How a bitcoin transaction actually works

If you’ve ever felt a bit uneasy during the process of sending or receiving bitcoin, you’re not alone. Many people feel apprehensive when it comes to moving bitcoin around. 

After all, navigating self-custody within a decentralized system means there’s no third party responsible for facilitating your transactions. If you’re careless and send bitcoin in error, there’s no one else to blame, and no one who can reverse the action. This stands in stark contrast with the traditional banking and credit card system, and it’s a tradeoff associated with unchaining yourself from these institutions—with great power comes great responsibility.

On the other hand, it’s also common for people to feel anxious about their bitcoin transaction in instances where they don’t need to be. For example, you might follow all the correct procedures, but then feel some uncertainty about the transaction successfully “going through.” Or if a transaction has been broadcast and is currently pending, you might find yourself hoping that the bitcoin doesn’t “get lost along the way.” 

Concerns like these stem from an inaccurate perception of how bitcoin transactions work. In this article, we’ll provide a framework for better understanding the mechanics of bitcoin transactions, to help you feel more comfortable and confident about what’s actually happening behind the scenes.

Bitcoin is never dispatched, in transit, or delivered

Any time you’re learning a new concept, it’s tempting to use comparisons with other things you’re already familiar with. Analogies can be useful for introductory education, but they’re never perfect. Getting too caught up in an analogy can cause you to make incorrect presumptions, which is often the case with bitcoin.

In our earlier article about bitcoin addresses, we used some analogies to explain them, suggesting that they could be compared to email addresses or physical mailing addresses. However, that comparison only goes so far. It can lead to the incorrect perception that quantities of bitcoin are “in transit” before eventually “being delivered” to a bitcoin address. After all, this is what happens with physical mail, or data being sent in text message or email—and all of these suffer from the possibility of an unsuccessful delivery.

Examples of delivery failures are prominent in both the physical and digital world.

Fortunately, this type of “unsuccessful delivery” isn’t a concern for bitcoin, because contrary to popular belief, bitcoin never really moves from one place to another! Bitcoin doesn’t travel through wires, nor is there any person, program, or entity responsible for carrying bitcoin from Point A to Point B. Bitcoin is never in transit, and it never exists somewhere between the sender and receiver. Even the words “send” and “receive” are analogies that fail to provide an accurate representation of what’s occurring during a bitcoin transaction.

Instead, the correct framing is that updated knowledge of who bitcoin belongs to is spread globally. If you pay someone in bitcoin, a better analogy is that you are making a public announcement. You are verifying yourself as the owner of some bitcoin by using your private keys, and declaring to the world that a portion of that bitcoin no longer belongs to you, it belongs to the person you are paying. This knowledge is irreversibly spread, until the entire network is aware, at which point the payment is complete. Let’s take a closer look at how this works. 

Ownership changes with decentralized ledger updates

As we covered in an earlier article, bitcoin wallets don’t actually hold bitcoin. A bitcoin “wallet” is yet another imperfect analogy. While it may help people conceptualize where they can view their bitcoin balance and how to keep it protected, the term is also a common source of confusion regarding where bitcoin is really stored.

Everybody’s bitcoin (eventually, all 21 million) exists in the same place—the bitcoin blockchain. The blockchain is a ledger, or digital record book, keeping track of all the bitcoin transactions and how the supply is divided among various addresses. The blockchain has copies existing in many different physical locations, wherever someone runs a bitcoin node. If you run a node yourself, you can have a copy of the entire blockchain stored in your home! No single node is the definitive source of truth, which is why the bitcoin network is described as decentralized or distributed.

When a transaction occurs, the blockchain ledger must be adjusted to reflect the updated balances, across all of the nodes worldwide. This is what happens when a new block is added to the blockchain, approximately once every ten minutes. Each new block contains updated information about the bitcoin values attributed to various addresses. Nodes validate that the new blocks are following all of the rules, and then help spread the new block information to other nodes plugged into the network.

A block on the blockchain adds new transactions to the ledger, thereby reallocating bitcoin away from some addresses and towards others.

