Bitcoin For Beginners: The Basics

Bitcoin has swiftly gained prominence in the global economy, but its inner workings remain a mystery to many. Its distinct characteristics and novel nature make it challenging to draw parallels within traditional financial systems. In this article, we'll explore the core characteristics of Bitcoin and how they set it apart from traditional finance.

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What Is Bitcoin?

Bitcoin is a protocol comprising of a distributed ledger and a native digital currency, launched on January 3, 2009, by Satoshi Nakamoto. In short, it is the "internet of money," a peer-to-peer monetary system independent of a centralized financial authority.

Here are the basics every Bitcoin beginner should know.

Finite Money Supply

Bitcoin is limited to a maximum number of 21 million bitcoins forever. This makes Bitcoin completely resistant to inflation—no one can print more Bitcoin. As such, Bitcoin has been an incredible investment for wealth preservation over long periods.

Traditional currencies issued by the government, known as fiat currencies, are prone to inflation. The printing of more units of currency is the primary cause of inflation. Historically, fiat currency issuers have been unable to resist the temptation to expand their monetary supply, leading to severe currency devaluations. For the first time, we have money that no one can print more of, marking a new era of finance.

This absolute resistance to debasement is the main incentive for individuals, companies, and countries to hold this digital asset as a store of value. In 2020, MicroStrategy became the first listed company to hold Bitcoin on its balance sheet. In 2021, El Salvador was the first country to recognize Bitcoin as a legitimate form of money and make it legal tender.

Blockchain

The blockchain underpinning Bitcoin is a public ledger that records all Bitcoin transactions, providing transparency and security to all users. Every node running the Bitcoin software maintains a separate copy of the Bitcoin blockchain, ensuring no one entity has control over the state of the network's ledger. With over 50,000 nodes distributed globally, Bitcoin has no single point of failure, making it more resilient than centralized systems.

Digital and Borderless

As a purely digital currency, Bitcoin transcends any geographical borders, allowing it to function as global money. This global nature promotes significantly greater financial inclusion over traditional financial systems, which have left many behind—especially in developing economies.

Additionally, Bitcoin facilitates faster transactions with minimal fees compared to traditional financial systems. Bitcoin is efficient money for an increasingly digital and fast-moving world.

Immutable Ledger

The Bitcoin ledger is immutable. Once a transaction is made, it cannot be reversed and is permanently recorded on the Bitcoin blockchain. This maintains the integrity of the blockchain and ensures no one can tamper with past transactions or manipulate fraudulent balances.

Not only is this ledger immutable, but it is also transparent. Being a public blockchain, anyone can view and verify transactions in real-time, which is a stark difference from the trust-based fiat system, where the public cannot audit the ledger their debit and credit cards run on.

Pseudonymous

Bitcoin transactions are pseudonymous, meaning your identity is not tied to a transaction, but rather, a cryptographic public address serves as a custom identifier. This is similar to how email works—your email address does not represent your identity but rather a custom identifier for people to send digital mail to.

Digital Bearer Asset

Bitcoin is akin to digital cash—you can hold it yourself without relying on a bank. The ability to self-custody your Bitcoin is one of the features that empowers its users, granting them near-perfect property rights. As long as you hold the keys to your Bitcoin, no one can take it from you, enabling unprecedented control and ownership over your money. This mitigates counterparty risk and enables full financial sovereignty—there are no bank runs in Bitcoin.

When you make a Bitcoin payment, it's as direct as if you were handing someone cash from your wallet or a physical bar of gold, making it a bearer instrument. But because it is digital, you can send any amount of value anywhere in the world and reach final settlement infinitely faster than you could with gold, which is hard to wrap your head around as a newcomer.

24/7 Accessibility

Bitcoin is accessible around the clock, always providing access to your money. This varies from conventional banking, which operates within the confines of standard business hours. Since Bitcoin is digital, you can take it anywhere and always have access to it right at your fingertips. With a Bitcoin wallet on your smartphone, there is no need to travel to a physical banking location for your financial needs or carry around a hefty wallet of cash.

Open Source

Bitcoin is an open-source technology. The Bitcoin code is openly accessible for anyone to review, providing transparency and fostering trust. Anyone can download the Bitcoin software, and its open-source design allows developers to contribute to its ongoing development and improvement.

How Bitcoin Works

Following a basic understanding of what Bitcoin is, the logical next step is to ask how it works. It's a question with never-ending answers, but here are some more fundamental things to know about Bitcoin as a beginner.

