What is bitcoin? Bitcoin 101 and a brief history
In this section, we’ll give you a very quick and dirty overview of Bitcoin, introducing the important concepts so that you have a solid grounding in the basics before getting into the nitty-gritty. Throughout this book, we’ll discuss the concepts covered here in more detail.
Bitcoin is a digital currency that runs on the Bitcoin protocol. A protocol is a set of rules and algorithms that govern a system. The Bitcoin protocol implementation most commonly used is called Bitcoin Core. It is open source, which means that anyone can inspect and use the code 1. The main point of Bitcoin is that it is decentralized and censorship-resistant. The Bitcoin protocol has no single point of control, and it would be very difficult for any actor or state to shut down the system.
Bitcoin works because it solves the double-spend problem for digital currency, i.e., no one can spend the same bitcoin twice. This works because every bitcoin is unique, and every Bitcoin transaction is recorded on the Bitcoin blockchain. Blockchains are a type of distributed open ledger. In the Bitcoin blockchain, it’s possible to see every transaction ever made. This way, independent nodes can make sure that transactions are valid. New transactions are grouped together into a block, which is then connected, or ‘chained’, to the previous block. All blocks in the Bitcoin blockchain are connected sequentially, all the way back to the first block, or the genesis block.
The Bitcoin blockchain functions similarly to a database, and that database is updated by nodes and miners. Up-to-date copies of the blockchain are hosted by computers running the Bitcoin software, called nodes. Miners are computers that compete to solve extremely difficult and tedious math problems. The miner that solves the problem first wins the right to choose the next block. They are rewarded with a fixed amount of newly-minted bitcoin, as well as transaction fees associated with every transaction in the block.
A brief history of bitcoin
At the time of writing, it’s been a little over a decade since Bitcoin was introduced. From its humble origins as a paper on a niche cryptography mailing list, Bitcoin has grown to become the progenitor of a multi-billion dollar industry, creating controversy all along the way.
To understand Bitcoin’s position today, it’s helpful to get a brief overview of where it’s been. The story has heists, hackers, cases of mistaken identity, and a shadowy coder at the heart of it all. Whatever the history of Bitcoin is, it’s rarely boring.
To set the scene for the invention of Bitcoin, we need to go back to 2008. The worst financial crisis since the Great Depression has just gutted the global economy. Trust in central banks is at an all-time low. In an effort to prevent complete financial ruin, central banks begin to utilize, among other strategies, quantitative easing.
Quantitative easing (QE) is a monetary policy used by central banks in order to stimulate the economy. By buying longer-term securities, the domestic money supply is effectively increased. Detractors referred to this as “printing money”, a not entirely accurate assessment. They argued that QE can result in the devaluation of domestic currency and inflation without economic growth.
At the same time, a cryptographer and programmer known as Satoshi Nakamoto was working on a new type of digital currency that would eliminate the need for third parties and cut out banks entirely. The website bitcoin.org was registered on August 18, 2008 via an anonymizing domain broker. 2
The Bitcoin whitepaper was published on a cypherpunk mailing list called metzdowd.org. Your average cypherpunk was technologically literate, interested in mathematics and politics, and had a passion for privacy and free speech.
Cryptography, the mathematical and computational discipline of creating and breaking codes (more on that later) figured large in their ideology. They believed that the wide use of encryption in online communication was the best way to protect free speech and combat centralized control of the internet. 3
The cypherpunks were interested in making a form of digital currency that could not be controlled or surveilled by the state or centralized banks. Prior to Bitcoin, several attempts were made to create a viable form of private digital money, like David Chaum’s DigiCash, Mojo Nation for file sharing, and Adam Back’s anti-email spam service HashCash. Satoshi acknowledged intellectual debts to Wei Dai’s b-money, and Nick Szabo’s BitGold, both of which used proof of work and public-key cryptography.
Bitcoin was able to solve several of the problems associated with earlier currencies and became a hit because of it. The Bitcoin whitepaper was published in late 2008, and the first bitcoins were mined around January 3rd, 2009. The first-ever transaction in the genesis block, called the ‘coinbase’ transaction, contained the following text:
In 2012, the Bitcoin Foundation was established to promote the development and uptake of Bitcoin.
By 2013, Bitcoin had become established enough to attract the attention of the American regulators tasked with enforcing laws against financial crime and money laundering. 5 The first Bitcoin ATM opened in Vancouver 6, and the People’s Republic of China started the first of many crackdowns on Bitcoin usage, barring financial institutions from using bitcoins in December. Bitcoin also hit $1,000 USD for the first time. 7
2014 saw widespread acceptance of Bitcoin as an asset class, as the U.S. Commodity Futures Trading Commission approved Bitcoin based derivative products.8 Disaster struck when papers leaked showing that Bitcoin exchange Mt. Gox was insolvent due to the theft of 744,408 bitcoins over a span of years. At the time, Mt. Gox was responsible for the majority of the world’s bitcoin transactions. The price of Bitcoin dropped by 36% in the months following the disclosure. The fiasco went on to become legend in Bitcoin communities.
