bitcoinbook/ch02.asciidoc

[[ch02_bitcoin_overview]]
== How Bitcoin Works

=== Transactions, Blocks, Mining and the Blockchain

The bitcoin system, unlike traditional banking and payment systems, is based on de-centralized trust. Instead of a central trusted authority, in bitcoin, 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 and is finally recorded on the blockchain, the distributed ledger of all transactions. 

==== Bitcoin Overview

In the overview diagram below, we see that 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. In this chapter, we will trace a single transaction as it travels across the network and examine the interactions between each part of the bitcoin system, at a high level. Subsequent chapters will delve deeper into the technology behind wallets, mining and merchant systems. 

[[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. In <<getting_first_bitcoin>>, Alice met with her frined Joe to exchange some cash for bitcoin. The transaction created by Joe, funded Alice's wallet with 0.10 BTC. Now Alice 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, by adding a bitcoin option to his point-of-sale system (see <<bitcoin_for_merchants>> for information on using bitcoin for merchants/retail). The prices at Bob's Cafe 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 at the register. The point-of-sale system will convert the total price from US dollars to bitcoins at the prevailing market rate and 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
----

[[payment-request-QR]]
.Payment Request QR Code - encodes a payment request URL as defined in BIP0021
image::images/payment-request-qr.gif["payment-request"]

[[payment-request-URL]]
.The payment request QR code above encodes the following URL, defined in BIP0021
----
bitcoin:1GdK9UzpHBzqzX2A9JFP3Di4weBwqgmoQA?amount=0.015&label=Bob%27s%20Cafe&message=Purchase%20at%20Bob%27s%20Cafe

Components of the URL
A bitcoin address: 1GdK9UzpHBzqzX2A9JFP3Di4weBwqgmoQA
The payment amount: amount=0.015
A label for the recipient address: label=Bob%27s%20Cafe
A description for the payement: message=Purchase%20at%20Bob%27s%20Cafe
----


[TIP]
====
Unlike a QR code that simply contains a destination bitcoin address, a "payment request" is a QR encoded URL that contains a destination address, a payment amount and a generic description such as "Bob's Cafe". This allows a bitcoin wallet application to pre-fill the information to send the payment while showing a human-readable description to the user. See <<payment request URL>>, for more details. You can scan the QR code above with a bitcoin wallet application to see what Alice would see. 
====

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.

In the following sections we will examine this transaction in more detail, see how Alice's wallet constructed it, how it was propagated across the network, how it was verified and finally how Bob, the owner of the cafe, can spend that amount in subsequent transactions

[NOTE]
====
The bitcoin network can transact in fractional values, e.g. from millibitcoins (1/1000th of a bitcoin) down to  1/100,000,000th of a bitcoin, which is known as a Satoshi.  Throughout this book we’ll use the term “bitcoins” to refer to any quantity of bitcoin currency, from the smallest unit (1 Satoshi) to the total number (21,000,000) of all bitcoins that will ever be mined. 
====


=== 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. 

Transactions are like lines in a double-entry bookkeeping ledger. In simple terms, each transaction contains one or more "inputs", which are debits against a bitcoin account. On the other side of the transaction, there are one or more "outputs", which are credits added to a bitcoin account. The inputs and outputs (debits and credits) do not necessarily add up to the same amount. Instead, outputs add up to slightly less than inputs and the difference represents an implied "transaction fee", a small payment collected by the miner who includes the transaction in the ledger. 

[[transaction-double-entry]]
.Transaction As Double-Entry Bookkeeping 
image::images/Transaction Double Entry.png["Transaction Double-Entry"]

The transaction contains proof of ownership for each amount of bitcoin (inputs) 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 identified by a bitcoin address. 


[TIP]
====
_Transactions_ move value *from* _transaction inputs_ *to* _transaction outputs_. An input is where the coin value is coming from, usually a previous transaction's output. A transaction output assigns a new owner to the value by associating it with a key. The destination key is called an _encumberance_, it imposes a requirement for a signature for the funds to be redeemed in future transactions. Outputs from one transaction can be used as inputs in a new transaction, thus creating a chain of ownership as the value is moved from address to address. 
====


[[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 (encumbered) 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.

