Bitcoin is many things, but we’ll focus on the design elements here.
Firstly, Bitcoin is a peer-to-peer network of computers all following a set of rules and instructions (the Bitcoin protocol) for validating transactions and issuing new coins. Any computer running any software that respects these rules can participate in the Bitcoin network. These are called Bitcoin Nodes.
Think of this protocol as the banking laws of a country. Any bank can operate, so long as they obey the laws. The difference is that the Bitcoin protocol is enforced by code, and not by courts – meaning it’s much more reliable.
Second, Bitcoin has a ledger of all the transactions, called the Blockchain. Transactions are recorded in blocks, which are created at set intervals and connect to the previous block to create a chain.
Lastly, there is the mechanism for adding blocks to the Blockchain and reaching agreement (consensus mechanism) that the transactions are valid, and the whole chain accurate. This is called Mining.
Participants don’t need to trust each other; they need only trust the rules and the code.
So how does this work in practice?
The blockchain: trust but verify :
The most revolutionary feature of Bitcoin is its ledger – also known as the blockchain – and in the way transactions are validated.
We must trust banks to keep the integrity of their ledgers, but we can’t verify it for ourselves. If one bank sends one euro to another bank, we must trust them to remove that euro from their accounts. That’s because only they can see and update their ledgers. We can’t see if they make a mistake, or if they make poor choices when extending credit. As the 2008 financial crisis has taught us, this isn’t always a good idea.
Banks are incentivised to uphold the law, but history shows that they can go around or even change regulations to their benefit.
In 2008, banks and other lenders exploited the rules to recycle an ungodly amount of debt into “subprime” financial products that were so complex that virtually no one could understand them.
This was made worse by the fact that few people even had access to the books – and the few who did had a hard time understanding the complexity. When these rotten products defaulted, the world economy broke. The result? Trillions in bailout money for the same banks that caused it.
Bitcoin turns this logic upside down. Instead of a single ledger kept locked away by a central authority, Bitcoin ensures anyone can have a copy of the ledger containing all transactions that ever happened. Everyone can mathematically verify that every transaction in it is legitimate. Transactions that don’t respect the rules are automatically rejected by the software.
Bitcoin transactions are batched approximately every 10 minutes into a block, which is then added to a long chain of blocks containing all previous transactions (hence the term blockchain). This process of adding the new blocks into this shared ledger is called mining.
The problem with a shared ledger is, how do we all agree that the current version is the most up to date one? How can thousands of different computers all over the world reach consensus without someone in charge?
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