Introduction to Bitcoin

by Andrew McGuinness  //  jan. 09, 2018

What are cryptocurrencies?

A cryptocurrency is a digital peer-to-peer currency that uses cryptography as a security measure. This means that a transaction can be carried out between two parties without intermediary. The parties can then agree on price and execute the transaction without revealing personal information.

Cryptocurrencies are decentralized, and that is one of the main advantages of cryptocurrencies to traditional currencies. This means, that no central entity exerts control over its creation, management, or value.

If we take the U.S dollar for example, the Federal Reserve controls the aforementioned elements, thus controlling the value of the U.S. dollar, depending on political or economic conditions. A cryptocurrency has no limit on value and it can reach thousands, or hundreds of thousands, of U.S. dollars in value.

In centralized systems, the central bank controls the supply of currency by printing money. But with decentralized cryptocurrencies, the creation of additional units is made by the entire cryptocurrency system, at a publicly-known defined rate.

Most cryptocurrencies have a cap on the total amount that will ever be created, which mimics precious metals.

Popular cryptocurrencies

More than a thousand cryptocurrencies exist today with a total market capitalization of several hundred billion U.S. dollars in circulation. The most popular and also with the highest market capitalization is undoubtedly the bitcoin. All the other cryptocurrencies go under the name of altcoins. Most of the altcoins are forks of bitcoin with small changes, where some of them have different proof-of-work algorithm. The most popular cryptocurrencies are:

What is bitcoin?

Bitcoin is the first decentralized peer-to-peer digital currency. Transactions with bitcoin are executed between users through military-grade cryptography and without an intermediary (a bank, for example). This makes it fast – unlike banks, where the waiting time is usually 3-5 business days – and without extra fees for international transfers. It also has no limit on the minimum or maximum amount for transactions. Every transaction is verified by network nodes and recorded in the blockchain. As per the words of bitcoin developers: the technology behind bitcoin is open-source; Nobody owns it or controls it, and everyone can take part.

Bitcoin was developed by a person or a group, going under the name of Satoshi Nakamoto in 2008. They also were the first to solve the double-spending problem.

Units of bitcoin

There are three main denominations of bitcoin.

  • Bitcoin (BTC) – 1 bitcoin
  • Millibit (mBTC) – 1 thousandth of a bitcoin
  • Microbit (µBTC) – 1 millionth of a bitcoin

Micro-bitcoin is the most frequently used denomination.

The smallest unit of bitcoin is called a satoshi, which is one hundred millionth of a bitcoin (0.00000001 BTC).

As of 2014 there are two tickers used to represent bitcoin – BTC and XBT. Bitcoin has its own Unicode character, which is ₿.

History of Bitcoin

After the market crash in 2008, Satoshi Nakamoto, the brilliant and so far unidentified creator of Bitcoin, saw that all centralized currencies failed, which led him to create a digital cash system by using the concept of peer-to-peer network.

In 2008 a paper authored by Satoshi Nakamoto called Bitcoin: A Peer-to-Peer Electronic Cash System details the use of peer-to-peer network to create a system for electronic transactions without relying on trust. In 2009 the bitcoin network was created, along with the first open source bitcoin client and the first bitcoins. Satoshi Nakamoto was the first to mine bitcoins and the first block of 50 bitcoins is known as the genesis block.

It is estimated that Satoshi Nakamoto has mined 1 million bitcoins in the early days, before transferring the project to a developer named Gavin Andersen, and disappearing completely from Bitcoin involvement.

The value of the first bitcoins was negotiated by individuals on the bitcoin forum. Since then, a lot has changed. Today, bitcoin exchanges exist where anyone can buy/sell bitcoins, based on supply and demand.

What is blockchain?

The technology behind the Bitcoin is called blockchain. Each block contains a cryptographic hash of the previous block, using a SHA-256 hashing algorithm, which links to the previous block, thus giving the blockchain its name. This cryptographic technology gives people who don’t know or trust each other to create a record of who owns what.

