THE ULTIMATE BITCOIN GUIDE – HELPFUL AND ILLUSTRATIVE
October 31, 2008. A few years from now, this date could potentially be immortalized as one of the most critical days in the history of humanity. Fed up with the banking system following the Housing Crisis of 2008, an unknown programmer(s) going by the name of Satoshi Nakamoto released a whitepaper titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” on that very date. In this guide, let’s learn about one of the most revolutionary inventions of this millennium – Bitcoin.
Blockchain – The Heart and Soul of Bitcoin
At the very heart of Bitcoin lies the blockchain technology. Traditional finance is built on a centralized architecture. Your bank has full control over your money and your transactions. While you may not notice it much in your day-to-day life, it is incredibly evident in international transactions. Suppose you are a freelancer living in India and your client is from the USA. If they send you some money via SWIFT then your bank may hold on to it if they don’t have enough context behind this transaction. As you can imagine, this can be extremely problematic and goes to shows that you don’t really have any control over your money.
As an individual, you should have complete control over your money and it should be your right to transact with whomever you please. Satoshi Nakamoto realized this and wanted to create a currency that was not going governed by a single centralized entity. The way he did that, was by integrating the blockchain technology into Bitcoin’s core architecture.
So, what exactly is the blockchain?
As the name suggests, it’s a chain that connects blocks of time-stamped, immutable record of data. Each of these blocks of data is secured and bound to each other via cryptographic hash functions. The data in the blockchain is managed by a wide-area network of computers instead of one single entity.
To understand why the blockchain has been considered so revolutionary, lets checkout its three main features:
Checkout the following diagram:
This is the traditional client-server model we are all very familiar with. Whenever we want to interact with a website, we send a request to the server hosting that website. While this model has served us very well so far, the fact is that it is pretty vulnerable since it is completely dependent on the central server working optimally.
So, what’s the alternative to the traditional client-server system? The peer-to-peer (p2p) network:
Here, the information is shared by everyone in the network instead of one privileged entity. If you wanted to interact with someone else in the network, then you could do so without having to go through a central body like a server. That happens to be the core philosophy behind Bitcoin as well. Instead of going through an intermediary like a bank, you can directly transact with anyone in the Bitcoin network.
So how does it manage to do that?
The Bitcoin blockchain is hosted by a group of peer nodes. Each of these nodes downloads and maintains a copy of the blockchain in their systems. The blockchain gets automatically updated within their system. As such, all the data that is inside the blockchain is stored by everyone in the network.
The current financial structure is extremely opaque. All your money is inside the bank and they can do with it as they please. The 2008 financial crisis happened only because the banks decided to play God with the common man’s money. Bitcoin, on the other hand, gets complete transparency due to the integration of blockchain technology. Anyone can look inside the Bitcoin blockchain and keep track of all the transactions happening in real-time. Each and every single Bitcoin can be traced back to its very origins.
However, transparency doesn’t mean a lack of privacy.
Confused? Well, let’s elaborate.
Suppose Alice sent 0.015 BTC to Bob. If you look inside the blockchain, then you won’t explicitly see Alice and Bob mentioned by their names. You will simply see their public addresses. So, instead of “Alice sent 0.015 BTC to Bob,” you’ll see:
Don’t get scared of these random alphabets and numbers. We will explain public addresses and private keys in a bit.
Immutability, in the context of the blockchain, means that once something has been entered into the blockchain, it cannot be tampered with. This happens because of a handy little tool called “cryptographic hash functions.” A hash function takes in an input of any length and gives an output of fixed length. This output is called a hash. In a blockchain, the hash of each preceding block is stored in every subsequent block. Since all the blocks are connected to each other, it is impossible to tamper with the data in any of the blocks. It’s pretty amazing how this simple innovation imparts such a high level of security to the modern blockchain.
Wallets – Your key to the world of Bitcoin
So, how do you actually use bitcoins? Think of how you would typically interact with the fiat currencies. When somebody sends you money, they send it to your savings account, right? Now, if you were to send someone money, one of the ways that you can do that is by withdrawing money from an ATM and giving it to the recipient. Since Bitcoin uses public-key cryptography, the public address can be thought of as the savings bank account, while the pin code is like your private key. Checkout this image:
See those alphanumeric values below the QR codes? That’s the public address and the private key. As you can see, the private key is much longer than the public address. You should never ever share your private key with anyone like we just did. If someone gets your private key, then they pretty much get full control over your Bitcoins. Having a public address and private key makes you your own bank and gives you full control over your money.
Ok, so how does a transaction actually work? Suppose Alice wants to send $500 in bitcoin to Bob. This is what she will have to do:
If that sounds too complicated to you, then don’t worry, your Bitcoin wallet will automate all this for you. Which brings us nicely to our next topic.
