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What Is Bitcoin And How Does It Work? | Everything Worth Knowing

 

Updated By Block Angels Jan 03, 2025

 

 

Bitcoin is popularly considered the most secure cryptocurrency and blockchain with the largest market dominance and capitalization.
 

Bitcoin is a digital or virtual currency/asset powered by blockchain technology, enabling borderless global trades/payments without centralized intermediaries.

 

This comprehensive guide covers everything worth knowing about Bitcoin, from fundamental designs to broader market applications in digestible paragraphs for both beginners and experts.

 

Bitcoin was founded by an anonymous individual or group of individuals using the pseudonym Satoshi Nakamoto. The concept was introduced in the Bitcoin whitepaper, titled "Bitcoin: A Peer-to-Peer Electronic Cash System," which was published on October 31, 2008.

 

The Bitcoin network itself officially launched on January 3, 2009, when Satoshi Nakamoto mined the first block, known as the genesis block or Block 0, which included the following embedded text:

 

"The Times 03/Jan/2009 Chancellor on brink of second bailout for banks."

 

This message referenced a headline from The Times newspaper on the same day and symbolized Bitcoin’s purpose as an alternative financial system free from traditional banking institutions.

 

On this day, January 03, 2025, this article update officially highlights that Bitcoin ranks top 1 against publicly traded companies as the youngest to reach a $2 trillion market capitalization before 16 years of age. 

 

Understand Bitcoin, The Blockchain 

 

What Is The Bitcoin Blockchain?

 

The Bitcoin blockchain is a distributed ledger technology that employs a proof-of-work (PoW) consensus algorithm, facilitating peer-to-peer transactions without the need for centralized intermediaries, and is incentivized through cryptocurrency rewards.

 

Distributed Ledger Technology (DLT) represents a decentralized digital framework for the systematic recording of data across various nodes or computers within a network. In a distributed ledger system, such as Bitcoin, each participant — a computer or node — possesses access to an identical copy of the ledger. This ledger is updated in real-time with each transaction, thereby enhancing its resilience against potential attacks.

 

Utilizing a proof-of-work consensus mechanism, which is characterized by its computational intensity, Bitcoin effectively safeguards against hostile network takeovers. This approach not only enhances security but also incentivizes miners and node operators to systematically organize legitimate transactions into blocks for inclusion on the blockchain.

 

How Does The Bitcoin Blockchain Work?

 

Proof-of-work (PoW) serves as a fundamental component of Bitcoin's functionality, distinguishing it from other blockchain technologies.

 

As a consensus mechanism, proof-of-work requires network participants to engage in complex computational problem-solving in order to earn the privilege of adding ordered blocks of transactions to the Bitcoin blockchain.

 

In addition to its consensus mechanism, proof-of-work, Bitcoin operates on a variety of cryptographic algorithms designed to ensure secure transaction processing and maintain overall network security.

 

At its core, the Bitcoin blockchain serves as a database or ledger capable of storing diverse types of data, with each element secured through advanced cryptographic algorithms.

 

To effectively understand the Bitcoin blockchain and how it works, one requires a comprehensive walkthrough of the fundamentals as follows:

 

Bitcoin As A Cash System 

 

Bitcoin's peer-to-peer digital cash system's primary goal is to enable users to transfer value directly, without needing trusted intermediaries like banks. This trustless operation is achieved using the blockchain's distributed ledger technology.

 

A transaction on the Bitcoin blockchain is a basic operation that involves sending Bitcoin from one address to another.

 

Every bitcoin transaction contains:

 

Inputs: Verifiable data on the Bitcoin being spent coming from prior transactions typically traced back to the genesis block — the first block of transaction on the network.

 

Outputs: New data on the Bitcoin being sent including the possible "change" back to the sender — a technical term for this is unspent transaction output (UTXO).

 

Bitcoin's Ledger For Transactions

 

The Bitcoin blockchain is a sequential and cryptographically secured ledger that accurately records all transactions. It can be conceptualized as a shared database encompassing all activities within the Bitcoin network.

 

This process materializes through:

 

Blocks:

 

A system comparable to individual storage units within a warehouse that contain critical information. In the context of Bitcoin, these blocks store transactions along with all relevant data pertaining to the origin and destination of each transaction. New blocks are appended to the blockchain approximately every 10 minutes.

 

And

 

Chaining:

 

The process of organizing blocks into immutable sequences of data. Each block contains a unique cryptographic identifier, known as a "hash," which references the preceding block. This structure establishes a chronological chain of blocks, thus giving rise to the term "blockchain.”

 

The Bitcoin blockchain ensures that all participants in the network agree on the same history of transactions proven by the chain of blocks. This prevents problems like double-spending, where individuals may attempt spending the same Bitcoin twice.

 

Bitcoin's Cryptographic Foundations

 

To ensure the security of transactions and the blockchain, Bitcoin employs advanced cryptographic techniques and algorithms specifically designed to provide robust protection for all network participants. The following solutions are implemented:

 

● Cryptographic Hash Functions

 

A hash function is a mathematical algorithm that processes an input, such as a data block, to generate a fixed-size, unique output known as a "hash."

