bitcoinbook/ch02.asciidoc

[[ch02_bitcoin_overview]]
== How Bitcoin Works

=== Transactions, Blocks, Mining and the Blockchain

Bitcoin is a system based on de-centralized trust, which means that there is no central trusted authority, but instead trust is achieved as an emergent property from the interactions of different participants in the bitcoin system. In this chapter we will examine bitcoin from a high-level by tracking a single transaction through the bitcoin system and watch as it becomes "trusted" and accepted by the bitcoin mechanism of distributed consensus. 

==== Bitcoin Overview

At a high level, the bitcoin system consists of users with wallets containing keys, transactions which are propagated across the network and miners who produce (through competitive computation) the consensus blockchain, the authoritative ledger of all transactions. 

[[blockchain-mnemonic]]
.Bitcoin Overview
image::images/Bitcoin Overview.png["Bitcoin Overview"]

==== A simple transaction

Alice, who we introduced in the previous chapter, is a new user who has just acquired her first bitcoin. Now she will make her first retail transaction, buying a cup of coffee at Bob's coffee shop in Palo Alto, California. Bob's coffee shop recently started accepting bitcoin payments, as advertised by a sign declaring _"Bitcoin Accepted Here"_ in the window. At the counter, the prices are listed in the local currency (US dollars) but at the register, customers have the option of paying in either dollars or bitcoin. Alice places her order for a cup of coffee and Bob enters the transaction on his point-of-sale system that has been adapted to convert each price to bitcoins at the prevailing market rate. The register displays the prices in both currencies, as well as showing a QR code containing a payment request for this transaction:

----
Total:
$1.50 USD
0.015 BTC
----

Bob says _"That's one-dollar-fifty, or fifteen milibits"_.

Alice uses her smartphone to scan the barcode on display. Her smartphone shows a payment of +0.0150 BTC+ to +Bob's Cafe+ and she selects +Send+ to authorize the payment. Within a few seconds (about the same time as a credit card authorization), Bob would see the transaction on the register, completing the transaction.

=== Transactions

In simple terms, a transaction tells the network that the owner of a number bitcoins has authorized the transfer of some of those bitcoins to another owner. The new owner can now spend these bitcoins by creating another transaction that authorizes transfer to another owner, and so on, in a chain of ownership. 

[TIP]
====
_Transactions_ move value from _transaction inputs_ to _transaction outputs_. An input is where the coins (value) is coming from, either a previous transaction's output or a miner's reward. An output "sends" value to a new owner by locking it with their key. 
====

The transaction contains proof of ownership for each amount of bitcoin whose value is transfered, in the form of a digital signature from the owner, that can be independently validated by anyone. In bitcoin terms, "spending" is signing the value of a previous transaction for which you have the keys, over to a new owner. 

[[blockchain-mnemonic]]
.Transaction Chain
image::images/Transaction chain.png["Transaction chain"]

Alice's payment to Bob's Cafe utilizes a previous transaction as its input. In the previous chapter Alice received bitcoin from her friend Joe in return for cash. That transaction has a number of bitcoins locked against Alice's key. Her new transaction to Bob's Cafe references the previous transaction as an input and creates new outputs to pay for the cup of coffee and receive change. The transactions form a chain, where the inputs from the latest transaction correspond to outputs from previous transactions. Alice's key provides the signature which unlocks those previous transaction outputs, thereby proving to the bitcoin network that she owns the funds. She attaches the payment for coffee to Bob's address, thereby "encumbering" that output with the requirement that Bob produces a signature in order to spend that amount. This represents a transfer of value between Alice and Bob.

At this point you may begin to wonder: "If every transaction refers to value in a previous transaction, where does the value come from originally?". All bitcoins are originally _mined_ (see <<mining>>). Each block contains a special transaction which is the first transaction in the block. This is called the _generation_ transaction and it generates bitcoin out of a special input, which is called the _coinbase_ and is reward for creating a new block. In simple terms, miners get the privilege of a magic transaction that create bitcoins from thin-air and pay those bitcoins to themselves. If you were to look at the chain of transaction for a bitcoin payment you have received, you can track the inputs to a previous transaction's output. Go back far enough and you will find the block where the bitcoins you hold today were once mined.
	
A transaction, in bitcoin terminology, also refers to the signed data structure that contains a series of inputs and outputs transferring value, as encoded in the blockchain or propagating on the bitcoin network. In the blockchain, a transaction is stored as a variable-lenght data structure, that contains an array of _transaction inputs_ and an array of _transaction outputs_. 

