How does Bitcoin work? Blockchain and the Internet of value

In the previous article, we saw what Bitcoin is, the first cryptocurrency to reach mass adoption without any government, bank or intermediary to exist and run. In this second installment, we will delve into the problems of fiat money, such as the dollar, which has lost almost 90 % of its value since 1971 due to inflation and debasement, the uncontrolled issuance of monetary authorities.  

Bitcoin offers a fairer and more transparent alternative, allowing users to own their money without trusting an intermediary like a bank. By design, Bitcoin has a fixed number of units, 21 million, making it impossible to issue more Bitcoin beyond this number, creating the digital scarce good par excellence.  

But how does Bitcoin do all this? How does this network work that allows you to send and receive value safely, quickly, and cheaply without trusting any third party? What makes Bitcoin unique and different from other money or value transfer forms?  

2/3. In this article, we will explore these questions and better understand the functioning of the technology that underpins it and the concept of the Internet of Value.  

We will not delve into the technological aspects, and I will seek to avoid the nerd complexities that make it difficult for a non-specialist to read. However, I'm forced to be just a little geeky to convey the beauty of this unique piece of software. To understand how Bitcoin works, you don't need to be tech-savvy, but you need to make an effort to understand its logic.  

Centralized finance  

Centralized finance relies on an entity that keeps a ledger of the inputs and outputs in each account. For example, John and Hannah have an account with Bank A. If John decides to transfer $100 to Hannah, the bank holding their accounts' ledger subtracts $100 from John's account and adds $100 to Hannah's account.  

This is very practical and effective; the problem is that human beings manage all these entities. To prevent bad practices and scams, entities like central banks establish regulations and controls. The problem is that these other organisms are also managed by humans, with all that implies.  

Let's take a look at some of the centralized entities that, beyond the controls of others, have defaulted on their customers:  

• Northern Rock (2007)  
• Lehman Brothers (2008)  
• Washington Mutual (2008)  
• Bear Stearns (2008)  
• Landsbanki, Kaupthing, the Glitnir (2008)  
• Banca Monte dei Paschi di Siena (MPS) (2010s)  
• Dexia (2011)  
• The Cyprus Popular Bank (Laiki Bank) (2013)  
• Popular Spanish (2017)  
• Silicon Valley Bank (2023)  
• Signature Bank (2023)  

In these cases, when Hannah wanted to withdraw the $100 that John had transferred to her, they were not there. For many people, that meant losing their life savings and going bankrupt. In many of the defaults mentioned above, there were bailouts by central banks with tax money. Everyone pays to correct the malpractice of some.  

The system works, but badly. The controls work, but poorly. Controlling entities work but poorly. They usually allow us to withdraw our balances, but sometimes, this is impossible.  

In code we trust  

Bitcoin created the first decentralized finance system. Instead of relying on the honesty of a centralized entity and its leaders, we rely on computer code, which has been audited by tens of thousands of people and has never caused Hannah to lose her holdings.  

Suppose I don't have an entity that records all transactions. How do I prevent John from sending the same $100 twice to two different people (double spending) when there is no longer a centralized entity, a single ledger where balances can be cleared? The answer: Blockchain and Consensus Mechanisms.  

Bitcoin, a peer-to-peer network

To understand how Bitcoin works, we first need to remember that Bitcoin is a network. A network is a set of nodes that communicate with each other to share information or resources. For example, the telephone network is a network of phones that connect to each other to make calls. The electrical grid is a network of generators, wires, and plugs that connect to each other to provide electricity. The internet network is a network of computers, routers, and servers that connect to each other to exchange data.  

Bitcoin is a network of computers, called nodes, that connect to each other to exchange bitcoins, which are the network's units of value. Each node has a copy of the ledger, the famous blockchain, where all the transactions made on the network since its creation are recorded. Whenever someone wants to send or receive bitcoins, they must create a transaction and broadcast it to the network for the other nodes to validate and include in the blockchain. This way, the Bitcoin blockchain, this tamper-proof ledger, is constantly updated with new transactions. All nodes participating in the network have the same information and balance for each user. 

What makes the Bitcoin network unique is that it is a peer-to-peer network. This means that there is no central node or authority that controls or regulates the network. All nodes are equal and have the same roles and responsibilities. There are no trusted intermediaries or third parties to verify or approve transactions. Everything is decentralized through a consensus between the nodes, based on mathematical and cryptographic rules that guarantee the network's security, integrity, and immutability.  

Blockchain, Bitcoin's ledger  

Blockchain is the critical element that makes Bitcoin's operation possible. It is a digital ledger, public and distributed, where all transactions made are stored. Each transaction is a record that contains the sender's address, the receiver's address, the number of bitcoins sent or received, and a digital signature that authenticates the transaction. The network nodes verify each transaction, checking that the issuer has sufficient funds, that the signature is valid, and that the transaction is not a copy or a double-spending attempt.  

