If you read this, you’ve definitely heard of Bitcoin. While the cryptocurrency has been covered from all possible sides, it’s still reasonable to come up with an extensive guide on Bitcoin. As most countries are facing the worst economic crisis in decades, many people are interested in investing in cryptocurrency. Given that the influx of newcomers is increasing, I’ve created this concise guide for those who want to understand the basics of Bitcoin.
What is Bitcoin?
Bitcoin, with the ticker BTC, is a digital currency system that revolves around an eponymous unit used to make transactions between two parties. Since both the system and the unit are called the same, it might be confusing for newcomers, but it’s not that difficult. We have:
- Bitcoin as the blockchain network that represents a global, decentralized ledger that records all transactions conducted since its inception.
- Bitcoin as the cryptocurrency unit that one can buy, sell, hold, or use for various financial operations, including payments.
The main attribute of the Bitcoin system is that it allows peer-to-peer (P2P) transactions without intermediaries like governments, central banks or any other financial institutions. The cryptocurrency unit is digital and resides exclusively on blockchain.
Bitcoin was launched in late 2008 as a reaction to the financial crisis caused including because of the vulnerabilities of the traditional system and the wrongdoings of its players that favored the rise of a real estate bubble in the US.
We still don’t know who created Bitcoin, though the individual or entity behind it goes under the pseudonym of Satoshi Nakamoto. He proposed an electronic payment system in a Bitcoin White Paper published more than a decade ago.
Bitcoin is the first use case of blockchain, the technology that underpins the system. It is considered the first cryptocurrency ever created. Today, we have thousands of them.
Key Aspects of Bitcoin
Decentralization – This is a buzzword today, but Bitcoin took decentralization to another level. It defies the authority of governments and central banks by giving full control of the system to the masses. There is no single entity that may control the network, though a theoretical risk of a so-called 51% attack still persists.
Bitcoin has no single point of failure because the ledger of records resides on an open network of servers spreads globally.
To address the risk of double-spending, Bitcoin uses a mix of cryptography and economic incentives. Specifically, the system rewards so-called miners with Bitcoins for their effort of recording the blockchain blocks (basically recording transactions chronologically and making sure they’re genuine) and maintaining the good health of the network.
Deflationary Model – Another aspect of Bitcoin is its limited supply and resulting scarcity. Fiat currencies like the US dollar and euro have an unlimited supply. The central banks can print as many banknotes as they consider to be needed, which devalues the cost of each unit.
Elsewhere, the total supply of Bitcoin is capped at 21 million coins. The circulating supply is constantly increasing at the expense of the new coins generated by miners, who eventually sell their coins on secondary markets. There is a rigorous algorithm that governs the increase of the circulating supply, which will stop expanding when the 21 million mark is reached. As of May 2020, the circulating supply is 18.3 million coins.
Immutability – One cannot reverse Bitcoin transactions, unlike electronic transactions with fiat money. Once a transaction is recorded on blockchain, it will stay there forever, or at least as soon as the internet exists.
Anonymity – Initially, Bitcoin was supposed to favor anonymity, but it’s more accurate to say that it allows pseudonymity. While you may hold your coin anonymously so that no one could ever realize your identity, once you try to spend it, the chances are that your identity can be traced.
Today, most crypto exchanges require users to go through ID verification procedures. In other words, while the Bitcoin system doesn’t know and doesn’t care who the sender and receiver of a coin are, the infrastructure and layers built on top of Bitcoin can help authorities track users. Thus, contrary to popular belief, Bitcoin is not an ideal currency for terrorists, criminals, and money-launderers.
Divisibility – Bitcoin can be divided into smaller units called “Satoshi”, which makes it relevant for microtransactions even when the price per one coin surges to thousands of US dollars. One satoshi is one hundred millionth of a BTC (0.00000001 BTC).
While Bitcoin has many characteristics that make it unique, decentralization is the key aspect that sets it apart from any other monetary system. Blockchain can achieve true decentralization thanks to its Byzantine fault tolerance (BFT), which is a property that enables the network to stay safe against failures related to the Byzantine Generals’ Problem.
