Bitcoin 101: A gentle introduction to Bitcoin

This article is a gentle introduction to bitcoin and assumes minimal technical knowledge.

In the popular media, you will often read comments like “Bitcoins are stored in a digital wallet”, or “Bitcoin is actual money” or “You can send money using the bitcoin technology”. These comments can be misleading and can confuse. By the end of this you should understand enough to participate in a dinnertime conversation about bitcoin, and not be mystified by the topic.

What is Bitcoin?

Although people refer to bitcoin as a decentralised digital currency, I prefer to think of it as an electronic asset; to sidestep questions around which government backs it and who sets the interest rate, which are often a mental block in understanding bitcoin.

As an electronic asset, you can buy bitcoins, own them, and send them to someone else, whenever you please. Currently (March 2017) there are about 16 million bitcoins that have been released, increasing by 12.5 bitcoins every 10 minutes, with an agreed limit of 21 million, of which the last of which will be created in the year 2140.

Transactions of bitcoins from account to account are recognized globally in a matter of seconds, and can be considered securely settled within an hour, usually. They have a price (usually in USD, but can be against any currency e.g. KES, GBP, etc, as with anything else), and the price is set by normal supply and demand market forces in marketplaces where traders come to trade, just like with oil or gold.

What are bitcoins designed for?

A 2008 whitepaper written by a computer scientiest with the pseudonym Satoshi Nakamoto introduced the concept of bitcoin, and the design principle behind bitcoin is:

A purely peer-to-peer version of electronic cash [which] would allow payments to be sent directly from one party to another without going through a financial institution like a bank, Western Union, M-Pesa, etc.

So, there is the concept of electronic cash: cash being a bearer asset, like the cash in your pocket which you can spend at will without asking permission from a third party.

Before Bitcoin there was never electronic cash; we had numbers being stored in the databases of  financial institutions like banks, Paypal or M-Pesa, whose rules you had to comply with in order to open an account and use, and whose permission you had to seek before being able to move the money.

Why use Bitcoin?

I think of bitcoin like just another international currency whose ‘home ground’ is the internet, as opposed to any geographical location. Put another way: if the internet were a country, bitcoin would be its currency. For the first time we have an entirely digital asset which can be controlled by the end user, without requiring signing up with an institution.

Bitcoin payments.  Bitcoin payments can be made from one person to another, irrespective of geographical location or jurisdiction. Payments are relatively fast – the initial notification is within seconds, and it ‘settles’ in about an hour. In situations where the normal financial system is inadequate, it can be a useful way of transferring value to anyone who has access to the internet.

Potential users.  Some communities are under-served by banks due to the cost/benefit of the brick & mortar banking model and regulatory cost; some international transfers are unreliable, or can take many days, with manual processes and faxes being used as part of the plumbing; some people may want to accept digital money for selling digital goods; there may be use cases where small payments, in the order of pennies, may be useful, which is currently difficult with existing fee structures with credit cards. There also may be other uses which we haven’t discovered yet…

Price volatility. Just like other currencies, bitcoin’s price fluctuates. Bitcoin’s price is more volatile than a lot of currencies (though the volatility is decreasing), so if you account for your wealth in your local currency, then owning bitcoin is essentially a bet on bitcoin’s future exchange rate price. Just like other currencies, if you have one currency (say, Kenyan shilling or a US dollar), and you want to convert it to bitcoin, you need to find someone to exchange it with. This necessarily has some friction and fees: either dressed up as commissions; or built into the spreads (the conversion price). With time, conversion is getting easier and cheaper as more exchanges are springing up in more countries.

Maintain cynicism.  You may hear of bitcoin being ‘fast’ and ‘free’ or ‘low cost’. While that is true when you are strictly in bitcoin, it’s worth maintaining some cynicism and thinking about the costs involved in the ‘on’ and ‘off’ ramp getting from sovereign currencies into bitcoin and back.

It’s worth noting that while bitcoin has spawned many other similar cryptocurrencies such as ethereum, litecoin, dogecoin, bitcoin is still the most widely used, most valuable and traded due to its network effect and relatively higher levels of security and robustness.

How does it work?

A network of computers validates and keeps track of bitcoin payments, and ensures that they are recorded by being added to an ever-growing list of all the bitcoin payments that have been made.

Keeping track of payments: The Bitcoin Blockchain

There is a file (well, split into several files) called “The Bitcoin Blockchain”, sitting on thousands of computers across the world. When you read the word “blockchain”, think “database” or even “list” and you have the right kind of idea. This “database”contains data about all the bitcoin transactions, that is payments of bitcoins from one account to another, that have ever happened. This is often called a ledger, similar to a bank’s ledger which keeps a record of payments between bank accounts.

When you make a bitcoin payment, a payment instruction is sent to the network. The computers on the network validate the instruction and relay it to the other computers. After some time has elapsed, the payment gets included in one of the block updates, and is added to The Bitcoin Blockchain file on all the computers across the network.

