How the Bitcoin Ecosystem Works
Metallic Bitcoin symbol with financial chart over dark background.
Bitcoin
The main stakeholders in the decentralized bitcoin ecosystem include node operators, who distribute blockchain data, bitcoin miners, who confirm bitcoin transactions in exchange for block subsidies plus transaction fees, bitcoin tool and product developers, and, of course, bitcoin users.
Nodes
A bitcoin node supports the network by validating transactions that propagate them to other nodes. Thousands of people and organizations around the world operate their own independent nodes. Some people download node software onto their own laptops, while others build node devices using a Raspberry Pi. Some companies also run nodes with industrial hardware. Either way, the node is what gives every bitcoin user their own full copy of the blockchain, rather than relying on someone else’s hardware to keep track of the public ledger. The public ledger is what makes the bitcoin network permissionless. Anyone with an internet connection can view a complete record of bitcoin transactions and verify transaction information, as well as the access to bitcoin that currently exists.
Miners
Bitcoin miners run hardware devices that complete transactions by guessing random numbers, and the miner who guesses the correct number gets to create the next block. Imagine, metaphorically, these mining units filling the blocks of the well-known blockchain. Bitcoin miners worldwide, including hundreds of industrial mining operations, create a new block for the Bitcoin network approximately every ten minutes.
Theoretically, miners can affect Bitcoin Core code by rejecting transactions with a certain update. This will by default mean that node operators will have a harder time finding the broadcast data. Whatever the majority of nodes broadcast is the current state of the Bitcoin blockchain. Bitcoin Core code maintainers will most likely follow the majority in such a case. So far in bitcoin’s 15-year history, such conflicts have been resolved through community consensus. There is a historical update called Taproot, which we will explore later in greater detail, where it was unknown whether the various companies involved in bitcoin mining would accept updated information and formalize it as part of the network.
Fortunately, all bitcoin miners, for their own independent reasons, have so far found it beneficial to incorporate all network updates with popular consensus. Just like the way courts and lawmakers provide a system of checks and balances in government, bitcoin miners, node operators, and developers work together as a type of checks and balances in the bitcoin ecosystem.
Sponsors and developers
A wide variety of bitcoin companies, from exchanges like BitMex to wallet makers like Jack Dorsey’s charitable Square spinoff, Spiral, sponsor grants for independent, open-source developers to maintain Bitcoin Core code and other like-minded software projects. A few companies have open source contributors on staff, as Blockstream and Coinbase have done in the past. However, most open source bitcoin software developers, including tool makers such as wallet creators, earn grants and accept donations from the community for independent work. This helps keep the bitcoin network out of the control of one company or developer group. There are developer organisations, such as the non-profit organization Brink and the research institute Chaincode Labs. As became clear in the Taproot upgrade we’ll explore shortly, these organizations can only influence public opinion on Bitcoin Improvement Proposals, called BIPs. The Bitcoin developer ecosystem, with hundreds of active contributors, receives funding and contributions from so many different people that there is no single entity that can force a change. This is only possible because all the code related to important Bitcoin network functions is already widely broadcast and freely available from many different sources, and each node operator has a choice in which version of the code they want to use.
The taproot example
Let’s take a look at one example of how bitcoin’s open source development process works. On November 14, 2021, the Bitcoin network received its first major makeover since the SegWit (segregated witness) fork in 2017, first introduced by developer Pieter Wuille in 2015. As you can already see from these dates alone, achieving consensus with an open source developer community requires years of work.
In August 2017, an upgrade called Segregated Witness increased Bitcoin’s transaction capacity within a given block by providing a discount to certain data used in transactions. In short, the SegWit upgrade allowed bitcoin miners to process more transactions with each block. Similarly to SegWit, Tapioca was also a soft fork upgrade, meaning that network participants who do not install it right away will not be cut off from the network. This makes it easier for various actors across the industry to ease into the transition. The alternative to a soft fork is a hard fork, which results in participants being cut off from the network if they do not upgrade.
Taproot’s predecessor, SegWit, inspired a contentious debate over whether a soft fork was the best approach. This debate resulted in a brand new cryptocurrency called Bitcoin Cash which was created with a hard fork. In contrast, Taproot received wide support from developers, miners and users. There were concerns about whether bitcoin miners would agree that the update was beneficial. This turned out to be the case! On June 12, 2021, the Taproot upgrade reached a 90% consensus among miners, give or take, thus locking in taproot activation in November.
