What is Bitcoin and how does it work? Explained. : Price Analyses

What is Bitcoin and how does it work? Explained.

Bitcoin is the world’s first peer-to-peer electronic cash system.

The currency was designed to be heavily resistant to tampering and surveillance through the use of pseudonymous addresses and public encryption.

The currency also introduced the blockchain into mainstream awareness, which is a decentralized public ledger technology that anyone can access.

Decentralized

The bitcoin network is decentralized, which contrasts sharply with the primarily centralized architecture we know and use today. Banking establishments, payment processors, and foreign exchange companies are all centralized entities.

When we use these services we trust that they will keep our money and personal information safe. Also, as these financial institutions form the backbone of the world’s economy, one wrong decision or lapse in judgment on their side can lead to widespread disaster (as we saw in the financial crisis of 2007).

Taking these facts into consideration, bitcoin then prompts us to consider an interesting question:

Would it be possible to send money from A to B without either party trusting each other or its intermediaries?

The answer: “Yes. With a blockchain, you could.”

Quick Bitcoin History

Bitcoin was invented by a psuedoynmous person or group named Satoshi Nakamoto in 2009. Nobody knows for certain who this individual or group is, or why they invented bitcoin.

What we do know, however, is that the author intended to create “a new electronic cash system” that was “completely decentralized with no single or centralized authority,” according to the bitcoin whitepaper.

The code for bitcoin was released to the public back in 2011. Shortly after, Nakamoto vanished; we have not heard from this group or individual since.

People who have been speculated to be Satoshi Nakamoto include: Vili Lehdonvirta, Shinichi Mochizuki, Hal Finney, Craig Wright, and Dorian Nakamoto.

Bitcoin’s dangerous mystique has also attracted numerous myths and conspiracies involving the coin. We’ve heard stories involving the NSA, robot aliens, Elon Musk, and time travelers.

While we don’t know who the creator of bitcoin is, we do know that they have not touched a single cent (or satoshi) from their bitcoin bag. To put these numbers into perspective: one account held over 66 btc at the climax of 2017’s bullrun, which, at the time, was worth USD $132 million.

So, what was it about bitcoin that lent itself so easily to people’s greed, to people’s fear, and to the people’s final disillusionment after the bubble burst?

To answer these questions it pays to consider bitcoin’s unique properties and scope for growth as an alternative currency.

Bitcoin’s Properties

Irreversible
Bitcoin’s first property is that transactions are irreversible.

This also means that accidental transactions cannot be remedied due to the currency’s lack of a centralized intermediary (such as a bank or payment processor).

Fast
The bitcoin network is fast and decentralized, with nodes spread throughout the world. The number of nodes and raw computing power (hash rate) the network yields allows for transactions to be settled within minutes.

Trustless
You don’t need to trust a (centralized) network provider with bitcoin, thus removing the middleman and enabling trustless settlements.

Anonymous
Bitcoin’s is pseudonymous; no transaction or address on the bitcoin network can be linked directly to a person’s real-world identity.

Although it’s possible to view all transactions coming in and out of a bitcoin address, proving ownership of said account or transaction would require external evidence.


Assets
The blockchain allows for the creation of unique, non-fungible tokens and assets for other applications.


Lower fees
Cryptocurrency payments are generally cheaper and faster than using SWIFT or a service such as PayPal (depending on market prices).

What is the double spending problem?

Double spending involves one user spending the same lot of money over multiple transactions. Bitcoin solves this problem through the use of a blockchain, which is a massive peer-to-peer network of computers (nodes) dispersed throughout the globe.

When bitcoin is sent from one address to another, nodes in the blockchain check to ensure that the transaction is unique. This way, it makes it easy to check the integrity of a transaction (if the same coins have been sent before) and either confirm or deny the transaction.

What are bitcoin private and public keys?

Every bitcoin transaction interacts with a user’s public and private key pair. Private keys are used to sign transactions thereby providing a decentralized proof of ownership.