==== Common Transaction Forms

The most common form of transaction is a simple payment from one address to another, which often includes some "change" returned to the original owner. This type of transaction has one input and two outputs and is shown below:

[[transaction-common]]
.Most Common Transaction
image::images/Bitcoin Transaction Structure - Common.png["Common Transaction"]

Another common form of transaction is a transaction that aggregates several inputs into a single output. This represents the real-world equivalent of exchanging a pile of coins and currency notes for a single larger note. Transactions like these are sometimes generated by wallet applications to cleanup lots of smaller amounts that were received as change for payments.

[[transaction-aggregating]]
.Transaction Aggregating Funds
image::images/Bitcoin Transaction Structure - Aggregating.png["Aggregating Transaction"]

Finally, another transaction form that is seen often on the bitcoin ledger is a transaction that distributes one input to multiple outputs representing multiple recipients. This type of transaction is sometimes used by commercial entities to distribute funds, such as when processing payroll payments to multiple employees.

[[transaction-distributing]]
.Transaction Distributing Funds
image::images/Bitcoin Transaction Structure - Distribution.png["Distributing Transaction"]

=== Constructing A Transaction

Alice's wallet application contains all the logic for selecting appropriate inputs and outputs to build a transaction to Alice's specification. Alice only needs to specify a destination and an amount and the rest happens in the wallet application without her seeing the details. Importantly, a wallet application can construct transactions even if completely offline. Like writing a cheque at home and later sending it to the bank in an envelope, the transaction does not need to be constructed and signed while connected to the bitcoin network, it only has to be sent to the network eventually for it to be executed. 

==== Getting the right inputs

Alice's wallet application will first have to find inputs that can pay for the amount she wants to send to Bob. Most wallet applications keep a small database of "unspent transaction outputs" that are locked (encumbered) with the wallet's own keys. Therefore, Alice's wallet would contain a copy of the transaction output from Joe's transaction which was created in exchange for cash (see <<getting bitcoin>>). A bitcoin wallet application that runs as a full-index client actually contains a copy of *every unspent output* from every transaction in the blockchain. This allows a wallet to construct transaction inputs as well as to quickly verify incoming transactions as having correct inputs. 
	
If the wallet application does not maintain a copy of unspent transaction outputs, it can query the bitcoin network to retrieve this information, using a variety of APIs available by different providers, or by asking a full-index node using the bitcoin JSON RPC API. Below we see an example of a RESTful API request, constructed as a HTTP GET command to a specific URL. This URL will return all the unspent transaction outputs for an address, giving any application the information it needs to construct transaction inputs for spending. We use the simple command-line HTTP client _cURL_ to retrieve the response:

.Lookup all the unspent outputs for address 1Cdid9KFAaatwczBwBttQcwXYCpvK8h7FK
----
$ curl https://blockchain.info/unspent?active=1Cdid9KFAaatwczBwBttQcwXYCpvK8h7FK

{
	 
	"unspent_outputs":[
	
		{
			"tx_hash":"eff2be9869ec5d80198c5924157f4be8135d12e0d6b4cfa9aaa6729da2a9098a",
			"tx_index":103732607,
			"tx_output_n": 0,	
			"script":"76a914096b74a8acff9d13bdcc698b6054c67ebf470d4188ac",
			"value": 10000000,
			"value_hex": "989680",
			"confirmations": 212
		},
	]
}
----

The response above shows that the bitcoin network knows of one unspent output (one that has not been redeemed yet) under the ownership of Alice's address _+1Cdid9KFAaatwczBwBttQcwXYCpvK8h7FK+_. The response includes the reference to the transaction in which this unspent output is contained (the payment from Joe) and it's value in Satoshis, at 10 million, equivalent to 0.10 bitcoin. With this information, Alice's wallet application can construct a transaction to transfer that value to new owner addresses.



=== Transaction Data Structure

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, her wallet software would find a previous transaction that has a similar value, to minimize the need for generating change. 

.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 referred to as index number 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 dozens of inputs, aggregating the value, as we will see Bob's wallet do to add up all the small payments into a larger payment. A transaction can also have hundreds 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, index number zero. 

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. 

[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.