I Invested in Bitcoin, Now I Am Trying to Understand How It Works
I recently made my first investment in Bitcoin; A minuscule sum in comparison to the sums retail and institutional investors have been putting forward.
My plan is to grow my position slowly and hold it for many years. I doubt anyone can confidently say what the price of Bitcoin and other cryptocurrencies will be in the short term. It is always hard to time the market, which is why I am dollar-cost averaging.
The first time I became aware of Bitcoin and the blockchain technology was during the 2017 Bitcoin bull run. The media was picking up on it and I had many lightweight discussions about it with some friends at University.
I didn’t understand how blockchains worked. But I have always held a strong conviction that the technology was sound and possibly revolutionary.
Now since I am invested, I have no choice but to delve deep into the crypto world and try to understand concretely what a blockchain is.
The following is what I understand so far about first-generation blockchains such as bitcoin. By writing this I hope to educate myself, and at least give some of the readers an initial grasp of the subject matter.
No Central Authority
The Bitcoin network does away with a central authority that verifies and authorizes transactions among entities. The verification of transactions is instead conducted collectively by everyone participating in the network.
Transactions are recorded on a public ledger and transmitted to all nodes in the network. Each node has a public address that can send or receive bitcoins.
Each transaction is encrypted using the SHA-256 algorithm. Given some string data about any particular transaction, the algorithm generates a 256-bit hash.
This is a one-way process. Getting hold of the hash will not reveal anything about the metadata of the transaction unless brute force is used to compare hashes of known strings to the hash. With a hash that has 256 bits, this process can take a substantial amount of time.
A Chain Of Blocks
At any point in time, there is a pool of peer-to-peer transactions. But how does the network work? How do the participants come to a consensus so that there is trust in the network?
In addition to regular nodes that can run the Bitcoin software and see all of the transactions on the public ledger, there are also Bitcoin miners that sacrifice their time and energy in order to keep the network going.
Just like gold or coal miners carry out arduous tasks to extract gold or coal from the ground, Bitcoin miners run brute-force algorithms to decrypt transactions and verify them.
Since all miners are using the same algorithm, the speed with which transactions are verified by the miners is determined by the amount of computing power they have.
A miner collects a bunch of transactions from the public pool, runs the algorithm to verify them, and adds them to what is called a Block. The block is then chained to the latest block in the existing chain. Hence blockchain.
As a reward for being the first to verify the transactions, the Bitcoin miner receives a predetermined reward in Bitcoins.
How is Consensus Reached?
With so many miners competing to verify transactions as fast as possible to earn Bitcoins, how is the consensus reached about the Blockchain? What if parallel chains are forked by different miners?
The rule is to always accept the longest chain, which has the most work put into it. This ensures miners would want to contribute to the longest accepted chain, rather than creating a parallel chain and wasting their efforts for no Bitcoin rewards.
Transactions are made peer-to-peer. But these transactions cannot remain floating in a public pool.
Bitcoin miners ensure that transactions are added to the longest Blockchain to serve as the transaction history and public ledger which gives validity to the transactions and creates trust among all nodes in the Bitcoin network.
Bitcoin miners are incentivized to sacrifice their time and energy in the form of electricity by earning Bitcoins. The number of bitcoins earned for every Block added to the longest valid chain is predetermined.
I realize this is a very abstract explanation of how Bitcoin works but I hope to keep learning and building on my present grasp.
This first step of delving deep into Bitcoin will add to my confidence level in investing in the asset, as well as giving me the foundations to understand how the crypto world works and is evolving.