Bitcoin and the Rules of Consensus

May 4, 2023

In this article, we’ll be talking about the “Rules of Consensus”, or “Nakamoto Consensus”, what it is and why it is important.

There are certain aspects of the Bitcoin protocol that can't be changed unless the majority of its participants agree to do so. These hard-set rules are enforced by open-source software. If a node detects a participant who is not following these rules, the offending participant would get immediately banned and forbidden from relaying information through the blockchain.

Here are the rules that we’ll be covering:

  • Difficulty adjustment
  • Bitcoin’s monetary policy
  • Transaction fees
  • Transaction structure
  • Block Size Limit

Let’s start off with the difficulty adjustment. Bitcoin adjusts the difficulty for finding new blocks so that one is found approximately every 10 minutes. Below is a chart of the historical block time, and you can see that it tries to average around 10 minutes.

This first rule of the Nakamoto Consensus ensures that the production of bitcoin remains at a controlled level and transactions are sent at regular and predictable intervals. The difficulty adjustment happens every 2,016 blocks or as you and I would understand it, roughly every two weeks.

You’ll notice that time is often measured in terms of blocks and that the difficulty of mining a new block has risen significantly over time in response to increased numbers of miners joining the network, and the advent of more sophisticated mining technology.

Bitcoin Network Difficulty.

Without a difficulty adjustment, blocks would be found in less than a minute and all 21 million bitcoins would’ve been probably produced by now…

This leads to the next rule of consensus: The maximum reward for each block found. Unlike fiat money, which can be infinitely printed, Bitcoin has a built in maximum number of coins that can ever be produced, at a pre-determined rate.

According to Bitcoin’s monetary policy, the amount rewarded for mining a block occurs every 210,000 blocks which approximately equates to halving every 4 years until the last bitcoin is mined sometime in the year 2140. The total amount of bitcoin is capped at few decimals under 21 million(20,999,999,976.9 to be exact!). As miners make progressively less money for mining a block, they will need to rely more and more on the transaction fees levied to send Bitcoin across the network.

Transaction fees are another aspect of Bitcoin governed by the rules of consensus. Transactions that have been sent out but are waiting to be confirmed sit in what is called ‘the mempool’. Miners that win the right to mine the next block will scan ‘the mempool’ to decide which transactions to confirm. Typically, miners want to make the most money possible, so miners will include the transactions that pay the highest fees.

As you can see from the above graph, the higher-fee green transactions make up the bulk of the transactions picked up from the mempool, whereas the lower-fee blue transactions have to wait longer to get picked up. The fee you pay only matters in BTC where the traffic can get congested.

With Bitcoin Cash and Bitcoin SV, the traffic gets cleared every time no matter what fee you pay, and we’ll explain why a little later in this article.

A common misconception is that transaction fees are based on the amount of bitcoin sent when in actuality, it’s based on the amount of data your transaction takes up in bytes.

Here is an example of a large amount of bitcoin sent with lower data size:

And you can compare this to a small amount of bitcoin sent with high data. The amount of data used in a given transaction can vary based on the type of address or the number of inputs, or to get technical, ‘UTXOs’. But what do we mean by inputs?

This leads us to our next rule of consensus: The transaction structure.

Just like the banknotes in your pocket, Bitcoin works the same way but using inputs and outputs. Let us explain this with an example. Alice wants to send Bob 0.5 BTC.

A SIMPLIFIED OVERVIEW OF BITCOIN UTXO’S

Let’s cover the key terms first:

In Bitcoin transactions:

- Whenever you’re sending something, it’s called an input.

- Whenever you’re receiving something, it’s called an output.

- When you have money that hasn’t been spent, it’s called an Unspent Transaction Output or ‘UTXO’.

Just as an analogy, every “paper bill” in your wallet would be called a UTXO in Bitcoin, as you haven’t spent it yet. Your “Wallet Balance” would be a collection of your unspent transactions, or, UTXOs.

So going back to the example, if Bob wants 0.5 BTC from Alice and Alice only has a UTXO of 1 BTC from a previous payment, Alice has to send 1 bitcoin input and will receive 0.5 bitcoin back in change as an output. Bob would get his 1 bitcoin output and in the end, Bob now has a UTXO of 1 bitcoin and Alice has a UTXO of 0.5 Bitcoin.

To an outside observer looking at this, it’s hard to tell the difference between the output generated for the purchase, and the output generated for the change.

Now that you’re familiar with the transaction structure, let us look at the format of Bitcoin addresses.

A Bitcoin address is similar to an email address. In order to send or receive an email, you need an identifier such as an email address that can be shared and a private password to log in to the system. In Bitcoin, the “email address” is known as a ‘public key’, and the password is known as a ‘private key’. However, unlike most email networks, there’s no password reset function for Bitcoin, so it is extremely important to keep your private keys safe because it ultimately determines the ownership of your money.

Here are some examples:

— 1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2

— 3J98t1WpEZ73CNmQviecrnyiWrnqRhWNLy

— bc1qar0srrr7xfkvy5l643lydnw9re59gtzzwf5mdq

— bitcoincash:qq44rpwdylsn5pnw86d0qdye6rupfkxmhqedldpw50

Bitcoin addresses can follow a few different formats, which have evolved over time but most addresses always start with a certain character, like ‘1’, ‘3’ or ‘bc1’. To avoid any confusion, Bitcoin Cash uses a certain address type that starts with a ‘q’, and sometimes includes the prefix “bitcoincash:”. There are free tools online where you can convert these types of addresses back to a legacy address that starts with a 1.

The last, and most controversial rule of consensus states that the size limit of blocks cannot be changed. Earlier in this article, we spoke about the fact that BTC experiences traffic congestion, and this is because of the block size capacity.

Because the block size capacity is low and can only fit a certain number of transactions post each confirmation, it forces users to enter a bidding contest, making the fees for a fast confirmation to sometimes pass a few dollars. Proponents of increased block sizes wanted lower fees and could not convince the majority, so they were forced to branch off and continue their own version of Bitcoin, in a process known as a ‘hard fork’ — this is how Bitcoin Cash (BCH) and Bitcoin SV (BSV) were created. For more on the many different forks of bitcoin see our previous article, ‘The Other Bitcoins — A Closer Look at Bitcoin’s Hardforks’.

One of the beautiful things about Bitcoin is the lack of a centralized governance system. There is no one person in charge. Bitcoin’s governance system was designed so that decisions are made by miners and users of the network.

Satoshi wrote about this elaborate system in his whitepaper: “Proof-of-work is essentially one-CPU-one-vote. The majority decision is represented by the longest chain, which has the greatest proof-of-work effort invested in it. If a majority of CPU power is controlled by honest nodes, the honest chain will grow the fastest and outpace any competing chains.”

Disclaimer: The information within this post is purely informational and does not constitute investment, financial, trading, or any other sort of advice and you should not treat any of OTC Supply’s content as such.

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