Private keys also prevent the same transaction from being altered by anyone else (no double spending). Transactions are finally broadcasted to every node in the network and are typically confirmed within 20 minutes or less.

Every node in the blockchain has the same “snapshot” that every other node has. To put it another way, if you wanted to start your own bitcoin node you’d first need to download a record of every transaction that was ever made for that blockchain. This duplicity works for keeping the network synchronized (at the same block height/level) as well as protecting against certain network attacks.

Sending bitcoin to someone requires you to have: your public (wallet) key, the recipients wallet address and your own private key for confirmation. Transactions can typically be made from any wallet except for those in (long-term) cold or paper storage.

Bitcoin's Disadvantages
Bitcoin offers unbridled freedom with a proportionate downside: hacks and scams are a normal part of its ecosystem. Other criminal elements such as money laundering and the facilitation of illegal goods has tainted cryptocurrencies further.

Bitcoin’s other weakness is that it lacks accessibility. There’s no simple way of purchasing bitcoin that’s open to everyone without some technical expertise. For example, to get started you need to download specialized software; know how to use private and public keys; then go through a KYC (Know Your Customer), and AML (Anti-Money Laundering) process to verify your identity. Then there’s the actual management and use of the bitcoin account itself which involves additional time and expense.

In short, all of this complexity makes bitcoin hard to use. Until it becomes as easy as swiping your credit card, bitcoin could remain as an exotic curiosity and not something that’s part of our every day lives.

The other weakness of bitcoin are its sometimes long transaction times for approving payments. In extreme cases, people on Reddit have reportedly waited hours for their payments to be confirmed by the network.

But the worst side to bitcoin is the potential for criminal damages. The pseudonymous nature of the blockchain lets people get away with a whole spectrum of crimes that range from the hundreds to even millions of dollars in damage and sophistication.

For instance, operators of the Benebit ICO — one of the industry’s largest exit scams — reportedly made off with at least $2.7 million before investors realized what happened. The Benebit criminals were using stolen Linkedin photos, (reportedly from a boy’s high school in the United Kingdom) before the scam was discovered. Who knows how much further it would have gone otherwise?

While another scam works by impersonating official accounts and celebrities. Although common and clearly unsophisticated, these scams reportedly generate between “$50,000 to $100,000” per day according to an article by Bitcoinist.

 


Who controls Bitcoin?

As stated previously, no single person or entity controls the bitcoin network as it is decentralized from the network to the governance layer. Most of the development work for bitcoin is made by volunteer programmers.

For group decisions, they are made by group consensus and who has the most processing power. To put it simply, if you have bigger or more machines than anyone else then you are contributing more to the network than others. Therefore, your vote on network decisions will carry more weight.

This voting mechanism makes it more likely that only positive or beneficial actions will be passed for the health of the bitcoin network (as the price of btc is ultimately the same as the miners bottom dollar); it also makes it harder for a single person to manipulate the currency.

How does bitcoin mining work?

Bitcoin mining is a required process for transactions to be confirmed on the blockchain. So if there were no miners, nobody could sell, buy, or send bitcoin.

Miners therefore play a pivotal role in the bitcoin ecosystem, but you may be surprised to learn that mining is in fact a relatively simple exercise in math and a process of elmination — although its execution is neither.

Below is a chart that summarizes the bitcoin mining process.

source:
www.gao.gov/products/GAO-13-516

When someone sends bitcoin from one address to another, the network takes a “snapshot” of that transaction and all other transactions in the same timeframe. All those transactions at that point in time become a “block” and are sent to miners to confirm or process.

By using fast computers and specialized software, miners then transform those transaction blocks into bits of code called hashes. The goal then for miners is to find the right hash that matches the specific transaction for settlement.

Miners don’t know beforehand what the matching hash might be, so they often team up to create “mining pools” to find the correct hash – doing so greatly increases the chance that a correct hash will be found and profits can then be shared proportionately to the miners in the pool.

Once a matching hash is found, the hash is then appended to the end of the blockchain and a new block is started. In theory, this practice should continue forever. All nodes then update their records to reflect the latest block and miners are paid for their troubles in btc.