 

In the context of Bitcoin, the SHA-256 hash function is employed to ensure deterministic behavior, meaning that the same input will consistently yield the same hash value.

 

Moreover, SHA-256 is characterized by its irreversibility, as the resulting hash does not allow for the reconstruction of the original input.

 

Additionally, this hash function exhibits collision resistance; it is designed so that no two distinct inputs will generate the same hash, and even a minor alteration in the input will result in a significantly different output.

 

Each block within the Bitcoin blockchain contains the hash of the preceding block within its header, thereby establishing a linking mechanism. Hashes play a crucial role in various elements, such as Proof-of-Work, transaction verification, and Merkle Trees.

 

● Public-Key Cryptography

 

Bitcoin employs elliptic curve cryptography, a sophisticated form of public-key cryptography that leverages the mathematical properties of elliptic curves. This approach ensures robust security while utilizing smaller key sizes in comparison to conventional public-key cryptosystems. In the context of Bitcoin, this cryptographic framework is essential for transaction signing and verification, utilizing a private key that remains confidential to the user and a public key, which is derived from and associated with the private key, commonly recognized as the public Bitcoin address.

 

Users generate signatures for their transactions using their private key to validate their ownership of the Bitcoin being transacted. Meanwhile, network participants are able to verify these signatures using the corresponding public key.

 

Bitcoin's Proof-of-Work Consensus Mechanism

 

Proof-of-Work (PoW) serves as the consensus mechanism employed within the Bitcoin network, ensuring uniform agreement among all nodes regarding the addition of blocks to the blockchain.

 

In this system, miners engage in competition to resolve a computational puzzle by identifying a specific value known as a "nonce." This nonce, when hashed, must satisfy particular conditions, such as commencing with a designated number of leading zeros.

 

To maintain an average interval of ten minutes between block creations, the difficulty of the computational puzzle is automatically adjusted every 2,016 blocks, approximately every two weeks.

 

Upon successfully finding a valid solution, the miner disseminates the block to the network. Other nodes then undertake the verification process, confirming that the hash complies with the requisite difficulty and that the transactions within the block are valid.

 

The miner who completes the puzzle is rewarded with newly minted Bitcoin—commonly referred to as the block reward or "coinbase reward"—in addition to transaction fees associated with the transactions included in the verified block. It is essential to clarify that the coinbase reward is unrelated to the US-based cryptocurrency exchange, Coinbase.

 

Proof-of-Work guarantees that only legitimate blocks are added to the blockchain and significantly raises the computational expense required to execute a successful attack on the network, rendering such attacks impractical.

 

The process is termed "proof-of-work" because the generated nonce serves as tangible evidence of the computational effort expended to solve complex mathematical problems, thereby enhancing the security of the blockchain and facilitating transaction validation.

 

Bitcoin's Merkle Trees: Efficient Data Verification

 

The Merkle tree utilized in Bitcoin represents a sophisticated data structure designed to efficiently summarize and validate transactions within a block.

 

When each transaction in a block is hashed, pairs of transaction hashes are combined and rehashed, thereby forming "branches." This iterative process continues until it culminates in a single hash known as the Merkle Root.

 

The Merkle Root is subsequently added into the block header, effectively summarizing all transactions contained within the block.

 

This design enables nodes to verify the inclusion of a specific transaction without necessitating the download of the entire block, a method referred to as Simplified Payment Verification (SPV).

 

The significance of this process within the Bitcoin ecosystem lies in its ability to facilitate efficient transaction and data verification, as only a portion of the Merkle tree needs to be scrutinized. Furthermore, the structural integrity of the block is maintained; any alteration of a transaction results in a change to the Merkle Root, thereby invalidating the block.

 

Understanding Bitcoin (BTC), The Network’s Coin

 

Bitcoin (BTC) serves as both the reward currency and payment medium within the Bitcoin blockchain ecosystem. Although it does not directly impact network-level operations—due to its reliance on the proof-of-work consensus mechanism rather than alternative token stake-based solutions such as proof-of-stake (PoS)—the economic design of Bitcoin (BTC) is integral to the network's overall functionality.

 

Widely acknowledged as a store of value, Bitcoin's creation and design are grounded in a cryptographically secured and decentralized framework that guarantees scarcity, enables trustless transactions, and provides resistance to censorship. BTC operates on principles that challenge conventional fiat monetary systems, thereby introducing a novel economic paradigm.

 

Beyond being a mere digital asset, Bitcoin (BTC) signifies a transformative shift in the creation, storage, and transfer of money. It exists solely in digital form, devoid of any physical counterpart.

 

The total supply of BTC is capped at 21 million coins, an attribute that is hardcoded into Bitcoin's protocol. This fixed supply stands in stark contrast to fiat currencies, which are subject to inflationary pressures imposed by central banks.

 

Similar to traditional currencies, Bitcoin operates as a fungible form of digital cash, characterized by its interchangeability and enforced scarcity.

 

Importantly, one Bitcoin (BTC) can be subdivided into 100 million smaller units known as satoshis (sats). This exceptional level of divisibility facilitates microtransactions and enhances its usability, particularly as the value of BTC appreciates.