To summarize the activation process, an individual developer, Pieter Wuille, proposed an upgrade that would improve the Bitcoin network’s functionality. Developers discussed the software update for a long time. Once they agreed, they updated the free, publicly available software that most users rely on when using bitcoin. Miners continued to process transactions as usual, signaling their support by running the latest code, and node operators around the world did the same. Thus, within a few months, the update had spread across the vast majority of Bitcoin network nodes.
Regarding what this bitcoin update did, Taproot consists of three innovations to the bitcoin protocol, the proposal included a culmination of BIPs: Schnorr signatures, Taproot, and Tapscript, all of which enabled increased functionality for bitcoin transactions.
Important changes, thanks to Taproot:
- BIP 340, Schnorr Signatures: Previously, bitcoin used Elliptic Curve Digital Signature Algorithm (ECDSA) encryption as the mechanism to ensure that bitcoin can only be used by its rightful owner. It is believed that bitcoin’s creator Satoshi Nakamoto chose it largely for convenience because of its wide acceptance and successful history, but also because the use of Schnorr signatures was restricted by a patent until a few years ago. Schnorr signatures build on this foundation because they are able to take signatures from multiple parties involved in the same transaction and produce a single unique signature, thus making complex multisig transactions indistinguishable from ordinary ones.
- BIP 341, pile root: Allows the use of Schnorr signatures and integrates the Merkelized Alternative Script Trees (MAST) method – essentially a way to hide private transaction information and commit less smart contract transaction data to the blockchain.
- BIP 342, Tapscript: Gives developers more freedom to create bitcoin smart contracts. It does so by removing the 10,000-byte size limit on bitcoin scripts, a set of programmed instructions that are recorded with every transaction made. Currently, smart contracts can be created both on bitcoin’s core layer and on the Lightning Network, an additional bitcoin layer designed for near-instant transactions. Smart contracts executed on the Lightning Network lead to faster and cheaper transactions.
Why Bitcoin Updates Matter
To underline Taproot’s importance, it’s worth noting that bitcoin is much more conservative than other blockchains when it comes to upgrades. Updates are rare. Since bitcoin’s inception in 2009, only a few dozen BIPs have been used across much of the network. Many BIPs are rarely or never used. While the full extent of Taproot’s improvements will be proven over time, they are expected to increase the efficiency and privacy of bitcoin transactions and reduce the amount of data to be transferred and stored on the blockchain per transaction. Committing less data also creates room in each block for more transactions, increasing overall throughput.
In addition, Taproot opens doors to more flexible smart contracts using bitcoin. As such, the upgrade could further expand the use of bitcoin through new applications and use cases we see emerging on other chains. First, bitcoin could become a bigger force in the decentralized financial ecosystem, fast-growing financial applications designed to cut out the powerful middlemen like banks and brokerages.
How Bitcoin Updates Affect the Average User
Node and mining hardware operators generally look for software updates every quarter anyway, or more often on rare occasions when developers fix bugs. So soft fork updates are already part of network participants’ existing workflow. Bitcoin users who do not use their own hardware rely on service providers, and developers of wallets and other services will also update their codes. Some users may choose to upgrade their wallet to take advantage of the latest features. Bitcoin users who want to know about recent updates can check the Bitcoin Core mailing list, the Github repository, and other publicly available sources.
On the other hand, to be clear, the transition triggered by a soft fork will take time. As of March 2023, Bitcoin Core developer Luke Dashjr estimates that 41% of node operators have adopted the network change by running the latest software. In particular, in the four years since SegWit’s launch, almost half of the adoption, now at 80%, happened just this year.
From an investment perspective, the impact that updates like Taproot have on bitcoin’s price volatility remains unclear. After SegWit was activated in 2017, bitcoin’s price had risen from about $3,000 to a then-record high of $19,660 by the end of the year. In comparison, immediately after the Taproot upgrade went live, bitcoin traded flat in the low-$60,000s and peaked around $69,000 in November 2021. Market analysts are now closely watching bitcoin software developments, so these projections are now priced in when traders assess the evolution of bitcoin’s price. Regardless of whether a software update directly affects bitcoin’s price, the open source development process remains a key factor in determining bitcoin’s long-term value as a global currency.
