How does Bitcoin work? A comprehensive guide to blockchain, mining, and digital currency

Understanding Bitcoin

Bitcoin is a decentralized digital currency and payment system, created by an individual or group under the pseudonym Satoshi Nakamoto, who introduced it through a whitepaper on an online forum.

Unlike traditional currencies, Bitcoin operates independently of financial institutions or government authorities, offering an alternative to fiat money or a potential investment via cryptocurrency exchanges. It enables peer-to-peer transactions over a digital network that records and secures all activity. This network is built on blockchain technology, an open-source platform that links transaction histories, ensuring they cannot be tampered with.

Investors profit from Bitcoin through asset appreciation, as its market value increases over time. Although the Bitcoin network might seem complex, this primer aims to clarify how this revolutionary digital asset works.

The Bitcoin blockchain

The Bitcoin blockchain is a decentralized, encrypted ledger of transactions, validated by participants in the network. Instead of being stored in a single location, the blockchain is distributed across numerous computers, known as nodes. Each node holds a copy of the blockchain, and whenever a transaction is validated, all copies are updated simultaneously.

The blockchain is composed of blocks, which hold data related to transactions, previous blocks, addresses, and the code that powers both the transactions and the blockchain itself. To grasp the blockchain, it's essential to first understand blocks.

Blocks

When a new block is created, the blockchain generates a block hash, a 256-bit number that encodes the following details:

• Software version: The current version of the Bitcoin client.
• Previous block's hash: The hash from the preceding block.
• Coinbase transaction: The initial transaction in the block, where the Bitcoin mining reward is recorded.
• Block height: The block's numerical distance from the first block.
• Merkle root: A 256-bit number representing transaction information in the block.
• Timestamp: The date and time when the block was created.
• Target bits: The target difficulty for the network.
• Nonce: A 32-bit number added to the block hash.

Transactions are added to the block, and once it's finalized, the blockchain generates the block hash. Since each block contains data from previous blocks, the blockchain remains secure and immutable, with each block "chained" to the one before it. The process of validating and adding new blocks is known as mining.

Bitcoin mining

Mining is the process of verifying transactions and adding new blocks to the blockchain. It is carried out by specialized software running on computers or machines specifically designed for mining, known as Application Specific Integrated Circuits (ASICs).

The core of mining focuses on producing a hash—the output generated by processing block data through a hashing algorithm. Regardless of the data's size, this process always results in a fixed-length string of numbers and letters. Hashes are expressed in hexadecimal form, allowing them to be translated into a numerical value.

Mining process

Mining programs continuously generate hashes, attempting to produce a value equal to or below the network's target value. This is done by adjusting a variable called the nonce, which starts at one and increments by one with each guess. The speed at which a miner generates these hashes is referred to as its hash rate.

Miners across the network compete to be the first to generate the correct hash. The miner who succeeds receives the Bitcoin reward, a new block is added to the blockchain, and the process starts over with the next set of transactions.

Mining difficulty

Bitcoin's mining difficulty adjusts based on the number of miners participating in the network. Difficulty is modified every 2,016 blocks to maintain the target of generating one new block approximately every 10 minutes. The level of difficulty is tied to the number of miners and the average number of attempts needed to solve the cryptographic puzzle, which has significantly increased since Bitcoin's inception. Today, it takes trillions of attempts to solve a hash.

Mining resources

Mining is a resource-intensive process, requiring costly hardware and substantial electricity. Since the nonce that solves the hash is unpredictable, miners must go through as many as possible, as quickly as possible. This has led to the creation of mining farms and mining pools, where miners combine resources to improve their chances of earning rewards.

Bitcoin keys and wallets

A common question from new Bitcoin users is, "I've bought a bitcoin, so where is it?" The best way to think of this is to imagine the Bitcoin blockchain as a shared digital ledger where everyone’s funds are recorded. You access your balance through Bitcoin wallets, which function similarly to your bank’s mobile app.

Just like many people today rarely use physical cash, Bitcoin users don’t physically handle their cryptocurrency. Instead, they use tools, such as credit or debit cards, to manage their finances. With Bitcoin, you use a wallet and keys—digital tools that allow you to access and use your cryptocurrency.

Bitcoin keys

Bitcoin is essentially a digital token that represents value. This token exists virtually, and your public key is used to assign ownership of the token to you. When a Bitcoin transaction occurs, ownership is transferred to someone else's public key. Your wallet functions like an app, enabling you to send or receive Bitcoin.

When Bitcoin is allocated to you through a transaction on the blockchain, you receive a private key. This private key proves ownership. Meanwhile, your wallet provides a public key, similar to how an email address is used for sending emails. When someone sends you Bitcoin, they use your public key.

Bitcoin wallets

A Bitcoin wallet is a software application that allows you to view your balance, send, and receive Bitcoin. The wallet communicates with the blockchain to locate your Bitcoin. Since Bitcoin consists of transaction inputs and outputs stored across the blockchain, your wallet gathers and sums them up to display your total balance.

There are two types of wallets: custodial and noncustodial.

Custodial Wallets: In this type, a trusted entity (like a cryptocurrency exchange) holds your private keys on your behalf. For example, if you create a Coinbase account, you can choose to let the platform store your keys.

Noncustodial wallets: Here, the user is responsible for managing their own keys, often through a mobile wallet app. 

Hot and cold storage

Hot storage refers to wallets that store your private keys and are connected to the internet, such as a wallet app on your smartphone. This is the most vulnerable form of storage, often targeted by hackers.

To reduce risks, there are cold storage options, which store keys offline. These could include USB drives or paper wallets (where the private key is written down). 

For even greater security, deep cold storage involves methods that add extra layers of protection beyond simply storing a USB drive. Examples include locking your keys in a personal safe or safety deposit box, making it harder to access them.

Bitcoin security

While the Bitcoin blockchain and network have many components, you don't need to understand them all to use this digital currency. The key is knowing how to manage your Bitcoin keys through a wallet to send, receive, and store Bitcoin. For enhanced security, it’s recommended to use cold storage since wallets are software-based and can be vulnerable to hacking.

Cryptocurrency exchanges that hold customer keys can also be targeted by hackers. However, many of these platforms now employ sophisticated security measures, often adopting enterprise-level cold storage solutions similar to those used by businesses for long-term data protection.

Many people have legitimate concerns about Bitcoin’s security, particularly because it involves exchanging money for encrypted ownership data. However, it's important to highlight that the Bitcoin blockchain itself has never been compromised, thanks to its community-driven consensus mechanisms.

The main security risk lies with wallets, making it crucial for Bitcoin users to understand the importance of cold storage and keep their private keys out of easily accessible hot wallets.