How Bitcoin Transactions Work
In essence, Bitcoin operates as a system that records value transfers between various addresses, storing these transaction details in the blockchain. Transactions are the fundamental data stored on the blockchain, ensuring transparency and permanence.
What is a Bitcoin Transaction?
At its core, a Bitcoin transaction represents the transfer of funds (measured in bitcoins) from one Bitcoin address (the sender) to another (the recipient). Each transaction is permanently recorded on the blockchain, guaranteeing its immutability and transparency.
To better understand how transactions work, let’s use a simplified analogy involving bank checks.
Imagine a world where there are no fixed-denomination coins or banknotes—everyone uses checks for payments. To make a payment in this world, the sender would provide one or more checks in their name to the bank, endorse them, and request the issuance of a new check payable to the recipient. If the checks total more than the payment amount, the sender receives a new check for the “change.” The original checks would be voided, leaving only the new checks valid for further transactions.
While this process would be overly complicated in real life, it becomes efficient and manageable in the realm of digital currency.
Bitcoin transactions work in a similar way.
When someone “owns” bitcoin, what they actually hold are UTXOs (Unspent Transaction Outputs), which represent unspent outputs from previous transactions. To spend bitcoin, a new transaction must be created. This transaction consists of two key parts:
- Input: Gathers one or more UTXOs, each unlocked by the sender’s digital signature.
- Output: Creates new UTXOs that replace the old ones and are directed to the new owners, identified by their Bitcoin addresses.
For instance, if Nick has a UTXO worth 50 BTC but needs to pay Mary only 0.5 BTC, he cannot simply use part of that UTXO. Instead, he uses the full UTXO to create a transaction. In this process:
- 0.5 BTC is sent to Mary.
- The remaining 49.5 BTC is sent to a “change address” controlled by Nick, ensuring he retains access to his remaining funds.
How is a Bitcoin Transaction Verified?
For a transaction to be accepted and transfer value, it must adhere to a set of rules and pass several checks.
Bitcoin protocol enforces over 40 validation rules for each transaction. Some key checks include:
- Each UTXO in the input must be signed by its legitimate owner.
- The signature must match the owner’s Bitcoin address.
- The entire transaction must be signed by the sender.
- The total value of the outputs cannot exceed the total value of the inputs (no creation of new bitcoins).
Notably, there isn’t a centralized authority verifying transactions. Instead, every participant in the network performs these checks independently, much like verifying the authenticity of a received check.
Once a transaction passes these checks, it is propagated across the network for further verification by other nodes.
How is a Bitcoin Transaction Confirmed?
Validation alone doesn’t finalize a transaction. For a transaction to take effect, it must be included in the blockchain. This happens through a process known as “mining,” where miners add the transaction to a block.
The lifecycle of a Bitcoin transaction can be summarized as follows:
- The transaction is created and signed by the user’s Bitcoin wallet.
- It is broadcast to the network, where the first receiving node verifies its validity.
- If deemed invalid, the node ignores it.
- If valid, the transaction is propagated to other nodes.
- The transaction enters the mempool, a temporary storage for pending transactions.
- A miner selects the transaction to include it in a block.
- The block containing the transaction is mined and added to the blockchain.
- The transaction is removed from the mempool and considered confirmed once added to the blockchain.
- Each new block built on top of the block containing the transaction adds another confirmation.
- After six confirmations, the transaction is universally regarded as finalized.