The steps of a bitcoin payment

If you want to make a payment in bitcoin using the traditional method, you must work through the following steps:

1. Build a transaction by specifying how much bitcoin is going to be transferred from an address you control to an address the recipient controls. 
2. Officially authorize the transaction by using the correct private keys to cryptographically sign it. 
3. Use a node (your own node or your wallet software’s default third-party node) to broadcast the signed transaction to the network of other bitcoin nodes.
4. Bitcoin miners become aware of the signed transaction, because they run nodes themselves. At this point the transaction is considered “pending,” because it hasn’t been added to the blockchain yet, and would be vulnerable to double-spending.
5. Wait for bitcoin miners to include your transaction in a new block being added to the blockchain—whether it’s the next block or a subsequent block will depend on the fee rate chosen while authoring the transaction, relative to the current fee market.
6. As the transaction is added to the blockchain, nodes spread that information as well. The transaction is considered “confirmed” and no longer vulnerable to double-spending.
7. The recipient can use their own node or someone else’s node to verify that the bitcoin network recognizes the payment as valid and completed.

In summary, you create a transaction and announce it publicly. Then, a decentralized and trust-minimized network of nodes and miners serve as intermediaries, validating your announcement and spreading knowledge of it until the recipient is reasonably satisfied. Despite the bitcoin whitepaper referencing a “peer-to-peer electronic cash system,” this title is another imperfect and colloquial description of how bitcoin truly functions.

You can be offline and receive a bitcoin payment

This transaction model explains why you can receive bitcoin payments while being completely offline. As long as you’ve shared an address that belongs to you, other people can subsequently broadcast transactions to the network which are paying bitcoin to that address. Only the sender needs to be momentarily connected to an online node to facilitate the broadcast, or the “payment announcement.” The bitcoin network automatically takes care of the rest. Once the transaction has been confirmed by being added to the blockchain, the bitcoin is officially attributed to your address and under the control of your keys. Whenever you come back online by connecting to a node, you will be able to see your updated balance.

Transactions can get “stuck,” but your bitcoin can’t

If a transaction is pending, that means it has been broadcast but not yet confirmed to the blockchain. Transactions are usually pending for less than an hour, if a recommended fee rate corresponding to the current fee market was chosen by the sender (which is the default option for most wallet software). 

However, the fee market could experience a sudden increase in fee rates at any time, due to an influx of global demand to move bitcoin quickly—often when the bitcoin price becomes particularly volatile. If you author and broadcast a transaction at a lower fee rate before such a spike, miners won’t be focused on including your transaction in the next block. They will earn more fees by choosing the newer transactions paying higher fee rates. Instead of being near the front of the queue, your transaction could be much farther back in line. In some cases, it could be “stuck” for hours, days, weeks, or even months before fee rates fall back down to match the bid from your transaction, and it is finally mined into a block.

Scenarios like this have been known to cause anxiety among transaction participants. Neither the sender nor the receiver might feel like the bitcoin is in their possession. So where is the bitcoin? Could it be lost or vulnerable? To answer these questions, we must remember that the blockchain is the source of truth. Since the transaction hasn’t been added to the blockchain yet, the payment hasn’t been settled. The bitcoin technically remains in the possession of the sender, until the blockchain is finally updated to credit the bitcoin to the recipient.

Getting a transaction “un-stuck”

Once a transaction has been broadcast, it’s impossible to “un-broadcast” or cancel it. By default, the bitcoin will eventually transition to the recipient’s address, unless further action is taken. There are a few things that can be done:

• RBF: If the settings of the pending transaction or the broadcasting node allow for it, then the sender can perform a Replace-By-Fee transaction. This intentionally double-spends the bitcoin from the original transaction, but applies a higher fee rate. Miners will prioritize mining the new, more profitable transaction, causing the old one to become invalid. This is a way to speed up a stuck payment, also called “fee bumping.” It’s worth noting that the sender can also use this method to change the destination of the bitcoin, to a new recipient such as back to themself. This is why a recipient should never consider themselves paid until the transaction has been mined into a block.
• CPFP: A recipient can also influence a pending transaction. A Child-Pays-For-Parent transaction is when a recipient creates and broadcasts a “child” transaction, that spends some of the bitcoin they will be receiving from the pending “parent” transaction. If the fee rate on the child transaction is high enough, it will attract miners to include it in the next block. But since the bitcoin doesn’t technically belong to the recipient yet, the child transaction will be invalid unless the miners also include the parent transaction. Therefore, if the fees justify it, they will include both the parent and the child transaction together in the same block. This is another method of fee bumping. Child transactions can also be used to send the bitcoin to the same wallet as the parent transaction, so choosing a new destination isn’t necessary.
  
