What is Bitcoin and how does it work?

Ask five people what Bitcoin is and you’ll get five different answers. Internet money. Digital gold. A waste of energy. An inflation hedge. An ‘old’ cryptocurrency.

People tend to form opinions on Bitcoin before attempting to understand it. Many of these opinions are based on snippets of information gleaned from the media, or on specific use-cases for digital cash in general.

Very few people take the time to understand what Bitcoin actually is. If you’ve found yourself here, perhaps you are among the intrepid few who’ve decided to try and answer that question for yourself.

In this guide, I’ll explain Bitcoin from first principles. Using interactive diagrams and demos, we’ll discover what problems Bitcoin is attempting to solve, how it functions as a decentralised network, what it means to own (and mine) bitcoin, the role of transactions and wallets, and what its future may hold.

1. The problem with digital money
2. A network of strangers
3. Mining
4. Owning bitcoin
5. Sending bitcoin
6. So what?

1. The problem with digital money

When money was primarily physical - gold coins, for example - there was little room for ambiguity about who owned what. A physical coin cannot be in two places at once; either you hold the coin, or you don’t.

In a digital system, this becomes more complicated. When you email someone a photo, the recipient gets a copy of the original that lives on your computer. The photo is just binary computer code which can be infinitely copied.

In the world of digital money, this is known as “the double spend problem”. If a digital coin can be copied and sent to two people at the same time, it’s worthless. Two solutions have arisen:

1. Trusted third parties (a centralised approach)
2. Distributed ledgers (a decentralised approach)

In the first approach, a trusted central authority - like a bank - maintains a ledger of balances. The prevailing mental image of a bank is that of a secure institution with many safe deposit boxes holding customer funds. In reality, a transfer between two accounts rarely involves anything being physically moved - the bank simply changes a number in their database. This is ultimately what we’re trusting the banks to do:

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy […] and not to let identity thieves drain our accounts.” - Satoshi Nakamoto

So, let’s turn instead to the decentralised approach.

Under this system, each participant can transact directly with any other participant without any central authority getting involved. They do this by broadcasting every transaction to the entire network and maintaining their own copy of the ledger.

But how does this prevent double spends? What’s to stop someone from writing a fraudulent transaction into the shared ledger? How do you get thousands of people who don’t know or trust each other to agree on which transactions are valid and in what order they occurred?

2. A network of strangers

In Bitcoin, each network participant is called a node.

A node is just a computer running the Bitcoin software. Anyone can download it and run a node. With a Raspberry Pi you can build a standalone node that fits in the palm of your hand. Bitcoin is a permissionless and borderless form of money, meaning anyone who follows the rules can participate on an equal footing. There’s no application form, no membership, and no bailouts.

You don’t have to run a node to send, receive, or hold the currency; a Bitcoin wallet can simply use a public node to get its transactions into the network. But understanding the role of nodes is crucial to grasping how the system works.

A node has two jobs:

1. Keep a copy of the ledger (i.e. the entire history of bitcoin)
2. Broadcast information to other nodes (both the historic ledger and any fresh transactions it has heard about)

As it does these things, it follows the consensus rules. There’s nothing to stop a dishonest node from rewriting the rules for selfish purposes; Bitcoin is open-source software, and can be modified freely. But honest nodes can verify for themselves whether a transaction is valid using their copy of the ledger, and will only rebroadcast transactions which follow the rules. A dishonest node that broadcasts invalid information is simply ignored — provided the honest nodes are in the majority.

But the real world isn’t like this. With huge financial incentives at play, two problems make a “majority of honest nodes” system unworkable.

First, identities on the internet are effectively free. A bad actor could spin up thousands of nodes on a cloud computing provider overnight for little expense - a threat known as a Sybil attack. A system that treats one node as one vote wouldn’t survive this.

Second, even with well-behaved participants, getting them to agree on a single version of history is hard. Messages take time to travel across the network. Two conflicting (but legitimate) transactions might reach different nodes in a different order. Participants might go offline and not hear about fresh transactions until later. Coordinating agreement between strangers who might be slow, faulty, or dishonest is known as the Byzantine Generals Problem, and it’s one of the hardest problems in distributed computing.

A naive solution to both would be to appoint a ledger keeper. But this just reintroduces centralisation: the chosen individual could be bribed, threatened, or regulated - and any fee they charge becomes a tax on the rest of the network.

