A Brief Introduction to Bitcoin

You may have heard about Bitcoin thousands of times, but never got a chance to really dig in and find out what the fuss it is all about. Well, like the old saying goes, it is never too late to learn. This article is a really brief (literally) introduction to Bitcoin. The intended audience is general public. You don’t need to have solid programming skills to understand the fundamental concepts. If you are ready, buckle up and let’s deep dive.

What is Bitcoin?

Bitcoin is a worldwide cryptocurrency and digital payment system called the first decentralized digital currency, as the system works without a central repository or single administrator.

It was invented by an unknown person or group under the name Satoshi Nakamoto and first released in 2009.

It is said to be one revolutionary technology. The invention of the steam machines started the Industrial Revolution which brought humankind to the machine age, the invention of the internet connected us to a level nobody could even imagine one hundred years ago. Nobody knows exactly yet what is the impact of bitcoin and the associated blockchain technology. But in the bulk part, it is gonna be enormous. Let me explain why.

One reason is related to the monetary system. Take Federal Reserve for example. The Fed controls how much USD is printed and how much to circulate in the market. It is a central agency backed by Uncle Sam. We use cash or credit card to pay for stuff. That is our traditional perception and usage of money. If you look at bitcoins, a bitcoin is no more than a unique string of characters. It is not tied to any real-world currency. There is no central agency controlling supply and value, and no middleman taking a slice. Neither a single person nor a single group is in charge of bitcoin. Everyone is. The reason it has values is because people believe in it and actually use it. No matter where you are in the world, sending and receiving money is as easy as clicking a mouse. You can even remain anonymous if you want. Nobody can really pin point the real identity of a bitcoin account. Now you see why it is so revolutionary?

Another reason is more profound. Bitcoin is more than a cryptocurrency. It is a decentralized trust network, a trust network which can provide basis for so much more than just currencies. This is probably the most important reason which makes bitcoin and the associated blockchain technology so hot and everybody wants to get something out of it.

How Bitcoin Works?

As always, the best learning experience is through examples. Your bitcoin is stored in a bitcoin wallet. A bitcoin wallet contains one private address (aka private key) and potentially multiple public addresses (aka public key). If people want to send money to you, they only need to know your public addresses. But if you need to send money to someone else, you need to use your private address to sign the transactions. Basically, you need to verify that the money belongs to you before you can consume it. Keep your private address safe and make sure only you have access to it.

To begin with, the two parties involved are Bob and Alice. And Bob wants to send Alice 0.2 BTC. Initially, Bob has 1 BTC in his bitcoin wallet. In order to acquire bitcoins, the easiest way is to go to some specialized currency exchanges such as Bitstamp, Coinbase. Let’s see how the 0.2 BTC flows in the bitcoin network:

1. First of all, Alice needs to provide Bob with her public address (or public key, they are usually interchangeable).
2. Once Bob receives the public address, he initiates a transaction of transferring 0.2 BTC to Alice’s public address. Before he sends out the transfer request, he needs to use his private address to sign the transaction. Then he sends a request to broadcast the transaction to the bitcoin network. The bitcoin network is a peer-to-peer network, with the ability to propagate transactions and blocks to all participants (bitcoin network node or client). Any bitcoin network node that receives a valid transaction it has not seen before, will immediately forward it to other nodes it is connected to. Thus, the transaction rapidly propagates out across the peer-to-peer network, reaching a large percentage of the nodes within a few seconds.
3. After the transaction is propagated in the bitcoin network, now what happens? The transaction needs to be verified and included in a block which becomes part of the shared ledger (blockchain). This may sound obscure, but be patient and bear with me. After Satoshi published his first white paper, some people asked him how he can prevent double-spending of the bitcoins. Satoshi’s solution is the blockchain. Every new transaction will be verified and included in a block, and the new block will be generated on top of the previous block. The transaction can be traced backwards all the way up to the block #0, the genesis block. In that case, every transaction is well documented and traceable, which effectively prevents the double-spending.
4. So how is the transaction verified and included in a block? I bet you have heard this word millions of times: mining. Mining serves two purposes in bitcoin: One is to create new bitcoins in each block, almost like central banks printing new money. The other one is to create trust by ensuring that transactions are only confirmed if enough computational power is devoted to the block that contains them. In bitcoin, mining can be described as solving a difficult puzzle, whose difficulty can be adjusted automatically to ensure that it takes approximately 10 minutes to find a solution. Finding such a solution, the so-called “Proof-of-Work” requires huge amount of hashing operations, across the entire bitcoin network. The algorithm for “Proof-of-Work” involves repeatedly hashing the header of the block and a random number with the SHA256 cryptographic algorithm, until a solution matching a pre-determined pattern emerges. As miners build a new block, they add the unverified transactions into their block and attempt to solve a hard problem to prove the validity of the new block, if the miner finds the solution that makes the new block valid, the miner wins the rewards because their block is successfully added into the global blockchain. The current award per new block is 25 BTC. This is also how new bitcoins are generated.
5. Assuming the transaction of 0.2 BTC from Bob to Alice has been added to a new block #888. After ten minutes, a new block #889 is mined on top of #888. One block mined on top of the block which contains the transaction, is called “one confirmation” of that transaction. By convention, any block with more than 6 confirmations is considered irrevocable, as it would require an immense amount of computation to invalidate and re-calculate six blocks. Satoshi’s white paper gives more details on the mathematical theory behind this convention.
6. I hope you have a basic idea of how bitcoin works by now. If you are interested in learning more, check out the references listed in the end of this article.

Bitcoin Supply

Is there infinite supply of bitcoins? No. When Satoshi first created bitcoin, he set the maximum number of bitcoins to 21 million. So far, about 80% of all bitcoins have been mined. Based on the current mining speed, all bitcoins will have been mined by 2140.

Motivation for Miners

There are currently two ways to motivate miners to participate in the bitcoin network and make contribution to the computing power.

1. New Block Reward. Adding a new block to the global blockchain is equal to 25 BTC. According to the current bitcoin price (5500$/BTC), it is more than 130,000 $, which is a lot of money.
2. Transaction fees. Miners charge transaction fees for each transaction for their effort of verification. For example, take the example above, when Bob sends Alice 0.2 BTC, he has to pay transaction fee to the miner (say 0.0005 BTC). In the end, a total of 0.2005 BTC will be deducted from Bob’s bitcoin wallet. When all the bitcoins are mined, transaction fees will probably be the only motivation for miners.

Bitcoin Security Vulnerabilities

The most prominent incident of bitcoin theft happened in 2014 when Mt. Gox, a Tokyo-based bitcoin exchange announced that approximately 850,000 bitcoins belonging to customers and the company were missing and likely stolen, an amount valued at more than $450 million at the time. They are valued more than $4.5 billion at today’s rate. If you are seriously considering investing in bitcoin, make sure you select an exchange which has good reputation in security.

Conclusion

This article is not meant to make you an bitcoin expert. If you feel you learn something new after reading my article, I will be extremely happy. No matter what you think of bitcoin, it is getting more and more popular every day. I wouldn’t be surprised if one day, most of our money is stored in bitcoin, and we use bitcoin to buy stuff the way we use cash or credit card today.

References

1. Bitcoin: A Peer-to-Peer Electronic Cash System, Satoshi white paper.
2. Mastering Bitcoin, Andreas M. Antonopoulos.