What is Bitcoin? The Beginner’s Guide

Bitcoin is the most popular and best-known cryptocurrency. It hit the mainstream media like a bomb in 2017, when the price of Bitcoin moved from 1000$ to 20,000$ in less than a year. Bitcoin has grown from a small anarchist movement to a global phenomenon. Even if Bitcoin has become somewhat known lately, very few people know the fundamentals and history behind it. So, what is Bitcoin? In this article, we have it thoroughly explained.

Bitcoin was created by Satoshi Nakamoto

According to popular belief, a mysterious person called Satoshi Nakamoto created Bitcoin and blockchain technology ten years ago. This is only a half-truth. Digital currencies have been developed since the dawn of the internet. There have been many cryptographers paving the way for Satoshi Nakamoto’s ideas, which were presented in October of 2008.

Cryptographer David Chaum is probably the best-known pioneer in this field. He developed a virtual currency called DigiCash back at the 1980s. It became so popular at the 1990s that Microsoft founder Bill Gates wanted to integrate it into Windows 95 operating system. Gates was ready to pay Chaum 100 million dollars, but the man said no.

The concept of blockchain technology has also been presented as early as the 1990s by Stuart Haber and W. Scott Stornetta. They built a system, where document timestamps couldn’t be changed after they were created.

All this means that Satoshi Nakamoto didn’t invent Bitcoin out of nowhere. There’s a long history of successful and failed experiments in the field of cryptocurrencies, which were paving the way for Bitcoin’s existence.

Eventually, Satoshi Nakamoto was able to put all the pieces together and create a trustless and decentralized system in a way that wasn’t implemented before. His timing was also perfect. There were many people with open ears for such proposals after the financial crisis of 2008.

Bitcoin was born in 2008

The real person behind Satoshi Nakamoto is still unknown to date. Many people have claimed to be Satoshi, but none has successfully proven it. Some think he’d be Japanese, but Satoshi could be also a group of people.

Embed from Getty Images

Picture: Japanese physicist Dorian S. Nakamoto was drawn into a media fuss in 2014 when Newsweek magazine “revealed” he was the founder of Bitcoin. These claims were untrue, though.

According to his own words, Satoshi Nakamoto developed Bitcoin since 2007. He published the famous white paper on October 31st of 2018 to a cryptographer’s e-mail list. After this, a big wheel was set in motion.

The genesis block of Bitcoin’s blockchain was created on the 3rd of January 2009. This is widely accepted as the birthday of Bitcoin. The first transaction took place in the block number 170. It was between Satoshi Nakamoto and the main developer Hal Finney.

Information of Bitcoin started to really spread during 2010 and 2011. Many of the pioneers and long-time influencers in the crypto space got into Bitcoin back then. Satoshi Nakamoto left the project at the early stage himself and just left the project for others to develop. Most people agree that this was the most important decision he made, and it ensured the success of Bitcoin.

The crypto industry grows

The first real-world transaction with Bitcoin was made in 2010. A programmer called Laszlo Hanyecz used 10,000 Bitcoins to purchase two pizzas from the local pizza place. This transaction has become so famous, there’s even a Pizza Day celebrating the event yearly.

Mt. Gox exchange was also opened in 2010. It dominated the crypto space and made possible for many people to trade and speculate with the currency. Over 70% of all crypto trades were done via Mt. Gox at the time.

Bitcoin gained even more popularity in 2011 when Silk Road was founded. That was an underground market place, where drugs and other illegal items were sold and bought using Bitcoin. FBI eventually closed the site a few years later.

More and more services started to rise to the crypto space. But, the popularity of Bitcoin brought also more bad actors in. Many services and individuals got hacked during the early years and lots of money was lost.

The fall of Mt. Gox in 2014 is still probably the biggest single event in the crypto space. The exchange was hacked and over 850,000 Bitcoins were lost. The whole exchange went bankrupt and people are still waiting for their Bitcoins back.

The entire crypto space started to develop further. Bitcoin was no longer the only game in town. Litecoin, which is one of the most popular cryptos besides Bitcoin, was founded in 2011.