Instead, Bitcoin rotates the role of ledger keeper. Every 10 minutes, a different participant gets to write the next ‘page’ of the ledger and broadcast it to the network as the official record. Nobody holds the position long enough to be corrupted, and nobody knows in advance who the next writer will be.

How do we decide which node gets to do this? With a competition.

3. Mining (or: how Bitcoin rotates ledger keeper)

The idea which underpins Bitcoin’s competition is proof-of-work. This is a process similar to rolling a dice or flipping a coin - you do some “work” that involves an element of chance. Let’s say you watch someone tossing a coin until they throw five heads in a row; you can instantly verify whether they’ve been successful, even if the process takes a long time.

In Bitcoin, the proof-of-work competition looks like this:

1. A miner - a node that wants to be ledger keeper - takes the latest batch (or “block”) of transactions that have been broadcast for entry into the ledger
2. The miner runs that block - plus a very large, effectively random number - through an agreed-upon algorithm to produce an output
3. If the output matches the agreed-upon condition for a win, the block is valid, and - if accepted by the network - the miner is rewarded with freshly minted bitcoin

The type of algorithm used as Bitcoin’s proof-of-work is called a hash function, and it underpins a lot of what we’ll cover next.

A brief detour: what is hashing?

A hash function takes any input — a word, a sentence, an entire novel — and produces a fixed-length output called a hash. Bitcoin uses the SHA-256 algorithm, which always outputs 256 bits (64 hexadecimal characters).

Type something, then change a single character and watch what happens.

A few properties make this useful:

• Deterministic: The same input always produces the same hash. It looks random, but it’s not.
• One-way: You can’t reverse-engineer the input from its hash. The only way to find an input that produces a specific hash is to guess.
• Avalanche effect: A tiny change to the input produces a completely different hash.

In short, there are no shortcuts. You can’t work backwards from a hash to discover the input which produced it. The only strategy to get a specific hash is guess inputs until you get it right.

How to mine a Bitcoin block

So, what’s the agreed-upon winning condition for those competing to be ledger keeper?

It’s very simple: the hash has to start with a certain number of zeroes. If this sounds like a strangely arbitrary and gruelling task, it’s because it is. The miner changes the random number part of the input (which is called a nonce), thereby taking advantage of the avalanche effect, and runs the hashing algorithm again.

You can try your hand at it below. I’ve made the win condition a single zero, so you won’t be kept here all day:

Using the SHA-256 hashing algorithm as the basis for Bitcoin’s proof-of-work gives our competition the following properties:

1. Anyone can enter: no central authority is needed to issue tickets or decide who’s allowed to enter - you just need a computer
2. Anyone can verify winning tickets: the definition of winning is agreed beforehand, and it’s easy to validate winners - all nodes verify the blocks they receive to check the hash meets the criteria
3. It costs something to enter: to prevent someone from entering millions of times and gaming the system (a Sybil attack, as discussed previously), each entry requires a tiny amount of electricity to calculate
4. The competition runs on a schedule: blocks are added roughly every 10 minutes, which gives all nodes a chance to update their records from the previous win, while not making everyone wait too long to get their transactions written into the ledger
5. There is a prize: to ensure there is an incentive to be an honest ledger keeper, blocks accepted by the network are rewarded with new bitcoins

That final point is key. Each block in the chain includes a special transaction called the “coinbase” transaction, which lets the miner reward themselves with newly minted bitcoin. This is the only way new bitcoins are created; they are exclusively paid to those who expend real-world resources securing the network and keeping participants honest.

The strict controls around new coin minting are key to the network’s monetary policy. There will only ever be 21 million bitcoins, and they’re issued on a gradually diminishing schedule to the miners who validate transactions. Critically, no amount of extra computing power can speed up the issuance schedule. Every 2,016 blocks (~2 weeks), the network automatically adjusts the difficulty of the proof-of-work competition to maintain an average of one new block every 10 minutes. Double the hashing power, and the puzzle gets twice as hard.

This difficulty adjustment is arguably Bitcoin’s most important innovation, because it means the currency is issued on a fixed, predictable schedule which is immune to the whims of individuals, corporations, countries, or the global economy.

4. Owning bitcoin

So far we’ve focused on the fundamental problems that Bitcoin attempts to solve - transfer of digital scarcity in a network where not all participants are honest or trustworthy - along with the high-level mechanics of the system. We’ve explored the concept of nodes and of miners validating batches of transactions.

Next, we will dive deeper into the practicalities of Bitcoin for users of the currency: owning and sending coins.