Decentralized Network

Bitcoin operates without a central authority or a CEO. Instead, it functions as a global network of computers worldwide, all running the Bitcoin software. Bitcoin's global network of computers, known as nodes, makes it resistant to control from any one entity, enabling it to function on a peer-to-peer basis without intermediaries. Anyone can download and run the Bitcoin software on their computer.

This starkly contrasts traditional financial systems, which are inherently centralized. In the current financial system, the government issues currency, a central bank controls the supply and cost of money, and a network of banks facilitates transactions. By automating these processes through code, bitcoin renders these intermediaries obsolete, enabling seamless transactions and global commerce.

Peer-to-Peer Transactions

Bitcoin enables transactions directly between users, eliminating the need for financial intermediaries like banks to facilitate transactions. Individuals can transact directly with one another, allowing for lower fees and faster transaction times. The absence of intermediaries also makes Bitcoin resistant to financial censorship and seizure, as well as free of any discrimination. You do not need permission to use Bitcoin; it is available to anyone with an internet connection.

Proof-of-Work (PoW)

Proof-of-Work serves as the consensus mechanism of the Bitcoin blockchain. It records Bitcoin transactions and determines how network participants maintain consensus regarding the state of the network's ledger.

In Proof-of-Work, Bitcoin miners employ specialized computer hardware to solve cryptographic calculations and mine Bitcoin blocks. Miners compete with one another by dedicating computing power to solve the calculations and mine the block. The first miner to solve it proposes the block to the network of nodes, which quickly validate it to ensure it follows the rules of the network.

Once validated, the block is mined and added to the blockchain. Whoever mined the block earns new bitcoin and transaction fees as a reward. With the addition of a new block to the blockchain, all the network's nodes update their ledgers to reflect the network's latest activity. This process has been repeating itself every 10 minutes since the inception of the blockchain in 2009, forming an immutable chain of all the network's activity.

Continue Reading:  Proof-of-Work Explained

The Lightning Network

Bitcoin's mainchain, the base layer payment network, offers secure transactions without a third-party authority. But it comes with a trade-off: On-chain Bitcoin transactions are confirmed on an average of 10 minutes, which is not ideal for daily purchases. This has spurred innovation on secondary layer protocols built on top of the rails of Bitcoin.

The Lightning Network is a layer 2 payments network built on top of Bitcoin designed to enable near-instant and low-fee payments while preserving the core characteristics of the Bitcoin base layer. Recognizing that Bitcoin's global adoption hinges on its effectiveness as a medium of exchange, the Lightning Network was built to make that a reality. By leveraging Lightning, Bitcoin transactions become remarkably fast, cheap, and accessible, allowing you to avoid high network fees that often accompany the Bitcoin base layer.

Dismissing the notion that Bitcoin lacks practicality for everyday transactions, the Lightning Network emerges as a powerful scaling solution, offering a viable means to engage in everyday transactions using Bitcoin with unparalleled efficiency. Utilizing the Lightning Network is as easy as downloading a Lightning Wallet from the App Store, such as Strike.

The Bitcoin Halving

The Bitcoin Halving is a pre-programmed event in the Bitcoin protocol that occurs approximately every 4 years or after the creation of 210,000 blocks. During this pivotal event, the Bitcoin block reward (i.e., the rate at which new bitcoins are created) is reduced by 50%, creating a supply shock for Bitcoin. The halving plays a key role in maintaining Bitcoin's inflation rate and underpins its scarcity.

Bitcoin Wallets

A Bitcoin wallet is a software application that allows you to interact with the Bitcoin network. They come in many forms, but the most common are mobile apps (hot wallets) and hardware devices (cold wallets). Bitcoin wallets can also be custodial or non-custodial.

Custodial Bitcoin wallets hold your private keys for you, and in effect hold your Bitcoin on your behalf. Non-custodial wallets provide you with your private keys when you open the wallet, meaning you maintain complete control over your Bitcoin. Holding your own private keys is known as self-custody and as the saying goes: "not your keys, not your coins."

Whether you choose a hot vs. cold wallet or a custodial vs. non-custodial wallet will depend on your needs and level of expertise. Once you set your wallet up, you're set to send and receive Bitcoin from anywhere in the world.

Bitcoin Security

Although digital, Bitcoin's security model, bolstered by its Proof-of-Work consensus mechanism, a decentralized set of nodes, and its use of advanced cryptography make Bitcoin impervious to hacks and establish it as one of the most robust computer networks. Bitcoin's PoW backs the network with an immense amount of computational power (energy) that makes attacking the network prohibitively costly. Bitcoin's global network of nodes (computers running the Bitcoin software) prevents any single point of failure; even if some nodes go offline, the network will continue to function as intended. Finally, Bitcoin employs advanced cryptography within its transaction architecture to ensure all activity on the network is authentic and legitimate.

