A Beginner’s Guide to Understanding Bitcoin

Interdax

Published in

Interdax Blog

16 min readJan 8, 2020

A quick starter guide to everything you need to know about the world’s leading cryptocurrency, bitcoin.

Photo by André François McKenzie on Unsplash

1. What is Bitcoin?

2. Background & History

3. Economics

4. Technology

1. What is Bitcoin?

As the leading crypto-asset, bitcoin is central to the cryptocurrency market.

After gaining a first mover advantage and achieving a substantial network effect, bitcoin has become the most valuable crypto-asset in existence. Bitcoin also possesses the most decentralized and robust network out of any digital currency.

Introducing the innovation of blockchain technology, Bitcoin is the most successful application of this new invention. For the first time in history, people were able to store their wealth and transact across borders without having to rely on a third party.

The main defining properties of Bitcoin are: censorship resistance, digital, peer-to-peer, provably scarce, impossible to counterfeit, and secured by cryptography.

2. Background & History

A primer on Bitcoin’s beginnings and influences.

Satoshi Nakamoto, the mysterious creator of Bitcoin (BTC), synthesised existing ideas and technologies, successfully putting the pieces of the puzzle together to solve the Byzantine Generals problem sometime around 2007.

As a result, the first peer-to-peer, electronic currency that is not controlled by a government or any single entity was created. The whitepaper outlined the system in October 31, 2008 and the network went live on January 3, 2009.

To provide provenance to the creation of Bitcoin, and a hint that Nakamoto was sceptical of the banking system, The Times’ headline “The Times 03/Jan/2009 Chancellor on the brink of second bailout for the banks” — was embedded into the genesis block of Bitcoin’s blockchain.

Often associated with the Cypherpunk movement and Libertarianism, Bitcoin has enabled individual sovereignty by providing an apolitical and uncensorable currency that governments cannot stop or disrupt. As a result of the affinity with the Libertarian political philosophy, the cryptocurrency got off the ground with early adopters that sympathised with the Libertarian view.

In fact, many of the foundations of Bitcoin were discussed in the Cryptography Mailing List and amongst cypherpunks for over two decades prior to its introduction.

Bitcoin also resonates with Austrian economists since this school of thought postulates that the main cause of business cycles is because of central banks manipulating the money supply and interest rates. A monetary expansion leads to malinvestment, an artificially low interest rate and a manufactured expansion. But eventually a deep decline in growth and investment is realised as mis-allocated resources lead to misleading relative price signals which necessitates a correction.

Instead of central banks and politicians taking decisions about monetary policy, instead Bitcoin gives control to an algorithm to enforce a strict, rules-based monetary policy. As a result, the supply schedule cannot be changed (at least without a wide consensus).

Perhaps the most well-known Austrian economist — Friedrich Hayek — advocated for privately issued currencies in his 1976 book, Denationalisation of Money: The Argument Refined. Other ‘Austrians’ such as Murray Rothbard and Ludwig von Mises advocated for a return to the gold standard. If many of these Austrian economists were alive today, they’d most likely be proponents of Bitcoin.

Bitcoin’s Predecessors

The major building blocks and predecessors of Bitcoin — in chronological order — are: e-gold, DigiCash, HashCash, b-money, the Liberty Dollar, and bit gold.

These ideas are detailed below:

