Introduction to Bitcoin
Historically speaking, Fiat currency made things a lot easier for us. Imagine living in the Stone Age period when money or banks did not exist. If you needed to buy anything, you would have to exchange some of your goods or provide a service in exchange for what you need. But how were these goods measured? What portion of a bag of rice has the same value as a pair of sandals? All this seems rather hectic, right? However, we solved this challenge more than three millennia ago using Fiat currency.
Although Fiat currencies favor most countries and economies, it’s still flawed. Fiat currencies are based on coercive rather than voluntary market relationships. As such, a central authority is needed to keep it in place. We as citizens don’t have any say in how these fiat currencies operate. Enter cryptocurrencies.
The main point o cryptocurrencies are to fix traditional currencies’ problems by putting power, and responsibility in the currency holders’ hands. Bitcoin was the first digital currency to successfully use blockchain technology to bring this to reality.
What exactly is Bitcoin?
Bitcoin is a peer-to-peer electronic cash system developed in January 2009. It follows the ideas set out in the whitepaper by the pseudonymous Satoshi Nakamoto, the creator of Bitcoin. According to the white paper, Bitcoin is a set of algorithms that generate new bitcoins and distribute them to computer users (also known as miners) who solve pre-specific mathematical challenges. The mathematical challenge requires computational power to solve.
The mathematical problem aims to get a solution that is a number only used once, known as a nonce. Nodes need to find the nonce to generate a solution. The solution is a 64-digit hexadecimal number (like 7B316) that is less or equal to a determined target hash. So, simply put, Bitcoin is a number such as B12345.
To illustrate this, let’s say you have a $5 bill with the serial number G6607081974P. According to the Federal Reserve (FED) policies, no other bill bears the same serial number as your $5 bill. Since the FED backs your $5 bill, it has a face value, and you can use it to purchase anything worth $5.
Now let’s say you and your friend agree that Bitcoin bill B12345 has a face value of $30,000, and you can use it amongst yourself to trade products. Let’s also assume that bill B12345 is an online entry on the internet.
So, the only difference between G6607081974P and the bitcoin bill is that G6607081974P has a physical existence, and face value and the FED backs the bill. On the other hand, the bitcoin bill does not have any physical presence or intrinsic value. Its value is determined by what two people are willing to pay for it.
A short history of Bitcoin
Who created Bitcoin?
Bitcoin was developed by an anonymous person or group of people who went by the pseudo name Satoshi Nakamoto. He published the Bitcoin whitepaper under the same pseudonym. Nakamoto envisioned a bitcoin to be a token of transaction that the world would widely adopt to protect the economy against inflation in the whitepaper.
However, Up to date, nobody knows who is behind the pseudonym. After developing the Bitcoin blockchain, Nakamoto was the first to mine the first Bitcoin blockchain and then mysteriously disappeared in 2010.
Digital cash before Bitcoin
Bitcoin was not the first digital currency to be invented, but it is the most successful. Early developers like Nick Szabo had suggested digital cash systems. Satoshi used most of these previous works to develop Bitcoin.
Some of the earlier inventions include:
Digicash
Founded by David Chaum in 1989, Digicash was one of the earliest electronic money companies. Chaum designed Digicash as an alternative means for users to pay for internet goods and services securely. It wanted to make electronic payments anonymous but unfortunately went bankrupt before fully realizing this goal.
B-money
Proposed in 1998 by Wei Dai, B-money proposed using a Proof-of-work system and distributed databases where users sign signatures. Wei also suggested an idea similar to staking, which is implemented in cryptocurrency projects today. Moreover, B-money is cited in the Bitcoin white paper, and it’s not hard to see why.
Bit Gold
At its core, the Bit Gold concept consists of a ledger that records strings of data originating from proof-of-work operations. Bit Gold and Bitcoin have much resemblance, and many believe that the developer of Bit Gold, Nick Szabo, might be the developer of Bitcoin. Bit Gold is also commonly referred to as the precursor to Bitcoin.
However, much like B-money, Bit Gold was never developed further.