Ethereum development started in 2013, which was the birth of the 2nd generation of cryptocurrencies. Ethereum was officially launched in 2015. The platform made it possible to program your own decentralized apps (Dapps) and smart contracts.

The birth of Ethereum gave a platform for ICOs and helped Bitcoin into a long bull run between 2015 and 2017.

Bitcoin has been also developed further over the years. The software updates are called forks. The most important upgrades include the SegWit soft fork and the development of the Lightning Network. However, the role of the Bitcoin has remained unchanged. It is (and probably always will be) essentially a digital currency. Ecosystems like Ethereum don’t compete directly with Bitcoin.

The whole industry moves forward with giant leaps. Since late 2017 we’ve seen the 3rd generation platforms such as EOS and Tezos emerge. They offer scalability on a level that Bitcoin and Ethereum can’t process yet.

Blockchain is the backbone of Bitcoin

How does Bitcoin actually work? Let’s dive into the technology next.

First, one should understand the nature of Bitcoin. The software has always been open source. It means that anyone can use the code and create their own version of Bitcoin if they want. This has been done multiple times. Litecoin and Bitcoin Cash are currently the two most popular alternative versions of the Bitcoin software.

You should also understand that Bitcoin is both a payment system and a currency. There are digital payment systems in the world such as Skrill or Paypal. These systems exist regardless of the currency used in them.

bitcoin payment system - paypal
PayPal is a global payment system, which can be separated from the currencies it uses.

Even if Euro or Japanese Yen would cease to exist tomorrow, Skrill and PayPal would run the same way with dozens of other currencies. On the other hand, if Skrill or PayPal would be shut down tomorrow it’d have no impact on any currency.

These examples don’t apply to Bitcoin, which cannot exist without its payment system called the blockchain. Bitcoin is not a currency, which you can move out of blockchain and print to a piece of paper instead.

The technology behind Bitcoin is a bit fuzzy concept to many. Where is this mystical blockchain? Are my Bitcoins in some cloud service? Who runs the blockchain?

Blockchain technology comes from the fact that it consists of blocks in a chain. One block is in practice a list of transactions. In all simplicity, a blockchain is just a form of ledger. There is one word that makes blockchain so special: distributed. Hence, blockchain is also referred to as DLT – distributed ledger technology.

If you want to dig deeper into DLT, read our in-depth guide: What is blockchain (distributed ledger technology)?

In a traditional model, information is stored in a centralized database. It could be a bank system or Facebook’s database or an e-mail list of a local association.

The underlying problem of a centralized system is trust. All users must trust one single party to control and store the information and access to it. This was the reason why Bitcoin was born after the 2008 financial crisis.

Satoshi Nakamoto (and many others) wanted to create a financial system that wouldn’t be controlled by a centralized operator.

Blockchains are used more and more in closed environments as well. This could be a blockchain run by a bank, other corporations, or even a nation-state. Many feel that using blockchain like this kills the very idea of why it exists. If it’s not distributed, it’s just an inefficient database with no real advantages. Why wouldn’t you then use a traditional database instead?

What is Bitcoin? It’s a network of nodes.

Blockchain is a distributed ledger, where all transactions are stored by every member of the network. These operators are called nodes. You can compare them to servers running the internet. A Bitcoin network node is essentially a computer running the Bitcoin software.

There are tens of thousands of nodes in the Bitcoin network and anyone can run one. All you need to do is download the Bitcoin software. This means the network is permissionless and global.

bitcoin nodes
Bitcoin node locations from bitnodes.earn.com

Some of the Bitcoin network nodes are called full nodes and others are called lightweight nodes. Full nodes keep track of the entire ledger since it was born in 2009. That requires quite a bit of space because the ledger is hundreds of gigabytes and growing fast. This means that a regular Bitcoin user doesn’t download the blockchain to his laptop or mobile device.

The purpose of nodes is to control all transactions sent to the network. They make sure that the sender has enough bitcoins to process the transaction. Nodes pass on their information to other nodes if they confirm it is legit.

Nodes are only run by people, who want to support the network by giving part of their internet bandwidth and computing power to it. You can buy and store Bitcoin to your wallet without running a node. More nodes there are, safer the network becomes. And more decentralized.

