How Bitcoin Works - and the 5 Big Ideas Behind it

Satoshi: “Let's build an electronic system for money that does for cash what the internet did for information.”

You: “How would it work?”

Satoshi: "First let's call it Bitcoin, but we can’t just send notes as pretty images back and forth in email, they’d get copied relentlessly until the money was worthless.”

You: “So what can you do?”

Satoshi: “Big Idea #1: We don’t share the individual electronic notes, but instead share a long list of all the transactions that have ever been made. It’s like a spreadsheet that records who sent what money to whom and therefore how much they have. If everyone shared an accurate copy of this list they could agree on how much electronic money everyone has.”

You: “I’m not sure I get why that’s an improvement. What’s to stop someone from just increasing a number here or there in that list to give themselves more money? Even if you were honest and wouldn’t do that, how would you know that someone else has shared a valid copy that hasn’t been tampered with? Isn’t this the same problem as just sharing the images of the money?”

Satoshi: “Big difference is that we can get people to agree on which list is the correct one. We can do this by bundling all those transactions into blocks and creating a single chain out of them. This chain of bundled transactions we will call the Blockchain.”

You: "But how does that help?”

Satoshi: “Big idea #2. Each block in the chain includes a fingerprint of the previous block and this is the same for each block down the chain. If any of those fingerprints don’t match you know someone has tampered with the chain you’re reviewing. But if they do agree, then you know you’ve got the true untampered chain and therefore the true list of all transactions.”

You: “I see that’s a pretty cool way of locking the chain going into the past, but what’s to stop the chain from growing off in multiple directions going forward?”

Satoshi: “Big Idea #3, you make it hard to generate the next block but you offer a juicy reward to do it. You make it hard by making the fingerprint I mentioned before very difficult to calculate, but you make it juicy by allowing whoever makes that next block able to issue themselves a limited amount of the electronic cash. This way, there’s strong competition to create the next block and because it’s hard to do, this next winning block will hang around long enough for another person to build off of it. As more people build off the new block, it becomes secured into the true chain and will forever be part of the blockchain. It is possible to have a short term split in the chain, but quickly one end will become longer than the other and the shorter one will be discarded. BTW you can think of these people creating new blocks as miners digging up new Bitcoin.”

You: “Ok, so you’ve got the chain locked going back into the past, and the chain being kept together going into the future. Each block contains bundles of all these transactions recording who has how much Bitcoin and everyone is in agreement. But … what’s to stop me from creating the next block and just sending other peoples money into my account?”

Satoshi: “Big Idea #4 is that anyone who wants to send their money can only do so if they know a special secret code (or private key). They use that private key to create a request that sends the funds. So unless you know that code, you can’t move that money period. Really sending Bitcoin to someone else is just broadcasting this request to send money to the miners.”

You: “That’s lots of rules about creating the chain and new blocks. How do you ensure everyone follows them? If I was creating the next block why couldn’t I make it easier to calculate the fingerprint, or give myself more money, or any other bad action?”

Satoshi: “Big Idea #5: Police the system with network effects. Just like a peer-to-peer phone system or file-sharing applications, Bitcoin is a peer-to-peer network with many individuals running the rule following software. These 'nodes' send Bitcoin transaction requests around, keep a record of the blockchain and confirm new blocks follow the rules. Those individuals who run these nodes can choose what software to run and hence any changes made to the rules come about through a distributed consensus.”

You: “Let me see if I get this. Everyone shares a list of transactions, not the money itself. This uses some clever mathematics to ensure that all the past transactions are legit and only those who wanted to send their money did. Also you’ve setup a competition to ensure that the chain stays together moving into the future, and finally all the rules are checked by multiple interested parties via their computers checking the blockchain.”

Satoshi: “Pretty much”

You: “I think I’m starting to understand it, but I have one last question that maybe only you can answer … who exactly are you? … You still there? … Satoshi???”

* Please note that Satoshi Nakamoto, refered to in this article, is a pseudoanonymous name created out of thin air for the purpose of identity hiding. Although the originator of Bitcoin is also called Satoshi Nakamoto which is another pseudoanonymous name created out of thin air for the purpose of identity hiding, they are not related.