How Bitcoin work ?

Imagine a ledger like #Splitwise, where Alice, Bob, and Charlie pay each other, and at the end of the month, everyone settles up in cash. In the digital world, this concept evolves into the idea of cryptocurrency: Ledger + Trust + Cryptography = Cryptocurrency. Instead of a bank verifying every transaction, we rely on mathematical calculations rooted in cryptography.

The Digital Ledger

A ledger records all transactions. In our analogy, anyone can add a line to the ledger, and everyone settles up at the end of the month. The challenge is verifying each transaction. For instance, if Alice pays Bob $100, how can we be sure it actually happened?

Enter Digital Signatures

To tackle this, digital signatures come into play. Alice adds a signature to the transaction, proving Bob’s approval and ensuring no one can forge the signature. The formula is simple:

Sign(Message, Secret Key) = Signature
Verify(Message, 256-bit Signature, Public Key) = True/False

With 2^256 possibilities, the security is immense—imagine 8 x 4 billion possibilities. 

This cryptographic assurance ensures that only valid signatures are recognized.

Addressing the "Charlie Problem"

What if Charlie takes on $1000 in debt and refuses to show up? The solution lies in prepayment or ensuring transactions are only accepted based on what one can afford to lose. This way, bypassing the system is nearly impossible.

The Ledger: A History of Transactions

In essence, the ledger is a history of transactions, forming the currency. Traditionally, everyone trusts a centralized system. But who owns this system? Who adds the lines? The solution? Everyone keeps their own copy of the ledger, broadcasting transactions to the network.

Synchronizing Ledgers

The challenge is ensuring all ledgers stay synchronized and receive the same information. Here’s where SHA256 comes in. SHA256("Lakshit") yields a specific hash, like 1010101010101010101. This hash is deterministic, providing the same output for the same input, though it looks random.

Proof of Work: The Computation Race

Proof of Work simplifies the process. Each ledger has a unique code, SHA256 encrypted. Suppose it needs the first 30 digits to be zeros. Miners then guess and check billions of numbers to find the correct pattern. This computational effort is what proves the work.

Blocks and Blockchain

Successful cryptocurrency relies on decentralized ledgers. Each ledger has a block containing a proof of work and a previous hash, creating a chain. This structure is the blockchain. Miners, who solve complex puzzles, create new blocks, broadcast them, and get rewarded. This reward mechanism, called the block reward, isn’t from anyone but is intrinsic to the protocol.

Mining: The Lottery of Computation

Mining is the process of creating these blocks. Miners listen to transactions, create blocks, and broadcast them. They are rewarded for their computational work, akin to a lottery. The key is that the more computational work put into finding a block, the higher the chance of being rewarded.

The Longest Chain Consensus

Our protocol updates to define the valid chain. The longest chain with the most computational work is the valid one. In case of a tie, we wait for a new block. Alice trying to defraud Bob by not broadcasting a ledger is futile. She’d need 50% more computation power than the entire network combined, making it nearly impossible.

The Bitcoin Reward System

The block explorer shows that miners used to get 50 bitcoins as a reward, but this amount halves over time, capped at 21 million bitcoins. This gradual reduction ensures scarcity and value preservation.

This article synthesizes the workings of cryptocurrency, inspired by 3blue1brown. From digital ledgers and signatures to the intricate dance of proof of work and mining, cryptocurrency is a marvel of modern cryptography, ensuring trust and security without central authority. Welcome to the future of finance!