Bitcoin and other cryptocurrencies have accomplished a lot in the last ten years. Changing from a fringe Internet sensation into a currency accepted at actual stores, we’ve experienced a pretty seismic shift in how the world thinks about these technologies. More people and more businesses are rushing to get involved in crypto. In fact, even the ultra-popular payment service Square is looking to get into Bitcoin mining.
Still, one question remains: Why doesn’t everyone invest in Bitcoin?
One large reason is that Bitcoin is very volatile, and some people are risk-averse. However, the biggest hurdle seems to be a lack of understanding. Plenty of people are still confused about the idea of digital currency and transactions on the blockchain.
Maybe you’re a little unsure, too, since you clicked on this article. Not to worry: this stuff can seem a little complicated at first. Let’s break down exactly how these transactions work so you can start talking the talk — and walking the walk — when it comes to Bitcoin.
What Is a Bitcoin Transaction?
A Bitcoin transaction isn’t dissimilar from a regular transaction in its simplest terms. Think about the money you have in your pocket.
Say you’ve got five bucks. Right now, that money is yours. You own the five-dollar bill you’re carrying. We don’t always talk about money this way because it can be fluid, but technically speaking, that is your five dollars.
When you give your five dollars to a friend or a business, you’re transferring ownership of that money to them in exchange for goods, services, or just the pleasure of being generous. Whatever the case, it’s now their five dollars.
If you can understand a basic transaction like the one above, you can understand Bitcoin transactions. It’s the same basic concept, just mapped onto blockchain technology… with a few extra steps at the backend.
The blockchain is one of those words you hear a lot but may not always understand. Blockchain is the technology that Bitcoin and other cryptocurrencies are built on. It’s what enables them to call themselves peer-to-peer currency.
Okay, so what is it? The blockchain is basically a log that documents every time a Bitcoin has been transferred since it was initially ‘mined.’
(Mining Bitcoin is a whole other thing — and the US just became the premier destination for it. Today, we’re sticking to the topic of what happens to Bitcoin after it’s produced.)
To understand how Bitcoin is sent and received, you need to know about an interlocked trifecta: the public key, the private key, and the wallet address. These three components are like multiple layers of fancy math encryption that come together to protect and facilitate your Bitcoin transactions.
The Private Key, the Public Key, and the Wallet Address
The first owner of any Bitcoin token is given a wallet address which allows them to send the money elsewhere if they choose to do so. They own the Bitcoin token, and their signature is attached to it.
These wallet addresses are derived from something called a public key. A public key is kind of like an email address or social media handle. It says a Bitcoin token belongs to a specific person. When you purchase Bitcoin from anyone, they need your address to send it to you.
That public key is itself derived from a private key. The public and private keys are a matched set in that you can prove the public key is yours by using the private key.
The private key is a password that empowers you to send Bitcoin somewhere else. This is like your email password or debit card PIN. It’s a layer of privacy that prevents someone from taking all your Bitcoin.
When you send Bitcoin and transfer ownership, you are basically adding another signature to the blockchain. The blockchain keeps a record or ledger of every additional signature (and owner) ever processed.
By documenting these transactions on the blockchain rather than channeling them through a single structure like a traditional bank, Bitcoin remains a true peer-to-peer currency.
How Does a Bitcoin Transaction Work?
Next, let’s get a little deeper into how this technology works.
If we dealt strictly in whole numbers, Bitcoin transactions would go like this: One person with one Bitcoin decides to send it to another person. This person is now one Bitcoin richer, and the blockchain has a new link.
That may paint a simpler picture, but no currency is that simple. Think about dollars and cents. We have different tokens representing a quarter, a twentieth, a tenth, and a hundredth of a dollar. We call them quarters, nickels, dimes, and pennies. Similarly, Bitcoin can and often is divided.
This makes the blockchain far more complicated when documenting transactions and exchanges of ownership.
Plus, Bitcoin transactions can be energy-demanding, and the transaction process is slowed down by a complex mathematical equation that needs to be solved. This equation is what makes Bitcoin transactions so demanding on computers, but it’s also what makes them so difficult to fake.
