Bitcoin Basics

So you've come to find out what Bitcoin is. Good on you. You will need to know more and more about it over the course of this decade, so let's get started.

Key points: 

• Bitcoin uses a decentralized peer-to-peer network, meaning it does not rely on intermediary figures (like banks or credit card companies).
• The Bitcoin ledger is open-source and public, meaning anyone can access it.
• Every transaction is timestamped and permanently added to the ledger.
• It is virtually impossible to hack the Bitcoin network.
• There is a limited supply of Bitcoin that can be mined (21 million BTC)

Defining Bitcoin

Bitcoin’s creator Satoshi Nakamoto defined it in the 2008 whitepaper as a “purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” So is Bitcoin basically digital money? Well, not exactly.  

When we talk about Bitcoin, we are in fact referring to two things: bitcoin, the cryptocurrency (abbreviated as BTC), and Bitcoin, the decentralized, peer-to-peer network that supports it. The native bitcoin currency is stored and managed on the Bitcoin blockchain, a distributed and public digital ledger.

Nakamoto defines an electronic coin (in this case, a bitcoin) as a chain of digital signatures. This is important because what gives bitcoin its value is its record of ownership. And this record is not confirmed by a trusted central authority but rather by a distributed network of computers.  

Bitcoin is the first cryptocurrency, and while others like Ethereum, Litecoin, and Dogecoin have since entered the market, Bitcoin is still the largest by market capitalization. Precursors to Bitcoin include Bit Gold, B-Money, and Hashcash (mentioned in the Bitcoin whitepaper), which introduced key features like the Proof-of-Work consensus algorithm and distributed ledger system so integral to the Bitcoin network.  

Bitcoin succeeded in making a viable electronic payment system without the need for a trusted third party. This is revolutionary because it introduced a new economic model based on proof instead of trust. Let’s dive in and discover what (and why!) Bitcoin is.

Why Was Bitcoin Created?

If you know your contemporary financial history, then the year 2008 will stand out as a milestone. This was the year in which global financial institutions began to collapse under the pressure of unpaid mortgages and over-extended investment strategies.

People were denied loans, had their houses foreclosed on, and much worse. Satoshi Nakamoto, the pseudonymous creator or group behind Bitcoin, saw this as a problem that blockchain could fix. Nakamoto set out to create a digital transaction system without the need for a trusted third party.

Censorship

There is also the problem of censorship of transactions by banks. This is where a bank may reject your wire transfer or withdrawal of your money. A fundamental goal of Bitcoin was therefore to replace this trust-based system led by banks with one based on cryptographic proofs.  

The Double-Spend Problem

In a centralized system, a trusted third party verifies each transaction for double-spending. Unlike with physical cash payments, electronic payments run the risk of fraud, counterfeiting, and double-spending. Double-spending is when the same asset is used for two different transactions.  

Bitcoin successfully addressed this problem of double-spending, which was a significant issue for electronic cash systems seeking to operate in a decentralized way.  

Security and Accessibility

This is desirable for several reasons. A centralized system is only as secure as its central authority. Replacing the central authority with an unlimited number of decentralized verifiers prevents personal information from being compromised.  

Related to this is another fundamental feature of the Bitcoin network: accessibility. Bitcoin is permissionless, meaning that anyone with Internet access can use it, including the undocumented and the unbanked. And as Bitcoin is exchanged online, it also supports wider global use across borders.

How Does Bitcoin Work?

The Bitcoin network is built on a blockchain – a decentralized and public digital ledger. While blockchain technology has been around since the 1990s, Bitcoin was the first cryptocurrency to use it.  

The Bitcoin network is decentralized, secure, and transparent. Users do not have to disclose personal information, and all transactions are made available to the public. Data is not stored in a central server but rather across a distributed network of computers called nodes. Each full node has its own copy of the entire Bitcoin blockchain (i.e., all the transactions that have taken place), which allows the network to cross-reference itself for any discrepancies. By including a timestamp on each new transaction, the data is stored permanently in chronological order.  

Each node on the network comes to a consensus on each transaction, using an algorithm called Proof-of-Work (abbreviated as PoW). With PoW, miner nodes participate in a lengthy and expensive activity called mining. Mining is done with a physical GPU, like what you use to play video games on a PC. Mining is essentially the process of competing to solve a mathematical problem set by the Bitcoin protocol. The winner is rewarded with newly minted bitcoin, which importantly emits new coins into the system.  

Miners

Miners first gather data, including the new transactions and the previous block’s identification information (called a block header), then must use guesswork to find an additional value called a nonce. PoW requires so much computational power because the faster a miner can guess nonces, the more likely it is to beat the other miners.

The first node to solve the puzzle broadcasts its candidate block to the network. Once approved, the new block is unanimously added to every copy of the blockchain. The consensus mechanism supports coordination across a distributed system, and also makes it very hard to hack the blockchain. Any tampering of the blockchain would be immediately apparent and would invalidate the chain.  

51% Attack

In theory, an attacker that controls 51% of the Bitcoin network could approve the addition of an invalid block. This hypothetical situation is virtually impossible, especially on a blockchain as well-established as Bitcoin. The amount of computing power and real cost required would be immense. And the gains? Questionable, as the hacked blockchain and its crypto asset would decrease quickly in value. Contrast this with the many economic incentives of supporting the network, and you get a glimpse at how ingenious the Bitcoin infrastructure really is. 

How To Use Bitcoin

While Bitcoin can be used to make payments, it may also function as a store of value. Unlike fiat currencies, it cannot be easily produced, nor does it run the risk of depreciating because of inflation. Bitcoin also has a supply cap, meaning that there is a fixed amount of BTC that will ever exist (21 million BTC).  

For the layperson, Bitcoin is fairly easy to use. Once you buy some Bitcoin through an exchange, you can send the BTC to other wallets. This is currently done by using long, randomly generated wallet addresses. They look like nonsensical numbers and letters, but they are actually the holding places of bitcoin on the network. You can send bitcoin to a friend, to another wallet that you own, or to a merchant for purchases - just as Nakamoto had envisioned!

Most mobile apps for spending bitcoin allow you to scan a QR code to easily send and receive BTC. Over time, it will become even easier.

Here is an example of a Bitcoin wallet address presumed to belong to Satoshi Nakamoto: 12c6DSiU4Rq3P4ZxziKxzrL5LmMBrzjrJX

An increasing number of companies are beginning to accept Bitcoin as a form of payment for their services. So yes, you can use BTC to buy your next plane ticket. Or your Tesla (for a time). And soon, maybe anything on eBay. 

Takeaways

So why Bitcoin? Many consider Bitcoin as a solid investment choice for several reasons, not least of them being that it breaks down some barriers to entry into traditional finance that the un-banked face. By providing a decentralized, transparent, and accessible alternative, Bitcoin overcomes the gatekeeping practices that the financial sector usually implements. The Bitcoin network requires far less sensitive information from users, while simultaneously safeguarding the data it does have through public-key cryptography. And the larger the network, the more secure it becomes.  

We have seen that more outlets, not fewer, are supporting payments in bitcoin. We are also seeing more and more traditional financial institutions include bitcoin in their books. Expect this trend to continue through the decade.