Bitcoin has opened the era of cryptocurrency and still remains at the top spot among digital currencies a decade after its birth.
Enthusiasts admire it, governments feel threatened by it, and newbies are both curious and cautious of its use.
So what really is Bitcoin, and how does it work?
Let’s dig into an introductory lesson of this crypto giant that many have claimed to be the currency of the future.
Understanding How It Works
Bitcoin is a virtual currency created to eliminate the need for middlemen and banks.
It has had a colorful history (which we will tackle later) and continues to draw attention even as many other digital currencies have already joined its ranks.
Here, transactions take place with incredible privacy. It’s one of Bitcoin’s best features — you can buy some merchandise and simply pay with bitcoin anonymously.
Here’s how it works.
Peer to Peer
Bitcoin (the concept/system; goes with a capital “B”) makes use of peer-to-peer technology to enable instant and direct payments of bitcoins (the “coins” or currency; goes with a lower case “b”).
Peer-to-peer (abbreviated as P2P) systems allow for direct transactions between “peers,” which means there’s no need for a central server. That’s the case for Bitcoin, as there’s not a bank or government that regulates or owns it.
Bitcoins are purely digital. There is no physical “coin” — only a distributed ledger containing all transactions and balances. This ledger’s in the cloud, and it’s open to the public eye.
This ledger system is called the blockchain.
As a fully peer-to-peer electronic cash system, Bitcoin has no trusted third party and is not controlled by anyone.
Bitcoin transactions are instead verified by a network of computers.
Private Keys and Public Keys
“Keys” are long strings of letters and numbers that are linked together through an encryption algorithm. Bitcoin was created through this mathematical algorithm. It’s the keys that record the balances of Bitcoin tokens.
There are two kinds of keys in Bitcoin terminology and operation: public and private. The public key functions like your bank account number. It’s open to the world, and it’s the address through which anyone can send you bitcoins.
The public key appears in the blockchain (the ledger) as your digital signature.
Meanwhile, the private key is like your PIN. It has to stay private as it’s used for authorization purposes during Bitcoin transactions.
If you lose your private key, you will lose your access to your Bitcoin wallet — just like what happened to this man in December 2017.
Mining and Keeping the Ledger Updated
“Mining” bitcoins is how they are released into circulation. Those who participate in the process are called “miners.”
Miners try to solve computational puzzles through their computers. These puzzles are actually processes that try to validate the bitcoin transactions that take place between users. So in a way, miners act as auditors.
When miners complete a new block of verified transactions, this block is then added to the blockchain — the public ledger. So the mining process actually keeps the ledger updated.
As a reward for discovering the solution to the computational puzzle first, a few new bitcoins are released to a miner.
The release is executed at a fixed rate, but this rate drops periodically as the total bitcoins in circulation approach 21 million.
You see, one block was initially rewarded with 50 new bitcoins. For every 210,000 new blocks discovered, the reward is halved. So, when the first 210,000 blocks were reached, the prize became 25 new bitcoins per block.
So, the closer we get to 21 million, the more difficult the mining endeavor becomes.
Not Every Coin is in Circulation
Currently, there are less than 3 million bitcoins that have not yet been mined.
It appears that we’re close to the release of all bitcoins — but not really. If ordinary desktop computers quickly solved the puzzles before, they’re far from being competitive now.
To mine bitcoins at this stage, miners need to use high-powered computing systems with advanced GPUs (Graphics Processing Units) and sophisticated hardware with ASIC (application-specific integrated circuit).
Computers (or a network of them) that are optimized for mining are called “mining rigs.” One bitcoin miner named Kevin Groce has built a $4,000-worth set of mining rigs in 2011 and has mined a steady flow of bitcoins, generating about a thousand dollars worth of them per month.
Today, mining rigs may need to be more powerful and costly to be competitive enough against the supercomputers of pooled computer networks by groups of miners.
Designed to Be Deflationary
Unlike centralized banking systems where the rate of currency release matches that of the growth of goods, Bitcoin is designed to be deflationary.
A deflationary currency is related, nearly, to being inelastic. Bitcoin is inelastic; it has no counterparty risk. It also solves the “double-spend problem” – the problem in which the same currency can be spent more than once.
In fact, the double-spend problem is characteristic of fiat currencies, where counterfeit paper money can be created to conduct more transactions through the new (but fake) amount that did not exist previously. Such problems lead to inflation.