Transactions are not stored individually but are grouped into blocks of transactions made in a given period. Each block has a unique identifier, called a hash, which is generated from the data in the block using a mathematical function. Each block also references the previous block's hash, creating a chain from the first (Genesis) to the last (called the tip) block. Thus, the blockchain is an orderly, chronological sequence of blocks containing the complete history of all transactions made on the network.   

The blockchain is public, meaning anyone can access it and see every transaction. It is also distributed, meaning each node has a copy of the blockchain constantly synchronized with the other copies. This makes the blockchain secure and censorship-resistant, as there is no single point of failure or attack.  

Miners, the guardians of the network  

One of the most frequently asked questions about how Bitcoin works is: how are blocks created and added to the blockchain? Who decides which transactions are valid and what order they have? What's stopping someone from creating fake or invalid blocks and spreading them to the network? The answer to these questions is miners.  

Miners are people or organizations that invest by acquiring a particular computer to "run" a node, in this case, on the Bitcoin network. Anyone can run a node (it's a potent computer) and thus be in charge of creating the blocks and maintaining the security and consensus of the network. Miners are the gatekeepers of the network and are rewarded for their work.  

Creating a block is called "mining" and involves solving a complicated mathematical problem requiring much computational power, energy, and time. The problem is based on finding a number called nonce (it comes from the expression for the nonce, which in Old English means "for the occasion" or "for once") that, when added to the block, generates a hash that meets certain conditions.  

If many miners work, the hashing power increases and Bitcoin makes it more difficult to find a block. The reverse occurs when the hashing power is reduced. By design, blocks should be uncovered every approximately 10 minutes.  

The mathematical test miners must perform is called Proof of Work (POW). Bitcoin's consensus mechanism is based on this proof of work generated by miners and validated by the network's nodes.  

Mining: a reward-for-effort model  

The first miner to find the nonce and generate the valid hash wins the right to add the block to the blockchain and broadcast it to the network. The other nodes verify the block´s validity and accept it as part of the blockchain. The miner who creates the block receives a reward, which consists of a fixed number of bitcoins, called a block reward or subsidy, in addition to the fees users pay for including their transactions in the block.  

Halving  

The block reward is halved every 210,000 blocks, roughly every four years, in an event called Halving. This makes the issuance of bitcoins limited and predictable and does not exceed 21 million units.  

The following table shows the history of rewards (called subsidies) from the first Bitcoin block, the Genesis Block, to the last halving on April 20, 2024:  

As shown in the table above, miners' reward for their work grew exponentially in dollars beyond the halvings, which cut the subsidy in half.  

Bitcoin's monetary base  

These subsidies that miners receive are new bitcoins created by the protocol's design. By April 20, 2024, the date of the last halving, 19.6 million Bitcoins had been issued out of 21 million. Following this logic, the last Bitcoin will be created in 2140.  

This means that in the next 116 years, the issuance of Bitcoin will only be 1.3 million Bitcoins. Still, due to the decreasing logic of the halvings, between 2024 and 2032, of those 1.3 million, 1 million will be issued, leaving only 300k to be created in 108 years. Bitcoin is scarce by definition.  

Starting in 2140, miners will no longer receive subsidies and will sustain their activity only with user commissions.  

Why are miners honest?  

Miners are honest because it's the best deal.  

When a miner finds a valid block, they announce it to the network. All other nodes verify the new block is valid and confirm it quickly. The incentive to do it correctly and quickly is that, since a particular miner has already won the race to find a new block, the best business is to start processing the next one and eventually manage to form another new block and collect the next reward.  

Why aren't miners rogue?  

If a given miner wanted to be dishonest and validate an invalid block, they would face a severe problem. You need to get 51% of the nodes on the network to validate your dishonesty and confirm the invalid block. Bitcoin nodes are in the tens of thousands and distributed worldwide; it has yet to be known who operates them, given the network's decentralization. This makes it impossible to alter the blockchain, as it would require more power than all other miners combined.  

Honesty pays; the best business is to try to figure out how to form a new block.  

The fallacy behind excessive energy consumption of Bitcoin mining  

The mining process demands a lot of energy, and this demand is a point that critics of Bitcoin highlight negatively, pointing out that it consumes energy equivalent to that used by entire countries, such as Malaysia and Egypt. This is correct in absolute terms, but we must put this consumption in relative terms to form a solid opinion.  

Bitcoin is an alternative to the traditional financial system, so we should compare it to it.  

To calculate the energy demanded by the traditional financial system, we must include:  

• Bank branches.  
• ATMs.  
• Data centers.  
• The production and physical transportation of cash and coins.  
• The energy costs of buildings.  
• Employee travel.  
• The infrastructure needed to support these activities.  