 

Bitcoin’s economic framework is often characterized as deflationary, a result of its capped supply, predictable issuance rate, and mechanisms designed to maintain scarcity over time.

 

In terms of issuance, Bitcoins (BTC) are generated exclusively through mining activities, which grant miners block rewards, commonly referred to as coinbase rewards. These incentives are crucial for encouraging miners to secure the Bitcoin blockchain.

 

The deflationary aspect of Bitcoin is further emphasized by its distinctive halving mechanism, which decreases the rewards allocated to miners for successfully adding blocks to the blockchain.

 

The Bitcoin block reward undergoes a halving approximately every 210,000 blocks, which occurs roughly every four years. It is anticipated that this process will culminate in the year 2140, at which point the network's operations will transition to being sustained entirely by transaction fees levied on users.

 

Since its inception in 2009, the block rewards for Bitcoin have been halved from an initial 50 BTC per block to 3.125 BTC as of 2024.

 

As the supply of new Bitcoin declines exponentially, the resulting perception of scarcity fosters a supply-demand dynamic that often contributes to price appreciation.

 

That said, it is important to note that Bitcoin (BTC’s) max supply is fixed to 21 million, however, upon consensus by the Bitcoin community, this can be adjusted, however, most supporters have always campaigned against such changes amongst other things like Bitcoin's block space which limits transaction speed and transaction per second(TPS) handled by the network. 

 

Notwithstanding, in addition to Bitcoin (BTC's) on-chain economic strengths, the asset’s market performance often follows a 4-year cycle, often tied to the halving events. These cycles include an accumulation phase, a bull market, a distribution phase then a bear market and repeat. 

 

How Is Bitcoin(BTC) Used? | Genesis Block To Institutional Adoption 

 

Bitcoin is a highly volatile asset which means its market price and value can fluctuate frequently and may result in high profits or losses within short timeframes.

 

However, it remains a highly utilized digital asset sometimes referred to as the “digital gold” due to its scarcity and perceived value by its over 50 million community. 

 

The most common use case for bitcoin (BTC) is as a store of value and a hedge against inflation, especially in countries battling high inflation and increasing cost of living. 

 

Despite its shortcoming as an expensive chain for micro transactions due to its limited block space, Bitcoin is still an effective means of day to day transactions or payments through low cost layer 2 solutions like the Lighting Network, which enables faster Bitcoin transactions with very low transaction fees.

 

Bitcoin has earned numerous institutional interest over the years since its genesis block was mined by Statoshi Nakamoto in 2009. Primarily due to its potential as a store of value, hedge against inflation, and an alternative asset class, major players in the financial and corporate sectors are increasingly integrating Bitcoin into their operations, signaling growing mainstream acceptance.

 

For example, the largest asset manager in the world, Blackrock, filed for a Bitcoin spot ETF in 2023 which is now operational as the largest Bitcoin ETF amongst others, signaling institutional confidence in Bitcoin's potential as a regulated asset.

 

In January 2024, BlackRock's iShares Bitcoin Trust (IBIT) received approval from the U.S. Securities and Exchange Commission (SEC) to list options for a spot Bitcoin exchange-traded fund (ETF). 

 

In addition, countries like El Salvador, adopted Bitcoin as legal tender and actively accumulates Bitcoin for national reserves.

 

Furthermore, MicroStrategy Incorporated, a prominent business intelligence firm, has garnered significant attention for its substantial investments in Bitcoin (BTC). Under the leadership of co-founder and Executive Chairman Michael Saylor, the company has strategically integrated Bitcoin into its corporate treasury, positioning itself as a major institutional holder of the crypto asset.

 

As of December 23, 2024, MicroStrategy holds approximately 444,262 BTC, acquired at a total cost of $23.41 billion, averaging $58,219 per Bitcoin. This aggressive accumulation has been financed through various means, including equity sales and convertible debt offerings.

 

MicroStrategy's Bitcoin-centric strategy has significantly influenced its financial performance and market valuation. In 2024, the company's stock (NASDAQ: MSTR) experienced a remarkable increase of approximately 400%, elevating its market capitalization to around $80 billion. This surge is largely attributed to the appreciation of Bitcoin's value and the company's substantial holdings.

 

These adopting trends solidifies Bitcoin's role in the future of finance and investment, setting the stage for even greater use cases to fall through as the network and coin earn more exposure and acceptance globally.

 

The Bottom Line

 

Bitcoin has emerged as one of the most significant innovations of the past decade, consistently outperforming traditional companies and assets while maintaining a secure monetary framework, even amidst its remarkable growth.

 

Being a digital asset grounded in the principles of decentralized finance and scarcity, Bitcoin, a blockchain-powered asset with a market capitalization in the trillions, has become a focal point of discussion among global governments. As adoption intensifies while supply diminishes and increased interest from retail investors is witnessed, the proliferation of cryptocurrency and blockchain-related services aimed at a broader audience becomes inevitable, positioning Bitcoin for far greater milestones than those already attained.