Miners are also nodes, but nodes don’t do any mining. The only purpose of a node is to pass on transactions.

bitmain antminer s9
An ASIC mining device made by Bitmain, which is used to mine bitcoins.

But what is the purpose of these miners then?

You can think of a Bitcoin transaction like sending a traditional letter. You write an address and put a stamp on the envelop and deliver it to the nearest post box. From there it’s delivered to a local sorting center. From there it’s delivered further to anywhere in the world.

In Bitcoin’s world, nodes are the ones delivering your letter (= transaction) to the nearest sorting center. This is called a memory pool or mempool. It is a virtual pile of thousands of undelivered transactions. If the network is very busy, there could be hundreds of thousands of transactions pending in the mempool.

Miners are, in fact, just sorting machines. They pick transactions from the mempool and place them to a new block. Since each block has limited space, there are only so many transactions that can be processed at the time.

When a block is full of transactions, it’s added to the existing blockchain. There are hundreds of thousands of miners, each trying to be the lucky one whose block gets added. This competition is explained next.

Miners build the Bitcoin blockchain

Mining is maintenance work of the Bitcoin blockchain. It is required due to the consensus algorithm used by Bitcoin, which is called Proof of Work. PoW is like a decision-making process for a group of entities, which are in this case, miners. They all try to create a new block and add it to the blockchain. PoW is the process for deciding “the winning block”.

PoW is a very energy-consuming method. Each miner must run a special program, which means calculating difficult mathematical formulae 24/7. One of them eventually “wins the lottery” and gets to add the next block. This happens in the Bitcoin network every 10 mins by average.

High energy consumption means high electricity consumption. Mining of Bitcoin uses more electricity than the entire country of Ireland, as an example. When each block is mined, the creator is rewarded with Bitcoins. Currently, the amount is 12,5 bitcoins per block, but this gets halved after some years. The next halving comes in May 2020, when the reward drops to 6,25 Bitcoins per block.

This is also how new bitcoins come into existence. Over time, the inflation gets smaller and smaller and it eventually stops. There will be only 21 million Bitcoins created.

Anyone can start to mine Bitcoin. It’s not easy though, because the mining work requires so much computing power. Nowadays it can be only done profitably with specialized machines in mining farms near cheap electricity.

bitmain antminers
Bitcoin ASIC miners from a Chinese manufacturer Bitmain

Above is a picture of an ASIC miner built by Chinese manufacturer Bitmain. It’s a specialized computer built only for the mining work. Some cryptocurrencies can be also mined with GPU and CPU, but this hasn’t been profitable with Bitcoin in many years.

The purpose of mining is to create new blocks and new bitcoins into existence. If miners would stop, the whole network would die instantly. This is very unlikely, though. Even if half of the miners would stop, the rest would benefit greatly by getting a bigger share of the rewards. The free market takes care of this.

The block size of the Bitcoin blockchain has been a topic of heated debate for many years. Some developers wanted to increase the block size, which would increase the network capacity. Eventually, this group split from Bitcoin in August of 2017 and created Bitcoin Cash.

After that, there have been many other forks of Bitcoin, where the block size has been increased. This hasn’t influenced the popularity of the original Bitcoin, though.

It’s often argued that the whole concept of the Proof of Work is simply outdated. The rivaling option called Proof of Stake requires no physical mining machines. The mining is done virtually and called validating or verifying blocks.

There are no signs that Bitcoin would be moving out of PoW in the future. Instead, solutions like the Lightning Network are built to help the network to scale. PoW might be old, but it’s still the safest and most proven solution.

Private and public key make Bitcoin transactions possible

Next, it’s time to learn how Bitcoin transactions are done in practice.

Bitcoins are always stored in a public address in the Bitcoin blockchain. This ledger uses a simple bookkeeping method, which says: X bitcoins have been sent from an address A to address B. Since the Bitcoin blockchain is public, you can use a blockchain explorer and check any transaction from any block ever created.

The way Bitcoin’s UTXO model works is that your wallet balance is just a total sum of all transactions to (and from) your address. This is why the entire history of the blockchain must be used, which makes the system less efficient.

bitcoin transactions
Some random Bitcoin transactions from the Blockchain.info explorer.

