Day 4 of 100 | Crypto Basics | 5 min read
How Does Blockchain Work? A Step-by-Step Guide
Follow a transaction from start to finish on the blockchain. See exactly how your crypto moves from one wallet to another securely.
### A Step-by-Step Journey Through Blockchain Operations
Now that you understand what blockchain is conceptually, let us dive deeper into the mechanics of how it actually works. This lesson will walk you through the technical processes that make blockchain function, from the moment you initiate a transaction to the point where it becomes a permanent, immutable record. Understanding these mechanics will help you make better decisions about which cryptocurrencies to invest in and how to use them securely.
Blockchain might seem like magic from the outside, but it is actually a carefully designed system where every component serves a specific purpose. The beauty of the design is that it creates trust without requiring a trusted central authority. Instead of trusting a bank to keep accurate records, you trust mathematics and the economic incentives that keep the network honest.
### The Anatomy of a Block
Every block in a blockchain contains several essential components that work together to maintain the chain's integrity.
The block header is perhaps the most important part. It contains metadata about the block including the timestamp of when it was created, the difficulty target that was used for mining, and most critically, the hash of the previous block. This hash is what creates the chain, linking each block to all the blocks that came before it.
[TIP] The difficulty target is a number that determines how hard it is to mine a new block. The blockchain protocol automatically adjusts this difficulty to ensure that new blocks are added at a consistent rate. For Bitcoin, this rate is approximately one block every ten minutes.
The block body contains the actual transaction data. Depending on the blockchain, this might include anywhere from a few transactions to several thousand. Each transaction includes the sender's address, the recipient's address, the amount being transferred, and a digital signature proving the sender authorized the transaction.
The Merkle root is a single hash that represents all the transactions in the block. It is created by hashing pairs of transactions together, then hashing those results together, continuing until only one hash remains. This clever structure allows anyone to verify that a specific transaction is included in a block without downloading the entire block.
### How Transactions Are Created and Broadcast
When you decide to send cryptocurrency to someone, a fascinating process begins behind the scenes.
First, your wallet software constructs the transaction. It looks at your available balance, which is actually determined by looking at all the transactions where you received cryptocurrency minus all the transactions where you sent it. The wallet then creates a message specifying how much you want to send and to whom.
[EXAMPLE] Imagine you received 1 Bitcoin in a previous transaction. That transaction output is now an unspent transaction output, or UTXO. When you want to send 0.5 Bitcoin to a friend, your wallet creates a transaction that takes that 1 Bitcoin UTXO as input and creates two outputs: 0.5 Bitcoin to your friend and approximately 0.5 Bitcoin back to yourself as change, minus the transaction fee.
Your wallet then signs this transaction with your private key. This digital signature is what proves you have the authority to spend the cryptocurrency. It is mathematically tied to both your public key and the specific transaction, so it cannot be reused for other transactions.
The signed transaction is then broadcast to the network. Your wallet connects to one or more nodes and sends them the transaction. These nodes validate the transaction to make sure it is properly formatted, that the signature is valid, and that you have not already spent the same coins elsewhere. If everything checks out, they relay the transaction to other nodes they are connected to.
Within seconds, your transaction propagates across the entire network, ending up in the memory pool of nodes that are attempting to add new blocks to the chain. At this point, your transaction is pending, waiting to be included in a block.
### The Mining or Validation Process
This is where the real magic happens. The process by which new blocks are added to the chain is what secures the network and prevents double-spending.
In proof-of-work systems like Bitcoin, this process is called mining. Miners compete to solve a computational puzzle that requires enormous amounts of trial and error. The puzzle involves finding a number called a nonce that, when combined with the block header and hashed, produces a result below the difficulty target.
[WARNING] Mining is an extremely competitive and energy-intensive process. Unless you have access to specialized hardware and cheap electricity, it is generally not profitable for individuals. Most people are better off simply buying cryptocurrency rather than trying to mine it.
There is no shortcut to solving this puzzle. Miners must try billions of different nonce values until they find one that works. The first miner to find a valid solution broadcasts their block to the network and receives the block reward, currently 6.25 Bitcoin, plus all the transaction fees from the transactions included in the block.
