Following is a simplified explanation of how Bitcoin works technically:
- Wallets & keys — Your Bitcoin wallet creates one or more sets of “keys”. Each set has two parts — a public part that you can share with others (this is a Bitcoin “address”, and is what you give people who want to send you bitcoin), and a private part that can’t be shared with anybody. (Anyone who got hold of the private part, could steal your bitcoins!)
- Transactions — When your Bitcoin wallet sends some bitcoin to someone else, your wallet uses the private part of your key to “sign” the transaction, proving mathematically that you are in fact the owner of the bitcoin that’s being sent. It also adds a small “transaction fee”. The transaction fee is determined dynamically, based on the activity of the whole network. (The fee is usually small, say a few cents per transaction.) Once signed, your Bitcoin wallet “broadcasts” the transaction to the world on the internet.
- Miners — People all over the world run powerful computers that bundle newly broadcasted Bitcoin transactions into “blocks”, and then repeatedly try to solve a math problem looking for a solution. When one of these people, known as “Bitcoin miners”, finds a solution, they have the right to add the new block of transactions to the “Blockchain”, and in the process, are awarded some new bitcoins to compensate the energy they spent running their computers. While it does require a considerable investment in very powerful computers, anybody can become a Bitcoin miner at any time—you don’t have to ask permission! This permissionless participation is what makes Bitcoin so decentralized and secure!
- The Blockchain — The Blockchain is a ledger of all Bitcoin transactions that have ever happened, one linked to the next. It keeps track of how much bitcoin is owned by each Bitcoin address. Bitcoin miners continually add new blocks of transactions to the Blockchain. The Blockchain is copied so many times on the internet, that nobody can fraudulently modify it. The Blockchain contains every transactions that has ever been made, going back to the very first Bitcoin transaction in history!
- New bitcoins & transaction fees — As mentioned, when a Bitcoin miner successfully adds a block of transactions, the Bitcoin network itself rewards them with some newly created bitcoins. Over time, the Bitcoin network reduces the amount of new bitcoins awarded per block, until such time that there is 21 million bitcoins in total. At that point, no more bitcoins will be created, and Bitcoin miners will be compensated through the transaction fees included in each block of transactions they produce.
That, in a nutshell is how it works! Your Bitcoin wallet sends bitcoins to Bitcoin addresses, which are the public part of a two-part key. It signs the transaction with the private part of your Bitcoin address, and broadcasts the transaction to the Bitcoin network on the internet. Bitcoin miners process these transactions, adding them to the Blockchain, and are awarded new bitcoins for their effort. When the last bitcoin is created, miners from that point forward, will be compensated purely through transaction fees!
Finally, no technical description of Bitcoin would be complete, without a link to the original Bitcoin white paper, written by its inventor, Satoshi Nakamoto.
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