Keys, not accounts

In the traditional (fiat) financial system, money lives inside accounts. Your balance is a number in a bank’s database, and access is mediated by the bank: a debit card, an internet banking login, and so on.

As discussed previously, one of the goals of Bitcoin was to remove centralised control and single points of failure. So instead of having a bank control access, Bitcoin enables anyone to generate their own “account” without requiring permission.

It does this using public key cryptography, which was first invented in the 1970s. Each participant in the network gets started using a pair of cryptographic keys:

• Your private key is a very large random number. It’s secret. It’s used to authorise transactions, proving they came from you. If someone else gets it, they can spend your bitcoins.
• Your public key is mathematically derived from the private key. It can be shared freely. Your Bitcoin address - the thing you give to someone who wants to pay you, like an account number - is typically derived from your public key via hashing and encoding.

The one-way operation which turns a private key into a public key involves elliptic curve cryptography; it’s fascinating, but beyond the scope of this article. Check my Further Reading recommendations below to learn more. For now, the key point is this: you can derive a public key from a private key, but you can never go backwards:

When I first saw that it was possible to derive a valid Bitcoin address offline, I was sceptical. It felt like a cute thought experiment, too good to be true. But the address you generated above is as valid as any other, and it was derived entirely in your browser. No server was involved, no company was asked for permission, and no account was created in a database. The keys are derived from pure mathematics, and they work immediately.

Ownership is mathematically enforced

Here’s where Bitcoin diverges most sharply from the financial system you’re used to.

In a bank, your money is an entry in a ledger that somebody else controls. The bank can freeze funds, block transactions, or lend out most of your money as they see fit. “Owning” the money means being the person the bank currently agrees is owed something.

In Bitcoin, owning a coin means being able to produce a specific piece of mathematical evidence: a digital signature made with the private key that controls it. When you spend bitcoin, your wallet signs the transaction, and every node on the network independently checks that the signature matches the public key the coin was sent to. Without a valid signature, the coins cannot move. No authority can override this - the maths is the final word.

Try signing a message above, and then modifying the message. Or changing the public key. A few things worth noting:

1. Signatures are message-specific. Change a single character and the signature is instantly invalid. A valid signature is proof not just of who signed, but what they signed - nobody can take a valid signature and reuse it for a different transaction.
2. The wrong public key fails, too. Signatures only verify against the exact key that produced them. You can’t fake one without the private key, and you can’t brute-force your way to one either.
3. Your private key need never leave your device. Anyone on Earth can verify the signature using only the public key and the message. This is what makes Bitcoin broadcastable - every transaction is published to tens of thousands of nodes, while the private key remains secret.

There’s an old adage in Bitcoin which goes “not your keys, not your coins”. This is true in every sense. In Bitcoin, the ability to sign is the ability to spend. If someone else holds the keys on your behalf - an exchange, a custodian, a wallet app that controls the seed - then they are the ones who can sign, and therefore they are the ones who actually own the coins. You hold an IOU.

This cuts both ways. Because Bitcoin’s ledger is immutable and “identity” is simply mathematics, if you lose your private key, no-one can help you. This is why self-custody of Bitcoin should be taken seriously.

Wallets, addresses, and seed phrases

A wallet is a misleading name. Bitcoin wallets don’t hold any bitcoin - the coins live on the network, with ownership recorded in the shared ledger. A wallet is really a key manager: it stores your private keys and uses them to sign transactions when you want to spend your money.

From a single seed, a wallet can derive thousands of public & private key pairs. Each public key can be formatted as a Bitcoin address — a short string like bc1q... that you share with anyone who wants to pay you. Addresses are trivial to create; modern wallets generate a fresh one for every incoming payment to improve your privacy, all from the same underlying seed. To learn more about this, check out the Further Reading suggestions below.

5. Sending bitcoin

Most traditional payment systems work with balances. If you have $500 in your account and send $100, the bank debits your balance, and you’re left with $400.

Bitcoin doesn’t work like this. There are no balances in the ledger. Instead, your wallet controls discrete coins - technically called unspent transaction outputs (UTXOs). They’re more akin to physical cash than a bank account.

The key difference with physical cash is that UTXOs don’t come in fixed denominations. Each one is simply the output of a previous transaction - or, tracing the chain back far enough, a block reward paid to a miner. Each coin can therefore be any size: 50.2 BTC, 4.8721 BTC, 0.0001 BTC, and so on (with “BTC” being the currency’s three letter ticker). When your wallet shows you a balance, it’s actually adding up every UTXO it controls behind the scenes.