And Bitcoin is designed to defeat that through cryptographical rigor.
How Secure Is It?
The security of Bitcoin transactions against fraud – especially double-spend attempts — comes from two major points.
First, there’s this mathematical/computational barrier that makes it hard to “fork” or divert from the original and honest blockchain, i.e., the chain or ledger of verified transaction records.
Here’s an example.
Suppose Rob has 3 bitcoins that he’s already spent in buying a piece of cake from Fred. The transaction is recorded and is now being validated in the blockchain.
Now Rob wants to try and send the same 3 bitcoins to Suzy. The Bitcoin system itself makes this move impossible — unless Rob makes the effort of starting a “fork,” which essentially represents another version of the transaction history.
Rob can create his own fake transaction chain containing his attempt to use the same 3 bitcoins the second time, i.e., to make a double spend. But, for this chain to be believable, it has to be the “longest” or most worked-out chain out there, i.e., the chain that miners in the whole Bitcoin network trust and keep updating.
So, Rob has to solve the computational puzzles required to validate his fake chain. The difficulty is like trying to win the lottery, not just once. But again and again and again and again.
That’s just too improbable.
Now, even if this was at all possible with the use of incredible computing power. Assume that 51% or a majority in the Bitcoin network have decided to pool their resources just to help Rob make the fake chain become the new trusted chain. On the brink of execution, a second security factor then comes to mind and simply outweighs the very idea of executing the fraud.
And here’s the second security point. If Rob or his network of friends has, after all, all that kind of computing power necessary to fork a fake chain and make it the longest, then here’s the catch. It would be more rewarding for them just to use that computing energy to mine Bitcoins legitimately instead.
They could gain more.
And yes, that’s one of Bitcoin’s greatest strengths. There’s actually an economic incentive for Rob — or any other person who attempts to conduct a fraudulent Bitcoin transaction — to behave rather honestly.
Not only can he mine new bitcoins, but he can also get a transaction fee for each transaction in the block that he’s validated.
And if in any case, Rob’s friends would still decide to launch a “51% attack,” it’s possible that the rest of the network would pull out even sooner in the face of such a threat — leaving the value of each bitcoin to a considerable drop.
Again, the decentralized system that characterizes Bitcoin simply rewards honesty more than anything. And that fuels Bitcoin’s security.
How To Use It
Bitcoins can be used for an exchange of goods, just like traditional currency. In fact, many businesses already accept bitcoin as payments.
Other users may choose to hoard as much bitcoin as they can, trusting that the cryptocurrency will further increase in value and, therefore, can become very profitable in the future.
Where To Store It
Digital currencies need digital wallets for storage. As for storing bitcoins, well, you’re going to use a Bitcoin wallet.
A Bitcoin wallet exists either on your computer or in the cloud. It serves as a kind of virtual bank. With it, you can send or receive bitcoins, make payments, or simply store and save your money.
Unlike a bank account, though, a bitcoin wallet is not insured by the FDIC (Federal Deposit Insurance Corporation).
We’ll talk more about bitcoin wallets later as we look at how you can start buying or selling bitcoins.
In the meantime, let me brief you about Bitcoin’s history.
A Brief History
To many, Bitcoin has always been attractive as parts of it are shrouded in mystery, even from the beginning.
Inception – Satoshi Nakomoto
Bitcoin was created and launched on January 3, 2009, by a mysterious individual (or a group of individuals — we’re still unsure) who hid under the name Satoshi Nakamoto.
It was on this day that the first Bitcoin block — called Block 0 or the “genesis block” — was mined. It contained the following text along with standard data:
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
Satoshi Nakamoto, who had claimed to be a 36-year-old Japanese guy, was apparently disappointed by the financial crisis of that time.
Thus, he wanted to create this currency that was free from predatory politicians, bankers, and unpredictable policies.
As such, Bitcoin was conceived with that principle in mind. It’s software-operated, and Nakamoto wills it to be for as long as it exists.
It appears that for roughly a year before the launch, he’s already been working on the Bitcoin algorithm.
October 31, 2008 — Nakamoto made the announcement that he has been working on this new electronic cash system.
August 18, 2008 – A few months earlier, the domain name bitcoin.org had already been registered.
Then Nakamoto launched Bitcoin on that unassuming day in January, with 30,000 lines of code.
Nakamoto’s invention began to draw interest in a steady fashion. The second block, Block 1, was mined six days after the launch.