To be used as cash, bitcoin had to be able to change hands without being diverted into the wrong account or to be spent twice by the same person. In traditional currencies the avoidance of such abuses are achieved by passing through third parties, such as banks. In bitcoin, this is where the blockchain technology comes in – it replaces this third party. Blockchain also provides proof of who owns the currency at any given time. The Harvard Business Review also calls it an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way. This ledger is replicated through thousands of computers worldwide and is publicly available, and most important – it’s secure.

This technology makes contracts embedded in digital code and keeps them in a transparent, shared database, protected from tampering or deletion. When every payment has a digital record that can be identified, validated, and shared, intermediaries like lawyers, brokers, and bankers will be unnecessary and eventually will become obsolete. This is the potential of blockchain.

What are blockchain forks?

A blockchain fork is when the blockchain is split into two paths. On the Bitcoin network, forks regularly happen as a part of the mining process when two miners find a block at the same time. When this happens, the network for a short time will fork. The software then automatically selects the longest chain and drops the shorter chain.

Also, a blockchain can fork when developers change the rules in the software to determine valid transactions.

The forks can be:

  • Fork (where all nodes follow the same consensus rules, and it is resolved by the software)
  • Soft fork (a temporary divergence in the blockchain caused by non-upgraded nodes that don’t follow the same consensus rules)
  • Software fork (when some developers create a codebase separately from other developers)
  • Git fork (same as software fork)

Another type of fork is the hard fork, which is a change to the Bitcoin protocol that makes previous invalid blocks/transactions valid, and requires all users to upgrade. This can also change the block structure and difficulty rates.

Via blockchain hard fork, bitcoin has been split three times into:

What is a bitcoin wallet?

The software where bitcoins are stored is called a bitcoin wallet. Wallet programs create public keys to receive bitcoins, and they monitor the blockchain. To spend bitcoins, the user needs a private key and this key is saved in the wallet file. The private key must be kept secure, since this is the only access to the bitcoins in the wallet. If the private key is lost, the bitcoins stored inside the wallet are lost as well.

There are three parts of the wallet system:

  • A public key distribution program
  • A signing program
  • A network program

A full-service wallet is a software, which performs all three of these functions.

The only disadvantage of full-service wallets is that they store private keys on a device connected to the internet, which can easily compromise its contents. That is why some people prefer hardware wallets that store private keys offline so they can’t be hacked.

Bitcoin wallets also need to interact with the peer-to-peer network to get the information from the blockchain and to broadcast new transactions.

Based on the platform where they are installed, there are four types of Bitcoin wallets:

  • Desktop (Linux, Mac, and Windows). These wallets are a great option for users sending payments from their computer, and are completely free of cost.
  • Hardware. These are secure, offline devices, which range from $20 to $400.
  • Mobile (Android, BlackBerry, iOS, and Windows Phone). This type of wallet is meant for people who spend bitcoins on the go.
  • Web. These wallets run on a web browser, and they usually have the lowest security.

Some of the popular Bitcoin wallets are: Armory, Bitcoin Core, Bitcoin Knots, BitGo, Bither, Electrum, Green Address, ArcBit, and mSIGNA.

What is bitcoin mining?

With the utilization of computer processing power, bitcoin mining adds new blocks to the blockchain. In other words, it adds transaction records to the public ledger (the blockchain) of past transactions by creating new bitcoins in each block. However, for a block to be accepted by the network, it must contain a so-called proof-of-work. Bitcoin uses the hashcash proof-of-work as its mining core. The speed at which the computer is completing an operation in the bitcoin code is called a hash rate. The higher the hash rate, the higher the chance of finding a block.

When a block is discovered, the award is a certain number of bitcoins, which is agreed upon by everyone in the network. It started with 50 bitcoins per block and it halves every 210,000 blocks. In 2017 this number was 12.5 coins per block. With the current trend, the next halving to 6.25 coins is expected to happen in 2020.

There are two forms of mining today:

  • Solo mining, where the miner attempts to find new blocks alone. The mining fees and rewards go entirely to the miner.
  • Pooled mining, where the miner joins other miners to find new blocks. The rewards are shared among the miners in a correlation to their hashing power contributed to finding the block.

