How Does Bitcoin Work? A Ledger With No Bank Behind It

A bitcoin is not a coin or a file. It is an entry in a ledger, a list of every transaction ever made, from which the balance of any address can be worked out by adding up what has been received and subtracting what has been sent. The ledger is the blockchain: transactions are gathered into blocks, each block carries a cryptographic fingerprint of the one before, and the chain runs back to the first block in 2009. Anyone can download the whole ledger, about half a terabyte, and check every transaction in it. To spend bitcoin, the owner signs a transaction with a private key, a secret number that only they hold, and anyone can verify the signature with the matching public address without learning the key. Lose the key and the coins are lost for ever; there is no one to ask.

The problem the paper solved was how strangers who do not trust each other can agree on which transactions are valid and in what order, without a referee. The answer is a race. Computers called miners gather pending transactions into a candidate block and search for a number which, added to the block, makes its fingerprint start with a required run of zeros; there is no shortcut, only trial and error at trillions of guesses a second, and the first to find one broadcasts the block and the others check it in an instant and build on it. The winner is paid in new bitcoin plus the fees on the transactions. Rewriting an old block would mean redoing its search and every search after it faster than the whole network is adding new blocks, which is why the record is called immutable in practice. The rules that make it hold together:

• •A new block about every ten minutes, with the difficulty of the search adjusted every two weeks to keep that rate as machines get faster
• •A reward that halves every four years, from 50 bitcoin in 2009 to 3.125 in 2024, so that the total will never exceed 21 million
• •The longest valid chain wins, so an attacker would need more computing power than everyone else combined
• •Every full node checks every block against the rules, so a miner cannot pay itself more than the rules allow

The search that secures the ledger is deliberately wasteful; that is the point, since it has to be expensive to rewrite. The network consumes on the order of 150 terawatt-hours a year, comparable to a mid-sized country, and the mining that began on hobbyists' laptops is now done in warehouses of specialised chips near cheap electricity. The system is also slow by the standards of payment networks: about seven transactions a second for the whole world, against tens of thousands for a card network, with a confirmation taking ten minutes to an hour, and fees that rise when the chain is busy. Layers built on top, which settle many small payments off the chain and record only the net result, exist to address that, and other cryptocurrencies have replaced the energy-hungry race with systems in which validators put up coins as a stake instead.

Bitcoin has most of the features of money and lacks the one that matters most for daily use, a stable value. Its price has risen from nothing to tens of thousands of dollars and fallen by more than half at least five times, which makes it a poor unit in which to price a coffee and a good subject for speculation. Its supporters compare it with gold: scarce, portable, held outside any government's control, and useful in countries whose currencies collapse or whose banks freeze accounts. Its critics note that gold has industrial and ornamental uses and bitcoin has only the expectation that someone else will want it, that it has been the payment method of choice for ransomware and dark-web markets, and that most people who hold it do so through exchanges, which are exactly the trusted institutions it was designed to remove and which have failed repeatedly, most spectacularly in 2022. Both are describing the same object.

Whatever bitcoin's price does, the design solved a problem that computer scientists had regarded as unsolved: how a network of untrusted parties can maintain a shared record without a central authority. That idea, the blockchain, has since been applied, mostly without success, to contracts, supply chains, voting and art, and with success to the several thousand other cryptocurrencies that copied it. The author, who wrote under the name Satoshi Nakamoto, exchanged emails with early developers until 2011 and then stopped, holds an estimated million coins that have never moved, and has never been identified, which is either a security nightmare or the final proof that the system needs no one.

A widespread belief is that bitcoin is untraceable. In fact it is better described as pseudonymous. Addresses are long strings rather than names, but every transaction between them is recorded permanently on a ledger anyone can read. If a single address is ever linked to a real person, for example when they buy coins on an exchange that checks identity or post an address publicly, a trail can be followed backwards and forwards through every payment it touched. Specialist firms now analyse the ledger for banks, tax authorities and police, clustering addresses that appear to belong to the same owner.

A well-known example came in 2021, after hackers attacked the Colonial Pipeline in the United States and the company paid a ransom in bitcoin. Within weeks the US Justice Department announced it had traced much of the payment through the ledger to an address it could access, and seized most of the coins, though their dollar value had fallen in the meantime. Criminals respond with mixing services and other cryptocurrencies designed to hide amounts and senders, and governments have targeted those services in turn. If privacy matters to you, it is worth knowing that a public ledger is close to the opposite of a private bank statement.

The very first block of the bitcoin ledger, created on 3 January 2009, carries a line of text that has nothing to do with payments: the headline from that day's edition of The Times of London, 'Chancellor on brink of second bailout for banks'. Including it proved that the block could not have been made before that date, a simple way of timestamping the start of the chain. It was also widely read as a statement of purpose, coming a few months after the financial crisis of 2008 had forced governments to rescue the very institutions whose role as trusted record-keepers bitcoin was designed to do without.

The first well-known purchase of real goods came on 22 May 2010, when a programmer in Florida, Laszlo Hanyecz, received two pizzas in exchange for 10,000 bitcoin, after offering the coins on an online forum to anyone who would arrange the delivery. The coins were then worth roughly forty dollars. At the prices bitcoin reached in later years, tens of thousands of dollars per coin, those two pizzas would have cost hundreds of millions of dollars. Enthusiasts now mark the date as Bitcoin Pizza Day, a cheerful reminder of how unpredictable a currency's value can be.

A bitcoin wallet does not hold a balance the way a bank account does. It holds a set of unspent outputs, chunks of bitcoin received in earlier transactions, and each chunk must be spent whole, rather like a banknote. Suppose you received 0.5 bitcoin last month and now want to pay a shop 0.2. Your wallet builds a transaction that uses the entire 0.5 as its input and creates two outputs: 0.2 to the shop's address and about 0.2999 back to a new address of your own, called change. The two outputs add up to slightly less than the input.

That small gap, 0.0001 bitcoin in this example, is the fee. It is never written down as a separate item; whatever the inputs exceed the outputs by goes to the miner who includes the transaction in a block. Because blocks have limited space, fees are set by a transaction's size in bytes rather than by the amount sent, so a payment that must combine dozens of small earlier receipts as inputs takes more space and costs more than one funded by a single large output, even if it moves less money. It also explains why sending a tiny sum can sometimes cost more in fees than it is worth.

Bitcoin is a public ledger of every transaction, copied across thousands of computers, in which ownership is proved by cryptographic signatures and new pages are added by miners competing to solve a costly puzzle, so that rewriting history would cost more than the whole network's computing power. It caps its supply at 21 million, consumes as much electricity as a country, handles few transactions slowly, and has a price too volatile for everyday money, while remaining the first working answer to the problem of keeping a shared record without anyone in charge.