23
Jan
20

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:

 

  • Decentralization.
  • Transparency.
  • Immutability.
  •  

    #1 Decentralization

     

    Checkout the following diagram:

     
    3 computers requesting from a server. arrows depict the direction of requests and the cloud in the middle of the image depicts the network.
     

    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.

     

  • The central server acts as a target point for potential hackers.
  • If the server goes through a software upgaradation, then it will go offline and halt the entire system.
  • Plus, this system puts a lot of power in the hands of the centralized entity. If it turns malicious or rogue, then it will compromise all the data that has been put into it.
  • If you wanted to interact with someone else in the network, you would have to go through the central server.
  •  

    So, what’s the alternative to the traditional client-server system? The peer-to-peer (p2p) network:

     
    6 computer icons that are connected with lines depicting the interconnection of the network. also called peer to peer network where each computer is a server and a client.

    Image Credit

     

    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.

     

    #2 Transparency

     

    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:

     
    this image shows the transaction trace from one account to another account (address) within the bitcoin network.
     

    Don’t get scared of these random alphabets and numbers. We will explain public addresses and private keys in a bit.

     

    #3 Immutability

     

    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:

     
    This image shows the public key that can be used to receive Bitcoins and the secret key (also called private key) to use bitcoins for further transactions.
     

    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:

     

  • Create a transaction and sign it off with her private key.
  • Alice sends the bitcoins to Bob’s public address.
  • Bob decrypts the message by using Alice’s public key to verify that it really was Alice who sent the bitcoins.
  •  
    fulfilling a transaction via the bitcoin network by signing the transaction with a private key.
     

    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:

     

  • Hot wallet.
  • Cold Wallet.
  •  

    Hot Wallet

     

    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:

     

  • Exchange wallets: The default wallets linked to your account in the exchanges.
  • Desktop wallets: Exodus is a well-known desktop wallet. These are the wallets that you access from your PC/laptop
  • Mobile wallets: Electrum is a brilliant mobile wallet. You simply download the wallet on your phone and send and receive bitcoins.
  •  

    Pros

     

  • Quick to access funds.
  • A wide number of options, and support for different devices.
  • User-friendly UI.
  •  

    Cons

     

  • Since it is connected to the internet, it is vulnerable to hacks.
  • Damaging the device could destroy the wallet.
  •  

    Cold Wallet

     

    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

     

  • Hardware Wallets: Think of hardware wallets like USB drives where you can store your crypto. Ledger and Trezor are the two most popular hardware wallet companies.
  • Paper Wallets: The concept behind this is simple. Generate a wallet in sites like walletgenerator.net. Following that, just print out your public address and private key in a paper and keep them in a secured location, like a safe. This is one of the safest ways of storing coins in the long-term.
  •  

    Pros

     

  • Best way to store a large number of Bitcoins.
  • Since these wallets are completely offline, you are safe from hackers.
  •  

    Cons

     

  • You will have to take extra care of the device (for hardware wallet) or the paper (for paper wallet).
  • The bitcoins you store in cold wallets will not be that easily accessible to you.
  • The UI may not be as user-friendly as hot wallets. Newcomers may get a little intimidated.
  •  

    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:

     

  • Fiat-to-Crypto: These exchanges will allow you to buy cryptocurrencies in exchange for fiat. Coinbase is the most popular fiat-to-crypto exchange which allows you to directly buy bitcoin in exchange for fiat.
  • Crypto-to-Crypto:Crypto-to-crypto exchanges will help you buy cryptocurrencies in exchange for popular cryptocurrencies like Bitcoin, Ethereum, etc. Binance is a well-known crypto-to-crypto exchange.
  •  

    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

     

  • Agreement Seeking: Should give a result which helps in building agreement among the group.
  • Collaborative: The mechanism should allow the participants to work together and put the best interest of the group first.
  • Cooperative: All the participants shouldn’t put their own interests first and work as a team more than individuals.
  • Egalitarian: One vote will not be more or less valuable than another person’s vote and will carry equal weight.
  • Inclusive: The process should include all the participants in the decision-making process.
  • Participatory: The consensus mechanism should be such that everyone should actively participate in the overall process.
  •  

    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?

     
    two generals shout "attack", two shout "wait". The devil says "attack, no, wait, surrender"
     

    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:

     

  • The generals and their armies are very far apart, so centralized authority is impossible, which makes a coordinated attack very tough.
  • The city has a vast army and the only way that they can win is if they all attack at once.
  •  

    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:

     

  • The miner picks up pending transactions waiting in a place called “mempool,” to build their block.
  • The contents of the block are hashed.
  • Following that, an alphanumeric string called “nonce” is attached to the front of the hash.
  • The entire thing is hashed once again.
  • Before the mining process, the community decides on a value called “difficulty.” The hash of the block and the nonce must be less than the difficulty.
  • If the resultant hash is less than the difficulty, then the mining is deemed successful and the miner broadcasts the block, nonce, and hash across the network.
  • Anyone in the network can check the nonce and the hash to see if the miner is saying the truth or not.
  • If the resultant hash isn’t less than the difficulty, the miner changes the nonce and checks the resultant. The process of getting the correct nonce for the hash is extremely difficult and highly taxing on their system.
  •  

    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:

     

  • A block reward, which is currently worth 12.5 BTC.
  • They get to collect fees from the transactions they have put inside their block.
  •  

    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.

     
    25% of the miners in the bitcoin network are unknown. The other mining pools are known. This is depicted in a pie chart.
     

    Conclusion

     

    To conclude, let’s summarize everything that we have learned so far and give you the properties of bitcoin transactions:

     

  • All transactions in Bitcoin are irreversible. Once a transaction has been conducted, you can’t take it back. This is possible because of the blockchain’s immutability.
  • Transactions take place between public addresses, which are not linked to the user’s real name and identity. As such, bitcoin transactions are pseudonymous
  • Bitcoin transactions are global in every sense of the world. As long as you have a wallet, you will be able to receive Bitcoins.
  • It is impossible to send bitcoins without owning the corresponding private key, making the whole process extremely secure. You must keep in mind that the Bitcoin blockchain has never been hacked.
  • You and only you have complete control over your money.
  •  

    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.

     

    Rajarshi Mitra
    Blockchain Researcher