Soon, more and more people were invested in bitcoin mining. The fastest computers then won the first few bitcoins.
First Major Rush
The years 2011 to 2013 can be considered as the early adopters’ phase. During this time, Bitcoin has started to attract the interest of investors, entrepreneurs, and even the press.
The first generation of companies related to Bitcoin has also begun. This included merchant processors, exchanges, and wallet providers.
Second Major Rush
In 2013, the venture capital phase of Bitcoin was considered to have begun. World-class VCs poured over $90 million into Bitcoin-based businesses that year. The year 2014 saw more investments coming — reaching more than $300 million in total. Compare that to the $250-million investments in Internet-related ventures back in 1995.
The Bitcoin Fork
A Bitcoin “fork” is an offshoot of Bitcoin. I’ve used the term “fork” in describing a fraudulent attempt to create a new blockchain that carried a double-spend transaction. That’s one way of viewing a fork.
But the Bitcoin forks users approve of are actually solutions. As Bitcoin later became more popular, the technology slowed down, and transaction fees went higher.
This is where the forks are needed.
Forks introduce a new set of rules or protocols for Bitcoin to follow without compromising the original product.
Two types of Bitcoin forks exist — the soft and the hard forks.
A soft fork introduces a change to the protocol but not the end-product. It’s also backward-compatible, which means that the new set of rules is still recognizable by the older nodes in the network.
Meanwhile, a hard fork is a new version of Bitcoin — totally split from the original. It’s like an organizational split.
The most known examples of hard forks are the Bitcoin Cash and the Bitcoin Gold. These are separate cryptocurrencies that still belong to the Bitcoin family, but they operate independently under different rules.
Let’s take time to highlight Bitcoin’s fundamental properties.
It Is Decentralized
Everyone can take part in the mining and exchange of bitcoins. Its design is public and open-source. There’s no central controller — the users’ activities dictate Bitcoin’s movements.
It Has A Limited Supply
As I’ve already mentioned, there will be only 21M bitcoins. Nakamoto designed the total number to be finite. This actually gives each bitcoin more value than if there were an infinite number of bitcoins that can be generated.
This 21M bitcoin limit is expected to be reached by the year 2140.
It Operates In Semi-Anonymity
Bitcoin transactions are open to the public — but not the names of buyers and sellers. These individuals are only represented by their wallet IDs.
This semi-anonymity allows you to buy or sell anything while keeping the transaction from getting traced back to you and to who you’re transacting it with.
For this reason, bitcoin has become the currency of choice for some illicit activities, including the buying and selling of drugs online.
Its Transactions Are Irreversible
It’s not possible to reverse your bitcoin transaction. That means no refunds. In 2016, for instance, one user had accidentally sent $137,000 worth of bitcoin instead of $5. There was no way to retrieve it.
Its Divisibility Enables Microtransactions
Around the year 2140, as the last bitcoin is mined, there will be
20,999,999.9769 — or when rounded off — 21 million bitcoins in circulation. You might still be asking up to this point if that is even enough for the global userbase. Apparently, yes, thanks to bitcoin’s divisibility.
That is, 0.00000001 bitcoin = 1 satoshi. This means a bitcoin is divisible by eight decimal points, and the smallest unit is called a satoshi — obviously derived from the first name of Bitcoin’s creator.
In other words, one bitcoin can actually be broken down into 100,000,000 satoshis.
So, 1 satoshi could be about fractions of a cent in value.
In terms of online or digital sales, Bitcoin’s divisibility is quite significant. It enables the conduct of microtransactions. And these are transactions that require only small amounts of currency to be paid, and that would’ve otherwise been inefficient and costly if done with credit cards with their corresponding fees.
Legislation, Countries, and BTC
Since Bitcoin is still relatively new, countries all over the world have had varying responses to it.
How Governments Responded
Governments have become concerned about how to manage taxation with Bitcoin, as they lack control over it. Bitcoin is, essentially, a rival to fiat currency.
To regulating bodies, Bitcoin may pose dangers, especially if it’s abused in money laundering and tax evasion cases, as well as in black market transactions and other illegal activities.
As a result, some governments have already imposed rules around bitcoin use.
In 2015, the NYSDFS (New York State Department of Financial Services) had ruled that transactions worth $10,000 or over will need to be recorded and reported.