Adding a long math problem is like a limiter on high transaction volume. Waiting 20 minutes for one transaction may not be a big deal. However, if you try to do 200 transactions at one, you’re looking at over six hours twiddling your thumbs. These slow speeds are a fraud deterrent, and they were designed that way.
Here’s an Example
There are three components to any Bitcoin transaction: the input, the amount, and the output:
- The input simply describes the addresses related to the Bitcoin you will send.
- The amount constitutes how much of the Bitcoin you will send (aka, the value).
- The output is the recipient’s address, the unique destination that will become the new owner of these tokens or pieces of tokens.
Say, for example, you are the owner of 0.7 Bitcoin sent to you by Frank. You, Frank, and anyone else who’s owned that Bitcoin appear as a link on the blockchain. You also own 0.4 Bitcoin sent to you by Katie. In total, you have 1.1 Bitcoin.
Let’s say you want to send 1.0 of your 1.1 Bitcoin to Toby. First, you need to get Toby’s wallet address and submit that transaction to the network. Once you submit that transaction, computers known as mining rigs will process the transaction for a small fee and send the money to your wallet.
The way Bitcoin sends the crypto to the wallet is also simple: Bitcoin will group these 0.4 and 0.7 tokens together and add them into the input as 1.1 Bitcoin. You set the transfer amount to 1.0 Bitcoin, and the technology will deliver 1.01 Bitcoin to Toby and credit you 0.1 Bitcoin. In other words, it will give you 0.1 in change.
All of the Bitcoin that moved in that process still contains its ownership records. So, you can see how quickly the blockchain can grow more webbed and complex. This peer-to-peer process eliminates the banking system, providing people with access to their funds without having to pay high transaction fees or wait for three to five business days.
Confirmation of Transaction
Now, unlike receiving change at the grocery store, confirming a successful transaction of Bitcoin can take some time. The blockchain needs to check the records of any token exchanged and verify them to process the transaction. Because so many people are attempting to make transactions at any given moment, processing times can get backed up quickly.
Today, the Bitcoin blockchain can add a new block every ten minutes or so. When you submit a Bitcoin transaction, what you’re really doing is adding yourself to a queue to become that next added block. If you’re ever in need of faster processing, you can request that your transaction be prioritized, but that action is associated with a fee. The more people who opt for a faster transaction, the higher that fee becomes.
In April of 2021 — when cryptocurrency ostensibly blew up — the fees went up to $60, but now they’re back down to a far more manageable $5.
Whether you opt to wait around or pay the fee, you’ll receive a confirmation when the transaction has gone through.
The Environmental Impact
As we mentioned, verifying data on the blockchain and mining new Bitcoin can get complicated quickly. This process requires a staggering amount of computational effort. It can seem counterintuitive to think about processing as a transfer of energy, considering the only effort required from you is pushing a button. Truthfully, Bitcoin transactions are staggeringly inefficient.
Just how inefficient? Well, one recent study discovered that a single Bitcoin transaction uses 2,106.37 kilowatt-hours of electricity. Unless you’re an electrician, you may not know what that means, so here’s the translation: One Bitcoin transaction uses the same amount of power the average American household consumes over 72.2 days.
Bitcoin and other cryptocurrencies are a technology of the future that will only continue to influence how we exchange value and process transactions online. While you can’t discount the power of Bitcoin, you can also question why we are building and investing so heavily in technology that is so wasteful, especially at a time when our planet is suffering the impact of mass overconsumption.
It stands to reason that cryptocurrency is in for a big upheaval when it comes to processing power. At this rate, the technology has to adapt to become more efficient, whether due to government regulation or internal innovation.
Last Thoughts on Bitcoin Transactions
You don’t need to understand the complex mathematics behind cryptocurrencies to get involved, though cursory knowledge can help you make smart investments.
Our suggestion? Read as much as you can, and listen to crypto-centric podcasts to get a better hold of the language and evolving technology. The world around digital currency is changing quickly, and we don’t anticipate that growth stopping.
Now that you understand how Bitcoin works, what’s stopping you from inventing your own cryptocurrency? Just kidding… Unless?