E-gold was an electronic currency created in 1996 and was one of many digital currencies based on gold. The company allowed individuals to sign-up anonymously but the FBI and Secret Service shut it down in December 2005 as e-gold was being used by criminals. Law enforcement raided the offices of e-gold’s parent company and highlighted the importance of decentralisation — as Satoshi remarked years later, “Governments are good at cutting off the heads of a centrally controlled networks like Napster, but pure P2P networks like Gnutella and Tor seem to be holding their own.”
DigiCash was an electronic money company created by David Chaum in 1989. Its currency, eCash, used Chaum’s Blind Signature Technology to ensure fungibility and privacy and was an early use case of public-private key cryptography. Chaum’s electronic cash system was perhaps too early to benefit from the boom in e-commerce. DigiCash Ltd. filed for bankruptcy in 1998.
HashCash, created by Adam Back in 1997, was utilised to become Bitcoin’s mining function and was originally intended to serve as an anti-spam function for email. HashCash enabled Bitcoin to solve the “double spending” problem in a decentralized way, as well as putting new coins into circulating without a central issuer.
b-money was suggested by Wei Dai in 1998, intended to be an ‘anonymous, distributed electronic cash system’ but could not solve the “double spending” problem. His second proposal resembled Proof of Stake systems. However, Dai imagined b-money as a stable currency, in contrast to the highly volatile cryptocurrencies we know today.
The Liberty Dollar was also introduced in 1998, but was centralised meaning the FBI could ‘cut off the head’ of Liberty Dollar, which they did by raiding their warehouse that stored the gold that backed the Liberty Dollar. In 2011, the operators behind the Liberty Dollar were charged with federal crimes of ‘producing, possessing, and distributing their own coins’.
bit gold was first proposed in 2005 by Nick Szabo and included elements found in Bitcoin, such as time-stamped blocks, coins generated by Proof of Work strings and transaction details stored in a titling registry. Bit gold relied somewhat on trusted third parties, such as servers and timestamp services. Bitcoin solved this problem by having Proof of Work serve as both an award mechanism and consensus mechanism.

Key Dates and Milestones

Some important events over Bitcoin’s history are shown below:

October 31, 2008: Satoshi Nakamoto publishes the Bitcoin whitepaper.
January 3, 2009: Satoshi Nakamoto mines the genesis block and marks the beginning of the Bitcoin blockchain network.
January 12, 2009: The first Bitcoin transaction proves the network works as intended, where Satoshi Nakamoto sends Hal Finney 50 BTC.
May 22, 2010: The first purchase of a real good/service. Laszlo Hanyecz bought two Papa John’s pizzas in exchange for 10,000 BTC.
April 26, 2011: Satoshi’s last email to Gavin Andresen (who later took the helm of Bitcoin development). Bitcoin’s creator fades away into obscurity.
February 9, 2011: BTC reaches parity with the US Dollar on the Mt.Gox exchange.
June 8, 2011: Top of first bitcoin “bubble” at $31, followed by a price drop of more than 90 percent over the following five months.
June 14, 2011: Wikileaks starts to accept bitcoin donations.
November 28, 2012: The first Bitcoin block reward halving, cutting the block reward subsidy from 50 BTC to 25 BTC.
January 30, 2013: Bitcoin developer Jeff Garzik receives the first bitcoin ASIC miner.
November 28, 2013: BTC-USD tops $1,000 for the first time.
July 9, 2016: The second Bitcoin block reward halving, cutting the block reward down to 12.5 BTC from 25 BTC.
August 1, 2017: Bitcoin community fractures as Bitcoin Cash is launched with a user-activated hard fork.
December 17, 2017: BTC-USD reaches all-time high near $20,000.
December 18, 2017: CME launches Bitcoin futures contracts.
October 25, 2018: Chinese court ruled that bitcoin was a form of private property.
September 23, 2019: InternContinental Exchange-owned Bakkt launches Bitcoin futures contracts.
November 12, 2019: CME announces launch of bitcoin options in January 2020.

Check out this timeline for a more detailed history.

3. Economics

Demand and supply factors affecting bitcoin.

Supply of Bitcoin

The supply of bitcoin is known precisely at any moment in time and will never exceed 21 million.

The rate at which new bitcoins are mined is highly predictable. Mining refers to the process of using computers to solve complicated, cryptographic math problems and is the only way to create new bitcoins.

As an incentive to secure the network, miners are paid a subsidy for each block they find, which is currently 12.5 BTC (plus any transaction fees they earn). The block rewards are halved every 210,000 blocks (or roughly four years) until the subsidy reaches zero and all bitcoins have been mined. From then on, Bitcoin will rely on transaction fees alone to incentivise miners to support the network.

For the first four years, the bitcoin reward was 50 BTC. We are in the third block reward era where miners are rewarded 12.5 BTC. The next bitcoin halving will take place May 16, 2020 — where the block reward will be cut in half to 6.25 BTC. The rewards are cut in half periodically until the supply reaches 21 million, which is expected to occur in 2140.

