How Does Bitcoin Work? Blockchain, Network, Transactions

written by
Peter Schöllauf
Blockchain Lead
Reviewed by
Georg Brameshuber
Crypto Tax Expert & CPA
Last Updated:
July 12, 2024

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  • Bitcoin is based on a secure blockchain, a sequence of blocks linked by unique hashes that contain transaction data and ensure the chain's integrity.
  • Bitcoin mining generates new bitcoins, confirms transactions and secures the blockchain
  • The public key serves as a receivable address for Bitcoins, while the private key authorizes transactions and controls access to owned Bitcoins
Table of Contents

Bitcoin Basics

Bitcoin is a revolutionary digital currency, invented in 2008 by an unknown person or group using the pseudonym Satoshi Nakamoto. It is the world’s first cryptocurrency and responsible for introducing blockchain technology to the financial industry.

Unlike traditional currencies, Bitcoin operates on a decentralized network of computers, allowing users to transact directly without the need for a central authority, such as a bank or government. 

In this guide, we’ll take a closer look at the way Bitcoin works, focusing on key elements like the Bitcoin blockchain, Bitcoin transactions and the Bitcoin network. 

If you want to learn more about Bitcoin and its significance as the world’s first cryptocurrency, be sure to start with our guide "What is Bitcoin?"

Key Bitcoin Terms Explained

  • Blockchain: A digital ledger that records all cryptocurrency transactions in a secure and transparent way across multiple computers.
  • Cryptography: The art of protecting information by transforming it into a secure format, only readable by someone with the key.
  • Mining: The process of using computer power to solve complex puzzles, validate transactions, and secure the cryptocurrency network, earning digital currency as a reward.
  • Nodes: Computers connected to the cryptocurrency network that validate and store a copy of all transactions.
  • Public & Private Keys: A digital security measure where the public key is shared openly to receive transactions, and the private key is kept secret to authorize transactions.
  • Wallets: Digital tools that store your public and private keys, allowing you to send, receive, and manage your cryptocurrency.
  • Hash: A unique string of characters generated from data, ensuring the integrity and security of data in blockchain transactions.

The Blockchain: Bitcoin’s Backbone

Peeling back the layers of Bitcoin's underlying technology, we arrive at the blockchain. A marvel in digital architecture, the blockchain has revolutionized the way we think about data storage and transactional integrity in a decentralized environment.

Informative illustration of Bitcoin data in the Bitcoin Blockchain

How Blockchain Works

At its most basic, a blockchain can be visualized as a chain of blocks. Each block consists of two main components: a block header and a body. 

These blocks serve two primary functions: storing a list of transactions (within the body) and securing the blockchain's integrity through the block header.

The block header is vital, containing metadata that ensures the chain's security, including a unique identifier known as the hash of the previous block. This hash acts as a digital fingerprint, linking each block to its predecessor in a direct lineage. As a result, we get a continuous, unbreakable chain of blocks – the blockchain.

What Is a hash?

A hash is like a digital fingerprint for any piece of data. It's a way to take any amount of information, whether a single word or an entire book, and turn it into a short, unique code. 

Even a tiny change to the original data, as subtle as the difference between "Hello" and "hello", creates a completely different hash. 

The difference between the hash of "Hello" and the hash of "hello" using the sha256 hashing function

This uniqueness makes hashes crucial for checking if data has been tampered with and keeping information secure in technologies like blockchain.

Bitcoin predominantly employs the SHA-256 hash function, a member of the SHA-2 family.

The Role of Mining

Mining is a critical process in the Bitcoin network, serving two main purposes: creating new bitcoins and maintaining the security and integrity of the blockchain.

Think of it as a vast, global guessing contest where miners, armed with powerful computing resources, attempt to pinpoint a specific number. The miner who first lands on this number can add a new block to the blockchain, receiving newly minted bitcoins and all the transaction fees as a reward.

This incentive not only motivates miners to keep the network secure, but also controls the creation of new bitcoins, mimicking the rate of precious metals being mined from the earth.

Why the Blockchain Is So Important

Blockchain forms the bedrock of Bitcoin. It ensures every transaction is recorded transparently and remains undisturbed, fostering trust even in an environment devoid of centralized oversight.

The very structure of the blockchain, with its interlinked blocks and cryptographic security, underpins the integrity and reliability of Bitcoin. 

It's this ironclad nature of the blockchain that allows Bitcoin to operate free from the shackles of a central authority, ensuring that every transaction is not only traceable but also irreversible and tamper-evident.

An Introduction to Cryptography

Cryptography is the science of encoding and decoding information to keep it secure from unauthorized access. At its heart, it's about transforming readable data (plaintext) into a scrambled format (ciphertext) that can only be understood if you have the key to decode it. 

This ancient practice, dating back to Egyptian hieroglyphs, has evolved with technology. Today, it's foundational to digital security, enabling safe internet transactions, secure communications, and the protection of sensitive information.

Cryptography uses mathematical algorithms to ensure data confidentiality, integrity, authentication, and non-repudiation, making it a cornerstone of modern cybersecurity, digital currencies like Bitcoin, and much more. 

Its role in safeguarding digital data and communications in an increasingly online world cannot be overstated, making cryptography a critical field in both computing and the wider digital landscape.