There is another form of mining called Cloud mining. The users in this case purchase mining capacity in data centers to mine bitcoin without managing hardware, software, electricity, or other issues. This form, although convenient, is considered risky due to a high possibility of fraud or shady mining operations.

Cryptocurrency exchange

For people who are not interested in mining bitcoin but still want to get their hands on the digital currency, they can purchase either from other people through a marketplace, or through an exchange. Also, for those who are interested in trading cryptocurrencies to make a profit, the cryptocurrency exchange is the way to go.

Tokyo-based Mt. Gox was one of the first bitcoin exchanges, and at one point had monopolized the market. In 2013 it handled over 70% of all bitcoin transactions. The next year approximately 850,000 bitcoins were stolen at an estimated value of $450 million at the time. This event forced the company to file for bankruptcy.

Today’s exchanges claim that they have improved their security since Mt.Gox. The most popular cryptocurrency exchanges are:

  • Bitfinex. This is one of the largest cryptocurrency trading platforms, founded in 2012. It offers 22 cryptocurrencies to trade against the U.S. dollar. It also offers trading on margin, trailing stop, One Cancels Other types of trades, and hidden orders. This is a great exchange for day traders.
  • Bitstamp. This exchange was founded in 2011 in Slovenia, but in 2016 moved to Luxemburg. It offers 5 cryptocurrencies to trade. This exchange is more popular in Europe due to allowing deposits through the EU Single Euro Payments Area (SEPA), a convenient way of transferring money between European banks.
  • Coinbase. This exchange is based in California, and it was founded in 2011. It also acts as a wallet for storing or spending bitcoins, and it acts as a bitcoin processor for merchants. Coinbase doesn’t store client’s funds, instead it links their wallet to their bank account, and the purchase/sell may take 3-5 days to fulfill. This makes Coinbase unfit for day trading, but a decent option for directly purchasing bitcoins and storing them in their wallet.

Some of the other cryptocurrency exchanges are:

Other ways of buying bitcoin

If buying bitcoins through an exchange sounds complicated, there are two thousand active bitcoin ATMs throughout the world. Also, there is a possibility to buy bitcoins without using ATMs. Many providers offer bitcoin to cash and cash to bitcoin services.

Advantages of bitcoin over altcoins

Bitcoin is the world’s first peer-to-peer decentralized digital currency. This first-mover advantage over other cryptocurrencies is primarily due to:

  • Network effect and security. Military-grade cryptography secures transactions.
  • Accessibility and support. Bitcoin has more exchanges and merchants than the other cryptocurrencies, and it has bitcoin ATMs for direct purchase or sell.
  • Large developer ecosystem. This gives bitcoin more software implementations and improvements.
  • Large user base. Bitcoin has more clients, investors, and companies gravitating toward it.
  • Liquidity. Anyone can buy bitcoins at any given time with ease.
  • Available to trade as bitcoin futures on the Chicago Board Options Exchange (CBOE).

Advantages of bitcoin over traditional currencies

Satoshi Nakamoto, the creator of bitcoin, saw the weaknesses in traditional currencies, mainly as an electronic payment system. Bitcoin has turned these weakness to strengths:

  • Freedom in payment. The user can send/receive money worldwide at any point in time. There is no intermediary (a bank) to go through, and conform with bank holidays or other limitations.
  • Security. Since bitcoin is peer-to-peer based, merchants cannot charge extra fees without agreement from both parties.
  • Anonymity. Payments can be finalized without revealing personal information, which also acts as a safety measure for identity theft.
  • Cannot be manipulated. Bitcoin’s cryptographic nature adds too much cost and effort to protect the blockchain from changes, thus preventing transaction manipulation.
  • Low fees. At this time, there are either no fees or very low fees for bitcoin payments. Cryptocurrency exchanges help users and merchants convert bitcoins to fiat currency with lower fees than using other popular payment methods.
  • Low risk for merchants. Due to anonymity in transactions, and prevention in the blockchain for transactions to be reversed, this gives merchants protection, especially in areas where fraud and crime rates are high.
  • No limit on value. Since there is no central bank to print more units, or in any other way to limit its value due to political and economic conditions, bitcoin may grow to tens of thousands of U.S. dollars and more, but it could also drop in value fairly quickly.
  • No taxes. Since bitcoin is anonymous, there is no way for a government to know if their citizens own bitcoins unless someone decides to declare it to their government, or if the government forces a crypto exchange to give data on their users.

