How Bitcoin works?

Bitcoin – Overview of its key components

In the previous whitepaper, we presented a high level overview of Blockchain and how it can help us in creating a global ledger of transactions that is transparent to everyone and at the same time is secure. We also discussed about smart contracts and the various implementations of Blockchain such as Bitcoin and Ethereum.

In this paper, we will present an overview of how Bitcoin operates and also analyze its potential.

Bitcoin Components

Bitcoin consists of the following main components :-

• Bitcoin protocol :- It refers to the peer to peer network that is used by the bitcoin community to validate a transaction and add to the blockchain
• Blockchain :- This is the public ledger in which the transactions are saved
• Consensus rules :- These rules help in validating the transactions and issuing bitcoins
• Proof-Of-Work:- This is the backbone of the process by which the bitcoin community reaches a consensus on the validity of the blockchain

There are other components and processes also that are involved in a bitcoin lifecycle such as :-

• Private/Public keys
• Wallet
• Bitcoin mining

Let us look at some of the key entities that are involved in processing a Bitcoin transaction.

Bitcoin Transaction

A bitcoin is different from other currencies. It is a virtual currency which exists only in the form of a data entry. At a very high level, this data entry contains the “bitcoin addresses” of the sender and the recipient of the transaction, the amount that needs to be transferred and the “transaction fee”. The transaction fee is used to give “priority” to the transaction (by the transaction validators/miners) and influences the amount of time after which that transaction would be confirmed. Once the transaction is confirmed and added to the blockchain, only then will the recipient be able to use those transferred bitcoins.

Private/Public Keys and Wallet

Every user who is involved in a bitcoin transaction is provided with a private key and a public key. The wallet is just a database which at the bare minimum, keeps a reference to these two entities (The wallet may also contain additional information such as a local copy of the blockchain network, transactional logic depending on whether it is a full client or a light client). When the user does a transaction, then that transaction includes a digital signature of the user (generated from the private key) and the bitcoin address (generated from the public key). When the wallet needs to display the balance or the transaction history of the user, then it scans the blockchain network for all transactions related to the bitcoin address and accumulates their balances in order to calculate the net balance of the user.

Bitcoin Mining

Mining is used to validate new transactions and add them to the blockchain. At the same time, it also generates new bitcoins that are added to the account of the person who did the validation (“mining”). After validation, all the new transactions that are broadcasted across the bitcoin network are added to a “transaction pool” of the individual miners. The miners prioritize the transactions based on the transaction fee and add those transactions to a “block”. In order to add this block to the blockchain, the miners need to solve a mathematical problem. The solution to this problem is called the “Proof Of Work” and is included in the new block. The miner who solves the problem first receives the transaction fees and the new bitcoins.

Proof Of Work

After a transaction is validated, the miners are presented with a mathematical problem that is based on a cryptographic hash algorithm (using SHA256). This mathematical problem involves the block header (problem statement) that needs to be transformed below the provided result (target). The miners need to find the correct “nonce”/”salt” that can be used to transform that block header below the target hash. The difficulty of the problems are frequently adjusted in order to ensure that the average time to mine a new block is approximately 10 minutes. Once the problem is solved, the miner adds that solution to the new block. This constitutes “Proof Of Work” as a certain amount of work was performed in finding that solution. Currently, miners need to perform quadrillions of computations in order to find the solution.

Blockchain’s inbuilt security mechanism

The Blockchain contains an implicit security mechanism that prevents a malicious user from doing any significant damage to anyone. Each block within the blockchain is identified by its header’s SHA-256 hash and contains the hash of the previous block to which it was linked (referred to as “parent block”). This “parent block hash” also affects the hash of the current block. Therefore, any change to the parent block would trigger a change to its child block. If a parent block is many generations deep inside the blockchain, then any change to it would necessitate the recalculation of all its descendent blocks. Such a recalculation would require an enormous amount of computation and electrical consumption making it an impractical task for hackers. Therefore, the older blocks in the blockchain tend to be immutable and guarantee security.

Bitcoin’s Trading history

As of 11/13/2017, Bitcoin is trading close to $6500 per coin. But it was not always like this. It started with around $19 a coin in starting of year 2013 and was trading at close to $1000 by the end of that year. In fact, till March 2017, it was trading at close to $1000 before it saw a phenomenal price increase and went close to $7200 in the starting of November 2017. It makes one wonder if the bitcoin’s price will continue to soar in this fashion. Speculations are that it would reach $10,000 by the end of this year. Bitcoin critics have argued that it is a bubble which can burst. However, only future will tell if bitcoin can act as a global, stable currency.

Who is accepting Bitcoin?

There are tons of companies accepting Bitcoin right now including but not limited to WordPress.com, Overstock.com, Expedia.com, Bloomberg.com, Pizzaforcoins.com etc. And this list is growing on a daily basis. More and more companies are teaming up with Coinbase and accepting Bitcoin as a method of payment. After all, Bitcoin market cap is $108 Billion.

Conclusion and future of Bitcoin ?

Recently, Bitcoin was used to purchase a house in Texas. Bitcoin can be helpful for many people since it is a commercial currency and takes out the need for currency conversion in international transactions. There is a huge community which supports Bitcoin. It is true that Bitcoin has some disadvantages mainly because it is new and not many people understand its full potential. Our hope with this technical paper is to disseminate limited information regarding Bitcoin to help people better understand it because it is possible that one day, Bitcoin might replace official currencies.