Fundamentals of how Bitcoin works
Distributed Ledger Technology (DLT)
Bitcoin is backed by a DLT known as blockchain technology. Simply put, a blockchain is a decentralised and distributed ledger that records the provenance of a digital asset. As such, Bitcoin data stored on the blockchain is inherently immutable. Blockchain accomplishes this through hashing, which involves passing bitcoin transaction data through a one-direction algorithm. The algorithm produces a unique fingerprint that identifies that transaction.
Blockchain technology stores data in blocks linked together in the form of a chain, hence the name blockchain. Each block has a pointer that chains the hash values and links to the previous block in every subsequent block. Therefore, it’s very difficult to alter an old block as it would require you to change all the following blocks, which will need too much computational power. These features make Bitcoin inherently secure.
Bitcoin’s internal transaction architecture? (Cryptography)
The Bitcoin network and ledger is an open network that does not use encryption for security and privacy purposes. All the data passed is unencrypted to allow total strangers to interact with each other. To ensure privacy and security, Bitcoin implements digital signatures.
A digital signature is more like a physical signature but far more secure. The digital signature has three main parts: a public key, the data (which can be any digital data), and the signature itself.
In the Bitcoin network, a public signature is a form of identity that informs the network who is sending or receiving the data. The signature or private key is a mathematical proof of the public key’s owner and the corresponding public key.
Like your bank account data, you can look at it this way:
Public key: Bank account number
Private Key: Your password
Data: funds moving from one wallet to another
Sending or receiving bitcoin requires using a Bitcoin wallet, which is software or hardware that can interact with the Bitcoin blockchain. Each wallet consists of a public key, known as a wallet address. Unlike your bank’s account number, the Bitcoin address is a combination of numbers, letters, and characters, like 1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2. Bitcoin addresses are not attached to your personal data, and all your transactions are anonymous.
How are bitcoin transactions processed?
To better understand how Bitcoin uses digital signatures to ensure the integrity of transactions created on the network, let’s go through a case where Alice sends .05 bitcoin to Bob.
At a high level, Bitcoin transactions have three main components:
Input: Alice’s bitcoin address and a record of the BTC Alice wants to send,
Output: Bob’s public address
Amounts: the amount of bitcoin Alice wants to send.
For Alice to send 0.5 BTC to Bob, she will sign the transaction message with the transaction details and her private keys. The transaction message will contain Bob’s and Alice’s public address, the BTC amount, and the previous block’s hash value.
Alice then broadcasts the transaction to the Bitcoin network. Using Alice’s public key, the network nodes will verify that Alice is the one who initiated the transaction. They also confirm that the input amount is enough to support the transaction and pay the transaction fees. If everything checks out, the network directs transaction data to the memory pool — a space dedicated for valid but unconfirmed transactions.
If the transaction is valid, 0.5 BTC is sent to Bob, and the network updates their wallet balances into a new state. The state is passed to a mining node that orders this transaction in a block template (this is the blueprint of the block the miner wants to append to the blockchain). If the miner is successful, they append the block to the blockchain. The block becomes immutable once it is appended, and transactions are irreversible.
Bitcoin mining
From BitPanda
Bitcoin mining is the process of adding new transactions to the Bitcoin blockchain. When a user sends bitcoins, the network records the transaction details and any other transactions processed during that period. The transactions are hashed and added into the ledger in what are known as blocks.
To successfully append these blocks to the blockchain, Bitcoin nodes known as miners need to compete to solve extremely complex math problems in a Proof-of-work (PoW) mechanism. To append the block to the blockchain, miners need to prove that they have used computational power to solve the problem.
If a miner solves the problem and appends it to the block, the network rewards them with BTC (a block reward). As of February 2022, miners receive 6.25 BTC as block rewards derived from transaction fees charged to users and fresh bitcoins generated from every block generation.
Each block appended to the blockchain is attached to the previous block with a hash value. This ensures that the bitcoin balances are updated and balanced after every transaction. Blocks are also generated after every 10 minutes to ensure that two blocks do not process the same transaction.
