How Bitcoin Works For Beginners, Explained in Plain English, but Not at the Expense of Accuracy:
A Summary of Everything the Average Person Needs to Know About Bitcoin… and a Few Extra Details
Bitcoin (BTC) is a digital asset, specifically a “cryptocurrency.” Bitcoin transactions are recorded on a decentralized and distributed digital public ledger called a blockchain.
It is decentralized, because it isn’t centrally controlled.
It is distributed, because the software exists on many computers across the globe.
In other words, Bitcoin is software that keeps a public (but partly encrypted) ledger of transaction data, and that software is hosted on many computers across the world.
This ledger of transactions provides the information necessary to determine balances associated with “public addresses” owned by individuals (a public address is like Bitcoin’s version of a bank account number; it is associated with funds, funds can be deposited to it, an it can be shared publicly).
Further, everything from the creation of transactions, to adding transaction data to the ledger, relies on encryption.
It is a digital currency, that relies on encryption, a “crypto” “currency.”
The whole thing is a bit like online banking, but the ledger is decentralized and distributed rather than being controlled by a bank. And, instead of account numbers and passwords, there are public addresses and private keys.
Why is it called blockchain? Blockchain is both a type of database and the software that governs the database. A blockchain, in terms of it being a database, records data in sequential blocks linked together by cryptographic codes. It is a “chain” of “blocks” of data, a “blockchain.”
KEEPING IT SIMPLE: A Bitcoin user doesn’t need to understand much about Bitcoin to invest in it or use it. The reality is, you can use a broker/storage service like Coinbase to buy, sell, use, and store Bitcoin with almost zero knowledge of how Bitcoin works. To get started, all you need to do is sign up for Coinbase, add your bank account or credit card info, and click the buy and sell buttons. Meanwhile, sending and receiving Bitcoin just involves opening wallet software (like Coinbase) and defining amounts of Bitcoin you want to send and the address you are sending to. We cover other methods for buying, selling, storing, and using Bitcoin here.
There is no physical Bitcoin: To be clear, there is no physical Bitcoin. Instead, the system is all software based (the tokens, the blockchain, the wallets) and that software is all ensured by the principles of cryptography (nearly everything is “encrypted”).
Bitcoin is democratic: The blockchain is hosted on computers from across the globe (it is distributed) which helps ensure consensus (that people agree on the ledger). Changes to Bitcoin need to be made democratically, as to make a change the majority of people running the Bitcoin software need to adopt it.
How Bitcoin Transactions Work With Bitcoin Wallets
Bitcoin transactions are made using software programs called Bitcoin wallets.
A Bitcoin wallet lets users store private keys and public keys, view balances associated with public keys, and create Bitcoin transactions.
As a metaphor, a wallet is like the online banking software, a public key is like an account number, and a private key is like a password.
Private Keys and Public Addresses
Public addresses are a simple concept to understand, they let people to receive Bitcoin and each public address has a balance associated with it (that balance being the sum of all transactions associated with that account on the public ledger). Like an email address or bank account number, a public address can generally be shared with anyone.
Private keys are a little more complicated.
If you use a third party “custodian” like Coinbase, you don’t need to know how private keys work (as entities like Coinbase is a “custodial” service that keeps your funds safe for you).
However, if you use a wallet where you control your “private keys,” then it is important to understand the role private keys play.
Whoever has the private key to a Bitcoin address, has access to the balances associated with that wallet.
A private key allows people to send Bitcoin by creating a signature needed to move balances associated with a corresponding public address.
In other words, having a set of private and public keys is like having the keys to a safe or password to a bank account!
As you can imagine, private keys should never be shared with anyone.
TIP: Remember, there is no central bank, so there is no complaints department… if you lose your private keys, you lose your funds – period. This is why some people prefer custodial services like Coinbase (but even with them you need to make sure to secure your account).