Peer-to-peer.  The distribution of data works on a peer-to-peer basis, rather than client-server. Peer-to-peer is like a gossip network where everyone tells a few other people the news (about new transactions and new blocks), and eventually the message gets to everyone in the network. This is as opposed to client-server is more like a conventional organization where a boss tells subordinates the news, and the boss is a central point of reference, and potential failure.

One benefit of peer-to-peer (p2p) over client-server is that with p2p, the network doesn’t rely on one central point of control which can fail.

How are bitcoins stored?

Bitcoin ownership is tracked on The Bitcoin Blockchain, and bitcoins are associated with “bitcoin addresses”. The Bitcoin keys or passwords needed to make payments are stored, in “wallets” which are apps that manage the addresses, keys, balances, and payments.

Bitcoin accounts: addresses

In banking you have accounts which keep pots of money separate; in bitcoin you have addresses. A bitcoin address is similar to a bank account number, with a few differences.

Here’s an example of a bitcoin address: 1MKe24pNsLmFYk9mJd1dXHkKj9h5YhoEey. Just like with bank accounts, if you want to receive a bitcoin payment, you need to tell someone your bitcoin address, so they know where to send bitcoins to. 

Bitcoin wallets

With my bank, under one single username/password, I control a number of accounts (eg incoming salary, monthly savings, credit card, etc), each of which have a balance or amount of currency. Similarly, Bitcoin wallets are apps that display all of your bitcoin addresses, display balances and make it easy to send and receive payments.

For a wallet to provide accurate information, it needs to be online or connected to a Bitcoin Blockchain file, which it uses as its source of information. The wallet will read the Bitcoin Blockchain file and calculate the balances in each address.

Bitcoin wallets let you create bitcoin addresses to receive incoming transactions and make outgoing payments, plus have other features that make them user friendly.

How are bitcoins sent?

Payments, or bitcoin transactions

Each bitcoin address has its own private key, which is needed to send payments from that address. You can think of a key as a kind of password, but it’s mathematically linked to its respective address, so it can’t be changed, unlike a conventional password or PIN number.

For the address above (1KMe24pNsLmFYk9mdM1dXHkKj9h5YhoEey), the private key is 5KkKR3VAjjhXOPzi3pWEHVQWrVa3C4fwD4PjR9wWgSV2D3kdmeM. Whoever knows this private key, including readers of this article, can now make payments from the address.

To get your own address/private key combination, it is not given to you by some authority like a bank, but rather you pick a random number and apply some maths to it – the wallet software will do this for you.

Private keys.  The private key is something you want to keep securely and never expose. Because you can not change that private key to something more memorable, it can be a pain to remember. Most wallet apps will encrypt that key with a password that you choose. Later, when you want to make a payment, you just need to remember your password.

Because bitcoins don’t exist tangibly, bitcoin wallets don’t store bitcoins but store the keys that let you transfer or ‘spend’ them. Copying a wallet doesn’t double the number of bitcoins you own, you simply have a copy of the same keys. If someone manages to copy and read your wallet, they can empty the accounts, just as two people with duplicate keys to a bank’s safe deposit locker can race to unlock the locker, but the contents of the locker do not double.

What happens when I make a bitcoin payment?

A payment is an instruction to unlink some bitcoins from an address you control, and move them to the control of another address (your recipient).

Your payment instruction includes everything you’d expect, including:

1. which bitcoins you’re sending
2. which address you’re sending them from
3. which address you’re sending them to

Digital cryptographic signatures.  The instruction is then digitally signed with the private key of the address which currently holds the bitcoins. This digital signing demonstrates that you are the owner of the address in question (because only you know the private key).

Payment instructions are sent from the wallet software to any of the computers on the network (called “nodes” or “payment validators”).

Validators.  When the first computer receives the instruction, it checks some technical details, and some business logic details (eg, does my payment attempt to create bitcoins out of nothing? Have the coins being sent already been sent elsewhere? etc).If these tests pass, then the computer relays it to others on the network, who each run the same validation tests. Remember on this network, computers can’t trust each other so they have to run the same tests. Eventually all computers on the network know about this payment, and it appears on screens everywhere in the world as an “unconfirmed transaction”. It is unconfirmed because although the payment has been verified and passed around, it isn’t entered into the ledger yet.

How are bitcoins tracked?

A) How do transactions get entered into everyone’s blockchains?

As well as passing information about transactions between each other, specialised nodes (computers who form part of the network) work to add these transactions, in blocks, to the blockchain. This is known as “mining” bitcoin. This is often described as “solving complex mathematical algorithms to win the bitcoins”. In fact there is nothing complex about this process, and you can do this by hand without a calculator; it just deliberately takes many computational steps without shortcuts.

