Hodler’s Guide
Aka: What every bitcoin holder should know about bitcoin and modern bitcoin wallets.
Welcome to the first and probably the most important article of Hodler Cafe! I often find myself in the situation of introducing new people to bitcoin (and other cryptocurrencies). When searching for good introductory materials I have found some which are too hand-wavy for the kind of tech-savvy people I usually talk to, but some other materials I find are too involved and take too much time to digest. This article is an attempt to explain bitcoin and modern wallets in one medium-sized article to reasonably tech-savvy but crypto-novice people very quickly. In short time you will go from zero to a level where you have a basic but reasonably sound understanding on:
- Why holding bitcoin might be a good idea for you
- How bitcoin and modern wallets work
And most importantly:
- How to hold and use bitcoin securely.
This blog post aims to be the ideal place where you can send someone who is somewhat tech-savvy but novice in bitcoin land. Because of lack of space it will not contain step by step tutorials on how to use a particular wallet or how to use a particular exchange, but this post will give you the fundamentals to be ready to consume those kinds of tutorials.
After gathering feedback I will probably edit this post to make this introduction as effective as possible. Please contact me if you think the article misses something very important about holding bitcoin.
One bitcoin is $12000 now. I don’t have that much money to invest. I guess bitcoin is too expensive for me.
You can of course hold a fraction of a bitcoin (aka BTC). Similar to how the dollar has cents, bitcoin has ‘satoshis’. One bitcoin is 100 million satoshis. In fact using the term bitcoin is just a cultural tradition: the protocol itself calculates everything in satoshis.
Ok. There is something I never understood. Don’t laugh at me, but I am wondering: let’s say I have one bitcoin on my computer. Why can’t I just copy this bitcoin, and now have two bitcoins on my hard drive?
Because, in fact bitcoin is not stored on your computer. When we say that you store your bitcoin in your wallet this is just a methaphor. In fact, you should think about your bitcoin wallet more like the client application to your bank account. As your dollar is stored in your bank, your bitcoin is stored on the bitcoin network. You just use your wallet software (or hardware wallet) to access your account on this network.
Who owns/operates the bitcoin network?
There is no particular entity which we can point to and say that it owns/operates it. The network is decentralized. It is operated by thousands of computers on the inernet, the so called miners. This is a permissionless system: anyone can become a miner who can access the internet. There is simply no way to exclude someone from becoming a miner. There is a protocol (the bitcoin protocol) which miners respect. Not because of goodwill though... Miners are monetarily incentivized to comply with the rules of the protocol and it should require an absurd amount of malicious miners (behaving against their self-interest by the way) to make the bitcoin network disfunctional.
So, how does the bitcoin network work?
Each miner constantly writes into a huge log file, its local copy of the so called bitcoin ledger (aka the bitcoin blockchain). This huge log file contains transactions between so called bitcoin addresses. (Bitcoin addresses are character sequences like 12n12Bs8wUKxapFyPNiLMzAVda8Wpt6U6b) The transactions are organized into blocks. A new block is created every 10 minutes.
BLOCK 1
0.5 BTC from 1A6KAJ25R7FjQG2BHsewaX2QyfTMSug76t to 3JZwfYPAHh99xr1FKoQKXEXBQG53ShrErC
2.4 BTC from 1JZbRayxAYaYWpwy2WocHsoY2Tn7rgPVkP to 1PDau2synfy3DGySoRsJQQRr4zbtktZc5k
… (other transactions)…
BLOCK 2
… (other transactions)…
Each block is created by a lucky miner who could first find a solution to a hard calculation problem. (The calculation problem is different for each block.) The other miners will check the proof that this calculation work was really done (the solution is correct) and then copy the block into their local copy of the ledger. The miner gets a reward for their work. I do not intend to discuss all the details of this protocol and how this is resistant to so many attacks because that would not fit into the article and is a rather advanced topic. As of now you should just know that the info about your transaction is stored on thousands of computers on the internet, and the system is trustless, permissionless and anyone can be a miner and is incentivized to comply with the rules of the protocol.
This seems to be an interesting technology, but why should I hold bitcoin? Why has bitcoin value? Why is it better than the dollar?
Bitcoin has very important advantages over the dollar. I am not talking about some speculative future use-case, like ‘one day, you will be able to use bitcoin in every store’. I am talking about the advantages that bitcoin has right now:
- Finite supply. The bitcoin protocol ensures that no more than 21million bitcoin will ever exist. While the US government can print as many dollars as it wants.
- In case of dollars you either store a lot of cash with you which is insecure and inconvenient or you have to trust a bank with storing it for you. On the other hand holding bitcoin is secure and trustless at the same time.
In summary most people hold bitcoin because they think it will become a great store of value. As a store of value, it has even advantages over gold (like convenient transfer, easier to protect, easily divisible). As there is $7 trillion worth of gold on the planet but only $223 billion worth of bitcoin at the time of this writing, it is reasonable to expect that the price of bitcoin will go up singnificantly in the future. When reaching gold parity the price of one bitcoin will be $400000.
