How Does Bitcoin Work?

Bitcoin Transactions Explained

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Bitcoin transactions are more complex behind the scenes than you might think. You rarely send an amount of bitcoin in one go. Instead, your bitcoin wallet and the bitcoin network have to go through a set of steps to ensure that the right amount of electronic money gets to the recipient.

Key Takeaways

  • Bitcoin is an electronic currency that is exchanged on a bitcoin network.
  • Three elements in a bitcoin transaction are logged with every transfer.
  • A bitcoin can be divided into satoshis, which are 100 millionth of a bitcoin.
  • Your bitcoins are stored in a virtual wallet, which is where your transactions begin and end.

Bitcoin Explained

It’s important to understand what a bitcoin is. It isn’t a single record of a coin, as you might find on an accounting ledger or your bank statement.

Instead, it is a file (referred to as money hereafter) with a value that registers as a transaction when you initiate a payment or receipt. There are three elements involved in a bitcoin transaction: a transaction input, a transaction output, and an amount.

The transaction input is the bitcoin address from which the money was sent, and the transaction output is the bitcoin address to which the money was sent. If the bitcoin is in your wallet, that will be the bitcoin address under your control.

How a Bitcoin Transaction Works

The bitcoins that you send to someone were sent to you from someone else. When they sent them to you, the address they sent them from was registered on the bitcoin blockchain (the encrypted and unaccessible register) as the transaction input. Your address—the address they sent it to—was registered on the bitcoin network as the transaction output.

When you send that bitcoin to someone else, your wallet creates a transaction output, which is the address of the person you’re sending the coin to. That transaction will then be registered on the bitcoin network with your bitcoin address as the transaction input.

When that person sends those bitcoins to someone else, their address will, in turn, become the transaction input, and that other person’s bitcoin address will be the transaction output.

Using this system, people can trace bitcoin transactions all the way back to when the bitcoin was first created. Anyone can understand who sent it to who at any point in time. This creates an entirely transparent system in which all transactions can be checked at any time.

Bitcoin Amounts and Addresses

One problem with bitcoin is that the amount attached to these transactions with their inputs and outputs isn't divisible. For example, if Alice has a bitcoin address with one bitcoin in it and only wants to send Bob half a bitcoin, she would have to send Bob that entire bitcoin.

The bitcoin network would then automatically create 0.5 bitcoins in change from the bitcoin that Alice sent and send it to the third address in Alice’s control. That third address will also be a transaction output, meaning that the address will have multiple transaction outputs.

Over time, bitcoin wallets end up with lots of addresses containing varying amounts of bitcoin and change from bitcoin transactions.

When you send bitcoins to someone, your wallet will try its best to piece together the necessary funds using the addresses containing the different amounts.

That leads to transactions with several different inputs–different addresses with different amounts used to make up the funds. It’s unlikely that these inputs will deliver exactly the right amount, so you normally end up with change.

Sending Small Amounts of Bitcoin

What if you want to send just a tiny amount of bitcoin? Luckily, you can slice bitcoins very thinly indeed. The smallest divisible part of a bitcoin is called a satoshi, and it amounts to just one 100 millionth of one bitcoin.

You can’t send just one satoshi over the network, though—that’s too small and would clog up the network with tiny transactions. The smallest transaction value is 546 satoshis, which is still pretty tiny.

To complicate matters still further, many bitcoin transactions involve a transaction fee, which means that you have to add a certain amount of bitcoin on top of the amount you’re trying to send. If you don’t, then it’s likely that the bitcoin transaction will fail altogether.

This is something to consider, especially when sending tiny fractions of a bitcoin.

When you open your bitcoin wallet after a few transactions and begin to see multiple addresses containing lots of tiny amounts, you now know what’s happening. It isn’t effortless to read and makes bookkeeping a bit annoying, but it does make it possible to trace bitcoin transactions through the entire network—which is important, given bitcoin’s mantra of transparency and immutability.

How to Send Bitcoin

To send and receive bitcoins, you'll need a Bitcoin wallet. The exact process may differ per wallet, but overall it should be about the same. It seems just about as easy as using Venmo or another money transfer app. You'll use your Bitcoin wallet to select the type of currency you want to send (in this case, Bitcoin), write in the recipient's address, enter the amount you wish to send, pay any transaction fees, and then click on "Send Bitcoin."