B) Mining.  Mining is a guessing game where your chance of winning is related to the how quickly your machine can perform calculations compared to how quickly other miners are performing similar calculations. Whoever guesses the right number first wins the right to add a new block of transactions to everyone’s blockchains, and does this by publishing this to the other computers on the network. Each computer performs a quick validation of the block, and they agree that the block and transactions conform to the rules, then they add the block to their own blockchain. Why does the miner do this? Because as part of the block, they get to award themselves with some amount of new bitcoins (currently 12.5 BTC, and halving roughly every 4 years, the next halving being in 2020). This block-adding happens roughly every 10 minutes on the network.

Due to this reward, bitcoin mining has gotten very competitive, with companies developing specialized hardware (installed with mining software), which are very quick at the guessing game and associated number-crunching.

Bitcoin’s protocol and code ensures that it takes around 10 minutes for the network as a whole to guess correctly. This is the speed that transactions take to be confirmed onto the blockchain.

Slow for security.  By making it slow (10 minutes is slow compared to how fast it could be done if the guessing game was removed), and by making it computationally and therefore financially expensive to participate in this process, it also makes it financially expensive for miscreants to buy enough processing power to write their own abnormal blocks of transactions into the blockchain.

Bear in mind that even if miscreants were to do this, all the other computers would need to agree with all of the transactions, so they still cannot insert transactions that break the business logic rules, eg conjuring bitcoins out of thin air.

Bitcoin security

There are two parts to this:

1. Making payments
2. Block control

Making payments. As discussed earlier, the only thing you need to make a bitcoin payment is the private key of the address you want to spend from. You need to balance making it hard for people to steal your keys, and having backups in case you lose your keys – there are stories of people throwing away old laptops containing – not bitcoins – but bitcoin private keys controlling bitcoins worth millions of dollars.

Block control. There are two parts to this. Firstly there is block-creation (“mining”), performed by some specialized nodes; secondly there is block validation, which is performed by all nodes. Like an army of independent accountants and auditors all auditing the same ledger, the vision of bitcoin is to have many thousands of independent block validators to be participating in keeping the system honest. This independence and mutual validation of transaction and blocks is supposed to prevent any one person or entity from adding rogue blocks and dominating the network with their influence.

However, in practice, miners join forces into ‘mining pools’ in order to win blocks more often. In a mining pool, one participant creates the candidate block, and the others get to work ‘mining’ it. If any of the participants wins, the spoils are shared with the pool. This has the effect of each participant getting paid out more often, but less amount, like a lottery syndicate. This smoothing of cashflow works well for paying back capital needed to buy mining equipment. As a consequence, the mining pool owners have greater power over the bitcoin network in terms of creating blocks, voting on protocol changes, and potentially re-writing recent ledger entries.

What is this decentralised bit?

Let’s go back to “Bitcoin is a decentralised digital currency”. We’ve seen that bitcoin is digital, (though it is easy to send, and it has a value that is determined by supply and demand on a number of exchanges). What about the decentralised bit?

Distributed validators.  Centralised means one point or source of control, and decentralised is where control is shared among participants. In bitcoin, participants are the validators of the transactions and creators of blocks. If enough of them decide to play by different rules, then the others will need to follow suit. The validators have “voting power” proportional to how much computation power they have. Anyone can be validator, and get more votes, if they are prepared to pay for computing power, the costs of which are hardware, electricity, and support. So instead of one single authority who can change the rules, the rules can only be changed by consensus of those validators.

The validation logic (what does a valid transaction look like?) is baked into the code which is run by the validators.

Open source code.  This code is open source, meaning that validators can see exactly what code or logic they are running. The version that is most often used (called the ‘reference implementation’) is stored here: https://github.com/bitcoin/bitcoin. In theory, anyone can contribute to this reference implementation by uploading changes, though there are gatekeepers, people, who have the final say about what gets included.

In theory, anyone can write versions of this software, so long as they conform to the technical and business protocols of bitcoin. For example you could write you own version of the software, but with cooler graphics, or a more user-friendly interface. If you want to change some of the protocol rules, however, you’d need to persuade the majority of the validators (miners) to run your software with the new rules. 

Changing the rules.  So the rules can be changed, as long as you achieve majority consensus (another myth is that the limit of 21 million bitcoins cannot be changed. It can be changed, in one line of code, assuming you can get the majority of network participants to agree to run it). Getting the miners to agree to run code is the real challenge, as they have invested huge amounts of capital and will not readily agree to change anything which may harm their mining rewards – “The turkeys and goats won’t vote for Christmas”.

Conclusion

You have probably guessed by now that there is a lot more to bitcoin than I have been able to set out here; just take it in bite size portions and soon you will have a clear understanding. In giving a gentle introduction I have had to present some concepts at a high level, which in practice are complex and highly nuanced. But as you read and learn more on this Bitcoin topic, I hope to be able to take you into a more detailed understanding of bitcoin, mining and the underlying blockchain technologies in the weeks to come…

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Thank you.