Ok, maybe I want to hold bitcoin. How can I buy it?
First you need to set up your bitcoin wallet. Now you are ready to actually buy bitcoin. There are several ways. For example you can buy it from your friend: you pay them with dollars and they send you bitcoin. Another way is to buy it on a cryptocurrency exchange. You can send (deposit) dollars or euros to the exchange from your bank account and trade the dollars/euros to bitcoin. Then you can withdraw the bitcoins to your bitcoin wallet. Some people just keep the bitcoin on the exchange indefinitely. Don’t do that. The bitcoin on the exchange is in fact in the wallet of the exchange and they just keep a record on how much bitcoin they owe you. Once the exchange goes bankrupt or get hacked you lose your bitcoin. After trading, always withdraw your bitcoin to your wallet and HODL!
You mean HOLD?
No, I spelled it HODL intentionally and the spelling in the title of this article is intentional too. It is a funny internet meme, part of the cryptocurrency culture. Read https://en.wikipedia.org/wiki/Hodl if you are interested.
Ok, so let’s say I have a bitcoin wallet. Now let’s see… I guess it has a bitcoin address which I can share with my friends so they can send me bitcoin. Is it correct?
Actual wallets are more complicated than that and we will discuss it later in this article, but for a start, yes, a simple wallet could work like that.
Ok, let’s say I know the bitcoin address of my friend and I want to send them bitcoin. First I have to log into the bitcoin network I guess with some kind of password authentication… But wait, where is my password stored? On the thousands of machines of foreigners called miners?
No, you don’t log into the network. Your wallet uses public key cryptography, more specifically digital signatures.
What is public key cryptography?
Public key cryptography uses some involved math in the following way: It is possible to generate a pair of character sequences: a private key and a public key in such a way that:
- Knowing the private key you can calculate the corresponding public key but doing it in the other direction is not computationally feasible. (practically impossible)
- Having some ‘content’ (a character sequence) and a private key you can create another character sequence: a digital signature. Anyone knowing the public key can easily check that the signature was created by the combination of the content and its corresponding private key, but it is not computationally feasible to create this digital signature only knowing the public key.
So when you see a digital signature then you can be sure that someone knowing the private key actually created the content. They signed it with their private key.
Ok, and how are digital signatures used in bitcoin?
Your bitcoin address is a public key, and your wallet knows the corresponding private key. Your wallet creates the transaction describing that you send some bitcoin to your friend:
0.5 BTC from 1A6KAJ25R7FjQG2BHsewaX2QyfTMSug76t to 3JZwfYPAHh99xr1FKoQKXEXBQG53ShrErC
Your wallet then signes the transaction string using your private key and sends it to the miners. No one in the world can create a transaction signed by your private key because no one else knows your private key, but everyone (including miners) can check that the transaction is indeed signed by the private key of your bitcoin address (the public key). Until you keep your private key secret, your bitcoins are safe, because only you can send money from the given bitcoin address.
This is starting to get involved… Did you say that actual wallets are even more complicated?
Bear with me, there are only two more twists in this article I promise. The thing is… The bitcoin protocol deals with bitcoin addresses… But one wallet use multiple bitcoin addresses to protect your privacy.
My privacy?
Imagine you buy some food with bitcoin in your local shop. After you pay for your food the store owner will know your bitcoin address. He can then check the ledger (which is public) what other transactions you do. Your life would become an open book for him. But your wallet is smarter than that.
Imagine that your wallet creates thousands of addresses. It is cheap. You can create thousands of private and public key pairs (and thus bitcoin addresses) per second and the chance that you create the same as someone in the history of humankind is negligible.
Now every time someone asks you your bitcoin address your bitcoin wallet give them a new one from this generated pool of addresses. (Wallets have a button called ‘Receive’, which does nothing but generate a new bitcoin address which you can send someone so that they can pay you.) Analyzing the bitcoin ledger no one can clearly know which are the dozens of addresses that belong to your wallet and thus it is hard to track you. Bitcoin is not a privacy cryptocurrency, because this method is not a completely surefire way to make it impossible to track you, but it makes it very hard to track you in practice.
The important thing is that every bitcoin address once generated by your wallet is your address forever. It is good for your privacy to send the newest one to someone who wants to pay you, but you can send them any of them: Once someone sends bitcoin to any of these addresses it will be shown on your wallet balance.
You mentioned that the wallet stores all my private keys. So if I lose the wallet I lose my money I guess. Sounds scary.
Fortunately life is easier than that if you use a HD wallet. And you should use a HD wallet! In my opinion it is the best invention after bitcoin (which is the best invention after sliced bread).
