How Bitcoin Works: Watch This Video:
A “Bitcoin” is a currency object — an entity which is traded, though nothing prevents trades in fractional or multiple bitcoins. All bitcoins are intended to be equivalent, though they each have a separate, distinct history. A transaction creates and destroys (invalidates) bitcoins, creating the same amount as it destroys.
A bitcoin is defined by a chain of digitally signed transactions that began with its creation as a block reward. The owner of a bitcoin transfers it to the next owner by digitally signing it over to the next owner in a Bitcoin transaction, much like endorsing a traditional bank check. A payee can verify each previous transaction to verify the chain of ownership.
A Bitcoin Transfer Example:
Although it would be possible to handle Bitcoins individually, it would be unwieldy to make a separate transaction for every cent in a transfer. Transactions are therefore allowed to contain multiple inputs and outputs, and in that way Bitcoins can be split and combined.
Common transactions will have either a single input from a larger previous transaction or multiple inputs combining smaller amounts, and at most two outputs: one for the payment, and one returning the change, if any, back to the sender. Any difference between the total input and output amounts of a transaction is offered to miners as a transaction fee.
It should be noted that fan-out, where a transaction depends on several transactions, and those transactions depend on many more, is not a problem here. Since the network verifies every transaction along the way, there is never the need to extract a complete standalone copy of a transaction’s history.
Most currencies are created and controlled by a central authority that ultimately has power over prices. Bitcoin is decentralized and generated through open-source software, so the system is transparent, priced on the free market, and belongs to no one person or organization.
Financial systems take a lot of power to run. With Bitcoin, individuals and groups willing to dedicate computer processing power to support the network are rewarded with Bitcoins. This process is known as mining, and this is how every Bitcoin comes into existence.
· Digitally Created
· Secure – All newly mined Bitcoins, along with every transaction, are publicly recorded and verified through the network. This record is known as the Blockchain and is one of the features that helps keep the system secure from fraud and abuse. Bitcoins cannot be duplicated or forged.
Integral to Bitcoin is a public transaction log, the blockchain, that records bitcoin ownership currently as well as in the past. By keeping a record of all transactions, the blockchain prevents double-spending. Cryptography is used to protect the integrity of the blockchain.
This master list of all transactions is maintained by a distributed network of computers that does the payment processing work of Bitcoin. Users who devote computing power to maintaining the blockchain in this way are called “miners” and are rewarded with newly created bitcoins as well as fees. Payment processing work done by miners verifies each transaction as valid and adds it to the blockchain.
As more bitcoins come into circulation the reward for doing payment processing decreases and will stop altogether when the Bitcoin upper limit of 21 million bitcoins has been reached. As Bitcoin achieves wider recognition and more people compete to mine the coins, competition for the limited number of bitcoins awarded for payment processing work becomes steeper and more powerful computers are needed in order to compete—a fact which has spawned a technology boom in sales of Bitcoin mining technology. In addition, Bitcoin is designed to increase the difficulty of payment processing as more miners connect to the network.