Bitcoin’s code effectively replaces a central bank with a pre-programmed monetary policy, which can be described as asymptotic money supply targeting (which basically means the money supply will asymptotically approach a fixed level — 21 million). Since bitcoin is divisible into 100 million units (known as satoshis), the supply is high enough to become high-powered money and as a replacement to fiat.

Bitcoin’s supply cap was introduced as an adjustment to Nakamoto’s original supply through Bitcoin Improvement Protocol 42 (BIP 42), based on the fact that four gold mines are found every 1,024 years. Since the supply is fixed and the supply of freshly mined coins falls over time, this means that the inflation in the Bitcoin economy also declines over time. As a result, the purchasing power of one bitcoin should increase over long horizons.

Since miners release a fixed amount of bitcoin for each block they mine, they cannot increase the supply of bitcoin if the price rises, so Bitcoin has the property of being almost perfectly inelastic in supply. The inelastic supply explains bitcoin’s wild price volatility. No matter whether the price of bitcoin appreciates, the number of coins emitted over a given time period remains fixed. Since supply is fixed over the long run, a rise in demand should cause an upward movement in the equilibrium price.

In the very short-term, the supply of bitcoin may not be perfectly inelastic as some of the earliest miners and adopters collectively control millions of BTC. According to glassnode, the number of coins that have not moved in over five years is close to four million.

If some of the coins that have not moved for more than five years are controlled by a few people or some early adopters decide to sell their holdings, then these dormant bitcoins are introduced into the circulating supply and may dampen the price.

Demand for Bitcoin

The demand for bitcoin is highly uncertain.

People demand bitcoin for a variety of reasons with the most obvious examples being:

Access to a relatively cheap and global payments network that is available 24-7, 365 days a year,
As a safe haven asset or store of value to protect their savings from hyperinflation/confiscation,
As a speculative asset to trade and invest in, a funding currency for trading altcoins, and
As payment for goods and services bought from grey/underground markets.

What has been established in Bitcoin’s 11-year history is that the cost of a bitcoin transaction and the price fluctuations are closely linked. As the cost of the transact rises, there is a tendency for the price of bitcoin to rise as well. When the transaction costs reach levels that market participants cannot handle, the price of bitcoin corrects and the falling price puts downward pressure on transaction costs.

Therefore, we can look at the growth rate in the number of transactions and the cost of transactions as important indicators for the health of bitcoin demand, along with the average value of a transaction. The number of active addresses (or number addresses with a certain amount of USD or BTC) is another good proxy for the number of users and therefore demand.

Because of the highly predictable supply and extremely uncertain demand, BTC-USD is characterised by cycles or waves where public interest in the cryptocurrency ebbs and flows.

Attention increases slowly over time until reaching an inflection point which is closely linked to the local high in the price of bitcoin explodes, and a correction follows. Bitcoin has been through this cycle more than a dozen times with the infographic above illustrating each instance.

4. Technology

A look under the hood to see how Bitcoin functions.

Bitcoin is the first implementation of blockchain technology, where all transactions are included in a block that is then added onto a chain of previous blocks, hence the name blockchain.

The word ‘Bitcoin’ can refer to the protocol or the currency. Usually, Bitcoin with a capital b refers to the protocol, while the use of lower case b indicates the currency.

The Protocol

The Bitcoin protocol is a distributed, time-stamped ledger where transactions are stored in blocks. Blocks are linked together chronologically, such that to edit one transaction in one block, you would have to edit all the blocks prior to that one. As an open source project, anyone can submit improvements or develop their own software for bitcoin. Bitcoin Improvement Protocols (BIPs) are used to improve the protocol, where ideas are discussed and then put forward for implementation.

Mining is the name given to the process of confirming transactions and building Bitcoin blocks, which secures the network. The SHA-256 algorithm is used to secure and authenticate data through cryptographic hashing, where a miner checks for valid transactions by looking at hashes of the sender’s signatures from the mempool and confirms them in a block.

Full nodes receive a transaction from other participants, then validate it against the network’s consensus rules and propagates the transaction so that other full nodes can verify and propagate it throughout the network. Bitcoin developers have tried to keep the cost of running a node low to ensure that the network is decentralised and so people can verify transactions for themselves. The full size of the Bitcoin blockchain is around 200 GB.