The latter is a logical dilemma defined about four decades ago. In the problem, a group of Byzantine generals, let’s say four, are dispersed in different locations around a city must reach consensus on to either attack or retreat. However, the only possible communication can be achieved through couriers. In short, the problem has the following requirements:
- Each general has to decide to either attack or retreat.
- Once the decision is made, it can’t be changed;
- All four generals must agree on the same decision and execute it in a synchronized manner.
The problem is that the generals should trust the couriers even though their messages can get delayed or lost, which would compromise the entire operation. Even when a courier’s message is successfully delivered, the general may choose to act maliciously for whatever reason, which would also result in a total failure.
In the context of blockchain, each node is like a general of the Byzantine Generals’ Problem. The technology allows nodes to reach consensus once a new block is validated to the network thanks to the Proof of Work (PoW) algorithm, which we’ll discuss in the section about mining.
How Does Bitcoin Work?
A transaction is the key operation carried out within Bitcoin’s blockchain. It represents a transfer of value between two different Bitcoin addresses. Data about each transaction is validated and ultimately included in blockchain by miners.
Users can conduct transactions by holding Bitcoin wallets, each of which includes:
- Private Key – It allows users to sign transactions by providing mathematical proof that the holder indeed has the right to access the wallet and move his Bitcoins.
- Public Key or Public Address – This is an identifier that can be shared with anyone in order to receive Bitcoins. Each address starts with 1, 3, or bc1.
Basically, a digital wallet is a like a credit card, where the address is the equivalent of the 16 digit number on the card while the private key is like the PIN code to access the card.
Whenever a Bitcoin holder wants to send some of his crypto funds, he publishes his intention online, and miners check the entire blockchain to confirm that:
- The sender has the BTC that he/she wants to send;
- The sender hasn’t already sent it to someone else.
Once that information is checked, the transaction is included in a block that ends up on top of the previous block in the blockchain. Each block comprises a cryptographic hash of the previous block, a timestamp, and transaction data.
To recap, whenever a new user intends to initiate the first transaction with Bitcoin, he or she generates a unique pair of public and private keys.
The private key is generated randomly and contains numbers and letters. The string is always mathematically derived from the Bitcoin wallet address. Nevertheless, it’s impossible to figure out the private key based on the address given the strong encryption code base.
Elsewhere, the public key can be shared with the public to receive coins. While we mentioned above that the public key is the wallet address, in reality, they are not the same. The address is actually a hashed version of the public key, so they are mathematically related.
Each Bitcoin public key is 256 bits long, and the final hash represents the wallet address, which is 160 bits long.
What is Bitcoin Mining?
Satoshi Nakamoto used the term mining on purpose because it resembles gold mining. Just as the gold exists somewhere underground and expects to be mined, hidden Bitcoin currently exists in the system and expects to be mined until the total supply reaches 21 million coins. Miners generate these new Bitcoins by being rewarded for their effort of validating blocks and maintaining the network.
In theory, everyone can become a miner, but the competition today is so high that it wouldn’t be feasible for an individual to mine.
As mentioned, the blockchain resides on a network of nodes, which represents a computer that runs the Bitcoin software. Downloading the software is free for everyone, but you need over 240 GB of free storage in order to hold the entire blockchain – and this figure is constantly increasing. All in all, nodes are helpful because they spread bitcoin transactions around the network.
Some nodes can become mining nodes if they group the transactions into blocks and include the latter to the blockchain. Miners can do this by solving complex mathematical puzzles. The more hash power a node has, the greater its chances to solve the puzzle, validate the block, and get the Bitcoin reward. The competition is so fierce that mining requires incredible resources of computing power and energy. Here is what a Bitcoin mining farm looks like:
Bitcoin mining wouldn’t be possible without the so-called proof of world, abbreviated as PoW. This is an algorithm that prevents double spends and fake transactions on blockchain and is imperative for the mining process.
In Bitcoin’s blockchain, transactions are gathered into blocks that are validated and arranged chronologically by miners, who are responsible for creating new blocks. First, a miner collects transactions and includes them in a candidate block. When the latter is validated by other nodes, it becomes a confirmed block and added to the network.