Proof-of-stake systems work differently. Instead of expending computational energy, validators stake, or lock up, a certain amount of cryptocurrency as collateral. The protocol then selects validators to propose and attest to blocks, typically based on the size of their stake and other factors. Validators who behave honestly are rewarded with new cryptocurrency and transaction fees, while those who try to cheat can have their stake slashed.
### Block Verification and Chain Selection
When a new block is broadcast to the network, other nodes do not simply accept it blindly. They perform rigorous verification before adding it to their copy of the chain.
Nodes check that the block header hash is valid and below the difficulty target. They verify that the previous block hash matches the current tip of their chain. They check that all transactions in the block are valid, properly signed, and do not attempt to spend coins that have already been spent. They verify that the block reward is correct and that the miner did not pay themselves more than allowed.
[KEY] This verification is what makes blockchain trustworthy. Every node independently confirms that every block follows the rules. If even one rule is broken, honest nodes will reject the block. This is why you can trust the blockchain even though you do not know any of the nodes personally.
Occasionally, two miners find valid blocks at almost the same time, creating a temporary fork in the chain. Different nodes might receive different blocks first and add different blocks to their chains. This is resolved through the longest chain rule: nodes always consider the chain with the most accumulated proof-of-work or stake to be the valid one.
When one branch of the fork gets ahead, nodes switch to that branch and the transactions in the orphaned block return to the memory pool to be included in future blocks. This is why it is recommended to wait for multiple confirmations before considering a transaction final. Each new block added on top of your transaction makes it exponentially harder to reverse.
### Finality and Irreversibility
One of the most important properties of blockchain is that once a transaction is confirmed, it becomes increasingly difficult to reverse.
After your transaction is included in a block, we say it has one confirmation. Each subsequent block added to the chain increases the confirmation count. With each confirmation, the amount of computational work or staked value that would be required to reverse the transaction grows.
[TIP] For small transactions, one or two confirmations might be sufficient. For larger amounts, it is wise to wait for six or more confirmations. This ensures that the transaction is essentially permanent and cannot be reversed without an attacker controlling a majority of the network's hash power or stake.
This irreversibility is both a feature and a responsibility. Unlike credit card transactions or bank transfers, cryptocurrency transactions cannot be reversed if you make a mistake. If you send coins to the wrong address or fall victim to a scam, there is no customer service to call. This is why it is crucial to double-check every transaction before sending.
### The Economic Incentives That Keep Blockchain Secure
The security of blockchain is not just technical; it is economic. The system is designed so that honest behavior is more profitable than cheating.
Miners and validators invest significant resources to participate in the network. Miners purchase expensive hardware and pay for electricity. Validators lock up valuable cryptocurrency as stake. These investments create a strong incentive to follow the rules, because cheating would result in the loss of these investments.
[EXAMPLE] Consider a miner who has invested millions of dollars in mining equipment. If they try to add invalid transactions to a block, other nodes will reject their block, and they will have wasted all the electricity used to mine it. Worse, if they attempt a double-spend attack, they would need to out-compute the rest of the network, which would cost more than any amount they could steal. It is simply more profitable to mine honestly.
This alignment of incentives is what makes blockchain work without requiring trust in any individual participant. You do not need to trust the miners or validators personally. You only need to trust that they will act in their own economic self-interest, which means following the rules of the protocol.
As you continue through this course, keep these mechanics in mind. Understanding how blockchain works at a technical level will help you evaluate different cryptocurrencies, understand security best practices, and make informed decisions about how to participate in this revolutionary technology.
Knowledge Check
What makes it difficult to reverse a transaction once it has multiple confirmations?
- Password protection
- Bank regulations
- Each new block requires solving a complex puzzle, making older blocks harder to change (Correct)
- Customer service holds
Explanation: Each new block added after a transaction requires solving a computational puzzle, and to reverse a transaction, an attacker would need to redo all that work plus outpace the ongoing network - this becomes exponentially harder with each confirmation.