How Does Bitcoin Work

So how does Bitcoin work and what do these coins look like anyway ?  Well, “they don’t really look like much” is a suitable answer!  Its a little like asking “what does the money in your bank account look like?”  It really doesn’t have a physical state and exists as numbers and transactions inside a computer system.

Bitcoin is essentially a big mass of analogous electronic coins that a group of people agree to transfer between each other, by being bought and sold for traditional currency or in exchange for some goods and services.

A database log exists that tracks every transaction that has ever been made.  The log does not exist in a single place.  Most Bitcoin users hold a copy (or a cut down copy) of the database log locally which gives the whole system its decentralized, distributed nature.

The following shows a simplified example extract from the log as an example. The letters under sender and recipient represent Bitcoin addresses:

Example of the Transaction Log

Sender Recipient Amount TransCode
C A 5 coins CA5
D B 2 coins DB2
Z R 1 coin ZR1
A M 3 coins AM3-CA5

In the example,

  • A has transferred 5 coins to C
  • D has transferred 2 coins to B
  • Z has transferred 1 coin to R
  • Finally, A has transferred 3 coins to M

There is a transaction code showing the sender address, recipient address and the amount -CA5-, C transfers to A 5 coins !

In the last transaction, A has transferred 3 coins to M. You’ll notice that there’s an extra piece at the end of the transaction code that reads CA5. This refers to the first transaction where A receives the coins (5) that it subsequently transfers (partially) to M. This is essentially how the Bitcoin transaction log works, and shows how coin transfer can be traced back easily with transaction codes.

The Bitcoin Address

A,B,C,D,M,R,Z in the example represent addresses in the Bitcoin world. In reality, they are actually long alphanumeric strings either 34 or 35 characers long, starting with a ’1′

1HxhZrqBJfwiauhFgLVensaySjWRqEtpJH

Addresses can be on your home PC, a mobile device like a smartphone or on a server of a company specializing in Bitcoin trading. In practice, individual people will hold several addresses and indeed this is encouraged.  It’s considered more secure to hold multiple addresses and good for easy tracing of previous transactions.  Its often as easy as clicking a button. Groups of addresses can be grouped conveniently inside what is know as a wallet and the wallet will show your account balance as an aggregate of all the addresses you hold there.

The Private Key

Addresses are public and are contained in the Bitcoin transaction log. In order to spend your coins (more specifically, to transfer coins that are associated with the address to another address), you need to unlock the address with a private key.  This takes the form of another longer alphanumeric string -this time starting with a 5- that should always be kept secret.

5Kb8kLf9zgWQnogidDA76MzPL6TsZZ
Y36hWXMssSzNydYXYB9KF

 

The Public/Private Key Pair

The number is paired with the public Bitcoin address. It’s as if the address is a padlocked box containing Bitcoins. The box/padlock can be seen and handled by anyone, but only someone with the associated private key can unlock it.

1HxhZrqBJfwiauhFgLVensaySjWRqEtpJH

5Kb8kLf9zgWQnogidDA76MzPL6TsZZ
Y36hWXMssSzNydYXYB9KF

How does the transaction log remain reliable and secure when it’s not held in any one central place?

What stops people from making fraudulent transactions in such a distributed, unregulated network?

This is where Bitcoin shows just how ingenious it really is, and will be covered in an upcoming article.




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