How Transactions Get From Wallets to the Blockchain
When a transaction is signed using a private key it creates a type of cryptographic code called a “token.”
A token is a string of letters and numbers that points back to sensitive data, but contains no sensitive data itself.
In this case, the tokenized data allows the owner of the private key to prove they own the Bitcoin associated with an address without having to broadcast their private key to the world.
Transactions include tokenized (encrypted) parts and some key public transaction data (like public addresses and amounts of Bitcoin sent)
Transactions sent from wallets are broadcast to the entire Bitcoin network and are then queued up to be added to the public ledger.
The queued up tokenized transactions are then added to the ledger (AKA blockchain) in blocks by “miners.”
TIP: Sometimes people call cryptocurrencies “tokens,” this is largely because transaction data is “tokenized” to avoid sharing sensitive data like private keys.
How Transactions are Added to the Blockchain
Bitcoin miners are people across the globe who run Bitcoin software that attempt to add transaction blocks to the blockchain by solving cryptographic puzzles.
New coins are created when miners successfully add blocks of transaction data to the blockchain. Many miners trying to solve the same problems and add the same data to the chain at once helps create consensus.
The result of all the decentralized and distributed software, encryption, and tokenization is the ability to conduct secure and “trustless” peer-to-peer financial transactions (where balances of Bitcoin are tokenized and transferred as payment between peers and those transactions are recorded on a decentralized digital ledger; where the entire system runs without the need of a central third party playing middleman).
How Bitcoin is Traded and Why it Has Value
While there are many ways to value Bitcoin (scarcity, utility, work required to process a block of transactions, etc) the value of Bitcoin is ultimately determined by traders who trade Bitcoin on exchanges (like stock exchanges, but for cryptocurrency).
It is Like a Mix Between Online Banking and Email
As noted along the way, the whole thing is a bit like a mix between online banking and email in a few ways:
- There are public account numbers and private passwords used by end users.
- There is lots of technical aspects that rely on encryption working in the background.
- It involves sending encrypted information from one account/address to another and keeping a record of it.
To add some more details:
As email: A public address is like an email address (people can send to it). A private key is like an email password (it allows you to send). A wallet is like a mail platform where you can manage all your email addresses and emails at once. The Ledger is like your email server, were you don’t really need to know how it works, but it hosts the emails. Meanwhile, it’s all software and not a physical object despite us saying things like “you’ve got mail.”
As an online bank account: A public address is like an account number (people can send to it). A private key is like your PIN / online banking password (it allows you to send). A wallet is like your online banking platform where you can manage your different accounts. A bitcoin is like the dollars you can send and receive via your accounts. Your balance is the sum of all dollars sent and received from a given account. Blockchain is like your bank’s ledger (where withdrawals and deposits are tallied to arrive at a balance).
When you enter an email address into a website to join a mailing list, you’re often asked to check your email and click on a link.
The link looks something like this: //www.website.com/confirm_email?token=4bdebebc-135b-4748-b7ab-25b31a285df8
In this case, the ‘token’ is this string of characters which was sent to you. It’s a unique string of characters, which, when you click on it, tells the server that “yep, the guy definitely got the email, so the email account is definitely his.”.
Cryptocurrency tokens don’t exist as a string like we saw above (if they did, they would be easy to copy), but rather they exist conceptually as entries on a ledger (a blockchain). You own these ‘tokens’ because you have a key that lets you create a new entry on the ledger, re-assigning the ownership to someone else. You don’t store tokens on your computer, you store the keys that let you reassign the quantity. I prefer to think of these ‘tokens’ as specific amounts of digital resources which you control, and you can reassign control to someone else.
Blockchain: The Key to Bitcoin
Remember how we said all Bitcoin transactions are recorded on a digital public ledger called a blockchain? Well, that blockchain is the main thing going on with Bitcoin. So, let’s take a closer look at what that means.