2015 and 2016 saw Bitcoin continuing to gain widespread acceptance. The Mt. Gox hack did little to dissuade people from adopting Bitcoin. In 2015, an estimated 160,000 merchants were using bitcoin, and in 2016 the number of bitcoin ATMs jumped to 700+. A major hurdle was cleared when the Cabinet of Japan recognized virtual currencies as having a function similar to real money. 9
The ICO (initial coin offering) craze hit in 2017, bringing with it an influx of capital and a wave of scams. A speculative bubble emerged around Ethereum-based cryptocurrency projects, where founders crowdsourced enormous amounts of money by selling tokens to investors. The tokens generally had some proposed use, and investors hoped that a token bought for pennies would skyrocket in price, just as Bitcoin had.
While many founders were committed to their projects, plenty engaged in unethical behavior. One common strategy was the “pump and dump”, where founders and advocates would talk a token up until its price rose, and then dump their holdings, making off with a fortune while the price of the token crashed.
As interest in altcoins increased, the price of Bitcoin skyrocketed, reaching just under $19,800 in December. 10 Bitcoin prices plummeted in 2018 following a total ban on bitcoin trading in China. As the dust settled on the ICO bubble, countries moved to prevent financial crimes and further market manipulation by regulating cryptocurrencies. A staggering number of ICO projects failed, with nearly half of ICOs launched in 2017 going under by February 2018. 11
2018 was a rough year for the crypto economy. Plenty of people had been burned. Bitcoin’s price plummeted, going below $4,000 at one point. Payment provider Stripe removed support for Bitcoin due to problems with transaction times.
Things started looking up in 2019. The Lightning network was installed, improving the speed of Bitcoin transactions. Facebook attempted to launch its own cryptocurrency, Libra. The attempt failed due to regulatory pressure, but it did signal a renewed interest in cryptocurrencies by established corporate bodies.
Just three years after the ICO craze, the price of Bitcoin skyrocketed again. Due to a price collapse where Bitcoin halved in value, combined with anxieties about the Covid-19 pandemic, buyers rushed to purchase Bitcoin. 12 Several large investors bought millions in Bitcoin, and payment processor PayPal announced Bitcoin functionality for US users. 13 The price of Bitcoin skyrocketed, and by April, 2021 the price hit $63,000. While the price dropped down to $30,000 in relatively short order, Bitcoin reached a historic milestone when the Legislative Assembly of El Salvador voted to make Bitcoin legal tender.
– Is Bitcoin Just For Drugs and Crime?
Sometimes it seems like the press about Bitcoin falls into two camps: breathless hype people convinced the Bitcoin will change the world, and cynical naysayers that insist cryptocurrency is a giant bubble. There’s good and bad aspects to Bitcoin, but it doesn’t deserve much of the bad reputation it gets.
At this point in time, you can buy pretty much anything with bitcoin. Coffee, cars, computers, an apartment, illicit drugs, purebred dogs. You name it, you can buy it with bitcoin. Contrary to popular belief, bitcoin doesn’t play a big role in financing crime. In 2020, the share of all cryptocurrency activity taken by criminal activity fell to 0.5%. 14
How Does Bitcoin Work?
This is the section that will make you a hit in the workplace. Maybe less so at parties.
Bitcoin can seem intimidatingly complicated at first. Once you get down to it, however, it’s definitely possible to get a comfortable grasp on the underlying concepts and mechanics. This explanation doesn’t cover everything, but it will hopefully give you the tools to learn more about the bits you find interesting.
First, some distinctions. Bitcoin is a peer-to-peer technology. All actions, from sending and receiving transactions to mining bitcoins are carried out collectively by a network. There’s no central bank or authority.
Bitcoin was designed to solve the double-spending problem plaguing digital currency. This is not really a problem with cash. If I have $5 and use it to buy a beer, I can’t then take the same $5 and use it to buy a shot of something interesting. However, with digital currency, it’s theoretically possible to spend the same money twice. Before Bitcoin, this was generally solved by involving a central issuing body, like a bank or mint who would make and issue unique tokens.
Bitcoin solved the double spend problem in a decentralized manner by creating a distributed ledger, the blockchain, that anyone can see and check. The Bitcoin blockchain contains a complete transaction history. People can set up computers that hold copies of the ledger, called nodes. There are two types of nodes to be aware of: full nodes and light nodes. Full nodes contain a copy of the entire Bitcoin blockchain, and are constantly updated to reflect the mining of new blocks. Light nodes, on the other hand, usually only download enough blockchain data to verify new transactions. Every time a computer is connected to the Bitcoin network in order to send or receive a transaction, it is acting as a light node.
Every new Bitcoin transaction is broadcast to the nodes. Bitcoin is a proof-of-work based protocol, which means that miners must expend electricity in the form of computational power in order to participate in bitcoin mining. They compete to solve a complex computational problem embedded in the previous block. The first miner to solve the problem gets to choose the next block. They then broadcast the potential new block to the network. If the block is verified and added to the blockchain, the miner is rewarded with newly minted bitcoins and all the transaction fees in the block.