Meanwhile, other countries have been more welcoming in terms of taxation.
In 2014, Finland exempted bitcoin from VAT. It now treats bitcoin as a commodity — like gold.
Bitcoin is also VAT-free in Switzerland.
Current Legal Standing
Some countries have banned Bitcoin, ruling it as illegal. These include Saudi Arabia, Algeria, Bangladesh, Bolivia, Ecuador, Kyrgyzstan, Morocco, and Nepal.
Other countries aren’t fans of Bitcoin and aren’t sure about accepting it. Thailand, for instance, had banned Bitcoin in 2013, but in 2016, the Bank of Thailand suggested that it’s not illegal.
Meanwhile, China, Japan, and Australia have been eyeing out on Bitcoin regulations.
Bitcoins – The Birth of Blockchain
Bitcoin’s open-to-the-public ledger was the very first blockchain.
What is Blockchain?
Blockchain is just like a chain of blocks but in the digital sense. The “block” is the digital information, while the “chain” is the public database.
Blocks have three parts.
- Blocks store transaction data such as the date, time, and amount of purchase.
- Blocks store info about the participants of the transaction, but not their actual names — only unique identifiers called “digital signatures.”
- Each block stores data that allows them to be distinguished as a block unique from the rest. This unique code is called a “hash,” and it’s more like a unique name for each block.
On the blockchain, a single block can store up to 1MB of data. Many transactions take up only a few bytes to kilobytes, so there would mostly be a few thousand transactions within each block.
Blockchain could realistically be more important than Bitcoin
Researchers Stuart Haber and W. Scott Stornetta were the first to outline blockchain technology in 1991. It was only almost two decades after that that blockchain saw its first real-world application through the launch of Bitcoin.
But aside from just storing monetary transactions, blockchain technology turns out to be useful in many other areas.
For instance, the technology can be used to store information about property exchanges. It can even be used to record votes for a candidate.
In fact, a Deloitte survey of 1,000 companies has revealed that 34% had already integrated the blockchain tech in their production. Meanwhile, there’s another 41% that have been planning to follow the same path.
Among other industries, the banking industry can see itself profiting the most from an integration of the blockchain system. You know how banking verifications can take 1 to 3 days to settle.
But with the blockchain system that never sleeps or takes a weekend break, any transaction can be processed in as little as just 10 minutes. And that’s basically the time needed to add a block to the chain.
Blockchain technology sees potential uses in the following areas.
- Healthcare. Personal health records can now be stored in the blockchain, thereby preserving and ensuring their privacy.
- Property Records. Recording property rights can become more efficient, and your deed kept accurate and permanent.
- Smart Contracts. Contracts can be digitized, and terms can be carried out automatically.
- Supply Chains. It will be easier to verify the authenticity of the products and their labels.
- Elections. Tampering with votes can become nearly impossible. Transparency becomes a reality, and results can be obtained instantly.
By introducing a practical use of blockchain, Bitcoin has indeed inspired many other applications — including the birth of many other cryptocurrencies.
The Father of Many Many Crypto Currencies
Today, Bitcoin is not alone in the world of cryptocurrency.
The Rise of Litecoin
Litecoin was launched in 2011 as an alternative cryptocurrency. It’s patterned after Bitcoin and created by Charles “Charlie” Lee — an MIT graduate and former Google engineer.
Litecoins were aimed at being the silver to the gold of Bitcoin. Litecoin was in many ways similar to its father but has improved upon the inefficiencies of the pioneer.
It has four times faster block generation time (2.5 minutes) and four times the coin limit (84 million). Its rewards are halved every 840,000 blocks.
The Rise of Many other Alternative Coins
Aside from Litecoin, many other alternative cryptocurrencies rose after Bitcoin’s success. Collectively, they are known as altcoins.
Altcoins (in essence, “alternative coins”) include the following leading examples (listed with their launch dates):
- Namecoin (April 2011)
- Litecoin (October 2011)
- Ripple’s XRP (2012)
- Peercoin (August 2012)
- Dogecoin (December 2013)
- Ethereum’s Ether (July 2015)
The Rise of Ethereum
Ethereum is actually an open-source computing platform, and it’s used for its own cryptocurrency, known as the ether (ETH).
Launched in 2015, Ethereum has now become the second most valuable blockchain, just behind Bitcoin.