.A transaction data structure, as stored in the blockchain
[options="header"]
|=======
|Part|Size|Description
|Version| 4 bytes | The transaction type version (default and only type value is 1) 
|Number of Inputs | VarInt | How many inputs are listed below
|Inputs | List of Tx_In | One or more inputs, specifying where the value will come from
|Number of Outputs | VarInt | How many outputs are listed below
|Outputs | List of Tx_Out | One or more outputs, specifying where to "send" the value
|=======

From the perspective of Alice and Bob's transaction for the cup of coffee, the input would be Alice's coins from previous transactions and the output would be 0.015 BTC (or 1.5m satoshi) that would be "sent" to Bob's bitcoin address for payment of the coffee. Bob could then spend this bitcoin by creating transactions whose inputs refer to this transaction
s output. Each transaction's outputs become possible inputs for future transactions. What changes is who controls the keys that unlock them. For that we have to delve in a bit deeper into the data structure of the inputs and outputs themselves. 

The input always refers to a previous transaction. In the case of Alice's coffee purchase, he wallet software would find a previous transaction that has a similar value, to minimize the need for generating change. Let's assume that Alice had previously been paid 0.02BTC by someone else. Her wallet will use that previous transaction to pay Bob for the coffee.


.Alice's transaction input
[options="header"]
|=======
|Part|Value|Description
|Previous Tx Hash| 643b0b82c0e88ffdfec6b64e3e6ba35e7ba5fdd7d5d6cc8d25c6b241501 | a hash used to identify a previous transaction
|Previous Tx Index| 0 | The first output of that transaction is 0
|Script Signature | 30450...6b241501 | A signature from Alice's key to unlock this value
|=======

In the input above, Alice sources the funds to pay for the coffee. In this case, all the funds come from a single output from a previous transaction. It is possible to construct transactions that source value from thousands of inputs, aggregating the value. A transaction can also have thousands of outputs, so the _Tx Index_ is used to identify which of the previous transaction's outputs will be "consumed" in this new transaction. In this case, Alice will be using the first transaction output. 

You may notice that there is no value field in the input. That is because the *entire* value of the referenced output is consumed. You cannot use only part of an output, you must use the entire value. All the value from all the inputs listed in a transaction is aggregated and then disbursed to the various outputs, according to the value defined in those outputs. In attempting to pay Bob for coffee, Alice must create a transaction for the exact amount, even though she may not have "exact change" in the form of previous transactions that perfectly match. Alice will therefore have to either aggregate many smaller inputs (previous unspent outputs) to reach the price of the coffee, or use a larger input and then make some change back to her wallet. This is all done automatically by the wallet software, so Alice just sees the exact amount transacted, but behind the scenes there may be a flurry of inputs being aggregated and change returned. 

For simplicity, Alice was lucky enough to have a perfectly matching previous transaction, so her wallet only needs one input for this coffee transaction. 

[TIP]
====
Inputs don't have a value field. That is because the outputs of a previous transaction can either be spent or unspent as a whole. You cannot use part of an output, you must use all of it. If you only need part of the value of a previous output, you must spend all of it and generate "change", by creating an new output for the excess value back to your own wallet. 
====


.Alice's transaction output
[options="header"]
|=======
|Part|Value|Description
|Value| 1,500,000 | The value in satoshi to transfer to this output
|Script| OP_DUP OP_HASH160 <public key hash> OP_EQUALVERIFY OP_CHECKSIG | A script for spending this output
|=======

The second part of the transaction, is where Alice effectively pays Bob for the coffee. This is achieved by creating an output _that only Bob can spend_. In bitcoin, the script used to "lock" an output to a specific bitcoin address is +OP_DUP OP_HASH160 <public key hash> OP_EQUALVERIFY OP_CHECKSIG+, with +<public key hash>+ replaced by the public key of the recipient, in this case Bob's public key.

While this script looks rather complicated and confusing, it will be explained in great detail below (see <<script>>). This exact script is used in 99.99% of bitcoin transactions, as it expresses the simple goal of _"payable to whoever can generate a signature with the private key of this bitcoin address"_. With this output, Alice establishes a value of 0.015BTC "payable to Bob". Once this transaction is propagated on the network, included in a block and confirmed, Bob will be able to spend this output by constructing a transaction of his own.