How Bitcoin Works: A Simplified Guide

“The real problem with conventional currency is all the trust that’s required to make it work. The history of fiat currencies is full of breaches of that trust.” -Satoshi Nakamoto

How Bitcoin Works

Bitcoin is powered and created through a process known as “Mining”. Miners contribute computational resources to the network in effort to confirm pending transactions by adding them to the Bitcoin ledger. Using Proof of Work (PoW) consensus, every 10 minutes miners must “work” to solve a complex SHA-256 hash equation that confirms the contents of the block to be valid before new BTC is minted + given to the miner in the form of a block reward.

Distributed; Power To The People

Even as concentrated pools dominate the industry, mining can be done by anyone — assuming you have the right hardware. In the early days mining could be done on a consumer grade computer. Now, dedicated machines known as ASICs (application specific integrated circuits) + access to relatively cheap energy are requisite to be a profitable miner. Still, anyone dedicated enough can join in.

Proof of Work: Will Work For BTC

Since inception Bitcoin has used a proof of work consensus mechanism. Though critics have cited Bitcoin as an environmental threat due to massive energy requirements, the large power draw gives the network it’s tremendous security, its proponents tending to appreciate the physical commitment requisite to secure the network. Some have even described Bitcoin + PoW as “…the ability to convert energy — both technological + physical — into a scarce monetary good that cannot be censored, confiscated or copied…” How poetic.

Block Rewards: Ingenious Incentives

Issued every ~10 minutes, the block reward mints a fixed number of BTC that eventually enter circulation when miners sell the “virgin” coins. The reward is programmatically reduced by 50% every 4 years until 21M BTC have been minted. This supply schedule drives price action + encourages miners to add hash power, boosting network security in a virtuous cycle.

In theory, mining can be done by anybody, but the reality is quite different. Given the moat-like economies of scale that now surround the industry, it is far more difficult for any solo entity to profitably mine BTC. It can be done, but it’s almost certainly going to be a money-losing endeavor unless millions are invested into the operation. For most who remain adamant on mining, it would be advised to begin by joining a larger pool to keep startup costs to a minimum.

Nodes: Smooth Operator

Imagine if you could whip up a node that gave you access to the entire transaction history of JP Morgan or BlackRock. Pretty powerful, indeed.

What’s more feasible than mining is for somebody to run a node. Instead of mining + minting new BTC, ardent Bitcoin believers can run their own node, a continuously updating record of all transactions on the Bitcoin blockchain — independently owned + operated by whoever so desires to spin one up. Nodes aren’t responsible for solving any of the SHA-256 equations required to mint new BTC, but rather, they host + transmit an additional copy of the greater Bitcoin blockchain ledger. This allows node operators to have direct access to the global Bitcoin ledger. Yet another expression of commitment to the “Don’t trust, verify” nature of crypto. Imagine if you could whip up a node that gave you access to the entire transaction history of JP Morgan or BlackRock. Pretty powerful, indeed.

The proof of work consensus mechanism makes it difficult to attack or unilaterally control the mining network. Due to high energy demands, attackers would have to allocate a substantial amount of resources + energy to have a shot at launching a successful 51% attack on the Bitcoin network. Similarly attack resistant, though for different reasons, proof of stake consensus requires a sizable amount of capital to attack the network.

The key distinction to note is that it’s easier for somebody to begin mining in a PoS system as they could allocate the needed funds as a direct investment into the ecosystem, pool their funds together with other motivated investors, or they could join a larger pool established by a CEX or other large entity to contribute a fraction of the network’s requirement for solo staking.

Block Rewards: A Grand Prize

The cyclical issuance reduction puts significant pressure on Bitcoin’s supply…often having a notable impact on the price of BTC…as new waves of adopters learn about the asset’s programmatic scarcity for the first time.

Bitcoin’s block reward mechanism is directly associated with the famed four year “halving” cycle, which historically, has driven the entire crypto market in terms of bullish appreciation phases & bearish markdown phases. Every four years (approximately), the block reward issuance rate gets cut in half. This four-year halving schedule reduces the velocity of new Bitcoin issuance until it reaches the 21 million BTC target.

When Bitcoin debuted 50 BTC were minted every 10 minutes as a subsidy to reward miners for securing the network, a subsidy known as the block reward. In 2012 the block reward was reduced by 50%, with only 25 new BTC minted every 10 minutes. 2016 saw the reward drop to 12.5 BTC & 2020 halved the issuance down to 6.25 BTC. In 2024, the block reward will decrease by another 50% with the halving cycle continuing until all 21 million BTC are minted.

The cyclical issuance reduction puts significant pressure on Bitcoin’s supply, the resulting supply shock often having a notable impact on the price of BTC due to the ensuing demand shock as new waves of adopters learn about the asset’s programmatic scarcity for the first time. Or perhaps as they appreciate the asset’s programmatic scarcity for the first time.

Newly minted “virgin” Bitcoin comes onto the free market as miners sell their awarded allotment to cover operating expenses. Of course, some of these miners are holding on to their BTC as a long-term investment, but there remains a certain amount of turnover necessary for these miners to remain operationally solvent, let alone profitable.

Any BTC used, custodied, or otherwise interacted with after miners sell them to the open market can no longer be deemed “virgin” coins. Some exchanges & custodians have even gone as far as to ban or reject “tainted” BTC, coins that have been involved in illicit transactions according to interpretations of on-chain data. I add this simply to acknowledge that the argument of BTC being perfectly fungible isn’t entirely correct based on the policies of certain entities within the digital asset space. While most users will never be burdened by tainted coins, there are several ways to “clean” them should you need to.

Hint: It rhymes with “mixer”…