Ethereum was developed mainly for the creation of “smart contracts.” As described earlier, these contracts are self-executing agreements that are decentralized (no third party or central regulator needed) and are coded into the blockchain.
Ether exists as Ethereum’s internal cryptocurrency and is used for the settlement of the outcomes of smart contracts. But ether can also be mined and traded with bitcoin or other fiat currencies such as USD.
As Bitcoin miners are rewarded with bitcoins, corresponding “nodes” or miners in the Ethereum network are also paid with either for their computational effort.
An Extremely Crowded Cryptocurrency Scene
As of May 2018, there are already more than 1,500 altcoins. It can be said that the cryptocurrency scene is already too crowded for more altcoins to enter in.
And yet, Bitcoin retains its dominance. It has even been described as the “world’s most crowded trade,” according to fund managers.
Investing In Bitcoins
In 2016, the value of a bitcoin was $710.09. By the end of October 2019, the bitcoin price index (or the average of bitcoin prices across leading exchanges globally) has amounted to $9,225.
Now you’re thinking — if only I had bitcoins three years ago, or even earlier!
Well, it’s not yet too late to invest in the original cryptocurrency.
To buy bitcoin, you need to have the following.
- Digital wallet. It’s composed of your public key (your digital signature) and private key (your password).
- Personal documents. These are used when registering for digital wallets as required by the US SEC (Securities and Exchange Commission) under its Anti-Money Laundering Policy.
- Secure internet. It’s not safe to access your digital wallet and trade bitcoins over a public and insecure wifi network.
- Bank account or credit and debit cards. Your digital wallet can connect to these accounts, the funds of which will be used to buy bitcoins.
- Bitcoin exchange. Exchanges are similar to the platforms used for buying stock. A bitcoin exchange can connect you to the bitcoin marketplace, where you conduct the “exchange” of traditional currencies (from the payment method you’ve set up in item #4 above) for bitcoin.
Today, you can buy a fraction of a bitcoin more easily through a software wallet. Software wallets are user-friendly mobile applications that connect with your bank account. One drawback is that they put your money in a third-party company (which could be hacked).
Anyway, users with the most substantial sums of bitcoin would store their money in more secure places.
As for you, you may begin with Coinbase — the most popular software wallet in the US right now. It has both a mobile app and a website, plus it stores 98% of its customer currencies offline to provide greater security. Coinbase can be a great place to start if you’re a beginner.
Meanwhile, hardware wallets store your private key on physical hardware devices. Similar to a flash drive.
Now, with all the other essentials set up, you can start buying bitcoins. If you have $9,225 in the bank, you can already exchange for 1 BTC. But if you’re tight on your budget, you can try buying just 0.00000001 BTC for $0.00009225. Up to you.
Once you’ve already gained a few fractions of a bitcoin (following the above steps) and later you’ve just decided to sell part of that, then you can simply conduct trade on Coinbase.
Use your software wallet’s transfer function, and the rest of the exchange’s processes will be pretty much the wallet’s work after that.
Day Trading BTC
When day trading bitcoins, it’s crucial for you to study the charts yourself.
If you believe the entire cryptocurrency market will increase over time, then aim at collecting as many coins as possible. Get them at the right prices, i.e., buy the lows, and then let the profits run.
Also, seek to diversify your portfolio of crypto assets — don’t just rely entirely on BTC.
Enter and exit positions gradually when the lows get lower, or the highs get higher. Try not to trades over a few times weekly so you can save on fees. Let those bets perform.
Bitcoin Arbitrage and Automated Trading
Bitcoin exchange arbitrage is buying bitcoin on one exchange for a low price and selling on another for a higher price. The result is an instant profit.
In reality, though, executing the bitcoin exchange for arbitrage is not easy. If you conduct the buying and selling manually, the arbitrage opportunity might be easily lost in the process.
Secondly, the spread between exchanges is much smaller now. Such appear from time to time, and you have to be on the watch to spot them. Luckily, there are trading bots that can assist you in conducting automated trading and in profiting from these small differentials.
What The Future Holds For Bitcoin
As opposed to being just another hype, Bitcoin is enormously promising. Given that it has all the volatility and risks characteristic of virtual currencies, its core principle of giving the financial power back to the people remains dear to its believers and continues to inspire the curious newcomers.
To the skeptic, Bitcoin can be a future regret. To the risk-taker, it can be tomorrow’s reward.
You choose your side. After all, Bitcoin survives as long as the network thrives.