More conservative estimates indicate that Bitcoin's energy consumption is half that of the traditional financial system. The most aggressive say it is 28 times lower.  

Renewable energy  

A Bitcoin miner is agnostic to its place of installation. This makes it possible to take advantage of wasted energy, such as that generated by the venting of oil wells, renewable energies that are wasted at times of low consumption, etc. Today, 60% of Bitcoin's energy consumption is estimated to come from renewable sources. In the financial system, that percentage is only 20%.  

Not only that but sometimes, as in the use of venting gas, the emission of greenhouse gases caused by the oil industry is substantially reduced.  

Wallets  

A Bitcoin wallet is a software tool that comprises four basic functionalities:  

1. Store our private key.  

1. Generate our public address.  

1. Manage transactions.  

1. Check our balances.  

The wallet is the container for a private key  

When we talk about wallets, our mind takes us to the familiar item in the physical world, where we keep money. In the world of Bitcoin, this is different.  

When we create a new Bitcoin wallet, for example, using Muun, Trust, or any other, we create a new combination of public and private keys, which allows us to make an address.  

This private key consists of 12 or 24 words (depending on the security, 128 or 256 bits), which we must keep in a safe place where we know we will not lose them and to which only we have access. If we lose these keywords, it is impossible to dispose of that wallet's Bitcoin balance, i.e., that public key.  

Public addresses are a derivation of the public key. 

Wallets generate a public address on the Bitcoin network, derived from the public key, which is derived from the private key. When someone wants to send us Bitcoin, they do so to that address.  

For example, 1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa is Satoshi Nakamoto's first Bitcoin address, who received the 50 BTC he paid for the mining of the Genesis Block, the first Bitcoin block. Today, it contains almost 100 Bitcoins because it is customary for the network to send small amounts of Bitcoin to that address as a tribute to Satoshi.  

When I open the wallet and see the balance in Bitcoins, we are not doing what we do in the physical world, i.e., we are not counting the money in it. We are reading a balance in the network.  

A transaction is a record

The private key allows us to sign new transactions and dispose of the balance that the public key has.  

When we make a transaction with our private key, we sign the sending of all or part of our balance from our address to another address. We can only do this because we have the private key.  

Our Bitcoins, where are they?  

Bitcoins are balances.  

The balance we see when we open the wallet are not "coins" stored in a database or file. They are the balance of that address on the Bitcoin network.  

Let's look at an example: Someone sends 0.2 BTC to my new address, so my balance is 0.2 BTC. That transaction is recorded on the best and most secure ledger in human history, the Bitcoin blockchain. Then someone sends me 0.1 BTC more, so my balance is 0.3.  

The ledger of the Bitcoin blockchain has records that show that I, at my address, have a balance of 0.3 BTC not spent; therefore, if I have the private key, I can spend it. This balance is called UTXO, unspent transaction output.  

With my private key, I can sign any transaction to another address. The miners will validate this transaction, and the amount sent will be deducted from my balance, generating a new UTXO, which will be recorded by the miners on the blockchain.  

Hot wallet vs. Cold wallet  

There are two types of wallets: hot wallets and cold wallets. The main difference between a hot wallet and a cold wallet is that our private keys are stored in a physical offline device instead of in an application connected to the internet, with the risks that this implies.  

Hot wallets, connected to the internet, facilitate access and quick transactions. Its advantages include its convenience and the ability to exchange cryptocurrencies agilely. However, they are more susceptible to cyberattacks, fraud, and other security risks due to their constant connection to the internet.  

On the other hand, cold wallets provide a much higher level of security. They are ideal for storing large amounts of cryptocurrencies in the long term, significantly reducing the risk of hacks. However, they are less convenient for frequent transactions and may involve a more complex process to access funds when needed. 

Now, be careful! Anyone who gets their keywords because they wrote them down on paper and lost them can still access their funds. Keywords are the key to Bitcoin!  

Conclusion: Bitcoin, the Internet of Value  

Bitcoin is more than just a currency or a network. It is a technological, social, and economic revolution that allows us to create and transfer value decentralized, without intermediaries, censorship, or borders.  

Bitcoin is the Internet of Value, an open and inclusive platform that allows us to connect and collaborate with people worldwide, as well as access opportunities and services previously inaccessible or prohibitive. Bitcoin expresses individual freedom, financial sovereignty, and disruptive innovation.  

Bitcoin gave the Internet a new dimension: it added the possibility of transmitting value to the Internet of Information and the Internet of Social Participation.  

But this is just the beginning. Bitcoin is an ever-evolving technology, offering many possibilities and applications beyond what we've seen. It is also a global community sharing a vision and mission and working to improve and spread this technology. Bitcoin is, in short, the future of money and value.  

In this series's next and final article, we'll delve into the revolution that Bitcoin spawned beyond Bitcoin: Ethereum, Solana, layer 2, and the new crypto ecosystem.