Lesson 2

How Bitcoin Works

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Blockchain Basics:

At the heart of Bitcoin is blockchain technology, a decentralised digital ledger that records all Bitcoin transactions. What makes Bitcoin unique is that this ledger is not stored in a single location but across thousands of computers, known as "nodes," around the world.

It’s called a blockchain because it organises data into blocks that are linked together in a continuous chain. Here’s how it works:

Blocks: Each block contains a set of transactions, a timestamp, and a cryptographic reference (called a hash) to the previous block. This ensures that all blocks are connected in the correct order.

Hashing: Bitcoin uses the SHA-256 hashing algorithm to convert transaction data into a secure, fixed-length string of numbers and letters. This ensures the integrity of the blockchain, making it nearly impossible to alter past transactions without controlling more than 51% of the network’s computing power.

Decentralisation: Instead of being controlled by a single entity, Bitcoin’s blockchain is maintained by a network of independent participants, making it resistant to censorship and attacks.

Proof of Work and Bitcoin Mining:

Bitcoin achieves security and consensus—agreement on which transactions are valid—through a process called Proof of Work (PoW). This process is powered by mining, where miners use their computing power to solve complex mathematical puzzles that validate transactions and add them to the blockchain. The consensus mechanism ensures that all participants follow the same set of rules, making Bitcoin secure and decentralised.

Here’s how the process works:

Mining and Block Creation: Miners compete to solve cryptographic puzzles. When a miner solves a puzzle, it creates a new block of transactions, which is then broadcast to the entire network. Other participants verify the solution, and if valid, the block is added to the blockchain permanently.

Incentives for Miners: Miners are rewarded with newly minted Bitcoin (the block reward) and transaction fees for their efforts. This reward provides an incentive for miners to maintain and secure the network. However, the block reward decreases over time in an event called the halving, which occurs approximately every four years. As of 2024, the reward is 6.25 BTC per block.

Difficulty Adjustment: To keep the network functioning smoothly, Bitcoin automatically adjusts the difficulty of the puzzles miners solve. This ensures that new blocks are added roughly every 10 minutes, regardless of how many miners are participating. As more miners join, the puzzles become harder to solve, keeping the system stable.

Bitcoin mining is sometimes criticised for its high energy usage, as it requires substantial computing power. However, this energy-intensive process is crucial for securing the network and keeping it decentralised. By making it expensive to alter the blockchain, PoW ensures Bitcoin remains resistant to attacks and manipulation. Many miners now use renewable energy sources to minimise the environmental impact.

Consensus Mechanism:

The core of Bitcoin’s security is its consensus mechanism, which ensures that all participants agree on the state of the blockchain. In Bitcoin’s PoW system, miners compete to solve puzzles, but only the first one to solve it gets to propose the next block. Once a block is proposed and verified by the network, it becomes part of the permanent record.

This decentralised consensus ensures that no single entity controls the blockchain, and any attempt to alter or fake transactions would require controlling over 51% of the network’s total mining power—a feat that is nearly impossible given the size and security of the Bitcoin network.

The consensus mechanism also prevents double-spending, where a user might try to spend the same Bitcoin twice. By requiring network-wide agreement on transactions, Bitcoin ensures that once a transaction is confirmed, it cannot be reversed or duplicated.

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Lesson 3
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