by Sean Han
How does bitcoin work? I built an app to show you.
As Bitcoin rose to unprecedented levels, it caught my attention & curiosity. I wondered, how does bitcoin really work?
As I went down the blockchain rabbit hole, I found that many resources rarely go beyond the “revolutionary”, “distributed” and “immutable” dialogue. Many talk about the what, but not so much the why and how.
I resorted to reading technical papers and source code to uncover this black box. I started sharing what I learned by building apps that demonstrated the inner workings of the blockchain.
What I realized was bitcoin was just blockchain + transactions. This article will cover the transactions part of the equation. If you would like a refresher on blockchain, checkout Blockchain Demo or this article.
A block on the blockchain has the following parts:
- Index (Block #1): Which block is it?
- Hash (#00001834d29f33…): Is the block valid?
- Previous Hash (#000dc75…): Is the previous block valid?
- Timestamp (Tue, 19 Dec 2017 …): When was the block added?
- Data (I ❤️ freeCodeCamp): What information is stored on the block?
- Nonce (1263): How many iterations did we go through before we found a valid block?
Instead of having text (I ❤️ freeCodeCamp) as data, cryptocurrencies have transactions as data.
What is a transaction?
Transactions are a record of payment between two parties. When there is an exchange of value, a transaction is created to record it.
For example, let’s say Satoshi has 100 coins.
He wants to pay Dean 5 coins, with a mining fee of 1 coin. He uses the 100 coins he has to make the transaction. He expects to have 94 coins in change.
When Satoshi mines a new block with the transaction above, he is rewarded with 100 new coins.
The example above will create the following transaction outputs (to be explained):
Since the initial 100 coins Satoshi had was used as an input to create the above transaction, the initial 100 coins is now spent. (to be explained)
The above concepts will be explained next.
Three types of transactions:
- Reward — Satoshi rewarded with 100 coins for mining new block
- Regular — Satoshi paid Dean 5 coins with change of 94 coins
- Fee — Mining fee of 1 for whoever mines the transaction (Satoshi in example above)
A transaction consists of four parts:
- Inputs — Where value is coming from
- Outputs — Where value is going to
- Hash —Uniquely identifies the transaction (using inputs & outputs)
- Type — Reward, Regular, or Fee
Outputs — Where value is going to
An output has two parts:
- Address — What is the public wallet address to send the coins to?
- Amount — How many coins?
Inputs — Where value is coming from
An input has to come from a previous output. However, an output can only be used as input once. When an output is used, it is considered to be spent. Outputs that have not been used as input are unspent.
An input has five parts:
- Transaction Hash —Transaction hash of the (unspent) output
- Output Index — The index of the (unspent) output in the transaction
- Amount — Amount of the (unspent) output
- Address — Address of the (unspent) output
- Signature — Signed by the Address’s private key
Reward transactions are created as a result of finding a valid block on the blockchain. As a result, reward transactions do not have any inputs because it creates new coins.
For example: Satoshi mined a new block with a mining reward of 100. The transaction on the block will look like this:
- Address: Satoshi’s public wallet address
- Amount: 100 (reward specified by the cryptocurrency)
Hash: ?(inputs + outputs) = 000abcdefg…
Regular transactions are transactions created when one party pays another.
Continued example: Satoshi uses the (unspent) output from the reward transaction as an input to pay Dean 5 coins. He specifies a mining fee of 1 coin.
- Transaction Hash: 000abcdefg… (hash of reward transaction above)
- Output Index: 0 (first index of output is 0)
- Amount: 100 (output amount)
- Address: Satoshi’s public wallet address (output address)
- Signature: Satoshi signs this input with his private key
Output 1: (index 0)
- Address: Dean’s address
- Amount: 5 coins
Output 2: (index 1)
- Address: Satoshi’s address
- Amount: 94 coins= 100 - 5 (payment) - 1 (fee)
- The first output is the payment going to Dean.
- The second output is the change going back to Satoshi
Because Satoshi’s reward transaction output (from the previous example) has been used as an input for this payment, it is now spent and cannot be used again. If it is used again, then there is double spending.
Why doesn’t it add up???
The total input amount is 100.
The total output amount is 5 + 94 = 99.
In the example, Satoshi specified a mining fee of 1 coin. The difference between inputs and outputs of a regular transaction is the mining fee.
Inputs must be greater or equal to outputs. If inputs and outputs are equal, then there is no mining fee.
Whoever mines the above regular transaction will add the mining fee transaction. Because there was a deficit of 1 in the regular transaction, the fee amount is 1.
Continued Example: Bob mines Satoshi and Dean’s transaction.
- Address: Bob’s public wallet address
- Amount: 1 (fee, difference of regular transaction input and output)
Because Bob mined this transaction to the new block, there will be a reward transaction of 100 to Bob.
On the blockchain:
Satoshi: 94 = 100 (reward) - 5 (payment) - 1 (fee)
Dean: 5 (payment from Satoshi)
Bob: 101 = 100 (reward from mining new block with transaction) + 1 (fee)
Total currencies in circulation: 200 = 94 (Satoshi)+ 5 (Dean)+ 101 (Bob)
Two blocks were mined, and each block has a reward of 100, so there should be 200 coins in circulation.
On a new block, regular and fee inputs and output totals must equal. This ensures that only reward transactions generate new coins.
Deficits from regular outputs are offset with fee transaction outputs. Leaving the only output surplus to be reward transactions.