Initially, it was relatively easy to mine bitcoin, but it has become difficult over the years. The Bitcoin code is written in such a way that as the mining devices get more advanced, the mathematical problems become more complex. This is known as the hash rate — the measure of computational power used to verify transactions and add blocks in a Proof-of-work (PoW) blockchain. If miners use more advanced devices, the hash rate increases.
The economics of Bitcoin
Bitcoin halving (what is it?)
One of the most valuable aspects of Bitcoin’s blockchain is bitcoin halving. It induces inflation in bitcoin’s price by reducing the number of bitcoins generated each time miners generate a block. After every 210,000 blocks are generated, or roughly every four years, the amount of block rewards per block is split in half.
From Coindesk
During its launch, the block reward issued to miners was 50 blocks. After the first halving in November 2012, it was 25, then 12.5 on July 9, 2016, and recently 6.25 as of March 11, 2020. The next halving is expected in 2024, while the last halving is expected to occur in 2140.
Why does BTC halving matter?
Unlike Fiat currency, which has an unlimited supply and the Treasury can be print dollar bills at any time, Bitcoin is profoundly deflationary. It has a fixed supply of 21 million bitcoins and can only be produced by investing electricity and computational power.
Many cryptocurrency enthusiasts think of Bitcoin as the hardest form of currency ever known. Like gold, this means that Bitcoin has a limited supply and requires users to sacrifice something to generate new Bitcoins. If Bitcoin reaches its maximum supply, the demand for bitcoin will increase, and the prices will surge — Demand and Supply theory.
What are the implications (effects) of BTC halving?
In each of these halving events, the bitcoin price surged. The first halving in November 2012 saw an increase from $12 to $1,217 in just one year. The second halving on July 9, 2016, the price was at $647, and by December 2017, it surged to $19,800. At the most recent bitcoin halving on March 11, 2020, the BTC price was at $8,787, and after about 11 months, the price soared to $64,507. An astonishing 634% price increase since the BTC halving day.
How does the BTC halving affect the BTC network?
The theory behind Bitcoin halving mainly aims at:
Half the block rewards → and half inflation → lower the supply of BTC generated → increased demand → higher prices → miner’s incentive increases despite the small number of block rewards due to increased prices.
If a halving does not increase the bitcoin price, then miners would end up receiving low to no incentives. To counter this, Satoshi designed the Bitcoin protocol to lower the hash rate when the price of BTC drops after the block rewards go through a halving. This means that although the bitcoins released as block rewards are still few, the difficulty of processing transactions is also reduced.
Bitcoin halving generally means increased prices due to reduced supply and surging demand for investors. The trading activity also increases on the Bitcoin blockchain, inherently increasing transaction fees.
What will happen after the last bitcoin halving?
Around 2140, the last of the 21 million bitcoin will be mined, and the halving events will end since there will be no more bitcoins to be minted. After that, miners will still continue to validate and append to the Bitcoin blockchain since transactions on the blockchain will continue being initiated.
At this time, miners will receive rewards from transaction fees because the value of bitcoin is expected to surge significantly and the trading volume to increase. As such, the bitcoin price at that time will allow transaction fees to sustain and incentivize miners.
The blockchain trilemma and Bitcoin
The blockchain trilemma
From ICON Pinas Medium – Blockchain Basics: The Blockchain Trilemma
The blockchain trilemma is a widely known belief that decentralized networks like Bitcoin can only provide two of three benefits at any given time with respect to decentralization, speed, and security.
Why does Bitcoin need to scale?
Scalability in regards to blockchain protocols refers to the ability of a network to support high transaction throughput and further growth down the line.
The Bitcoin network is significantly low compared to traditional payment methods like VISA, which handle about 65,000 transactions per second. As it stands, Bitcoin processes seven transactions per second which are very slow for day-to-day payments.
The transaction fees on Bitcoin are also very high. As we discussed earlier, the miner rewards are partly derived from transaction fees. As such, they seek to make maximum return on their investment by giving priority to transactions with higher fees. If there are many transactions in the memory pool, the fees might significantly rise as users bid higher.