HD wallet? I heard this once but I did not know why the screen resolution is important in case of a wallet…
HD wallet is an abbreviation for Hierarchical Deterministic Wallet.
It works like this:
First you have to write down a so called seed phrase on a paper. This is a sequence of 24 english words, each word is one of the 2048 words defined in the BIP39 standard. You have to store this paper securely: if it is stolen, your bitcoins are lost. Once these words are entered into the wallet the wallet generates a sequence of private and corresponding public keys. This whole process is defined by standards (BIP39, BIP44), and it is completely deterministic. So anyone that has access to the seed phrase can type it into any implementation of a HD wallet and the wallet will generate the exact same private and public keys. This means that your wallet do not have to store anything besides the seed phrase. You can burn your wallet. Even the manufacturer of your wallet can stop producing new wallets: as long as you have your seed phrase you will be able to access your bitcoin with a wallet implementation that follows the standard. (A simple implementation can be written using a few lines of Javascript…)
Example seed phrase:
term drink spare high roast refuse brown cause radio phone social elder smoke chief finish toy island orchard seat zebra tunnel color labor cinnamon
Sequence of generated bitcoin addresses:
17BiDXV2VusiqbL84qJwT1pvCijfoMp2AS
12DPvpNnPeNPEt3RpuWBmJhPsmPULxbYWN
1LEVqfjAWwBoEKZLuqU3hrAk86JrbEy8QX
…
There is also a bonus: your seed phrase can also generate private and public keys for different cryptocurrencies too, so you can in fact hold multiple cryptocurrencies in one HD wallet.
Which wallet in particular do you suggest?
There are 2 must-haves in my opinion if you hold a significant amount of bitcoin:
- It should be a HD wallet.
- It should be a hardware wallet. In case of a hardware wallet the seed phrase and the private keys never leave the wallet itself. The digital signature of the transaction is created on the wallet device. You can read the transaction on the small screen of the device and you have to accept the transaction pressing a button on the device. Even if your computer is hacked you can be sure that only those transactions are sent from your wallet that you confirmed on the device. Obviously you should prevent your computer from being hacked, but having protection even against that is a huge advantage. If you hold let’s say thousands of dollars worth of bitcoin then it is a no brainer to buy a HD hardware wallet for around 60 dollars. Too many people lose their bitcoin either because they store their funds on an exchange and the exchange is hacked, or because they use a software wallet but they cannot protect their computer and their computer is hacked. I am an IT professional and can protect my PC fairly well but still would not ever consider not to use a hardware wallet. It gives a peace of mind to me.
Specifically I recommend the Ledger Nano X or the older and cheaper Ledger Nano S. The Ledger Nano series is the market leader HD hardware wallet currently, and this is the wallet I am using as well (I use the Nano S specifically, the Nano X was not available back then when I bought it.). If you like this article and you consider buying one, please use my affiliate link:
What if someone steals my ledger Nano or I lose it?
Obviously try not to lose it, but as you have to use a 6 digit PIN code to access the Ledger Nano, which they cannot brute-force, your money is still not lost in this case! You have to use your secret seed phrase to initialize another Ledger Nano, send the bitcoin somewhere else (like onto an exchange), create another seed phrase for your new Ledger Nano and send the bitcoin back. You are all secure now again. After your wallet got stolen! Just make sure that you don’t write down your PIN code near your Ledger Nano and you are safe as far as losing the Ledger Nano.
Nice. But I should not let the seed pharse stolen I guess.
Correct. But as you do not have to use the seed phrase daily you can store that at an absurdly hard to find place… I don’t want to write down ideas here, use your imagination. If you are super super paranoid there are all kinds of ways to store your secret in N parts such that M part is enough to recover the secret to all kinds of N and M where M < N. But this points beyond this small article: just store the seed phrase in an absurdly hard to find place for a start.
I think I will buy some bitcoin and I will HODL it in a hardware wallet… But isn’t HODL-ing boring?
Many people make the mistake and do too much day-trading as a beginner. This is not a good strategy because us humans have natural tendencies to buy high (fear of missing out aka FOMO) and sell low (panic sell). I recommend you not to daytrade as a beginner. At least for a while until you get more experience. Instead of daytrading let’s use your enthusiasm to learn about crypto or socialize in crypto communities.
Here are some URLS to entertain you while HODL-ing:
And although I don’t recommend you to check the price constantly, you will not be able to resist it, so I give you a link that millions of people use to check cryptocurrency prices:
Congrats, if you made it this far, you have the basic knowledge to HODL. If you liked this article please bookmark it and send it to people asking you about bitcoin.
Will there be more articles in Hodler Cafe?
Yes of course, but not necessarily only tutorials. I wanted the first article to be this basic tutorial which I will refine based on feedback by the way. But subsequent articles here will be opinion pieces on investment strategies, tips and tricks, describing interesting technologies in the crypto space: usually hopefully interesting and useful stuff, but not necessarily tutorials.
