In recent times, Bitcoin (BTC) has been making headlines that may make digital assets investors a bit queasy. Since the all-time high of US$ 64,863.10 on April 14, 2021, the price of Bitcoin has fallen over 45% in about two months. There could be a plethora of reasons for such a price downturn in the short run - like an overheated market needing a consolidation phase, the influence of large investors affecting market sentiment, regulatory crackdowns on digital assets, and so on - which might be too difficult to precisely factor in (read our newsletter for more information on this). However, unlike the price, the technology behind the Bitcoin network is absolute and is based on algorithms and governing principles that are indifferent to all externalities.
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The ultimate utility of the Bitcoin network is its ability to coordinate trust and facilitate the transfer and storage of value without any centralized authority. The mechanism of this coordination comes from Bitcoin's PoW consensus algorithm.
In a nutshell, PoW works on the principle of competition, where “miners” (analogous to “validators” in Proof-of-Stake networks) compete for block rewards by performing computationally intensive puzzles that require electricity. Hence, PoW incentivizes the expenditure of computational efforts and requires energy to run the machines that “mine” the PoW algorithm. The result of employing such a mechanism is a decentralized network, where anyone can add to the mining power with no upper limit. Due to this distribution, the network becomes highly secure unless an attacker can take control of more than 51% of the network's computational puzzle-solving power. With more than 51% of the network’s hashing power, the attacker can publish fraudulent transactions on the Bitcoin blockchain and exploit the network.
To further elaborate, the network is designed to listen for the “longest” chain (the blockchain with the most blocks). This means a fraud miner will have to consistently win against the block lottery in order to ensure that his/her version of the blockchain grows faster than the honest miners’ blockchain. Due to the probabilistic determination of block miners, this becomes impossible without the majority of network computation under control of the fraud miner. This also means Bitcoin transactions are irreversible because in order for someone to change the transactions in older blocks, he/she would have to recompute the hash for that block and all the subsequent blocks, at a faster rate than the growth of the current longest chain. Reverting transactions becomes more and more computationally infeasible with the age of the block on the chain.
However, critics of PoW deem the mechanism as inefficient and unscalable due to the never-ending energy demands of the network, whereas Bitcoin proponents see this as a fundamental feature that gives Bitcoin its value. Supporters argue that it is a necessary trade-off to secure trillions of dollars of value stored on the network.
After a primer on Bitcoin’s PoW, let us look at how a Bitcoin transaction looks like. The infographic below illustrates a Bitcoin transaction from Bob to Alice:
Source: Medium
Here is a glossary that will help explain things in greater detail -