EVG101 Part 5: Bitcoin Misc.
Welcome to Part 5 of Everest’s crypto and blockchain guide! For the past 4 parts of our guide, we have talked about most of the key mechanisms and incentives behind Bitcoin. In this part, we will wrap up with little bits and pieces of the Bitcoin puzzle to help to complete your understanding of Bitcoin.
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Table of Contents
- What is a wallet and why is it necessary?
- What is a 51% attack?
- How decentralized is Bitcoin?
- What is a fork? What is the difference between a hard fork and a soft fork?
- Will my money double after a hard fork?
- What are some shortcomings of Bitcoin?
TLDR;
1. What is a wallet and why is it necessary?
You can think of individual Bitcoin addresses as keys and a wallet as a keyring. Without a keyring, it is easy to lose your keys or misplace them. A wallet stores your private keys securely which are used in signing off on transactiosn where you spend your bitcoin.
In many cases, a wallet will also generate private keys and a new bitcoin address for you for every transaction you make (remember that each bitcoin address is associated with one public key, which in turn is associated with one private key). This makes it harder for your transaction activity or balance to be traced. Addresses identified as having a high balance are susceptible to attacks from malicious actors. By using a separate address for each transaction, your balance is split into many different addresses so your total balance is hidden from public view.
2. What is a 51% attack?
In general, a 51% attack is an attack on a blockchain by seizing enough resources to consistently steer the consensus of the network in their favor. What a 51% attack constitutes depends on the network (and consensus algorithm) in question.
For example, since Bitcoin utilizes the proof of work consensus algorithm, a 51% attack would mean that a single mining group has more power than the rest of the network combined. For a cryptocurrency utilizing proof of stake, which Ethereum will adopt, it means that a single actor or organization possesses more than half of the ether (the cryptocurrency of the Ethereum blockchain) in existence.
A 51% attack compromises the decentralization of the blockchain and eliminates the security that comes with decentralization. The entity with more than 50% of the mining power or stake has the power to approve double spend transactions and rewrite the history of the blockchain among other fraudulent behavior.
How a 51% attack works in proof of work:
An entity which owns more than 50% of the network power, on average, would be able to add (fraudulent) new blocks to the blockchain at a rate faster than the rest of the network combined. Eventually the longest blockchain in the network would be the one containing fraudulent blocks mined by this entity. Since the proof of work consensus dictates that the longest blockchain is the ground truth, at some point the rest of the network would accept that the version of the blockchain with fraudulent blocks is the true blockchain.
3. How decentralized is the Bitcoin network?
Recall that the only way to create new bitcoin is through mining. As the value of bitcoin increased over time, there were more and more reasons to hold hash power in the Bitcoin network, since greater hash power meant that there was a greater chance of winning the mining competition and receiving valuable new bitcoin as a reward.
In the history of Bitcoin, there was an instance where a single entity held almost half or more than half of the total mining power of the Bitcoin network (in 2014 with the Ghash.io mining pool). The centralization of the network is dangerous because it means that it is susceptible to a 51% attack which would destabilize the whole Bitcoin ecosystem. Fortunately, we have seen an increase in decentralization over time, especially in the wake of the bear market. As of 2019, no one mining pool controls more than 20% of the mining power of the entire network.
4. What is a fork? What is the difference between a hard fork and a soft fork?
Forks represent a change to the software protocol of the blockchain.
A hard fork is a radical change to the protocol which requires all users to upgrade to the new software.
A soft fork is a change to the software protocol which represents a tightening of the rules so that what is valid under the new rules will also be valid under the old rules. A soft fork is backwards-compatible and requires only a majority of the miners to upgrade to the new software.
An example of a hard fork of Bitcoin is Bitcoin Cash, where the block size limit was increased from 1 megabyte to 8 megabytes. Such a change would not be compatible with previous rules and thus cannot continue the original blockchain.
An example of a soft fork is the Segwit update for Bitcoin, where the block size was kept at 1 megabyte but the structure of transactions was changed to allow for more transactions per block. This change is compatible with the original blockchain since it abides by the 1 megabyte limit.
5. Will my money double after a hard fork?
After a hard fork, there will exist two blockchains, the original chain and the forked chain. Technically, the amount of digital currency that you held in the original blockchain prior to the fork will exist in both forks of the blockchain, with a new cryptocurrency being created in the forked chain. However, the digital currency associated with the new, forked chain will no longer be known as bitcoin. It is important to note that the value of a digital currency lies in the mutual acknowledgement and acceptance of that currency and the blockchain it is associated with. If vendors and other users ignore the fork of the blockchain, then the new digital currency created in the forked chain is worthless.
When hard forks occur, such as Bitcoin Cash (a hard fork off the Bitcoin blockchain), a measure known as replay protection is usually implemented to ensure that the the newly generated cryptocurrency can only be spent in its own chain. In other words, replay protection ensures that the newly generated bitcoin cash is spent only on the Bitcoin Cash network, and the original bitcoin is spent only on the Bitcoin network. The details of replay protection are beyond the scope of this guide, but you can read more about it here.
6. What are some shortcomings of Bitcoin?
- Energy wasted on pointless computation
This shortcoming is related to the proof of work consensus algorithm used in Bitcoin. The mining competition in proof of work consumes large amounts of electricty while serving no useful purpose; the electricity consumed in this process could have been used to improve lives in areas where electricity is actually needed. Other consensus algorithms, such as proof of stake, consume minimal electricity as consensus is achieved through other means as opposed to computation. Others have also proposed modifications to proof of work called proofs of useful work, where the computation used in the mining competition is directed towards efforts which give back to society, such as to scientific research.
- Slow transaction time
The Bitcoin network can only process 7 transactions per second. For reference, Visa can process 24,000 transactions per second. Bitcoin is hampered by the process by which blocks are added to its blockchain: right now, the network is constrained to adding a block every ten minutes, and each block has a size limit which in essence limits the number of transactions which can be added every ten minutes. However, developers are working on solutions to this for the Bitcoin network. We will cover scaling solutions for blockchains in more detail in later guides.
- Price Volatility
Like almost every other cryptocurrency, the price of bitcoin is volatile. According to cryptocompare, the 30-day standard deviation in price for Bitcoin stands at 5.4% as of January 2019, compared to 1.2% for gold and 0.5 to 1% for major fiat currencies. This makes it hard for Bitcoin to be useful: it is hard to use it as either a store of value or as a medium for transaction since its value fluctuates so much and so frequently. Recipients are hesitant to receive payments in bitcoin in the fear that bitcoin drops drastically in the future and renders their payment worthless.
Concluding Remarks
In this article, we have explained miscellaneous elements of Bitcoin which will help the reader to complete their understanding of how Bitcoin works. In the next article, we will look towards the other big elephant in the crypto room: Ethereum.
We see this guide as a continuous work-in-progress! Please leave any questions or remarks in the comments section and we will try our best to include them in updated versions of our guide. And if you found our guide useful, please leave some claps!
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