Notice how there is one or more addresses sending to one or more address? Those are the transactions that will be verified and added to the public ledger in sequential “blocks” by “miners” (miners are people running software to crack cryptographic puzzles that let them play digital accountant for a chance at getting freshly minted Bitcoin are a reward).
All confirmed transactions represent all ownership of all Bitcoins in circulation and provide an accountant of very transaction ever made using Bitcoin!
In other words, the Bitcoin blockchain is a digital public ledger of transactions between Bitcoin wallets, and if you have a Bitcoin address that relates back to one of those transactions, then you have Bitcoin.
FACT: The sequential blocks of transactions added by miners across the world is what secures Bitcoin and creates new Bitcoins. The software controls the algorithm, but otherwise miners are the ones playing banker!
What Does it Mean to Have Bitcoin?
“Having Bitcoin” means having a digital wallet that contains one or more “public addresses” with non-zero balances (and importantly, having the private keys to access those balances).
Each address relates back to one or more transactions recorded on the ledger (the “blockchain”).
The balance of a public address is the sum of all transactions sent to a from that address as recorded on the ledger (ex. 1 Bitcoin sent, 3 Bitcoin received, balance is 2 Bitcoin).
The balance of a wallet is the sum of all balances on all public addresses contained in that wallet.
A person’s total Bitcoin owned is the sum of all Bitcoin stored in all public addresses in all Bitcoin wallets they own (there is nothing stopping you from having many Bitcoin wallets, each with many addresses).
TIP: Sending Bitcoin between addresses involves paying a fee. This is true even if you send between your own addresses. It makes very little sense to send small transactions between addresses, thus most people will need only one Bitcoin address and one Bitcoin wallet (unless they use multiple platforms). Some third party platforms where you don’t control your private keys get around this rule for coins that shifted around internally.
How Do I Access My Bitcoins?
If you use a service like Coinbase, all you do is log into that platform and then buy, sell, or send your Bitcoin (see directions for buying/selling, see directions for sending).
If you have a wallet where you are in control of your “private keys,” then you need to use your private key to “send” bitcoin from your public address to another public address.
Private keys provide a signature, kind of like a pin number at an ATM or signing a check.
In this respect, and as noted above, this is all like online banking. There is an account number money can be sent to, the password is like a PIN number to access the funds, and the blockchain is like the bank’s ledger.
FACT: A Satoshi is the smallest fraction of a Bitcoin that can currently be sent: 0.00000001 BTC. When buying, investing, or trading Bitcoin, you can send or receive as little as one satoshi (although, with fees this would be nonsensical). Satoshis are sometimes called Sats for short.
If you just want to use Bitcoin, you really don’t need to know how it works beyond what we have discussed, and you can from here check out an exchange/broker/wallet service like Coinbase to buy/sell/use/store Bitcoin.
That said, if you want to really know how Bitcoin works, then keep reading and check out the next section on cryptography.
DEFINITION OF BITCOIN: Bitcoin is decentralized and distributed software that allows for trustless peer-to-peer global financial transactions and record keeping encrypted via one-way cryptographic hash functions. It can be described as a blockchain based smart contract system with a native cryptocurrency token. The blockchain (the digital ledger) is the main component, transactions are sent between public addresses using “keys” and wallets, and transaction data that is sent between wallets and stored on the blockchain sensitive information is tokenized (so that it can be safely sent and stored).
The Basics of How Bitcoin Works in Terms of Cryptography
The technology that makes Bitcoin transactions and the Bitcoin blockchain work is generally rooted in cryptography (as noted above, this is why it is called “crypto” “currency;” i.e. it’s a currency that relies on encryption).
Specifically Bitcoin uses a lot of cryptographic hash functions: Hash functions encrypt any amount of data to create a string that is always the same length regardless of the size of the original data. Meanwhile the term cryptographic hash function specifically implies the use of one-way functions. One-way functions are easy to compute one way, but next to impossible to compute the other way without a key. Cryptographic hash functions are used to link data on the blockchain and are used to output “tokens.”