Cryptography’s Role in the Way Bitcoin Works

Cryptography is central to how Bitcoin functions, serving several crucial roles:

  • Secure Transactions: Cryptography secures Bitcoin transactions by ensuring that only the owner of the bitcoins can spend them. This is done through the use of cryptographic keys (a public key and a private key) in a digital signature scheme, which proves ownership without revealing the private key.
  • Creation of Digital Signatures: When a Bitcoin transaction is made, the sender uses their private key to sign the transaction, creating a digital signature. This signature, verified by miners using the public key, confirms that the transaction has not been altered and that it was indeed the owner who sent it.
  • Maintaining the Blockchain: Cryptography is also used in the mining process, where miners solve cryptographic puzzles (hash functions) to add new blocks to the blockchain. This process secures the blockchain by making it computationally infeasible to alter historical transactions.
  • Ensuring Privacy: While Bitcoin transactions are public on the blockchain, cryptography helps keep the parties involved anonymous. Each transaction is linked to a cryptographic address rather than personal identifying information.

Bitcoin’s Private Key & Public Key

At the core of Bitcoin's security model is a cryptographic key pair: a public key, which is an address to which others can send Bitcoins, and a private key, a guarded secret that allows only its possessor to spend the Bitcoins sent to the corresponding public key.

The Private Key

The private key is a random 256-bit number. Think of it as an incredibly long and complex password. 

Because it's chosen from a massive pool of numbers, the chances of someone else guessing your private key are pretty much zero.

The private key is used to sign transactions, proving ownership of the bitcoins without revealing the key itself, and to securely access and manage one's cryptocurrency assets, ensuring that only the owner can send or use their bitcoins.

It's important to keep this key safe because if someone else gets it, they can use your Bitcoins. That's why it's usually kept in a very secure place, like a bitcoin wallet that has lots of security layers, and sometimes it's even protected in a way you can touch and see, to keep it extra safe.

The Public Key

The public key is like an address that you can share with others so they can send you bitcoin.

It is made from the private key in a one-way process using a one-way cryptographic function. This function makes it easy to create a public key from a private key, but nearly impossible to do the reverse.

You can use the same private key to create as many public keys as you’d like.

The Bitcoin Network

The Bitcoin network is a global system of computers working together to manage and record Bitcoin transactions. This network supports all the operations of Bitcoin, from creating new bitcoins through mining to verifying and securing transactions. It operates around the clock, maintained by a decentralized community of miners and node operators. 

Nodes and Their Function

Nodes are individual computers connected to the Bitcoin network that follow a set of rules and share information. They play a critical role in keeping the network honest and secure. Each node stores a copy of the entire blockchain and checks incoming transactions for validity according to the Bitcoin protocol. 

This decentralized approach ensures no single point of failure could compromise the network. To alter the blockchain, you would need control over 51% of the computing power in the entire network, a task that is practically impossible due to the vast and distributed nature of the network's participants.

Consensus Mechanism

The consensus mechanism is a fundamental principle that allows all the participants in the decentralized Bitcoin network to agree on the current state of the blockchain. 

This process ensures that every transaction is verified and recorded in a way that is agreed upon by the majority of nodes. 

The consensus mechanism used by Bitcoin, known as Proof of Work (PoW), requires miners to solve complex mathematical puzzles.

How Does a Bitcoin Transaction Work?

A Bitcoin transaction involves transferring value from one wallet to another through a series of steps, ensuring security and verification by the network. Here's how it typically unfolds:

  1. Transaction Initiation: The sender decides to send Bitcoin to a recipient. They need the recipient's public address (similar to an email address for Bitcoin) and the amount they wish to send.
  2. Transaction Creation: Using their wallet, the sender inputs the recipient's address and the amount of Bitcoin to send. The wallet then creates a transaction, which is essentially a message stating that the sender wishes to transfer Bitcoin to the recipient's address.
  3. Signing the Transaction: The transaction is signed with the sender's private key. This digital signature proves the sender owns the Bitcoin they wish to send, without revealing the private key. It's akin to signing a check in the traditional banking system but securely encrypted.
  4. Broadcasting the Transaction: Once signed, the transaction is broadcast to the Bitcoin network, where it's picked up by nodes and spread across the network. This is like announcing to the network that the sender wishes to transfer Bitcoin to the recipient.
  5. Validation and Verification: Miners on the network collect transactions from the memory pool and begin the process of validating and verifying them through mining. This involves checking the digital signatures to ensure the transaction is authentic and that the sender has enough balance to complete the transaction.
  6. Mining the Transaction: Miners compete to solve a cryptographic puzzle, which involves a lot of computational work. The first miner to solve the puzzle gets to add a block of transactions, including the one initiated by the sender, to the blockchain. This act of adding a block is what confirms the transaction and makes it irreversible.
  7. Transaction Confirmation: Once the transaction is included in a block and added to the blockchain, it is considered confirmed. The recipient's wallet notices the transaction has been confirmed, updating the balance to reflect the received Bitcoin.

Each transaction goes through these steps to ensure security, prevent fraud, and maintain the decentralized integrity of the Bitcoin network. Typically, a transaction is considered secure after receiving several confirmations, each representing an additional block added to the chain after the one containing the transaction.

Disclaimer: The information provided in this blog post is for general information purposes only. The information was completed to the best of our knowledge and does not claim either correctness or accuracy. For detailed information on crypto regulations, we recommend contacting a certified legal advisor in the respective country.

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