You’ve doubtlessly heard about Bitcoin (BTC), the world’s first decentralized cryptocurrency that anyone can harvest, trade, or hoard. You’ve probably also heard about Bitcoin’s related concepts like blockchains, forks, mining, wallets, and others. Bitcoin was made for a technical crowd to use essentially as a plaything, so many of its methods and mechanisms are difficult to understand.
In this article, we’ll walk you through Bitcoin from the start, explaining every concept in depth and giving you a feeling for the cryptocurrency’s history and future. By the time you finish reading, you’ll be ready to start trading—or mining—your Bitcoin currency.
What Is Bitcoin?
Bitcoin is a pseudonymous digital token which can be used to transfer value.
Bitcoin’s first release as an open source software package was in 2009. At the time, Bitcoin received little attention except in a few small communities, thanks mostly to a lack of publicizing by the mysterious inventor of Bitcoin, “Satoshi Nakamoto.” We’ll talk more about Satoshi later on.
At the start, Bitcoin had a few core tenets:
- Decentralized development of core software
- Digital tokens denoting value, “bit coins”
- Pseudonymous ownership of value, stored in “wallets”
- Periodic instantiation of new sources of value, created by “mining”
- New sources of value are progressively harder to instantiate
- Globally transparent transfer of value from one wallet to another wallet by transferring digital tokens
These core tenets meant that no single person could control the distribution of the supply of Bitcoins, and in fact, the only way to produce more Bitcoins was for users on the decentralized network to create them. We’ll talk more about mining later on.
If you’re still confused, don’t give up just yet. Just remember that Bitcoins are digital tokens which carry value and that these Bitcoins live in unique digital files called wallets.
Creating new Bitcoins wouldn’t add any worth to the currency if users simply changed the number of digits in their wallet. Just imagine if everyone could change the number of dollars in their bank account at will—money would be meaningless.
Bitcoin’s solution to this problem is to make wallets encrypted, and have their value determined externally. Users can’t alter the number of coins in their wallet without going through an outside authority.
The universal ledger called the blockchain defines the number of coins in each wallet.
What’s A Blockchain?
The blockchain is a log of how many Bitcoins are in every wallet that exists. It’s also the living log of who has earned newly minted coins. No matter where your wallet file is, the blockchain knows how many Bitcoins are in it.
The blockchain is made up of two parts: the block, and the chain. Each “block” is a big clump of text and numbers which contain information detailing transfers from one wallet to another, new wallets created, old wallets destroyed, and which wallets earned the latest chunk of new Bitcoins.
The “chain” is the sequential appending of blocks to previous blocks. Each new block adds to the bottom of the blockchain, and the ledger gains a new chunk of information. The entire blockchain continuously grows and carries a traceable record of every wallet and every Bitcoin from the present all the way back to the “origin block.”
But what causes a new block to add to the chain? Newly minted bit coins, of course.
What Does “Mining” Mean?
The blockchain grows when a new solution to the hashing algorithm is found, causing newly “mined” Bitcoins to distribute to the wallet which found the solution. If this is a bit confusing, don’t give up yet.
To “mine” coins, each user must contribute some of their computer’s power to run an algorithm which generates hashes. Think of hashes as solutions to a really hard algorithmic problem. Bitcoin’s value comes from the energy expended by the computers as they run the hash generating algorithm.
The term “mining” is a very apt description for the process of creating new Bitcoins because a metal like gold is only valuable in as so far as it is hard to find. Much like with gold, there are a finite number of Bitcoins that can exist because there are a finite number of valid hashes in the algorithm that the protocol uses.
Because of how computationally difficult finding hashes is, users typically band their computational power together into “mining pools” where they promise to split the proceeds of their work if any of them successfully find the hash.
In summary, the order of operations in mining is:
- User connects to the mining pool
- User contributes hashes to the pool
- Eventually (not necessarily in the pool) the correct hash is found
- Once the correct hash checks out, a new block issues with updated information
- If the correct hash was in the pool, everyone in the pool splits the reward (bitcoins) in proportion to the number of hashes they checked
This means that it gets harder and harder to mine Bitcoins over time—the easier hashes are found first, and the more computationally intensive hashes come last. Thus, Bitcoin holds value because of the work required to find valid hashes and increases in value over time as hashes become harder and harder to find. So far, Bitcoin’s price has borne out this economics.
Issues With Implementation
In theory, Bit coin value should rise uniformly over time as mining becomes harder and harder. As it turns out, the bit coin price is subject to a few economic factors that might not be obvious at first.
Because mining coins get harder and harder over time, people who mined Bitcoin in the early days upgraded their computer’s hardware to mine faster. During a period of rapid growth around 2011, commercially available computer hardware like graphics cards were selling like hotcakes because they were reliably useful in increasing the rate of mining to the point where people could make their money back quickly.
This changed with the advent of even higher mining difficulty, which coincided with the rise of Bitcoin exchanges where people could trade them as commodities. Once it was popular to trade Bitcoin and mining difficulty was extremely high, miners turned to custom built hardware designed specifically for mining efficiently.