What is bitcoin cloud mining?

Bitcoin cloud mining allows you to rent out powerful mining equipment in data centers around the world.

Renting a cloud server for mining could be initially profitable, especially when mining a currency in a strong up-trend and at a low block difficulty.

Cloud mining is usually a managed service, so you won’t need to configure your own server or know too much about the process to get started.

Although the monthly investment might be smaller than purchasing a miner outright, many mining contracts have minimum lengths of 6, 12, 24, and 36 months or longer.

Make sure you read the contract carefully and understand your risks & exemptions if things don’t go to plan.

If you’d like a quick way of calculating how much you could make using cloud mining, check out this free tool here.

Where does bitcoin’s value come from?

Supply and demand, or the dance between buyers and sellers is what ultimately sets the price of bitcoin. The price of bitcoin is therefore decided by its perceived value; current, future, and potential.

Bitcoin is not actually “backed” by anything unlike the US dollar bill (which is backed by the US Treasury) and is not a physical asset. You could argue then that bitcoin has no intrinsic value.

On the other-hand, the fact that people are willing to invest their hard earned money into something else that shares none of the signs of a “solid investment” such as physicality, rarity, and usefulness, could be reason enough to give bitcoin, (or anything else for that matter) value in the marketplace.

But bitcoin also has a unique property which makes it to different to others: inbuilt scarcity. There is a maximum of 21 million coins. Due to its scarcity, as well as its high speculative value, some investors refer to bitcoin as “digital gold.”

Bitcoin’s Economics

Although bitcoin has a strong potential for disrupting financial markets, its price is extremely volatile and does not seem to oscillate with other securities in the market cycle.

For instance, bonds are backed by a national economy and are usually the things to be purchased just before a period of recession. Governments often publish statistics on interest rates and GDP for investors to read and make decisions on.

Similarly, traded companies release reports the outline the company’s financial performance. In either case, both stocks and bonds are relatively black and white when evaluating a security’s price.

Bitcoin, however, has no such centralizing authority or yardstick to measure the coin’s price against — except perhaps for its own historic price trends.

Another complication with bitcoin is that its price does not seem to correlate strongly with movements in the stock, bond, or commodities markets. Instead, bitcoin appears to move by its own momentum while being sensitive to bad and good news about the future of the blockchain in general.

Bitcoin accounts for over 50% of the cryptocurrency market. So when good news hits for bitcoin, all altcoins rise. On the other hand, a poor short-term look causes panic selling that can shave billions from cryptocurrency’s market cap within hours.

We know that stocks, bonds, commodities move in waves because we have decades of data of to look through. By comparison, cryptocurrencies arrived here yesterday.

How to trade bitcoin
How do you trade bitcoin?

There are numerous strategies you can use if you’re interested in becoming a bitcoin trader. I’ll attempt to summarize my favourite method for trading if you’re just starting out.

But first let’s establish some terms. To “go long” means to buy bitcoin when it’s at a lower price than your target; to “go short” means to sell against the price of bitcoin, meaning you expect the price to drop below its current price.

To simplify matters, I recommend to “go long,” especially if you are inexperienced. Adding complicated trading strategies when you’re just starting is asking for trouble.

My basic trading strategy for bitcoin is this: “the trend is your friend.” If bitcoin is going up then it’s more likely to continue than to reverse due to its upward momenum, so I go long.

I set my target when the price is going up and aim to make at least 1.5% margin on each trade. I don’t “shoot for the moon,” nor do I try to “find the bottom.” While these risks can be calculated, my experience with crypto so far is that it’s volatile enough without trying to catch a falling knife.

I don’t stay in the market for more than a day, and sometimes, I’ll take a small loss. My strategy, called “scalping,” is to take as many 1,2,3% gains as possible to slowly bankroll my earnings like a skilled poker player.

Although you won’t make a huge amount of money on individual trades, the compounding effect of just 1% extra quickly adds up.

