How Blockchain Works?

Since we now understand what blockchain and bitcoin is, let's discuss how the blockchain technology works in the context of an online transaction, particularly using Bitcoin as an example. Bitcoin, being the most popular cryptocurrency, offers a clear illustration of how blockchain functions in real-world scenarios.

Step 1: Creating and Sending a Transaction

Let's say you want to buy a new laptop from an online store using Bitcoin. The process begins with you opening your Bitcoin wallet app and creating a transaction message.

This message specifies the amount of Bitcoin you wish to send; and includes the store's public key as the recipient address. To authenticate the transaction, you use your private key to sign the message. This use of public-key cryptography, which we will discuss in the following chapters, is crucial for ensuring the security and authenticity of the transaction.

Step 2: Broadcasting to the Network

After double-checking the details (since Bitcoin transactions are irreversible), you broadcast the transaction message to the Bitcoin network. This network comprises numerous nodes, each running the full Bitcoin blockchain.

Step 3: Verifying the Transaction

Nodes in the Bitcoin network fall into two categories: miners and verifiers. While miners will focus on creating new blocks, other nodes on the network play a role in verifying data. In our example, the network verifies that you have the amount of Bitcoin you're sending and it was you who authorized the transaction.

Step 4: The Mining Process

Mining is a computational race where miners contribute their computational power to solve a complex mathematical problem associated with creating a new block of transactions.

As we have already seen, each block has a unique identifier (hash). This hash is computed based on the block contents and must meet a certain criterion, such as having a specified number of leading zeros in the case of Bitcoin.

Miners have to find a certain number called nonce which when hashed with other block contents creates a hash that meets a required criterion.

Step 5: Adding to the Blockchain

Once a miner successfully creates a new block, it is broadcast to the network. Other nodes verify the block and add it to their copy of the blockchain. This process includes the hash of the previous block, creating an unbreakable chain of blocks. The miner who found the correct nonce first earns newly minted bitcoins as a reward.

Step 6: Transaction Confirmation

Your transaction, along with others, is now part of a block on the Bitcoin blockchain. Within about 10 minutes after creating the transaction, you and the store receive confirmation of the transaction.

Transparency and Pseudonymity

The blockchain is a public ledger, making all transactions transparent. However, participants' identities remain pseudonymous, as only their addresses are visible on the network. Anyone can view these transactions, but linking them to real-world identities requires additional information.

Let's take a look at a real transaction to illustrate this (you can view it here):

As you can see, we have the sender and recipient addresses here. There is also most-likely a so-called change address which corresponds to the same person if it is indeed a change address. In fact, most modern wallet applications follow the best practice of using a new address for the change enhancing privacy.

But why can't we simply send the exact amount of Bitcoin without having to send back the change? Don't worry, we'll discuss this and more questions later in the course.