In cryptocurrency “tokens” are a specific type of encrypted data that doesn’t contain the original data. Generally encryption takes data and encrypts it so it can get from point A to point B safely without being deciphered. Tokens are different in that they don’t contain the original data at all, all you get is a hash that points back at actual data. Learn more about tokens as used in payment systems and cryptocurrency.
Even more specifically, Bitcoin uses a type of one-way hash function to create tokens called public-key cryptography. Public-key cryptography is used for a number of things in crypto, for example it is used to create and verify transactions (public-key cryptography is a type of cryptography that uses matching public and private keys; where a public key, which can be known by anyone, relates back to a private key, which is meant to be known only by the holder of the key).
Put together and you get a private key, from which a public key is created, from which a public address is created, then the private key creates a signature which confirms that funds that funds on blockchain can be moved, and the blockchain is linked together with hash functions, and miners have to decipher puzzles involving all this to confirm transactions. Etc.
That is the gist, suffice to say it is called “crypto” currency for a reason.
How Bitcoin Transactions Work and How Transactions are Recorded on the Blockchain – Somewhat Complex
NOTE: Hardly anything in this next section is necessary to understand to use Bitcoin, further if you use a third party wallet like Coinbase then you won’t have to deal with most of the concepts noted below pertaining to private keys.
Expanding on the above, at the heart of Bitcoin is transactions between public addresses that are recorded on a decentralized digital public ledger called a blockchain. Meanwhile, those transactions are added to the blockchain in sequential “blocks” of transactions by “miners” (people who run software that confirms transactions). At the heart of all of that is cryptography. Transactions rely on public-key encryption, miners crack cryptographic puzzles, blocks of transaction data on the ledger are associated with cryptographic hashes. Etc.
Let’s walk through how that all relates starting with the creation of a transaction:
Bitcoins are sent between public Bitcoin addresses using a unique password (string of numbers) that relates to the address the Bitcoin is being sent from called a “private key.” Public addresses (which are encrypted versions of the public keys noted above) and private keys are generally stored in digital Bitcoin wallets. Wallets are software designed to store addresses and keys and to facilitate sending Bitcoin to other addresses (they can also store a copy of the ledger; thus the ledger is stored on many computers across the globe, helping to ensure “consensus”).
To send a transaction, the private key is used to create a signature (an encrypted version of the private key which proves knowledge of the private key). The signature and public addresses are shared along with the transaction.
NOTE: So we have Private Key (never shared) -> Signature (shared; an encrypted version of the private key, a token) -> Public Key (never shared) -> Public Address (shared; an encrypted version of the public key; it is a hash of the public key). Where a public address and keys are stored in the wallet and the wallet is used to create a signature and send a signed transaction. NOTE2: The public key is itself derived from the private key. They are all derived using “one-way” encryption (meaning it is simple to encrypt, but very difficult to decipher).
Moving on, “miners” then use software to solve a cryptographic puzzle that relates signatures and public addresses to confirm transactions.
Transactions are confirmed and added in blocks to the blockchain (where each block is a group of transactions).
Miners or groups of miners who successfully solve the puzzles to confirm transactions earn a chance awarded with newly minted Bitcoins (i.e. new Bitcoins are created as a reward for miners when a new block is successfully added to the chain).
This system of work to confirm transactions is called “proof of work.”
Other cryptocurrencies use slightly different systems (in terms of ledgers and mining), but most generally work the same way Bitcoin does.
That is a bit to take in, but it essentially is the gist of how Bitcoin works and how cryptocurrency works in general.
Wallets contain addresses which relate back to transactions, private keys are used to create signatures which allow one to send transactions from one address to another using wallet software, miners confirm transactions, and confirmed transactions are recorded as blocks of transactions on a digital public ledger called a blockchain. The result is that public addresses are associated with transactions and thus a spendable balance of Bitcoin (which can be used to create other transactions).