After that point, Bitcoin mining constricted to those who had a lot of cash to drop on sophisticated mining hardware. Users attempting to mine with consumer hardware simply didn’t produce enough hash solutions to receive an appreciable amount of Bitcoin in return for the wear and tear.
In this new “professionals only” mining landscape, an implementation issue became more apparent. In the Bitcoin protocol, those who have the most mining power have the most sway over when the blocks are added to the blockchain and also have the ability to agree on which blocks are legitimate additions to the chain, and which are not.
Thus, major miners could potentially form a monopoly of sorts where they rejected any new blocks that anyone had found with a hash before they did, provided that they held a majority of the computing power on the blockchain. The protocol was amended to reflect this vulnerability, and many of the largest mining pools willingly broke up to maintain the protocol’s integrity.
Why Bitcoin Was Groundbreaking
Bitcoin was compelling because it was the first cryptocurrency which gave the power of currency minting and distribution to the public, rather than “fiat” currency which is issued by states. Among many Bitcoin enthusiasts, Bitcoin is viewed as backed by “real” value—expended hashes—unlike fiat currency, which is backed only by governments’ promise to redeem it for goods and services.
Bitcoin also served as the currency of the underworld in a way that nobody could have thought possible. As wallets are pseudonymous and theoretically infinite in number, laundering Bitcoins is extremely easy, making them ideal for purchasing illegal goods in an untraceable way.
Though users could create Bitcoins themselves anonymously, soon after its inception there were exchanges which promised to exchange Bitcoins for USD, which allowed for easy use.
A Brief History Of The Bitcoin Markets
Once Bitcoins could exchange for dollars, Bitcoins could trade as commodities on exchanges. Early exchanges suffered from low liquidity, wild swings in prices, and deals as absurd as thousands of Bitcoins for three or four dollars.
As Bitcoins became harder to mine and more used on the black markets, the exchanges’ offered Bitcoin prices rose, too. Eventually, individual Bitcoins were worth hundreds of dollars.
Around the time that Bitcoin began to get popular attention and popular investment, trouble in the exchanges brewed. Members of the public that hadn’t ever mined their Bitcoins were flooding fiat currency into the exchanges, some of whom were struggling to buy enough Bitcoins to keep up with demand.
For others, the opposite problem developed.
One of the major Bitcoin exchanges, MtGox, was, at a time, unique. At MtGox, users could sell their Bitcoins for a higher price than they could elsewhere, and because of difficulties converting many currencies to Bitcoin around that time, there wasn’t much of an opportunity for arbitrage between exchanges.
This meant that Bitcoins were the most valuable on MtGox, and few were interested in buying at a higher price—yet many were interested in selling. This created a natural problem: MtGox was chock full of Bitcoins, yet didn’t have enough dollars to pay everyone out.
MtGox faced a few problems:
- Very low liquidity
- Unresponsive staff
- Higher asset price than other exchanges
- Offshore (Japanese) hosting
These problems led to other problems which the community quickly picked up on. Payouts in USD from MtGox after Bitcoin sales were slow—sometimes taking weeks. Inquiries were met with either silence or assurances that everything was fine.
There was trouble in paradise, and everyone knew it. Long after all the smart money had left MtGox for greener pastures, the exchange was forced to declare insolvency and bankruptcy, leaving many users with nothing to show for their investment.
The Coinbase Era
Happily, the explosion of MtGox paved the way for more reputable exchanges to flourish. Many of these new exchanges understood the legitimacy crisis that MtGox had brought onto Bitcoin and doubled down on providing quick, efficient, and professional brokerage services to their clients.
Among these new rising stars was an exchange called Coinbase.
Coinbase had some things going for it:
- High liquidity
- Easy USD to BTC conversion
- Two-factor authentication security
- Reputable ownership
Throughout the two massive price highs in Bitcoin’s history, Coinbase and other reputable exchanges have managed to stay solvent. Thanks to its careful operations, Coinbase is still around today and is probably the best place to go if you’re interested in getting started with investing in Bitcoin as a commodity.
Should I Invest In Bitcoin?
If you’re thinking about investing in Bitcoin, there are quite a few issues to consider. The price of Bitcoin tends to be extremely volatile, especially when massive hacks are resulting in people losing their bit coins. Over time, the price of Bitcoin has risen, but there are always massive shocks waiting around the corner, like with MtGox.
It’s important to remember that Bitcoin’s worth will theoretically continue to rise, but only on the black market do people genuinely use Bitcoin as a currency. For nearly everyone else Bitcoin is a technology experiment or commodity to invest in that is a bit too cumbersome to use as an actual currency.
If someone can figure out how to streamline Bitcoin’s use to be less technical, faster, and less open to security hazards, investing in it or using it as an online currency will become a much more enticing proposition.
Bitcoin itself is old news in the cryptocurrency scene, although it’s still the most used. Many in the financial services industries see the potential for using Bitcoins as financial instruments or investments, which is causing many of the original traders to exit for less exploited pastures.
Time will tell whether Bitcoin will become unseated by other, newer cryptocurrencies like Ethereum or one of the many “altcoins” which are effectively Bitcoin clones.