Behind the Scenes of a Bitcoin Transaction

How Do Bitcoin and altcoin Transactions Actually Work?

If your one goal in life is to learn how to spend Bitcoin, you're in the right place. The good news is you don't have to understand many technical details to begin using Bitcoin or altcoin (any other digital currency except Bitcoin) to buy something. 

The bad news is that to look under the hood at exactly how a digital currency transaction goes down might make you queasy - sort of like watching sausage being made. One thing is fairly certain. These digital or cryptocurrencies aren't going away anytime soon, so you might as well get familiar with them. Who knows? They might eventually replace the paper-based fiat currencies we've been using forever.

Cryptocurrency Ain't Your Grandfather's Cash

Probably the hardest part of wrapping your mind around a Bitcoin transaction is to stop thinking of it as a currency in the traditional sense of paper that you stuff in your wallet or coins that jingle in your pocket. Any cryptocurrency you own does not resemble a regular checking account balance, where exactly how much you have can be determined with a quick glance. A single bitcoin in any amount is comprised of three components:

  1. Transaction Input: the Bitcoin address from where the money was sent.
  2. Transaction Output: the Bitcoin address where the money was sent.
  3. Amount: the amount of Bitcoin covered by the transaction.

Before you can send Bitcoin to someone else as payment for something, it first must be sent to you. When you first received it, these three components were registered on the blockchain. By way of quick review, the blockchain is the distributed digital ledger which keeps a continually updated record of all Bitcoin transactions. Secured by various cryptographic algorithms, once a transaction is verified and registered on the blockchain, it cannot be altered.

Inputs and Outputs

When you receive a Bitcoin payment, the address you received it from is the transaction input and your address is the transaction output. When you turn around and buy something with that Bitcoin, your address becomes the transaction input and the address of the person you send it to will be the transaction output. And so on and so forth. This is how Bitcoin is sent and received over and over through various transactions. 

Don't be confused by the concept of addresses. The digital wallet you create when opening a Bitcoin account automatically generates these addresses, or unique digital identifiers when you start the process of sending or receiving money.

The bottom line to this process - and we think it's pretty impressive - is that a single Bitcoin's entire history is available for all to see on the blockchain. Do you want to view every transaction it's ever been involved in, who spent it, who received it? No problem. This transparency is one of the best selling points in favour of cryptocurrency and blockchain technology. There's no central entity sitting out there who can fiddle with the system and manipulate transactions.

The Tricky Part of Cryptocurrency Transactions

So far, the big picture idea of how a cryptocurrency transaction works hasn't been too much of a brain strain. Take a deep breath now and get ready to engage your neurons. 

For purposes of a transaction, Bitcoin amount attached to the transaction input and output is not divisible. What this means is that if Bob wants to send Alice payment for something that costs half a bitcoin but the only amount he has is a transaction in his wallet for a full bitcoin, well, that's what Alice is going to get. Then her wallet goes through the process of generating a return transaction to give him his change, trying to piece together the closest amount it can after sorting through the various transaction inputs and outputs in her wallet.

If this whole process seems a little clumsy, you're right. It is. There is rarely a perfect match between cost and the amount received and change given. We said all that to say this. Don't be surprised if you open your digital wallet after a few transactions and see a hodgepodge of multiple addresses containing minuscule amounts of Bitcoin. It's just the way the system works. If you want to use a cryptocurrency, you'll have to get comfortable with the idea of "close enough."

Thank Goodness for the Satoshi

With the value of a single Bitcoin still sitting north of USD 10,000 as of this writing, it should interest you to know that you can send payment using a tiny fraction of a single bitcoin. You don't have to spend the whole thing. In fact, for payment purposes, a bitcoin can be divided down to the one hundred millionth decimal place. This tiniest of Bitcoin slices is called a Satoshi, in honour of the currency's inventor. Note that you can't send a single satoshi. It's far too small and would clog up the network with tiny transactions. The smallest amount that can be sent is 5,340 satoshis.

A Final Bit of Advice

You also want to keep in mind that it's not free to send bitcoin to someone. There will almost always be some transaction fee, the amount of which you should be informed of in advance. 

The thing to remember is that the transaction will likely fail if you don't include enough money in the purchase to cover the transaction fee.