In other words, the transaction data encrypted on the digital ledger (blockchain) is “what Bitcoin is,” and the encrypted passwords that let you access amounts of Bitcoin associated with a specific address on the ledger is “having Bitcoin.”
The ledger says X address owns Y Bitcoins, thus if you have the password (private key) to X address, you can send those Y Bitcoins (or any fraction of those Y Bitcoins) to any other address by paying a transaction fee in Bitcoin.
Its a bit like how your bank keeps a ledger of transactions and balances and you can use an online banking platform to access your accounts, and thus access your funds (which are represented digitally as numbers in your bank account). Anyone who knows your account number can send you funds, but only you can move funds around or send them to other accounts using your PIN / Password / Signature.
Meanwhile, the value of Bitcoin is determined by the price a Bitcoin trades for on online cryptocurrency exchanges (which are like stock exchanges, but for cryptocurrencies). Thus, Bitcoin’s value is determined much the same way any other commodity or currency is, via exchange on the market (but influenced by factors like supply and demand).
A Summary of How Bitcoin Works
The following points will help give a basic overview of how Bitcoin works, going over the basics again one last time will hopefully help the concept solidify in your mind:
- Bitcoin is software. Almost every aspect of the software is based on encryption AKA cryptography.
- Bitcoin is a store of value and medium of exchange like gold or the dollar. You can’t pay taxes with it, it’s not legal tender, but otherwise you can use it as either currency or investment.
- The key components of Bitcoin are 1. a digital ledger of transactions called a blockchain, 2. digital tokens which represent entries on the ledger (each transaction is a “token” in that it is represented by a unique string of data that relates to other data, for example a public address), and 3. digital wallets which are software that contain public addresses that relate back to transactions on the ledger, private keys that allow you to access the balance of an address, and facilitate sending Bitcoin to other addresses.
- Bitcoins can be sent to any public address from any public address with a non-zero balance using passwords called “private keys.” Each public address has a matching public key, which has a matching private key, which can be used to create a signature that lets the balance of that address (where the balance is the sum of all transactions done by that address) be spent.
- Sending a transaction requires paying a fee in Bitcoin, so you must have enough Bitcoin left over to pay the fee when making a transaction.
- Bitcoins aren’t physical objects any more than bank credit is a physical object. Instead, both bank credit and Bitcoins are simply digital representations of balances on a ledger associated with account numbers and based on past transactions.
- Like with banking accounts, only people who own the accounts can send from them, but anyone who knows the account number can send to them.
- Many transactions are recorded together in a block of transactions on the blockchain. Transaction blocks are added to the chain sequentially. This is why its called “blockchain.”
- Everything noted on this page (almost without exception) is secured with cryptography (it is “encrypted”). The public address is actually an encrypted version of the actual address. The private key is a cryptographic code that relates back to the encrypted version of the public address that relates back to the public address people see. The blockchain is a somewhat complex cryptographic system that uses “consensus” (derived from more than one entity trying to add transactions to the block chain at once) and “hashes” (like little cryptographic puzzles). Mining is essentially the solving of cryptographic puzzles contained in public and private keys. Etc. Actually explaining the details of all this would not be beginner level.
- Mining is the process of using software to add transactions to the ledger (new coins are created as a reward for miners). With so many miners distributed across the world trying to add the same data to the blockchain, it helps prevent against fraud and ensures accuracy through “consensus.”
In summary, Bitcoin is essentially just a software digital ledger, hosted on computers across the globe, where numbers that represent Bitcoins are moved around using passwords, and everything is secured by and based on encryption. People refer to Bitcoins has “coins” or “tokens” but really “having Bitcoin” really just means having the ownership of passwords (public and private keys) which represent the right to move numbers around on the ledger.
“Bitcoin Basics and Beyond” contains information about the following Cryptocurrencies: