Beginner's Guide to Understanding Bitcoin

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Introduction

Knowledge is the most powerful tool in the markets.

The internet allowed people to gain access to almost an infinite amount of knowledge and wisdom. The leverage people can create for themselves is something we have never seen before in the history of mankind. The evolution of technology forces us to adapt to the ever-changing world, to change our habits and behaviours.

In a world that became digital so quickly, we might see people who struggle with their lives, trying to live in the analogue world of their childhood. Is there anything those people can do about their lives if they are unable to adapt so quickly? I do not dare to answer this question. What I would like to say though, is that we should spread the knowledge and try to educate those who are willing to learn. Unravel the mysteries of the modern world in a simple way and give them the most powerful tool we can imagine — knowledge.

Adapt or fail. Evolve or become the prey. Embrace the future or be the one that’s left behind forever.

The following article is an attempt to guide you through Bitcoin and equip you with the knowledge necessary to understand Bitcoin better than the majority of market participants, not to mention the society as a whole. So, without any further ado, let’s dive into the world of Bitcoin.

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The Inception

In August 2008, the domain name bitcoin.org was registered online. Two months later, on 31 October 2008, the Bitcoin whitepaper was published. Over the course of the following years, the whitepaper attracted and inspired people across the globe, not only technical engineers but also individuals who sought sovereignty. Since then, Bitcoin’s whitepaper has been read and studied countless times in order to understand the idea of Bitcoin at its core.

I highly encourage you to do the same and study the whitepaper on your own. You will become an individual who can proudly say you have dedicated your time to read the whitepaper of Bitcoin instead of just googling the phrase “what is Bitcoin”, reading the basic definition and not understanding the scope of the revolution taking place. The link to Bitcoin’s whitepaper is attached at the end of the article. The humble advice I will give you, is to go through the following article before reading the whitepaper to not to find yourself overwhelmed at first.

Bitcoin is not the first attempt to establish a digital currency enabling people to transfer funds in a peer-to-peer (P2P) manner. Throughout history, you might have heard of cryptocurrencies called Hashcash or Bit Gold. Those two Bitcoin’s predecessors did not attract enough attention and were unable to create the network effect, indispensable to becoming established in the mainstream world. After a series of struggles along the way, Bitcoin came out as the most successful cryptocurrency managing to survive and lead the way for all the other cryptocurrencies created since then.

The very inception of Bitcoin is tied to the mysterious individual called Satoshi Nakamoto, who was an active user on a site called bitcointalk.org. Whether Satoshi was an individual or a group of individuals remains a question to this day. The last time Satoshi logged into his account on bitcointalk.org was on 12 December 2010. Since then, he disappeared from the public, at least officially. That is why mysteries and conspiracy theories emerge concerning the actors behind Bitcoin’s creation. Personally, I have come across a number of different theories, some of them being severely deranged while some were quite persuasive and thought-through.

It is not about wondering who the creator was; it is about understanding the creation and its possibilities. The legacy Satoshi left has been changing the world ever since its inception and will continue doing so.

Blockchain — One Block at a Time

Bitcoin is often described as a distributed ledger. However, what does it exactly mean?

In short, everyone has the access to see all of the transactions made on the blockchain; however, no one can invert or delete the transaction that has once been verified and added.

Imagine you and your friends are eating out quite often, but only one person is paying for the meals. You are very scrutinous when it comes to the money and how much others owe you. How to solve the problem in a way everyone has the access to the data and the data cannot be altered?

You will get a notebook, and every time you go out, you will write down all the transactions made that evening. Everyone will get a copy of the page and return home. If one of you wanted to alter the data on the page, the rest of the group would see the difference and reject the data provided by the malicious friend. The consensus will be reached by the majority, and the data provided by the majority will be seen as official.

When it comes to Bitcoin, after every 10 minutes, a new block is produced by miners and is added to the main blockchain. The added block contains a number of transactions that took place and were verified by miners themselves. Now, with having added the following block, the next block is going to be produced by providing the network with the next set of transactions made by the users.

Proof of Work in Bitcoin — Prove Me You Earned It

For any company to run, we need employees who will put in the effort and work in order for the company to grow and provide services to customers. It is not as different as you think when it comes to Bitcoin.

The Proof of Work consensus mechanism implemented in Bitcoin needs people who will take care of validating and creating new blocks, as well as those who will verify whether everything is going smooth and there are no malicious actors in the network. Let me explain how the consensus mechanism in Bitcoin’s blockchain works.