As you can see from the image, addresses are long strings consisting of numbers and letters. Each address begins with a number 1 or 3 and it is always case sensitive, which means there is a difference between a latter X and x in an address. You should never try to write an address by typing it letter-by-letter. Use always copy-paste or a QR code.

Now we get to the essence of Bitcoin. Even if the ledger is public, you can’t connect a public address to a person using it.

Each Bitcoin address is derived mathematically from a user’s public key. This is always paired with a private key. Any public address funds can be only accessed with the private key connected to it, which is impossible to crack from the public key. This whole concept is called the public-key cryptography and it was developed in the 1970s already.

Bitcoin is an interesting combination of public and private ledgers. Anyone can explore the blockchain transactions without knowing the senders and receivers. You can only see that X amount of bitcoins have been sent from an address A to address B.

It’s easy to understand Bitcoin by using e-mail as an example. You can give your e-mail address to anyone publicly and it’s totally safe. Other people can only send you e-mails, but they don’t have access to your inbox. You can also give a Bitcoin address to anyone else and all they can do is send bitcoins to it.

Your private key is like your e-mail password. This enables you to unlock the wallet and makes it possible for you to send bitcoins from your address to other people. A bitcoin wallet is a bit like Outlook, Hotmail, Gmail, or other e-mail software. It’s a graphical user interface (GUI) to the Bitcoin blockchain.

There are a couple of important differences, though. A Bitcoin address is always a random string of numbers and letters. It’s not supposed to be recognizable, while your e-mail address is often in a format of yourname@domain.com. You want your e-mail to be simple and easy so people remember it.

Another difference comes from transaction history. As written earlier, the Bitcoin blockchain is public. If you give your Bitcoin address to someone, they can go and check the transactions. You wouldn’t want people to read your e-mails or even the subjects of your e-mails, right? This can be solved easily.

Practically every Bitcoin wallet is giving you the option to create a new address for every incoming transaction (or they might do this automatically). The wallet software the bundles all addresses to a single balance. This way you can share your address safely to people because you can always give a fresh address with no previous transaction history.

Why does Bitcoin have any value?

After reading all the technical features and history, you might still have the following question: why does Bitcoin have value? How come one Bitcoin was priced up to 20,000$ in December 2017?

There is no easy or obvious answer to this question. One reason is that there are no good methods for pricing up a financial instrument like Bitcoin. If you think about stocks, gold, art, collector’s items, oil, or consumer goods – there are price mechanisms and tools available for all these.

One issue comes from the fact that Bitcoin is not a commodity like gold and it’s not just a currency either. As explained earlier, Bitcoin is both a payment network protocol and a value-transfer unit inside that system. It is something for investor A and something different for investor B. Let’s go through some of the most common value propositions.

In the beginning, Bitcoin had no value. Bitcoins were given out for free and millions were lost during the early years. Slowly, Bitcoin transformed from a small hobby to a monetary phenomenon. The network grew in size, mining became more professional and there was more and more actual usage. This is when the network value of Bitcoin started to grow.

Think about applications like WhatsApp, which was born at the same time as Bitcoin (2009). WhatsApp is still a free-to-use app, which is simply a protocol for delivering messages. There is nothing unique about this – there have been hundreds of similar message protocols before and there are many more (even better ones) today. Yet, Facebook paid 11.6 billion euros of WhatsApp in 2014 when they purchased it.

bitcoin value whatsapp

WhatsApp has value because it has millions of users. This is the key to having a network effect and having network value. Roughly speaking, we could say that any protocol or application is valuable, which is used by lots of users. There have been endless examples of this theory in the past.

Bitcoin has also a first-mover advantage, which is a very important advantage to have. Bitcoin was the first cryptocurrency, which is why it attracted the best talent and most resources. Even today, almost every investor and crypto enthusiast starts their journey from Bitcoin. Most of the news is Bitcoin-related and BTC has still almost two-thirds of the entire market cap of cryptocurrencies. It’s practically impossible for other coins to close this gap.