Disadvantages of bitcoin

Cryptocurrencies are a relatively new phenomenon in the financial world. Because of that, there are some disadvantages of using bitcoin instead of traditional fiat currencies.

  • Not widely accepted. Bitcoins are accepted by merchants worldwide, but at this point, they are a minority. Because of that, it is unfeasible to rely on bitcoin alone.
  • Government regulation. At some point, governments may decide to ban bitcoin, which in turn will force merchants to stop accepting payments in digital currency.
  • Wallets can be compromised. If a hard drive crashes and the user didn’t save the key offline, all bitcoins can be lost. We also live in a digital world where every device is connected to the internet. This gives hackers the opportunity to steal all bitcoins in a wallet.
  • Price volatility. Despite growing in popularity, cryptocurrencies are still in their infancy. New investors are constantly buying in, which makes the price highly volatile. But once bitcoin is widely accepted as a currency by both users and merchants, the price will stabilize.
  • Non-reversible transactions. Once a transaction is made, it is impossible to reverse it. This makes it hard to dispute a transaction if a service was not delivered.
  • Technical risks. There may be a flaw in the system that hasn’t been detected yet, which could wipe some of the bitcoins.
  • Possible deflation. The total number of bitcoins is limited to 21 million. Once this number is reached, there is the possibility that investors who own bitcoin will decide to sell, which will in turn cause massive drop in price and deflation.
  • No limit on value. As previously said, there is no central bank to monitor and manipulate the value of bitcoin. This causes high price volatility.

Risks of bitcoin

A number of market analysts and banks consider bitcoin a risky investment. Warren Buffet, the so-called Oracle of Omaha for his investment picks, claims that bitcoin and other cryptocurrencies are not a value-producing asset and that bitcoin is a real bubble. However, this is not the only risk for bitcoin. Theft of bitcoins by hacking into wallets and exchanges has happened numerous times in the past.

It is worth noting that exchanges and wallets don’t offer the same protection as banks do. In case of theft or bankruptcy, there may be no way for the exchange to compensate their clients for the lost bitcoins.

Year

Place

Value at the time of stolen or lost coins

2011

Bitomat exchange

$220,00 (17,000 bitcoins)

2011

MyBitcoin processor

$800,000 (78,000 bitcoins)

2012

Bitfloor exchange

$250,00 (24,000 bitcoins)

2013

Instawallet bitcoin wallet

$4,6 million (35,000 bitcoins)

2013

Inputs.io bitcoin wallet

$1 million (4,100 bitcoins)

2014

Mt. Gox exchange

$450 million (850,000 bitcoins)

2015

Bter exchange

$5,1 million

2015

Bitstamp exchange

$5,1 million

2016

Cryptsy exchange

$3,3 million

2016

Gatecoin

$2 million

2016

Bitfinex exchange

$72 million

2017

NiceHash platform

$80 million

Conclusion

The rise of cryptocurrencies is the logical step in the financial world. To be able to make instant direct transactions worldwide with minimal fees and to have identity protection when making those transactions, and above all to have no government intervention in the value of cryptocurrencies makes them a great alternative to traditional currencies. On the other hand, the ecosystem is still new and cryptocurrencies aren’t accepted in the mainstream. The risks of owning or investing in cryptocurrencies still persist, mostly by the possibility of losing a wallet or having it hacked without a chance to be compensated; or the possibility of a sudden market crash. All of this, limits the use of cryptocurrencies to a group of people who don’t mind the risk.






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