In the overview diagram shown in Bitcoin overview, we see that the bitcoin system consists of users with wallets containing keys, transactions that are propagated across the network, and miners who produce (through competitive computation) the consensus blockchain, which is the authoritative ledger of all transactions.

Each example in this chapter is based on an actual transaction made on the bitcoin network, simulating the interactions between the users (Joe, Alice, Bob, and Gopesh) by sending funds from one wallet to another. While tracking a transaction through the bitcoin network to the blockchain, we will use a blockchain explorer site to visualize each step. A blockchain explorer is a web application that operates as a bitcoin search engine, in that it allows you to search for addresses, transactions, and blocks and see the relationships and flows between them.

Popular blockchain explorers include:

Each of these has a search function that can take a bitcoin address, transaction hash, block number, or block hash and retrieve corresponding information from the bitcoin network. With each transaction or block example, we will provide a URL so you can look it up yourself and study it in detail.

Alice, introduced in the previous chapter, is a new user who has just acquired her first bitcoin. In [getting_first_bitcoin], Alice met with her friend Joe to exchange some cash for bitcoin. The transaction created by Joe funded Alice’s wallet with 0.10 BTC. Now Alice will make her first retail transaction, buying a cup of coffee at Bob’s coffee shop in Palo Alto, California.

Bob’s Cafe recently started accepting bitcoin payments by adding a bitcoin option to its point-of-sale system. The prices at Bob’s Cafe are listed in the local currency (US dollars), but at the register, customers have the option of paying in either dollars or bitcoin. Alice places her order for a cup of coffee and Bob enters it into the register, as he does for all transactions. The point-of-sale system automatically converts the total price from US dollars to bitcoin at the prevailing market rate and displays the price in both currencies:

Bob says, "That’s one-dollar-fifty, or fifteen millibits."

Bob’s point-of-sale system will also automatically create a special QR code containing a payment request (see Payment request QR code).

Unlike a QR code that simply contains a destination bitcoin address, a payment request is a QR-encoded URL that contains a destination address, a payment amount, and a generic description such as "Bob’s Cafe." This allows a bitcoin wallet application to prefill the information used to send the payment while showing a human-readable description to the user. You can scan the QR code with a bitcoin wallet application to see what Alice would see.

Alice uses her smartphone to scan the barcode on display. Her smartphone shows a payment of 0.0150 BTC to Bob's Cafe and she selects Send to authorize the payment. Within a few seconds (about the same amount of time as a credit card authorization), Bob sees the transaction on the register, completing the transaction.

In the following sections, we will examine this transaction in more detail. We’ll see how Alice’s wallet constructed it, how it was propagated across the network, how it was verified, and finally, how Bob can spend that amount in subsequent transactions.

You can examine Alice’s transaction to Bob’s Cafe on the blockchain using a block explorer site (View Alice’s transaction on blockchain.info):

Transactions are like lines in a double-entry bookkeeping ledger. Each transaction contains one or more "inputs," which are like debits against a bitcoin account. On the other side of the transaction, there are one or more "outputs," which are like credits added to a bitcoin account. The inputs and outputs (debits and credits) do not necessarily add up to the same amount. Instead, outputs add up to slightly less than inputs and the difference represents an implied transaction fee, which is a small payment collected by the miner who includes the transaction in the ledger. A bitcoin transaction is shown as a bookkeeping ledger entry in Transaction as double-entry bookkeeping.

The transaction also contains proof of ownership for each amount of bitcoin (inputs) whose value is being spent, in the form of a digital signature from the owner, which can be independently validated by anyone. In bitcoin terms, "spending" is signing a transaction that transfers value from a previous transaction over to a new owner identified by a bitcoin address.

Alice’s payment to Bob’s Cafe uses a previous transaction’s output as its input. In the previous chapter, Alice received bitcoin from her friend Joe in return for cash. That transaction created a bitcoin value locked by Alice’s key. Her new transaction to Bob’s Cafe references the previous transaction as an input and creates new outputs to pay for the cup of coffee and receive change. The transactions form a chain, where the inputs from the latest transaction correspond to outputs from previous transactions. Alice’s key provides the signature that unlocks those previous transaction outputs, thereby proving to the bitcoin network that she owns the funds. She attaches the payment for coffee to Bob’s address, thereby "encumbering" that output with the requirement that Bob produces a signature in order to spend that amount. This represents a transfer of value between Alice and Bob. This chain of transactions, from Joe to Alice to Bob, is illustrated in A chain of transactions, where the output of one transaction is the input of the next transaction.

Many bitcoin transactions will include outputs that reference both an address of the new owner and an address of the current owner, called the change address. This is because transaction inputs, like currency notes, cannot be divided. If you purchase a $5 US dollar item in a store but use a $20 US dollar bill to pay for the item, you expect to receive $15 US dollars in change. The same concept applies to bitcoin transaction inputs. If you purchased an item that costs 5 bitcoin but only had a 20 bitcoin input to use, you would send one output of 5 bitcoin to the store owner and one output of 15 bitcoin back to yourself as change (less any applicable transaction fee). Importantly, the change address does not have to be the same address as that of the input and for privacy reasons is often a new address from the owner’s wallet.