The UTXO model is a detail about Bitcoin that took me a while to internalise, because it’s so at odds with the mental model I’d carried over from finance. Your “balance” in a Bitcoin wallet isn’t a number someone is tracking on your behalf - it’s a running total your wallet computes by scanning the ledger for coins your keys can spend. Your coins don’t live in your wallet - they live on the blockchain. You just control the keys.

Building a transaction

When you send bitcoin, your wallet does something quite different to a bank transfer. It consumes one or more of your coins (in full - a UTXO can’t be partially spent) and creates new ones.

In the simplest case, a transaction has two outputs: one going to the recipient (the amount you’re sending), and another back to you (returning change to your wallet, assuming you’re not sending an entire UTXO). Finally there’s the fee for the miner who includes it in a block. In short, a transaction’s inputs always equal its outputs. It’s easiest to understand with a visual example:

Try incrementing the send amount from 0.15 BTC to 0.3 BTC, and see what happens. The two smallest coins in the wallet aren’t sufficient to cover the send amount, so a third UTXO is included in the transaction, and the amount of change returned to your wallet increases proportionally.

Modern wallets will send your change to a freshly derived address, and not back to the address you’re sending from. This improves your privacy, making it harder for an outside observer to determine which output is the actual payment.

Miners choose which transactions to include in the blocks they mine, so the fee is effectively a bid for space. Pay a higher fee, and your transaction is more likely to be confirmed quickly. Pay too little during a busy period, and you might wait hours.

6. So what?

When I started writing this article, I gave it the less-than-imaginative title “what is Bitcoin and how does it work?” I set out to answer the question in precisely the level of technical detail that I would’ve appreciated when I first dipped a toe into the Bitcoin rabbit hole.

Hopefully I have done justice to those two questions, and you feel intrigued enough to continue your journey with some of the references I’ve provided throughout. But if you’re still in two minds, consider this my final pitch to keep learning about Bitcoin.

What is Bitcoin? (the short version)

Bitcoin is a system that lets strangers agree on a shared monetary ledger without having to trust anyone. Proof-of-work makes cheating prohibitively expensive. The difficulty adjustment keeps the clock ticking at the same pace regardless of how much computing power joins the network. Cryptographic keys give individuals sole control over their own money. Every transaction is verified independently by every node, and anyone can participate on a level playing field. And, crucially, you do not need permission to take part.

I’ve deliberately avoided mentioning the price of Bitcoin thus far. This is partly because the more you learn about Bitcoin, the more you realise the price is actually one of the less interesting things about it. But it’s also because a deeper understanding of Bitcoin - one that goes beyond the price to cover the ‘why’ and ‘what’ of the currency - can change your entire perspective of money.

Bitcoin is the hardest money on Earth. “Hard” in the sense that the supply schedule is fixed. There will only ever be 21 million bitcoin, and they are issued on a predictable, halving schedule that no person, company, or government can alter. This makes Bitcoin the first asset in history with a mathematically guaranteed finite supply - and a monetary policy answerable to nobody.

“Digital gold” is the comparison that gets reached for most often, and it undersells Bitcoin. Gold is scarce, but it’s slow to move, impossible to verify remotely, and historically has required trusted custodians to be useful at scale. Bitcoin is better by most measures that matter in a digital world: scarce, rapidly settleable to anywhere on Earth, and with native support for multi-signature wallets, time-locked payments, and escrow without any third party. It’s global, neutral, programmable money - not a shinier rock.

Continuing down the rabbit hole

A few suggestions for where to take it from here:

• Keep reading. Each link in this guide was chosen deliberately and will extend your understanding in a specific direction; support the authors when you can.
• Don’t trust — verify. This mantra crops up again and again in Bitcoin because it’s how the network itself operates. Don’t take my word for any of this, or anyone else’s. Run the code, verify claims, and be cautious.
• Practise self-sovereignty. If you decide to buy any bitcoin, start small and get it off the exchange. Learn to use a hardware wallet and back up a seed phrase properly. If any of that feels daunting, attend a local meetup and find a mentor - someone further down the road than you are.

I’ll leave you with this. Consider that before Bitcoin, every digital payment system required trusted intermediaries. Bitcoin replaced trust with verification, gatekeepers with maths, and accounts with keys. For the first time, anyone with an internet connection can hold and transfer value that no government or corporation can seize, freeze, or inflate. No permission is required. In fact, the only thing you need to get started is a really big number.

Thanks for reading! If you found this guide valuable, consider supporting my work:

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