How do people prove that they own bitcoins? The Bitcoin protocol relies on something called public-key cryptography, which we’ll get into later. For now, the important thing you know is that Bitcoin users need a public key and a private key to send bitcoins. A public key acts as a sort of address, similar to a bank account number. People can send money to public keys, and see what transactions public keys have been involved in.
A private key is needed to send any kind of transaction. You may have heard the phrase “not your keys, not your coins.” This refers to the private key. If anyone has access to it, they have full power over your bitcoins. It’s vital to make sure that your private key is kept secret.
Buying a beer with Bitcoin
Let’s say it’s Friday night. Alice is off work, and she’d like to buy a beer. She heads off to a bar that accepts Bitcoin. She orders her beer, gets out her smartphone with her Bitcoin wallet and copies the bar’s wallet address. She puts in the amount the beer costs, chooses her fee, and sends the transaction. On the surface, what happens next is a bit of waiting while the transaction goes through. But what’s happening under the hood?
Alice’s wallet signs the transaction with her private key. That transaction is then sent to network nodes. Full nodes hold a complete copy of the Bitcoin blockchain, which acts as a ledger. If she goes to a bar and buys a beer with Bitcoin, she’s broadcasting a transaction that is propagated through the network via something called a gossip protocol. With a gossip protocol, information spreads like a particularly juicy piece of information through an office. A few nodes get the information, who send it to a few other nodes, and so on until all nodes in the network know about the pending transaction.
Since the nodes hold full copies of the Bitcoin blockchain, they have access to the history of every transaction ever sent. With this, they can make sure that Alice hasn’t already spent the bitcoins she’s trying to pay with. If they verify the transaction, it gets sent to the miners.
Miners compete with each other to solve a complex math problem. The first one to succeed is rewarded with bitcoins and transaction fees. The winning miner combines pending transactions, including Alice’s transaction, into a block. The block is sent out to the network back to the nodes, who confirm that the block is valid. If everything looks correct, the nodes add the block to the previous block in the blockchain.
The bartender gets a confirmation, and Alice is free to go drink her beer until it’s time for the next round.
Bitcoin transaction fees
Every time a Bitcoin transaction is made, miners need to expend computing power to mine it into a block. How are miners incentivized to confirm bitcoin transactions? The network offers a built-in reward called a miner fee.
Miners are eligible to win all the transaction fees in a block, as well as the block reward at the time. Good services will dynamically calculate miner fees. Some wallets support custom fees, and some do not.
You find out how high bitcoin transaction fees are through wallet apps, or by searching online. Some wallet apps will dynamically inform users based on network conditions. The Bitcoin network operates with two major constraints: the average block creation time in 10 minutes, and the block size limit of 1 megabyte. The Lightning Network protocol has enabled faster transaction speeds.
Bitcoin miner fees operate on the principle of supply and demand – if there is a high amount of traffic on the network, miners will require correspondingly high fees. If you pay a very high fee, you can get the speed equivalent of priority airmail for your transaction. The size of transaction also affects the miner fee, in the same way postage varies based on the size and weight of a package.
Miners decide which transaction to confirm first based on the miner fee. If you want your transaction to be confirmed quickly, it’s best to provide an appropriate miner fee.
Bitcoin transactions are comparatively slow. For reference, Visa averages approximately 1,700 transactions per second (tps), while bitcoin averages 4.6 tps. 15 Bitcoin is actually one of the slower cryptocurrencies due to the relatively small block size (one megabyte per block) and 10 minute average block generation time. Block size is hard coded, but block generation time (TB) is adjusted by changing the difficulty of the hashing puzzle in order to keep block generation time at around 10 minutes.
Transactions speeds can also be slowed down by multiple factors, including network congestion, lack of miners, and any other number of factors. Transaction times reached legendary highs in 2017, during the ICO boom, with users paying exorbitant fees and waiting hours for their transactions to go through.
Multi-signature addresses are a type of address associated with more than one private key. In order for any transactions to be issued by the address, a proportion of the private keys need to sign off. Let’s say Alice, Bob, and Charlie all have private keys for a multi-signature 2-of-3 address containing a whole bunch of bitcoin. Charlie decides to steal all the coins, and move to a country with no extradition treaties. However, the address requires multiple signatures – since it’s a 2-of-3 address, this means that Charlie needs to get either Alice or Bob to sign off on the transaction in order to make off with the coins. Multisignature wallets can require any permutation of m-of-n, 2-of-3, 9-of-10, or 5of-5. Transactions can only be sent as long as all the private keys are able to sign the transaction.
Multi-signature wallets are now commonly used by large exchanges as a means of consumer protection. If a hacker wants to steal the private keys to a wallet and send the bitcoin inside to their own address, they need to work quite a bit harder.