bitcoin work? first appeared on Coin Insider.

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