Once the transaction is confirmed as valid, it is sent to the mempool — a backlog of unconfirmed bitcoin transactions — where it waits for mining nodes to confirm their inclusion into the next block. The main purpose of mining nodes is to empty the mempool of transactions, generally based on the transaction fee, starting with the highest and ending with the lowest.

*You can view Bitcoin’s mempool here:* *https://jochen-hoenicke.de/queue/#0,24h*

Miners compete with each other to pick up and confirm transactions. As more miners join the network, Bitcoin’s mining difficulty increases. The difficulty changes every 2016 blocks and it ensures that a block is always created, on average, every ten minutes.

The Nakamoto consensus mechanism ensures that mining nodes add new blocks to the chain with the most accumulated work, or in other words, the chain with the most energy expended based on the number of hashes. The chain with the most proof of work is valid, but if an adversary has 51 percent of the mining power under their control, they could rollback their own transactions and “double spend” — known as a 51 percent attack.

Bitcoin’s block size is capped to 1MB, and includes a list of transactions, a transaction counter, and the block header (which is made up of the block version, previous block hash, Merkle root, timestamp, target, and nonce). The transactions can be broken down further into inputs and outputs, where signatures (a part of inputs) take up the most space in a transaction.

With the Segregated Witness (SegWit) upgrade in 2017, signatures were removed from the transaction data. One benefit is that SegWit increased the effective block size to around 2MB and permitted Bitcoin miners to allocate more block space to process more transactions.

The Currency

The currency bitcoin (BTC) is based on public-private key cryptography (such that there are no identities linked to bitcoin addresses) and Unspent Transaction Outputs (UTXOs) — which are required to conduct a transaction.

A private key is a secret key that can sign transactions while a public key is hashed using SHA-256 to generate a public address, which is used to receive bitcoins. The generation of private keys in Bitcoin also involves SHA-256. The private keys produce a public key pair using Elliptic Curve Digital Signature Algorithm (ECDSA) but a public key cannot be reverse engineered to find the private key.

A scripting system is used for Bitcoin transactions, which is essentially a list of instructions recorded with the transaction that outlines how the recipient can gain access to them. When a new transaction is made, the inputs are deleted while simultaneously outputs are created in the form of UTXOs so that the recipient can spend the bitcoins associated with them, while the original sender no longer has them under their control.

Each UTXO represents a chain of ownership implemented as a chain of digital signatures where the owner signs a message transferring ownership of their UTXO to the receiver’s public key. So bitcoin is not a thing you actually send; you just transfer ownership of the bitcoins by signing messages.

Source: Bitcoin whitepaper. If Owner 1 wants to pay another person (Owner 2), they will use their public-private key pair to sign the transaction and transfer ownership of bitcoins to Owner 2. Owner 1 must use Owner 2’s public key to send the bitcoins.

Unspent outputs are the combination of all the change you received from any transfers you make and basically prove the amount of bitcoin you own, as you need UTXOs to be spent as inputs in a new transaction. This input-output system ensures that there is no “double spending” and is the reason why there is no counterfeit bitcoins in existence as there is with cash.

To conduct a transaction, you need a wallet, then send the coins to an address or a QR code that contains a payment request. Inputs act like debits against a bitcoin account while outputs are credits to a bitcoin account, but the inputs and outputs are not always equal since users have to pay transaction fees to miners. Transactions, which are created by the wallet’s software, are 258 bytes long and confirms that the spender has ownership of the funds.

Because of the public blockchain, you can view all transactions in the Bitcoin network which makes it useful for auditing purposes — the transparency ensures that Bitcoin’s hard coded limit of 21 million can be verified by anyone, anywhere.

Blockchain explorers (like blockchain.info and oxt.me) allow you to look up addresses, blocks and transactions to visualise activity on the network. Blockchain explorers can also show you how many confirmations a transaction has, i.e., how many miners have checked and confirmed that the transaction is legitimate. Most bitcoin services, such as exchanges, require two or three confirmations for your funds to become available.

Bitcoin Forks

Bitcoin’s UTXO set has been used to create countless bitcoin forks.