Scaling solutions on the Bitcoin network
Bitcoin developers added layer 2 on top of the Bitcoin blockchain to support more efficient functionality to counter the scaling challenges. This additional functionality includes faster transaction processing and lower transaction fees.
Most of the layer 2 solutions are achieved by processing the bulk of the transactions off-chain and transferring the completed transactions to the core Bitcoin ledger. Layer 2 protocols can be thought of as separate networks built on the core Bitcoin layer.
One of the notable layer 2 scaling solutions is:
Lighting network
From Blockonomics Medium – 7 Reasons why the Bitcoin Lightning Network is Growing
The Lighting Network is a scalability solution that allows users to send and receive BTC quickly with low transaction fees. It is built off-chain for users to conduct bitcoin transactions to reduce on-chain network congestion.
Two parties create a channel by locking up their bitcoin in a special address to get started. They can then use this channel to transfer bitcoin between themselves with near-zero fees. All these happen off-chain, and the transaction details are not broadcasted to the core Bitcoin network.
When either party wants to close the channel, they’ll have to settle the channel and mark the transactions as complete. The channel will send funds to each party according to the transfer history, summarised in one transaction passed to the core blockchain. Therefore, the only transactions send to the core blockchain are the opening and closing transactions.
The Lightning Network frees up block space and supports lower transaction fees and increased economic activity per block.
Some other popular Layer 2 scaling solutions on the Bitcoin Network are Liquid Network, Omni Layer, Liquid Layer, and Wrapped Bitcoin (WBTC) layer, to mention a few.
Bitcoin forks
Since the Bitcoin blockchain is an open-source network, anyone can contribute to the network code. However, there are cases where developers want to implement different solutions. If the developers disagree on which solution or upgrade to implement, the blockchain will diverge into other chains, each with its own rules.
Blockchain forks are also another through which Bitcoin solutions are implemented. There are two main types of blockchain forks.
Hard fork
In simple terms, a hard fork is a change to the blockchain protocol that renders the older version of the blockchain invalid. It’s a backward-incompatible upgrade to the blockchain. If the older version continues running, we end up with two different blockchain protocols, each with different rules and two currencies.
All the balances of the old protocol will also be cloned and updated to the new one. So if you had 10 BTC on the old protocol, you would have 10 BTC worth of the new cryptocurrency in your wallet.
A hard fork would be necessary with bitcoin when changing some of its determining parameters such as block size, mining difficulty, and data added on the block. For instance, in 2017, Bitcoin went through a hard fork when the users could not agree on the block size. On the one hand, some users wanted to increase the block size to ensure more throughput and cheaper transactions. On the other hand, the other users believed this to be an inefficient scaling solution.
Eventually, the Bitcoin network diverged, and Bitcoin Cash was developed. Bitcoin cash now allows a larger block size and has an independent community and roadmap.
Soft fork
Soft forks are a forward-compatible upgrade that allows developers to add new features and functionalities to the blockchain protocol without changing the rules it follows. They are often used to implement features at the programming level.
Let’s take a block size change as an example. If more than half the bitcoin community accepts to increase the block size, from there on, all blocks must match the newly accepted block size. Older blocks can receive transaction data from the new blocks, unlike hard forks.
Segregated Witness (SegWit) is a good example of a soft fork. Using new techniques, SegWit solves block size limitations that reduce transaction speed and allow for more transactions to be stored in a block.
Bitcoin: A new asset class and an alternative to Fiat currency
What makes bitcoin valuable?
Scarcity
Bitcoin’s primary value is a function of scarcity. The cryptocurrency has a maximum supply of 21 million. Therefore, as supply reduces, demand increases, and investors rush to get a share of cryptocurrencies. The bitcoin price has been steadily rising since it was created due to this increased demand and its deflationary nature made possible by Bitcoin halving.