Bitcoin is reaching a consensus on the network through the Proof of Work mechanism. In other words, the network is verified and secured via the computational power obtained with the use of CPU, GPU or devices designed specifically to mine Bitcoin, called ASIC (Application-Specific Integrated Circuit).

In order to reward miners for their efforts to secure and verify the network, they are given rewards in Bitcoin at the end of every block, which takes approximately 10 minutes. However, the chances of being the one who will finish the block are rather negligible. That is why miners often create pools, where they create the incentive to compound their computational power in order to have higher chances of gaining the reward.

In the early days of the Bitcoin network, establishing an individual mining system was far more popular than it is nowadays due to high maintenance costs and higher revenue perspectives. Time went by, and people began creating larger and larger Bitcoin mining facilities that needed a vast amount of space and sophisticated cooling systems in order to provide the desired temperature that would not damage the devices running all the time.

The proof of Work consensus mechanism is a key element of the Bitcoin network, as securing the network can be achieved only through the computational power of devices purchased in the real world for fiat money. In other words, miners have to be willing to invest money into mining facilities which leads to the creation of a separate branch of business, which is mining facilities ownership. The development of the Bitcoin mining business, however, is a topic broad enough for another article in the future.

Halving — The More You Mine The Less You Get

Bitcoin is often associated with scarcity.

Why do people consider it a scarce asset? It all comes down to the fixed supply of Bitcoin — 21,000,000 coins.

Do we have access to the whole supply of Bitcoin? No, we do not. Bitcoin’s supply is gradually added to the network until it reaches the limit of 21 million coins. Initially, Bitcoin was mined at the rate of 50BTC per block, and every block takes around 10 minutes to be produced. It is predicted the last part of Bitcoin will be mined around the year 2140.

But wait for a second; you don’t have to be a genius at math to calculate 50BTC every 10 minutes does not give me the year 2140. Indeed careful reader. That is why the mechanism of halving is so crucial in the Bitcoin blockchain.

What is halving?

In short, halving is the mechanism that reduces the reward given for producing the block on the chain by half — hence the name halving or halvening — every 210,000 blocks, which takes about 4 years to complete. As stated before, the initial reward was set to be 50BTC per block and has been reduced to 25BTC per block after the first 210,000 blocks have been produced. The first halving took place on 28th November 2012, after a total of 10,500,000 BTC had been mined, which was 50% of the total supply. As of today, i.e. April 2022, the reward for producing a block is 6.25BTC and is going to be reduced to 3.125BTC around 19th March 2024.

The mechanism of halving is closely related to the overall hashrate of the Bitcoin blockchain. You might have a quick look at what “hashrate” is here.

If a block is produced every 10 minutes with a given amount of computational power provided by miners, what if we increased the number of miners and hashrate they produce? Wouldn’t we produce blocks faster?

Blocks are produced by every 10 minutes with slight deviations to both sides at some times. However, the overall hashrate does not influence the time needed to produce blocks due to the baked-in mechanism of adaptive increase of difficulty. The more hashrate miners provide, the harder it gets to produce a block. That is why the time of 10 minutes per block is fixed, and we are able to predict the time when the next halving will occur.

Nodes and Blocks — A Little Bit of Building

For someone who has just got into the crypto world, you might be overwhelmed with the amalgamation of strange phrases and words meaning not exactly what you might have thought. However, you will also find words used in everyday language, and it’s not so hard to guess their meaning or even have a vague conception of what it means, how it works and what it does. Think about the blockchain technology you have read about before.

What are nodes, and what are blocks? Think about it for a moment. What is your first idea?

As described before, the blockchain is just a chain of blocks that got verified and added to the main chain. But what is this “block”? What does it contain?

Coming back to the idea of a book with all the transactions written in it being the blockchain, the block is just another page you will add that has been filled with information about transactions and got accepted by the majority consensus.

We will not go technically into what each block contains and how it is built as it is not as important as you have the idea of what it is and what role it plays.

What about nodes?

We might think of nodes as the main actors, along with the miners, in the blockchain responsible for independent verification of the state of the blockchain. But what does it mean?

To establish a full node in the blockchain, you have to download the whole Bitcoin blockchain and begin checking every transaction against Bitcoin’s consensus rules.

What is the size of the whole Bitcoin network? Make a guess. I’ll wait.

As of April 2022, the full Bitcoin blockchain size is estimated to be about 389.72GB.

And now, let’s have a little simile.

