We explain how Bitcoin works, the blockchain technology that underpins the digital currency, and its future business applications.
Today most of us use online banking to sort out our finances, but that’s still based on traditional currencies. However, there's an all-digital currency, and it's called Bitcoin. Unlike other currencies, Bitcoin only exists on the internet and not in physical form.
Bitcoin works a little differently, so instead of a central authority, it uses an encrypted peer-to-peer network to store your balance, confirm and verify any transactions or purchases. This is called the blockchain, and it can also be thought of as a huge list of every Bitcoin transaction that has ever taken place. It’s stored on every computer (or "node") in the bitcoin network, and lists the sender, receiver, value and approximate time of every Bitcoin transfer, all verified and anonymised.
So, how does Bitcoin work, what is the blockchain exactly, and does it have a place in business? Here's all you need to know.
How Bitcoin works
The best way to understand how the blockchain works is to follow how it’s added to step by step, starting with transactions. When a user wants to send bitcoins to someone else, they broadcast the details of the transaction – their public key, the recipient’s public key, and the bitcoin amount transferred – to a network of interlinked nodes.
This transfer information is independently verified by other computers in the network, analogous to having witnesses present when signing a contract. These other nodes use a "digital signature" to authenticate a transaction.
This long, complex string of letters and numbers is generated from a combination of a user’s private and public keys, along with the transaction message itself. The alphanumeric pattern is unique to every transfer and can't be used twice, to further guard against fraud.
Once it’s been confirmed that the transaction message is genuine, the transaction data itself must be added to the blockchain to be considered "confirmed". Nodes periodically collect "unconfirmed transactions" – those that have been verified genuine but not yet added to the blockchain – into sets, and broadcast them to the network as a new potential block.
These blocks are comprised of a group of transactions that have all been judged to take place at roughly the same time. Each new block that joins the chain must reference the preceding block, and in this manner, the blockchain establishes a traceable chronology that runs all the way back to the first bitcoin transfer.
The strength of the blockchain relies on group verification. Every node in the network has a copy of the blockchain, and if a node submits data that doesn’t match the rest of the network’s blockchain data, that information will be rejected.
Therefore, it’s important that all network nodes operate from identical blockchain information. In order to prevent clashes deriving from two different blocks being proposed by separate nodes at the same time, before a submitted block is accepted into the chain, nodes must first solve an incredibly complex cryptographic puzzle.
Involving highly complex mathematics and algorithms, the puzzle essentially boils down to each node guessing random numbers. The best comparison would be trying to guess the code to a combination lock, or the weight of a cake at a church fair.
Statistically speaking, a lone computer would take years to arrive at the right solution. Multiple computers on the network guessing simultaneously, however, average a solution time of about ten minutes. The first node to solve the puzzle gets their block suggestion added to the chain.
Nodes that perform this function are known as miners, and each node that successfully solves a block puzzle is rewarded with bitcoins, as an incentive to keep the blockchain going, and keep the system operational.
However, there is a finite number of bitcoins in existence, and every four years, the amount of coins generated per solved block is halved, in order to stave off the currency’s deflation. Some experts have stated that in spite of this, Bitcoin is unsustainable in the long term due to the gradual and irrecoverable loss of private keys.
One of the key benefits of Bitcoin over traditional monetary systems is its anonymity. What designates Bitcoin as a "crypto-currency" is that Bitcoin, and the transfers thereof, can't be traced back to individual users.
How the system achieves this is linked to the methods in which transactions are managed. Although the network has a public and open record of every transaction, the blockchain keeps no details of users’ individual balances.
Instead, the blockchain uses a reference system to ensure that users have enough funds to cover any bitcoin transfers. When sending money to another user, this transaction (known as an output) must be validated by referencing the information stored in the blockchain of one or more payments you received in the past (also called inputs).
To prevent users referencing the same input in more than one transaction – double-spending – each input can only be referenced once before it is considered "spent" by the system. For every transfer, the network checks these references against their copy of the existing blockchain data.
This is another aspect of the authentication system blockchain uses, in concert with the digital signature mentioned earlier. The signature ensures that the transfer is authorised by the account holder, while the input references make sure that they have sufficient bitcoins to send.
Another factor in Bitcoin’s anonymity, and the thing that makes it so attractive to criminal enterprises on the dark web, is that it’s possible to maintain complete separation between bitcoin transfers and your real identity.
Privacy-conscious users can use anonymising services such as TOR for extra identity protection, but this isn’t really necessary. The public keys that bitcoin holders use to receive payments are randomly generated sequences that can be generated at will by your wallet software, with almost limitless combinations.