Investor Sentiments
“Bitcoin has value because people think it does,” says Bryan Routledge, associate professor of finance at the Tepper School of Business at Carnegie Mellon University. Another critical factor that gives bitcoin value is people’s sentiments. Over the past decade, many people have accepted cryptocurrencies as an alternative to Fiat currency.
Bitcoin has intrinsic value
Another theory is that bitcoin has intrinsic value based on its marginal cost. Mining or generating bitcoin requires a great deal of electricity and computing power which are quite expensive. Evidence has shown that the price of Bitcoin tends to follow its hash rate (cost of production), which is why it is valued over 10 times more than Ethereum, the second-largest crypto by market cap.
Decentralised and easily accessible
Most investors also value Bitcoin because it is decentralised, meaning that no single entity can control it. Therefore, investors can access the Bitcoin network from anywhere globally without the need for any financial institution.
Is Bitcoin legal?
Bitcoin is legal in some countries, but a few have taken a rather strong approach and banned bitcoin. For most countries, their stand on crypto regulation is unclear, and investors can invest in bitcoin without worrying about taxes or compliance.
Governments have taken different approaches to handle taxation and compliance issues in countries that declared bitcoin legal. So, be sure to research the crypto laws in your jurisdiction before investing in bitcoin.
Ways to buy bitcoin
When it comes to buying bitcoin, you have several options to choose from, each with its pros and cons:
Cryptocurrency exchanges: this is the most widely used method to buy bitcoin. CEX.IO Exchange is a good example. Like most other crypto exchanges, CEX.IO provides a digital wallet, the CEX.IO Wallet, where you can securely store your bitcoins.
To buy bitcoin on the CEX.io Exchange, go to the Buy and Sell Bitcoin portal.
Peer-to-peer trades: allows you to buy bitcoin directly from another person who has bitcoin in their wallet. However, this is very risky, and you should be cautious when using this method.
Payment with financial service companies: some financial Apps like Robinhood, Paypal, and Venmo allow you to buy bitcoin. Such Apps have digital wallets embedded within them to store your bitcoin.
Bitcoin ATMs: Although not popular and quite expensive, bitcoin ATMs are the quickest and easiest method.
How to make money with bitcoin?
There are several different ways to invest in Bitcoin on CEX.IO, both directly, and indirectly.
Directly investors buy and hold bitcoins for the long term with the expectation that the price will rise in the future.
Other investors choose to actively trade bitcoin to take advantage of the price changes in the short to medium periods. While both strategies are risky, they offer more profits than other less risky strategies.
Some investors also want to take advantage of both strategies. They hold bitcoins in one wallet and then actively trade bitcoin on another wallet. As such, they get both the long and short-term profits from price changes.
Investors can also participate in Bitcoin mining outside our platform by joining a mining pool or creating your mining station (though it’s pretty expensive). This way, you can receive newly generated bitcoins, and bitcoins from transaction fees.
How to keep your bitcoin safe
Like your real-life wallet, your Bitcoin wallet should also remain secure. Bitcoin makes it possible to transfer value easily, and it allows you to stay in control of your money. However, unlike your traditional wallet, once a bitcoin transaction has been processed, it cannot be reversed. Therefore, you should always keep your wallet safe and ensure that no one gains access to your wallet details, more so your private key.
There are many options to store your bitcoins, each with its pros and cons
Storing bitcoin on CEX.IO
CEX.IO acts as a custodial wallet, meaning that CEX.IO will store your bitcoins on your behalf. CEX.IO will hold total control of your public and private keys in such a case. You’ll need to log in to the CEX.IO platform to make any transactions. If you are a frequent trader, this method is ideal since you can easily access trading pairs and other crypto assets.
Storing in a bitcoin wallet
Unlike a custodial wallet, non-custodial wallets give you total control over your private and public keys and your bitcoin funds. There are two types of non-custodial wallets:
Hot wallets
A hot wallet is a software that connects to the bitcoin blockchain and allows you to interact with it. It can be a mobile, web, or desktop application. Because hot wallets are always connected to the bitcoin network, they are ideal for frequent traders and day-to-day transactions.