Since Bitcoin is open source, anyone can take the UTXO set and start a new version of Bitcoin. This is exactly what happened in 2017 when the long-running block size debate fractured the Bitcoin community into two groups. ‘Small blockers’ believed that the block size limit of 1MB should remain fixed while ‘big blockers’ believed that to scale, Bitcoin needed to raise the block size limit as more people started to use the cryptocurrency.

‘Big blockers’ formed their own version of Bitcoin by rejecting the SegWit upgrade and continuing the main chain without it, which led to a new blockchain and cryptocurrency being created, known as Bitcoin Cash (BCH). Since Bitcoin Cash used the existing UTXO set to distribute BCH to Bitcoin holders, where every bitcoin owner received an equal amount of BCH on the Bitcoin Cash chain.

Following the fork of Bitcoin Cash, countless bitcoin forks appeared in late 2017/early 2018 and tried to ride the coattails of Bitcoin’s success. Many of these forks were copycats and scams, providing no new innovations of their own.

Technological Challenges

The two main technological challenges for Bitcoin are scaling and fungibility.

While Bitcoin has achieved consistency — in the sense that all nodes see and agree on the same thing — and decentralisation, it comes at the expense of scalability. Currently, Bitcoin can only handle about seven Layer 1 transactions per second compared to VISA’s 24,000 per second.

There are several options for Bitcoin to improve scaling:

Lightning Network: a Layer 2 solution on top of the Bitcoin blockchain where transactions happen off-chain. Lightning transactions are similar to a bar tab where you and the bartender agree on (and keep track of) the amount you owe. Once all transactions have been completed, they are then settled as one transaction on the main chain, making these transactions cheaper and reducing the load on the Bitcoin blockchain.
Sidechains: sidechains such as Blockstream’s Liquid network, Drivechain, MimbleWimble, and RSK can help Bitcoin to scale by facilitating transactions between businesses and individuals off-chain.
Schnorr Signatures: Work on Schnorr signatures will open up an interactive aggregate signature scheme where all inputs in a transaction are spent simultaneously with a single signature, known as cross-input aggregation. The interactions between signers happen entirely off-chain. In simpler terms, exchanges will be able to more efficiently batch transactions, reducing the load on the blockchain.
Taproot: Taproot will enable Schnorr Signatures to be used with SegWit addresses in Bitcoin. Taproot will also lower the load of Layer 2 networks on the Bitcoin blockchain, as scripts are made more efficient.
Increase the Block Size: Inaction on increasing the block size was the main reason for the Bitcoin-Bitcoin Cash split. This avenue is unlikely for Bitcoin, given that SegWit has paved the way for the Lightning Network.

The following projects and proposals aim to improve the fungibility of Bitcoin:

Lightning Network: The Lightning Network aims to improve privacy once it is in a more mature state and widely adopted since Lightning transactions are not stored on a public ledger. Also, Lightning uses onion routing, which does not reveal who the recipient of a transaction is. Finally, Lightning transactions do not mix inputs and hence cannot be clustered together.
Confidential Transactions: A way to encrypt (and hide) the value of a transaction so that the bitcoin amount you sent cannot be observed on the blockchain. Confidential transactions is likely to be implemented into Bitcoin via a soft fork or through a sidechain.
Schnorr Signatures/Taproot: Schnorr signatures enable multiple signers in a multi-signature transaction to combine their keys into an aggregated key that represents the group, which is known as key aggregation. The benefit of key aggregation is that it makes multi-signature transactions look like regular transactions, improving the fungibility of bitcoin. Taproot will extend this to make the details of a transaction output difficult to distinguish by observers for different transactions. CoinJoin transactions could end up looking like regular bitcoin transactions with a single signer, allowing for easier implementation into wallets to increase the anonymity set of CoinJoin implementations.
SNICKER: A non-interactive CoinJoin (a method of mixing coins to obfuscate the trail) proposal, which is an acronym for Simple Non-Interactive Coinjoin with Keys for Encryption Reused. Users can mix coins without being online and SNICKER hopes to improve the adoption of CoinJoin transactions in Bitcoin.

Is there something not covered in our guide that you wanted to know or are there any areas of Bitcoin you want to read more about in-depth? Let us know in the comments below.