A Beginner Guide on How Bitcoin Transactions Work

Beginner’s Guide / 20.10.2020

Introduction to Transactions

Transactions are a big part of how cryptocurrencies work. Almost anything that can be done on a blockchain is done through transactions, whether it’s sending cryptos, running Dapps, using Oracles, or even accessing DeFi services; they’re all done through transactions.

Much like traditional financial transactions, blockchain transactions involve the exchange of value, services, and commodities. But unlike traditional financial transactions, blockchain transactions do not require intermediaries and their fees and delays.

To understand how bitcoin transactions work, you need to understand blockchain transactions as a whole and what makes them special. Everything revolves around a blockchain’s self-governance and consensus protocols.

Introduction to Blockchain Transactions

Blockchain transactions differ from their traditional counterparts as no middlemen facilitate them; that’s blockchains’  whole point.

With traditional digital transactions, transacting parties require middlemen like banks and payment processors like Visa to facilitate transactions. These middlemen act as trusted authorities between transacting parties. While they are quite reliable in scalability and efficiency, they charge high fees and require time—sometimes spanning days—to fulfill transactions, especially international transfers.

Blockchain transactions are designed to remove the need for go-betweens by creating a trustless system where counterparties transact with one another directly. However, because they transact directly does not mean that there isn’t a third party facilitating transactions. There are. They just aren’t granted access to the content of the transactions they process.

To create this trustless system, the central middleman must be replaced with a distributed peer-to-peer system, and this is where cryptography comes in.

By cryptographically encrypting transactions, facilitators only help “pass messages and transactions along” without viewing or altering them. Now you have a network where there are many facilitators, where the content of transactions is invisible to third parties, and where there is no central authority. But all this can be achieved without a blockchain, so why build one?

The Case for Blockchains

A blockchain is a distributed public ledger that anyone can access and, on which anyone can view all processed transactions. (However, private blockchains also exist). Think of it like SQL on a large, public scale, but maintained by everyone who uses the database, not just one dedicated database administrator.

What makes a blockchain special is its mechanism for ensuring authenticity. The network built upon the ledger ensures that no one can alter transactions once they have been published, double-spend, i.e., spends the same funds twice, or spend funds they don’t have.

The network also guarantees ownership of digital assets and ensures authenticity in the transfer of said ownership. For example, a physical asset like a house cannot be duplicated and sold to multiple buyers. A car or computer cannot be duplicated and sold to multiple buyers; however, an e-book can be duplicated a million times and sold to tens of millions of buyers.

While selling several copies of the same e-book is legal and ethical, doing the same for other digital assets like rights or intellectual property may cause problems. Blockchain networks ensure that any particular resource can only be used once. The public ledger at the heart of the network is a database that can store more than transaction and cryptocurrency. The blockchain can also store ownership.

And because blockchains are immutable, any transaction or contract, once published on the ledger, cannot be changed, thereby reducing the risk of data tampering and fraud.

Characteristics of Blockchain Transactions

Haven established blockchain’s immutability and open-source nature, along with the network’s distributed and cryptographically encrypted anatomy, we still need to establish a way to ensure transactions run smoothly.

In a centralized system, transactions are overseen by a governing entity. However, seeing that distributed systems have no central governance system, protocols must be built into the system to govern activities. It is these protocols that govern blockchain transactions without the need for human interference.

These rules allow blockchain transactions to be:

Irreversible

Thanks to blockchain’s immutability, transactions are virtually impossible to reverse or alter. Transactions are also published on the ledger, where anyone can see it. Due to this irreversible nature, blockchain transactions can be trusted.

Autonomous

Blockchain networks like Ethereum allow the creation of smart contracts that run autonomously. Once written and implemented on the blockchain, these contracts will run unhindered until it executes every command coded into it.

Bitcoin Transactions

On the wallet/user side, when a transaction is sent, the system first checks to ensure that the wallet is authorized to send that transaction; the wallet must have enough bitcoin in its balance. The system also checks if the wallet is trying to spend the same currency twice. If everything checks out, the system approves the transaction.

While every blockchain is immutable, public, and secure, transactions are handled by the network. Protocols set the communication and transfer of data between nodes, and a consensus model ensures agreement between all nodes.

The nodes agree on what types of transactions to approve and which to decline, how those transactions are approved, and who gets to approve them.

The Bitcoin network processes transaction in blocks, where each block is 1Mb in size. The network uses a consensus model called the Proof-of-Work model or PoW that requires all nodes (or miners) to solve a hard, cryptographic puzzle. This puzzle demands large computing power, and nodes race against one other to solve it first.

When a node succeeds, it gets to process the next block of transactions. The other nodes inspect the block once the first node is done and, once verified, add the block to the blockchain. All the nodes then update their copies of the blockchain.

This process is called mining, and the nodes are miners. While it occurs every 10 minutes within the Bitcoin network, transactions can take anywhere from a few seconds to a long time as a very high volume of transactions may create a backlog that must be processed on a first-come-first-serve basis. Still, sometimes the transactions with a higher fee are processed with priority.

Benefits of Bitcoin Transactions

The Bitcoin Network ensures that all transactions are genuine, that users can’t spend what they don’t have, and that no one spends the same crypto twice. In essence, the network ensures a fraud-proof system.

The network’s distributed nature also reduces the cost of sending global payments as geographical constraints do not affect the network.

Problems Associated with Bitcoin Transactions

The world’s largest digital payment processor, VISA, handles 65,000 transactions per second. The second runner up, cryptocurrency network Ripple, handles 1500 transactions per second. The Bitcoin Network processes a mere 7 transactions per second, far too low to meet global demand.

Conclusion

Bitcoin transactions are safer and more secure than traditional ones offered by banks, but they still face scalability issues. However, new technologies like the Lightning Network are being developed to remedy this issue.

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Born in Bucharest, Marius is the founder of Crypto Adventure. Since his first contact with Bitcoin and cryptocurrencies, he never stopped believing that they are one of the most important innovations of our time, which will forever change the way business is done.