Why Bitcoin Works

To fully grok Bitcoin, it's worth exploring why it works. How could a shared ledger with no one controlling it keep an accurate, immutable record of global transactions? How could it be that the supply of Bitcoin is provably finite?

Here are some key things for a Bitcoin beginner to know, even if you're not a technical person.

Bitcoin's Network Effect

Throughout its 15-year history, Bitcoin has established a dominant network effect that no other crypto network has come close to replicating. Network effect refers to the phenomenon where the value and utility of a product, service, or technology increase as more people use or adopt it. In other words, the value of a network system grows exponentially with the number of users. Bitcoin's substantial network effect is the primary reason why Bitcoin can not be easily copied or replicated and why most other crypto assets trend toward zero when measured against Bitcoin.

To illustrate, consider an attempt to replicate Wikipedia, a widely recognized and established platform with a substantial network effect. While creating a similar platform might seem feasible, the real challenge lies in capturing the extensive user base, trust, and community engagement that Wikipedia has amassed over time. You may be able to create an exact copy but it will lack all of the web traffic, users, contributors and internal linking that the real Wikipedia has built over decades. Similarly, Bitcoin's network effect encompasses a vast user base, widespread adoption, and recognition as the first digital currency. The collective trust and acceptance it has garnered make it challenging for any competitor to replicate the same level of network effect and, consequently, market dominance.

Byzantine Generals Problem

The Byzantine Generals' Problem is often illustrated by a scenario where a group of generals must coordinate their attack or retreat on a castle in the presence of traitorous generals spreading conflicting information. If the generals do not all attack at once (i.e., form a consensus), their attack will fail. In the decentralized network of Bitcoin, the challenge lies in ensuring consensus among participants who may be acting maliciously or providing contradictory information.

Bitcoin addresses this issue by employing the Proof of Work (PoW) consensus mechanism. Analogous to the generals reaching a consensus on whether to attack or retreat, Bitcoin miners engage in solving complex cryptographic puzzles, demonstrating their commitment to valid transactions. Through this computational effort, the network achieves a decentralized consensus, thwarting the potential impact of malicious actors and solving the Byzantine Generals' Problem in the context of a peer-to-peer digital currency.

The Bitcoin Difficulty Adjustment

The difficulty adjustment is akin to the heartbeat of the Bitcoin network that adjusts the difficulty of mining new bitcoins to ensure a new block of transactions is mined roughly every 10 minutes. When more miners join the network, the calculations become more challenging to solve. Conversely, if miners exit, it becomes easier to solve the calculations. This dynamic ensures the Bitcoin network continues operating smoothly regardless of fluctuations in miner participation.

Bitcoin Cryptography

The Bitcoin network employs advanced cryptographic techniques to ensure authentic, legitimate, and secure transactions. Public/Private key cryptography is used to secure user identities and transaction outputs. Utilizing a pair of keys — a public key accessible to all network participants and a private key only known by the user — enables secure and verifiable transactions. Digital signatures, another critical component, serve as proof of ownership and authorization. When a Bitcoin transaction is initiated, the private key is used to sign the transaction (a digital signature) which is then verified by the public key. This ensures only the true owner of the Bitcoin can authorize transactions of their funds.

Hash functions are another important piece of Bitcoin's architecture that transforms transaction data into fixed-length strings of characters, providing a unique identifier or "hash" for each transaction. These hashes are critical for linking blocks on the Bitcoin blockchain. Hash functions contribute to the security of Bitcoin by creating a cryptographic link between blocks that forms an immutable chain of Bitcoin's entire transaction history. This ensures no one can manipulate the Bitcoin ledger, forging an immutable record and ensuring everyone's bitcoin remains safely in their own possession.

Summary

Bitcoin's fundamentals have the potential to redefine the world of finance and technology. Its decentralization, limited supply, and peer-to-peer design challenge traditional systems. The Bitcoin blockchain, secured by Proof-of-Work, maintains transparency and consensus. Its digital and borderless nature make Bitcoin global money, fostering financial inclusion and economic empowerment. With 24/7 accessibility and open-source transparency, Bitcoin ushers in a new era of finance by putting control over money back into the hands of the people. Bitcoin extends beyond just digital money; its novel characteristics and global nature have the potential to reshape the world as we know it.

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