In Bitcoin’s blockchain, we have two main actors, miners and node runners.

Let’s go back in time to the gold rush in the US. Miners are just… miners, they mine gold with the use of their own power (physical and monetary resources) and are granted gold (Bitcoin) in return. All of them get richer by having more gold, and the country grows richer if their citizens do.

Nodes, on the other hand, are like sheriffs, making sure everything is being performed according to the rules of general consensus, and whether there are no malicious actors among miners or other users of the network.

Bitcoin — Lost and Hodled

Does the price of Bitcoin you see on the exchange resemble the price of each and every coin? How many coins are available to us even when we reach 21,000,000? Is it 21 million, or maybe it will be less?

Common sense tells us to believe there is a fixed supply of 21 million coins.

What if I had 1BTC on a cold wallet and… I forgot the password?

What if I had 1000BTC, back in 2010, stored on a paper wallet and… it got damaged?

What if I had been mining Bitcoin back in 2010 and had thousands of coins there… but I lost access to the keys?

What about the coins Satoshi Nakamoto held himself? Those coins haven’t been moved ever since.

How many BTC are really in circulation?

That’s the question many people are trying to work out, and you might find a number of different studies or individual research made trying to find the true number of BTC in circulation. However, be careful about the findings as it is impossible to evaluate, and the given numbers are just vague assumptions.

On the other hand, we have people who are not short- or mid-term traders but rather long-term investors who are not going to sell their Bitcoin at any time or will sell small quantities in the future to cover the costs of mining or living.

Another significant piece of information you have to think about is that the price of Bitcoin is established through the supply and demand mechanism on the exchanges with the use of liquid BTC. If we subtract the number of lost BTC and BTC held on non-custodial wallets, how many BTC will be left? The answer is less than you think.

What you have to remember is we have far less Bitcoin in circulation than you think, which means the price might not resemble the true demand of Bitcoin if we were to know the exact number of coins available to purchase.

Do not underestimate the will and perseverance of true HODLers and diamond-hand investors who will never sell you their coins, no matter the market conditions.

UTXO — What Does It Even Mean?

What is UTXO?

Unspent (U) Transaction (TX) Output (O)

Imagine going to a shop with a wallet and a 100$ note inside. After you have picked the right beverage and some snacks, you are heading towards the checkout in order to pay for the goods. At the checkout, you are paying with your 100$ note, and the cashier takes it and gives you the change — 25.50$. You take it and put it inside your wallet.

Is it just the part of the 100$ note? Well… it is definitely not.

The truth is the 25.50$ in your wallet is not correlated with the 100$ note you have paid with. It is just the note and coins that hold the value of 25.50$ you have in your wallet. Inside your wallet, you might have the following variety of coins and notes:

2x 10$ 1x 10$

1x 5$ or 3x 5$

1x 0.50$ 2x 0.25$

It is important to remember that you can have any other combination of coins and notes holding the value of 25.50$. You are not concerned with it, and I would risk the claim that in your entire life you have not even given it a thought.

That is what UTXO is. Now, when it comes to the Bitcoin blockchain and how UTXO works, I will just describe the general overview of it, as it is important to understand what are the coins you are holding in your — I hope — cold wallet.

You have bought 1BTC on some exchange. Is it the whole coin? Probably not. It is just a mixture of UTXOs equaling 1BTC. Then you want to transfer your BTC into your cold wallet. Let’s say you pay the network fee of 0.001BTC and transfer 0.999BTC into your cold wallet. Is it the same 1BTC you have got a while ago? Well… yes and no. It is the same or similar mixture of UTXOs you have had a while ago, but the address on the blockchain has changed. It is as if you handed someone a wallet, the individual took the coins needed for a network fee, and the rest of the coins and notes were put in the new wallet and handed it back to you.

The idea of UTXO is not complicated, yet it is rather important to know how it works in order to understand what threats a dust attack might pose in the BTC network and how coins can be tracked, just to name a few cases.

Lightning Network — Quick Money

You might have heard about different blockchain projects referred to as “Layer 2 blockchain”.

What does it mean?

In short, Layer 2 on a given blockchain is an additional layer providing the main blockchain, Layer 1, with more scalability by increasing the speed of transactions and their number per minute as well as reducing the costs of making the transaction.

Imagine going to the obsolete bank and transferring the money to another account you will have to pay the fee for the bank to do so and wait some time until the money will appear on another account. On the other hand, you can do the transfer via your banking account or some mobile application, you don’t have to pay any fee at all, or the fee is negligible, and the funds appear almost immediately on the destined account. That is the difference between Layer 1 and Layer 2 payment systems.