Different wallets may use different strategies when aggregating inputs to make a payment requested by the user. They might aggregate many small inputs, or use one that is equal to or larger than the desired payment. Unless the wallet can aggregate inputs in such a way to exactly match the desired payment plus transaction fees, the wallet will need to generate some change. This is very similar to how people handle cash. If you always use the largest bill in your pocket, you will end up with a pocket full of loose change. If you only use the loose change, you’ll always have only big bills. People subconsciously find a balance between these two extremes, and bitcoin wallet developers strive to program this balance.

In summary, transactions move value from transaction inputs to transaction outputs. An input is a reference to a previous transaction’s output, showing where the value is coming from. A transaction output directs a specific value to a new owner’s bitcoin address and can include a change output back to the original owner. Outputs from one transaction can be used as inputs in a new transaction, thus creating a chain of ownership as the value is moved from owner to owner (see A chain of transactions, where the output of one transaction is the input of the next transaction).

The most common form of transaction is a simple payment from one address to another, which often includes some "change" returned to the original owner. This type of transaction has one input and two outputs and is shown in Most common transaction.

Another common form of transaction is one that aggregates several inputs into a single output (see Transaction aggregating funds). This represents the real-world equivalent of exchanging a pile of coins and currency notes for a single larger note. Transactions like these are sometimes generated by wallet applications to clean up lots of smaller amounts that were received as change for payments.

Finally, another transaction form that is seen often on the bitcoin ledger is a transaction that distributes one input to multiple outputs representing multiple recipients (see Transaction distributing funds). This type of transaction is sometimes used by commercial entities to distribute funds, such as when processing payroll payments to multiple employees.

Alice’s wallet application will first have to find inputs that can pay the amount she wants to send to Bob. Most wallets keep track of all the available outputs belonging to addresses in the wallet. Therefore, Alice’s wallet would contain a copy of the transaction output from Joe’s transaction, which was created in exchange for cash (see [getting_first_bitcoin]). A bitcoin wallet application that runs as a full-node client actually contains a copy of every unspent output from every transaction in the blockchain. This allows a wallet to construct transaction inputs as well as quickly verify incoming transactions as having correct inputs. However, because a full-node client takes up a lot of disk space, most user wallets run "lightweight" clients that track only the user’s own unspent outputs.

If the wallet application does not maintain a copy of unspent transaction outputs, it can query the bitcoin network to retrieve this information using a variety of APIs available by different providers or by asking a full-node using an application programming interface (API) call. Look up all the unspent outputs for Alice’s bitcoin address shows an API request, constructed as an HTTP GET command to a specific URL. This URL will return all the unspent transaction outputs for an address, giving any application the information it needs to construct transaction inputs for spending. We use the simple command-line HTTP client cURL to retrieve the response.

The response in Look up all the unspent outputs for Alice’s bitcoin address shows one unspent output (one that has not been redeemed yet) under the ownership of Alice’s address 1Cdid9KFAaatwczBwBttQcwXYCpvK8h7FK. The response includes the reference to the transaction in which this unspent output is contained (the payment from Joe) and its value in satoshis, at 10 million, equivalent to 0.10 bitcoin. With this information, Alice’s wallet application can construct a transaction to transfer that value to new owner addresses.

As you can see, Alice’s wallet contains enough bitcoin in a single unspent output to pay for the cup of coffee. Had this not been the case, Alice’s wallet application might have to "rummage" through a pile of smaller unspent outputs, like picking coins from a purse until it could find enough to pay for the coffee. In both cases, there might be a need to get some change back, which we will see in the next section, as the wallet application creates the transaction outputs (payments).

A transaction output is created in the form of a script that creates an encumbrance on the value and can only be redeemed by the introduction of a solution to the script. In simpler terms, Alice’s transaction output will contain a script that says something like, "This output is payable to whoever can present a signature from the key corresponding to Bob’s public address." Because only Bob has the wallet with the keys corresponding to that address, only Bob’s wallet can present such a signature to redeem this output. Alice will therefore "encumber" the output value with a demand for a signature from Bob.

This transaction will also include a second output, because Alice’s funds are in the form of a 0.10 BTC output, too much money for the 0.015 BTC cup of coffee. Alice will need 0.085 BTC in change. Alice’s change payment is created by Alice’s wallet as an output in the very same transaction as the payment to Bob. Essentially, Alice’s wallet breaks her funds into two payments: one to Bob and one back to herself. She can then use (spend) the change output in a subsequent transaction.

Finally, for the transaction to be processed by the network in a timely fashion, Alice’s wallet application will add a small fee. This is not explicit in the transaction; it is implied by the difference between inputs and outputs. If instead of taking 0.085 in change, Alice creates only 0.0845 as the second output, there will be 0.0005 BTC (half a millibitcoin) left over. The input’s 0.10 BTC is not fully spent with the two outputs, because they will add up to less than 0.10. The resulting difference is the transaction fee that is collected by the miner as a fee for validating and including the transaction in a block to be recorded on the blockchain.

The resulting transaction can be seen using a blockchain explorer web application, as shown in Alice’s transaction to Bob’s Cafe.

The transaction created by Alice’s wallet application is 258 bytes long and contains everything necessary to confirm ownership of the funds and assign new owners. Now, the transaction must be transmitted to the bitcoin network where it will become part of the blockchain. In the next section we will see how a transaction becomes part of a new block and how the block is "mined." Finally, we will see how the new block, once added to the blockchain, is increasingly trusted by the network as more blocks are added.