  Due to how UTXOs work, the sender who is trying to pay someone else bitcoin will almost always receive change back to their wallet. Therefore, technically senders are usually one of the receivers for their own transaction, as well. This would mean the sender is eligible to use either a RBF or a CPFP, while the payee is only able to do a CPFP.
• Paying miners out-of-band: While RBF and CPFP are tools available natively within the bitcoin protocol, it’s also possible to simply offer miners a direct payment to include your transaction within the next block they mine. This is perhaps the easiest or least technical method, using tools such as Mempool Accelerator, but it may also be a bit more expensive than an RBF or CPFP.

With these methods, it’s always possible to speed up a stuck transaction, for a price. If multiple fee bumping techniques are deployed simultaneously, miners are incentivized to choose the combination that pays them the most fees, and disregard any contradicting transactions.

Transactions outside of the blockchain

So far, we’ve covered information pertaining to the original and most fundamental method of conducting transactions: utilizing the blockchain directly. However, some have found other ways to transfer bitcoin ownership outside of the blockchain. 

This might seem impossible at first, given that all of the bitcoin supply exists on the blockchain and can’t be removed from it. If an amount of bitcoin exists at an address on the blockchain, in order to be moved to another address, the blockchain must be updated. But these other methods of payment manage to keep the bitcoin at the same address, and merely adjust who the bitcoin belongs to or who can access it. Here are some examples:

• Custodians: When you trust a custodian to control or “hold” bitcoin on your behalf, the custodian will mix your bitcoin with many other people’s bitcoin as well. A custodian might hold bitcoin for thousands of different people, but they won’t hold it across thousands of different addresses. They might use a few addresses at most, and simply keep track of how much bitcoin they owe people. Therefore, two people using the same custodian can transfer bitcoin ownership between each other by asking the custodian to update how much they owe each person. Various custodians could also form a settlement network that finalizes payments for thousands of people in just one or two blockchain transactions—this resembles the traditional banking system. Trusting a custodian comes with risks, which is why trust-minimized federations are preferable, if not self-custody.
• Bearer instruments: There are also ways to pass bitcoin ownership physically, by using a bearer instrument such as an OpenDime or SatsCard. These physical devices hold the private keys to an amount of bitcoin in a manner that tries to ensure only the person in possession of it can access the bitcoin (also preventing previous possessors from accessing it). These devices have limited flexibility in the payment amounts they can facilitate, however. 
• Lightning Network: The Lightning Network is the quintessential example of a “layer 2” payment system. It’s a decentralized and open source protocol for enabling payments outside of the blockchain, using Lightning channels. A Lightning channel is opened by depositing bitcoin into a 2-of-2 multisig address, which must be done using the blockchain, but afterwards the channel can facilitate any number of instant payments. The channel is operated by two different parties, each holding one of the keys, and each providing a transaction signature from their key to the other party. By updating the signatures over time, the portion of the balance within the channel that belongs to each party can be updated, meaning they can pay each other back and forth, like an open bar tab. Either party could close the channel at any time, sending each person their portion of the balance in an on-chain transaction. Furthermore, a chain of multiple channels across many network participants can allow for Lightning payments even between individuals who don’t have a dedicated channel together.

Conclusion

In summary, you shouldn’t worry about bitcoin getting lost simply because the transaction is taking a while to be processed. As long as you double-check that your transactions contain correct information relating to the amount and destinations, practically everything else will be handled by the bitcoin network. There are also ways for either the sender or receiver to speed up the transaction being added to the blockchain, or use a different payment method outside of the blockchain.

If you want a helping hand with transactions into or out of secure self-custody, you can sign up for Unchained Signature. After receiving help with setting up a collaborative multisig vault, you’ll unlock access to year-round support from a dedicated bitcoin custody expert, ongoing education and security reviews.