Bitcoin 101

  • April 10, 2021

Trying to figure out why everybody and their mother is talking about Bitcoin? Here’s a great place to start

Overview

If you’ve heard about Bitcoin before, but are not sure how it works or what all the hype is about, this is for you! Over the next few minutes, we’ll introduce the basic idea behind Bitcoin, blockchain, distributed ledgers, and cryptocurrency.

The concept that powers Bitcoin is called the blockchain. But, what does that mean? To explain, let’s use an analogy to a simple game.

Bitcoin, sometimes abbreviated BTC, is like a game. It has its rulebook and a scoreboard to keep track of how well each player is doing. The scoreboard can only be changed under the conditions and rules written in the rulebook.

Transactions on the Blockchain are recorded just like substitutions at the World Cup!

The game that Bitcoin was created to play is a game of money. More specifically, it’s meant to hold value across long periods – like a savings account. Bitcoin is also the token that is displayed on the Bitcoin scoreboard, which shows how much everyone has in their accounts. 

The rule book has all the necessary rules like how to create a new account, how to transfer Bitcoin from one account to another, and how to make sure that the real owner of an account is the only one that can transfer Bitcoin from that account to another.

Today, many people have joined in on the Bitcoin game. It has had more than a trillion US dollars worth of value secured on its network. With all of that money on the line, security becomes really important! 

Security

Bitcoin has extremely robust security against potential threats. Whether from individuals, hackers, the wealthy, or even governments, Bitcoin is resistant to attacks in ways that have never been seen before it.

In fact, today Bitcoin is already one of the most technically secure systems of money that have ever been created. And, hundreds of billions of dollars are spent to keep it that way!

So, how does Bitcoin’s security work? Let’s go back to our game analogy. 

Crypto is distribuited. Instead of having just one main scoreboard and rule book, many different people maintain copies of both. Whenever someone wants to change their balance from one account to another, they ask someone with a copy (in Bitcoin we call these Miners) to change it for them. 

At that point, the miners look at the rulebook and scoreboard to make sure they have enough funds to cover the transfer and that the request is signed by the real owner. If so, they add it to the batch of transactions (called a block) they are working on. If the majority of miners also agree that the block of transactions is valid, they will be accepted and go through.

Sometimes, miners can disagree about a transaction block. An example where this can happen is if one miner tried to cheat and spend money they have spent previously (called the Double Spend Problem). 

How Bitcoin resolves the Double Spend problem is one of the key innovations that made Bitcoin successful where many other digital attempts at money had before failed.

In Bitcoin, submitting transactions is not free. The owner of the account requesting a transfer pays a fee to do so. But, critically, the miner that helps him/her to complete the transaction also pays

Not only do miners do the work of validating the transactions, but they also have to submit something called a “proof of work.” This is a math problem that is meant to do nothing but make the miners spend a lot of money on electricity and specialized hardware.

Wait, so why would people waste money on math problems instead of just validating the transactions? Let’s walk through this.

If any miner is dishonest, others will wish to report them and reject the dishonest transactions. Thus, Bitcoin miners form a distributed effective self-policing force for the network. False transactions are not accepted.

But, the penalty for being dishonest is even steeper. The dishonest miner will not get back money spent on hardware and electricity. In contrast, those who play by the rules are rewarded with increasingly small but valuable amounts of new Bitcoin (called the Block Reward) for securing the network.

So, the key principle that makes Bitcoin secure is that those who try to cheat quickly lose money (in electricity, expensive hardware, and in losing their next block reward), meanwhile those who are honest make gains!

The second major principle that helps keep Bitcoin secure is that it’s technically a relatively simple system. This may be a surprising claim, but it is quite true.

Bitcoin only supports a couple of actions natively in its rulebook. For the most part, it just covers transferring, validation, security, and storage.

Perhaps related to the technical simplicity of the system, Bitcoin also does not change its rulebook much. Since it’s a computer program, the rulebook is written in computer code. Most of the Bitcoin code is a decade old and has never been changed.

This gives investors additional confidence because Bitcoin has successfully secured trillions of dollars worth of value in the past decade largely without security incidents. This system is still largely the same computer program or code still used as Bitcoin today.