Do not, however, make a false assumption that Layer 1 is obsolete; it just has more important things to focus on, like providing the whole blockchain with new, verified blocks, while Layer 2 solutions aim is to provide Layer 1 with already processed and verified transactions by doing the needed hassle. That is why the main blockchain, here it is Bitcoin, will be given only the final state of the wallets. The information about all the transactions taking place on the channel until the final closing of the channel and balancing the accounts with the final amount of funds is not relevant to the main chain.

So now you know what Layer 2 is and what the aim of the Lightning Network is. One more thing to remember, most Layer 2 solutions on different blockchains are also built as a blockchain, Lightning Network, however, is not built with the use of blockchain technology. Remember the following statement, as it is the most general idea behind the Lightning, and the best one to imagine what it is.

Lightning Network is a network of public and private channels between Bitcoin wallets.

One important thing to remember is that opening a private channel with another wallet informs only two parties involved about the existence of the channel. The creation and opening of a public channel, on the other hand, informs the whole network such a connection is available and might be used by anyone.

What is the point of creating and running a public channel on Lightning Network, you might ask?

Fees you get paid by every transaction go through your channel.

If you don’t know what it is all about, it is about money.

When in doubt, see who profits from it.

Anonymity — I See What You Did There

Have you ever heard Bitcoin allows you to be anonymous? Or that Bitcoin was used to launder money because of its anonymity features?

Well… You might have heard stories like that. However, the moment you ask a question about why or how it allows people to stay anonymous, the conversation ends as if it turns out to be just a narrative someone has heard, without giving it a second thought.

In fact, Bitcoin is not anonymous. It is pseudonymous.

You are given a wallet address as your pseudonym; but what if someone tracks the transactions and discovers who is the owner of the wallet? Where is your anonymity then?

The easiest way to think of Bitcoin is like bulletproof glass storage; you cannot so easily steal the money, and you cannot change what’s inside. However, you can see exactly what’s inside if you are determined enough to spend some time digging and analyzing the data.

Every action you take on the Internet leaves a trace, and if it leaves a trace, it can be traced. It’s the most important rule people seem to forget quite often.

A feature like that has its advantages as you might be able to see what the big players, whales, are doing with their coins when you are not sure about the market conditions. There is plenty of on-chain data to be analyzed, and many people spend a lot of time doing so. Is it worth it?

Ask yourself a question. If you can do it, what is the scope of possibilities of the big players on the market? Do you think they are allowing you to so easily see their wallets for a minimal access fee to the on-chain data?

Focus on the bigger picture and long-term trends, not short-term behaviours.

The more transactions you make with a given wallet, the more traces you leave. It is not a flaw if you have nothing to hide. The question is, can it lead in the future to regulating Bitcoin so that every transaction will be monitored just as it is in the banking sector nowadays?

But wait. How do criminals use Bitcoin to launder illicit funds and cash them out? They are doing it somehow, aren’t they?

There are multiple services, such as mixers, allowing you to anonymize your coins and thus might allow you to use them freely. This is not a guide on how to make your coins anonymous, as it might do you significantly more harm than good if you don’t know what you are doing or what the consequences might be.

One thing to remember, the more anonymous you want to be, the more attention you attract.

The final thought I’d like to leave you with is that Bitcoin is not the only cryptocurrency we might use to pay for goods or services. Among the wide array of different cryptocurrencies, we might find coins providing us with usability and a rather high level of anonymity if used properly. An example of such a coin might be Monero (XMR), Zcash (ZEC) or even Litecoin (LTC) after its recent Mimblewimble upgrade.

Summary

Congratulations! You have reached the end of the article and gained the necessary knowledge to enter the world of Bitcoin and cryptocurrencies in general. You have taken the first step to living in the world of the future.

At this point, you already know what Bitcoin is, how its blockchain works and why it is not anonymous despite common misconceptions. I bet you can explain what Lightning Network is and how UTXO works to your friends who have never heard about it before.

Knowledge is the most powerful tool in the markets. Equip yourself properly before taking the first step and go for a victory of your own. Let the knowledge be your edge.

If you found this article worthwhile and helpful, it would mean the world to me if you follow me on Twitter, as I would to like reach as many people who are eager to learn just as you. Thank you in advance, and I wish you a great day!

Also published here.