What is a Bitcoin wallet?
A bitcoin wallet is a digital wallet that you can use to store, send and receive various cryptocurrencies. Keep in mind that a wallet doesn’t exactly store your money as a real-world wallet does. Instead, it saves your public and private keys, which in turn helps you send and receive money. There are two kinds of wallets out there:
A hot wallet is one that is directly connected to the internet. Any wallet that exists on a device that will ever connect to the internet is a hot wallet. The best part about them is that they easy to access and if you live somewhere that accepts cryptos for micropayments, there’s nothing wrong with using one for day-to-day spending. However, you need to be careful that you don’t store a lot of bitcoins in these wallets. Since they are always connected to the internet, they can be easily hacked.
Examples of hot wallets:
The cold wallet is completely offline. This is the wallet that you should use to store the majority of your Bitcoins. Think of this as your savings account that you are not going to touch for a long time. While they are a lot more safe and secure than hot wallets, you still need to be careful about how you handle the private keys. Plus, since you won’t be using these wallets that often, you have to be doubly cautious about where you store them.
Example of cold wallets
Fine, so I know how to store and use Bitcoins. How do I buy them?
Back in 2012/13, getting your hands on bitcoins used to be a considerable challenge. However, the process has become a lot simpler nowadays. It doesn’t matter where you live or what you do, anyone can get their hands on Bitcoins. The way you do that is via an exchange. As per Wikipedia:
A cryptocurrency exchange or a digital currency exchange is a business that allows customers to trade cryptocurrencies or digital currencies for other assets, such as conventional fiat money or other digital currencies.
They play a critical role in linking up the fiat world with the crypto world and allows one to go back forth as they please. There are two main types of exchanges out there:
If you are a beginner who is looking to get their hands on some Bitcoin, then we will recommend a fiat-to-crypto exchange like Coinbase or Kraken. Just create your account and get through the KYC process. Following that, you will be able to interact with the exchange as and when you please. This guide will help you create your Coinbase account.
Mining – Creating Bitcoins out of thin air
We are pretty sure that you have heard of “Bitcoin mining.” So what exactly does that mean? Are people putting on hard hats and digging through tunnels to mine Bitcoins? Well, no, but it is a little more complicated than that.
To understand mining, you need to know how consensus works in Bitcoin’s network. Like we said, Bitcoin has a decentralized ecosystem. There is no centralized system that makes executive decisions. So, how does anything get done in Bitcoin?
Well, for that, you will need to understand how a consensus mechanism works. A consensus mechanism is a process used to achieve fair and unanimous consensus within the system.
Objectives of Consensus Mechanisms
However, we can’t just any old consensus system for Bitcoin. If Bitcoin were to become a global financial structure, then it needs to work in any and all situations. We can’t just trust the nodes of the Bitcoin network to act honestly and optimally all the time. It was imperative for Bitcoin to function despite having malicious nodes that may not work in the best interest of the system.
To create such a system, the consensus mechanism needed to answer the “Byzantine Generals Problem.”
What is the Byzantine Generals Problem?
Ok, so imagine that there is a group of Byzantine generals and they want to attack a city. They are facing two very distinct problems:
In this situation, collaboration and complete consensus are key. Imagine that a messenger takes a message from one general and runs towards the next one to ensure that all the generals are on the same page. However, imagine that one of the generals is corrupt. What if they tamper with the messenger and spread conflicting messages throughout the system?
This situation is called the “Byzantine General’s Problem.”
Answering the Byzantine Generals Problem means creating a system that is decentralized and will work even if some of the elements in the network turn malicious. Satoshi Nakamoto was able to answer this by creating the proof-of-work consensus mechanism.
What is Proof-of-Work?
Proof-of-work(POW) is a method that uses the computational resources of the miners to solve cryptographically hard puzzles. The process that happens like this:
This is how proof-of-work (POW) works in a nutshell. A successful miner gets to add their block to the bitcoin blockchain. For their efforts, they get:
The POW system works as long as more than 2/3rd of the system is working in the network’s favor. Bitcoin mining is an extremely resource-intensive process and hence miners prefer to pool their resources together to create mining pools. The hashrate distribution chart of Bitcoin shows us that four pools – Poolin, F2Pool, BTC.com, and AntPool own more than 50% of the network’s hashrate.
To conclude, let’s summarize everything that we have learned so far and give you the properties of bitcoin transactions:
In years to come, the invention of Bitcoin may go down as one of the most significant achievements in the history of global finance. Looking at the rate with which the blockchain is being adopted and how several countries are currently looking into creating their own digital currency, this may not be a far-fetched claim.