Something else I’ll share with you is that it’s still possible to make money in bitcoin even in a strong downtrend. The key is that people panic. When btc dumps, “stable coins” rally — which are tokens pegged to the US dollar. Examples include Tether, True USD and many others.

So, in a strong trend in either direction you can make money by quickly entering and exiting trades; this has been my most successful strategy to date and has yielded consistent profits. It just works.

Where can I get free bitcoin?

You can look up bitcoin faucets to play some simple idle/clicker games or you can see our list of bitcoin mining games here.

How can I store my bitcoins?

Just like with fiat money, you also store your bitcoins in wallets and there are a few different kinds to choose from.

You can choose from a desktop, mobile, web, hardware and even paper desktop wallets.

The bitcoin core wallet is a popular option if you’re looking for something to run on your home PC; there’s also a mobile option of the same software if you’d like to manage your bitcoin while on the move.

sending bitcoin from the core wallet

Hardware wallets are physical devices that plug into your PC. Most models will come with a screen and buttons which make it easy to navigate the user interface. Each transaction you make when using a hardware wallet will require your manual approval, thus significantly the security of your assets.

Some popular brands for bitcoin hardware wallets include Trezor, KeepKey, Bitbox, and Ledger Nano.

bitcoin hardware wallet

And finally there’s the paper wallet, which is the most basic and arguably the most secure method of all for holding your bitcoin. So how do paper wallets work?

Bitcoin paper wallets hold your private and public keys on them, usually with an included QR code for easy access. The idea is simple: keep your paper wallet stored away safely in a private area of your home. You can still make future deposits and withdrawals using your account.

Getting started with a paper wallet is easy. Visit a bitcoin paper wallet generator and follow the on-screen instructions. Make sure to create backups of your keys as there’s no getting them back if you misplace it.

Paper wallets can be great for long-term “cold storage” of funds if you don’t intend to make many transactions from your chosen address.

What do I need to know to protect my Bitcoins?

Below are some helpful tips to help you protect your bitcoin.

Keep a minimal amount of bitcoin in your soft wallets and the rest in a hardware wallet or cold storage.

Keep a backup file of your wallet and use encryption.

Your funds are most at risk on an exchange.

Do not keep unencrypted wallet files, hashes, or private keys on your computer.

Be wary of downloading extensions, apps, toolbars etc that were made for cryptocurrency users; some malicious files are infected with malware designed to steal your crypto.

Enable two-factor authentication (2FA) for manual approval of bitcoin moving in or out of your account.

Common bitcoin scams

The four primary cryptocurrency scams are Ponzi schemes (HYIPs — high yield investments), mining scams, fake wallets and fraudulent exchanges. The last two I feel are self-explanatory but Ponzis and mining scams can sometimes appear as legitimate investments.

Ponzi schemes promise you with high monthly, weekly, or even daily returns for a small upfront investment. Otherwise named high yield investment programs (HYIPs) the one thing they all have in common is that they offer an unsustainable return on investment.

A guaranteed return of 2-3% per day with a $1,000 initial investment quickly compounds to the hundreds and even millions of dollars with enough time. These returns are obviously unrealistic.

As with a traditional ponzi or pyramid scheme, HYIPs only work if enough new users join the scam. Once the stream of users runs dry, the scam falls apart, with the owners usually vanishing with their victim’s capital.

One common variant on the Ponzi scheme are mining scams which work in exactly the same way. Operators will promise a very good return for a few hundred dollars or less in exchange for “mining” bitcoin on your behalf.

The catch is there’s no actual mining being done and is simply a loose front for a ponzi.

What are some popular bitcoin exchanges?

I recommend that new users get started with Binance. The exchange is easy to use with no KYC requirements when starting with low deposits.

For US residents who want fiat deposits, you can try Coinbase.

Matthew North

I have a passion for trading, behavioral finance, technology, travel, and writing. Contact: matthew@priceanalyses.com.

Leave a Reply

Your email address will not be published. Required fields are marked *