Some of the most popular hot wallets are Trust wallet and Metamask.
Cold wallets
Cold wallets are hardware wallets that are not connected to the internet. They are ideal for investors who want to store large amounts of bitcoin for a rather long period. Some of the best hardware wallets are Ledger Nano and Trezor wallets.
Where can I spend bitcoin?
While the number of companies accepting bitcoin has grown over the past decade, large purchases are quite rare. There are several merchants that allow you to purchase airplane tickets, real estate, food & drinks, clothing, gift cards, and online subscriptions, to mention a few. Moreover, there are large companies that accept bitcoin as a payment method. Some of them include:
Online stores: Overstock, Home Depot, Newegg, Shopify, and Microsoft
Service provider: AT&T, Twitch, NordVPN, WordPress, Reddit, and Bloomberg
Travel companies: AirBaltic and Virgin Atlantic
Restaurants: Subway, Burger King, and Wholefoods.
How can you participate on the Bitcoin network?
Running Bitcoin nodes
In the context of the Bitcoin network, a Node is a program that supports the key functions of Bitcoin like validating and processing transactions and storing block data. Nodes can be any device, from mobile phones operating a digital wallet to a PC or Laptop that stores the entire blockchain.
There are two main types of nodes:
Full nodes
A full node is responsible for verifying, authenticating, and storing all transactions occurring on the Bitcoin network. It is a data incentive since it stores the entire Bitcoin ledger. Most full nodes run the Bitcoin core software, which is the reference implementation of the Bitcoin protocol.
Full nodes also ensure that transactions and blocks conform to the consensus rules of the Bitcoin protocol. If a transaction violates any of the Bitcoin rules, the full nodes have the authority to reject the transaction.
If a full node stores the entire Bitcoin ledger, they are referred to as archival nodes. Currently, the Bitcoin ledger is 324 GB. Some users opt to discard older blocks to create space on their nodes.
Light node
Unlike full nodes, light nodes do not contribute to the security of the blockchain as they do not store the entire blockchain. They mainly allow users to check if transactions are included in a block or not through the block header. The block header is a small portion of the block that contains all the block’s data but as a hash value. This hash value is used on light nodes to verify every transaction on the block without necessarily knowing all the data in the block.
Light nodes are ideal for devices with low bandwidth like mobile wallets and PC applications.
Bitcoin Mining nodes
Mining nodes are like full nodes but with the additional task of producing blocks. To be able to mine bitcoins, you have to invest in specialised mining hardware and programs. The mining nodes are composed of racks of servers with special-purpose chips (ASICs) designed to solve the complex mathematical problem in a proof-of-work mechanism.
With the current hash rate and increased competitiveness in Bitcoin mining, it’s almost impossible to mine bitcoin with just one ASIC miner. Most miners join pools where they join their mining power to increase their computational power and likelihood of solving the problem. However, if you want to run your own ASIC miner, you’ll need to run a full node.
Contributing to the Bitcoin Core project
The Bitcoin Core projects operate an open contribution model that allows anyone to contribute towards the development in the form of:
- Writing and reviewing code,
- Reporting bugs and security issues,
- Writing documentation for users and developers,
- Translating the user interface or
- Providing tech support to other users
Final Thought
Since its inception, Bitcoin has been the leading and most popular cryptocurrency. Although it was intended to facilitate decentralised peer-to-peer transactions, Bitcoin has evolved to be a store of value competing with traditional assets such as Gold.
“There’s going to be volatility, but it seems to me that now we have a universal acknowledgment that the world needs an inflation hedge, so if you have bitcoin, don’t sell it.” Michel Slayer says. Like Slayer, most experts believe that Bitcoin is the hedge against inflation and the needed solution to the challenges facing traditional fiat currencies and the financial sector.
Today, this transition seems more real than ever, with popular investors like Kevin O’Leary, a previous Bitcoin critic, investing in bitcoin and other crypto-assets.
Hopefully, you now understand how Bitcoin works and its features. If you feel like getting started in the crypto space,
CTA (Button) Buy BTC Today!
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