In this process, PoW requires that a miner uses some of his computing power to hash the block’s information until a solution to the puzzle is found. It means that the miner has to pass data through a hashing function (called SHA-256) to generate a block hash. It’s important to mention that the block hash is the identifier of a block.
The miner has to provide data whose hash meets a series of conditions. Since the miner doesn’t know how to achieve that, he/she has to pass data through the hash function and check whether it meets the conditions. If it doesn’t, the miner should make some slight changes in the data to get a different hash which could potentially match the protocol’s conditions. The change doesn’t happen at the expense of transactions data but based on a variable piece of data called a nonce. Miners change this variable data with every attempt in order to get to the hash that would match the conditions.
To recap, mining is the process of accumulating blockchain data and hashing it with the help of a nonce until finding a certain hash that meets all predetermined requirements established by the protocol. Once this puzzle is solved, the miner has the right to add the new block and get the reward. The other nodes would then update their network to include the new block.
The difficulty of the mining work is designed to limit the pace at which new blocks can be created to one every 10 minutes. Given that the probability of the successful generation of a new block is very low, it is almost impossible to predict which miner will generate the next block.
What Are Some Key Problems Bitcoin Should Address?
Bitcoin enthusiasts consider it an almost ideal invention, but the cryptocurrency faces several challenges that you should know about:
Scalability – One of the main problems of Bitcoin is its scalability, i.e. the potential of the network to continually grow and support billions of users. The Bitcoin community had to accept some slight changes in the system by adopting the so-called SegWit2 update, which caused controversy. However, this upgrade was needed to scale the cryptocurrency so that it could support more transactions per minute. Another proposal to scale Bitcoin is the Lightning Network. It is a system that acts as a layer on top of the blockchain that enables fast and cheap transactions.
Scams and Hacking Attacks – Since Bitcoin is still an emerging asset and newcomers are not familiar with its nuances, cybercriminals exploit this situation and organize hacking attacks, Ponzi schemes, and other types of crimes to defraud holders. Note that the blockchain itself doesn’t have any vulnerability. Instead, most of the attacks are focused on digital wallets held by individuals, crypto exchanges, or other entities.
Regulatory Risks – Many governments don’t want Bitcoin to interfere with their national currency and the economy in general. Thus, they can ban the use of cryptocurrency entirely or at least restrict it. For example, about three years ago, China banned local Bitcoin exchanges and discouraged any P2P transactions. Even so, the countries that allow Bitcoin would usually require strict KYC and AML rules to be followed by local players.
The Future of Bitcoin and Cryptocurrency
Is Bitcoin a threat to traditional finance? Yes and no. The launch of Bitcoin resulted in the emergence of a whole new category of assets known as cryptocurrencies. Thus, it is the entire crypto industry that has become a threat to the traditional banking system as we know it.
In 2019, Bank of America and JPMorgan listed cryptocurrencies among the risk factors that could impact their revenues and profits.
Central banks have monitored the evolution of Bitcoin very closely, and they seem to adopt some interesting changes. Particularly, major central banks are ready to create their own digital currencies powered by permissioned blockchains. While Bitcoin can be considered responsible for these changes, central banks are here to stay and will continue to dominate the financial system.
As I mentioned, Bitcoin has a limited supply, which is why the value of the cryptocurrency will increase along with the demand. Bitcoin is here to stay no matter what. Many have predicted the crypto’s doomsday on different occasions, but the industry always defied those forecasts.
While there are many predictions about the Bitcoin price in the future, including bold predictions based on the reliable stock-to-flow model, the important thing is that cryptocurrency will play an essential role in the economy.
In mid-May 2020, Bitflyer published a survey according to which 66% of Europeans feel optimistic about the future of Bitcoin. They believe that the cryptocurrency will be there ten years from now.
However, there is one major threat that can make the entire security of blockchain irrelevant. While today’s most powerful traditional supercomputers would require thousands of years to crack Bitcoin, this will be theoretically possible with so-called quantum computers, which are already here.
While the community is divided on how soon quantum computers will have the capacity to compromise Bitcoin, some experts claim that they would be able to do so in only a few years from now.
Still, when the threat becomes real, Bitcoin can update its protocol to become quantum-resistant either through a fork or by adopting an additional layer.