Store of Value

A great question is what is it that gives Bitcoin its value? Despite it being created by code and stored on the internet, Bitcoin is a scarce digital asset. This means that there is only a limited amount of it that will be created – ever!

Today, most of us rely on a computer at a bank to tell us how much money we have. We move that money with plastic cards and paper bills from a national central bank.

It hasn’t always been that way.

In the past, we’ve used many other systems of money including local bank-backed paper checks for precious metals, precious metal coins, cattle, giant rocks, seashells, barter, and other systems even stranger! 

Rai Stone: a limestone used as a currency on the Pacific Island of Yap

Many people have called Bitcoin “digital gold” because both have a scarce supply that decreases slightly over time. There are hard limits to the amount that can be found on Earth.

Bitcoin can only be created as a reward for miners who can prove that they follow the rulebook. This means even if other systems copy Bitcoin, the Bitcoin network only accepts the original Bitcoin. This means there is no way to copy new Bitcoin into existence.

Furthermore, the amount of Bitcoin that is created decreases every 4 years. This is roughly similar to the decreasing supply of newly mined gold as it’s taken from the ground.

Finally, another reason Bitcoin supply decreases is that some amount of Bitcoin has become lost or inaccessible over time. But don’t worry! We’ll cover how to keep your cryptocurrency safe without losing it later.

For now, just know that because some lose their Bitcoin, the remaining coins become even more scarce.

From Economics 101, we know when supply decreases and demand stays the same or goes higher that price goes up! So, a slowly decreasing supply of Bitcoin is the best thing that can happen for its holders (or, in crypto HODLers – Hold On for Dear Life-ers)!

With that background, it can be easy to see why Bitcoin and other cryptocurrencies have generally risen in value so much over the past decade. But, cryptocurrency has also been known for times of extreme price corrections to the downside as well.

Crypto Volitility

Even though Bitcoin and cryptocurrencies have gained more value faster than any other financial instrument in recorded history, the road uphill is not always smooth. Those who do not understand and prepare for the extreme volatility (or extreme swings) of crypto tend to make poor decisions that can cost them dearly.

The first largest single factor that has routinely been at the root of crypto’s infamous price volatility can be explained in one word – leverage.

In investing, leverage is when an investor buys an asset with money that they have borrowed rather than their own money. As long as the trade is going their way, they then can make even greater profits than they would otherwise be able to.

On the other hand, as soon as a leveraged trade goes against the investor they can lose everything AND destabilize the market for everyone else. This is because they have to sell no matter what to attempt to cover the price of their loan.

To explain the effects of excess leverage on asset prices, I’ll compare leverage to large explosives.

Like explosives, leverage can be a very useful tool. But, it should only be used under very limited circumstances. Both are intended to be used only by the most skilled professionals who follow strict protections and disciplines to prevent accidents.

Unfortunately and also like explosives, accidents while using leverage tend to be catastrophic.

When people begin to stack up many explosives in the same spot, the danger is magnified. This is because one set off will also set off all its neighbors. The same applies to leverage.

The crypto market is currently filled with inexperienced people using irresponsible quantities of leverage.

A second major contributor to the volatility of crypto is that most artificial volatility inhibitors imposed by governments on other assets do not and cannot be applied to crypto.

An example of one such law is if a stock drops more than 10% within a short enough period, trading is artificially halted by law. If it keeps dropping “too far or too fast,” trading can be halted for the entire day.

In contrast, Bitcoin has global near-constant liquidity. Even if an exchange goes down temporarily, the rest of the world will continue trading the price of the asset.

In crypto, there are no artificial tops, bottoms, halts, or limits to what can happen to price. Instead, crypto price is a more pure function of global supply and demand than any other market in history.

Together, this excess leverage by irresponsible traders coupled with the infeasibility of government-mandated direct volatility protections makes crypto the single most volatile major market.

Luckily, volatility tends to greatly decrease as more money from different people becomes involved in the asset. So, these difficulties can only affect price within a short timeframe. When zooming out, their effects are insignificant when compared with the general stable up-trend of crypto over the past decade.

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