One major advantage for Bitcoin to have value is the fact that Satoshi Nakamoto was able to create digital scarcity for the first time. Bitcoin has a unique monetary policy compared to fiat currencies and its rules cannot be altered just like that. They are basically set on stone. For the first time, there is truly a digitally scarce commodity in the world for investors to buy.

This is where the Stock-To-Flow model is based. S2F was published in early 2019 and it has become the first proper model of Bitcoin’s price development. Check the tweet from its developer “PlanB”, which was tweeted at the bottom of the March 2020 crash. The price was still very much within the model.

PlanB saw how the digital scarcity and the monetary policy of Bitcoin led to an inevitable price run every four years. This is due to the Bitcoin halving, which is an event taking place every 210,000 blocks meaning roughly every four years. There are more and more investors, who believe in this model. If it’s correct, Bitcoin will reach 100,000 dollars before the end of 2022.

On top of all these value propositions, there are lots of people who see Bitcoin as digital gold. It is an asset, which can be taken out of the banking system and stored safely in your own possession. For some, Bitcoin is just a revolution against the current monetary system. Then there are traders, who simply love the volatility and want to only speculate with price movements.

The point is that Bitcoin has different value drivers and every investor sees it in a bit different way.

Bitcoins are stored in digital wallets

Bitcoins are stored in wallets, which are applications. There are mobile wallets, desktop wallets, and online wallets. When using wallets, you log into them just like you’d log into Gmail or Hotmail account – with a username and password. The private key is held inside the wallet software and you don’t use it on your normal operations.

Regardless of the wallet used, your funds are always stored in the blockchain. Your bitcoins are not on your hard drive, in your browser, or in some USB stick. The transaction history is always in the blockchain and it’s immutable.

Remember: whoever controls the private key, controls the coins. If you don’t control the private key yourself, access to your Bitcoins can be taken away at any time. If you are storing your bitcoin sin a cryptocurrency exchange or in an online service, this is the case. You log in to your account using an e-mail and password. The operator has your private keys and controls your funds.

If you use a desktop wallet like Exodus, the private keys are store don your computer. The safest solution is to use a hardware wallet, which is like a USB stick.

Ledger Nano S - The secure hardware wallet

Ledger Nano X is currently the most popular option. When using a hardware wallet, you control your private keys all the time. The best thing is that our private keys are offline. No hacker can reach them.

How are Bitcoins being bought and sold?

Bitcoins can be bought these days from hundreds of different locations. Coinbase and eToro are the most popular ones for newbies, where you can easily exchange your fiat currency to Bitcoin. You can see all our recommended exchanges from here.

Buying Bitcoin is very simple. You register an account online, go through the KYC process, and deposit money from your bank account. You can also use a credit card. After that, you can buy bitcoins with a couple of clicks.

Bitcoins can be always held where ever you bought them as well. If your portfolio grows to thousands of dollars, it’s recommended to use a hardware wallet like Ledger Nano X and store the funds yourself.

Bitcoin is a reserve currency of the crypto world, a bit like USD in the real world. Many altcoins can be only bought with bitcoins. If you want to buy some rare cryptos, you must first buy bitcoins with your fiat currency and then exchange Bitcoin to other tokens.

Selling bitcoins is no different from buying them. You can exchange your cryptos back to fiat currency by clicking your mouse a few times. After that, the money can be withdrawn to your bank account instantly.

Bitcoin prices are usually followed in dollars. The official Bitcoin price is merged from the price of all different exchanges. The price you get is the price available in the exchange or service you are using. It might differ a bit from the official price.

The price of Bitcoin:

You can view all major cryptocurrencies from this page.

We also recommend reading this article: new ways to invest in cryptocurrencies.

Bitcoin explained – to put it all together

Let’s wrap up everything you have read so far and put it together.

Bitcoin is the world’s best-known cryptocurrency, which was founded by Satoshi Nakamoto in October of 2008. It is the first digital currency combining cryptography and blockchain technology. Bitcoin has had thousands of rivaling currencies and tokens over the years.

The Bitcoin software is open source. Anyone can use it and create their own version of Bitcoin.

Bitcoin is a so-called 1st generation cryptocurrency. Almost every single cryptocurrency in the market is more advanced and scalable than Bitcoin. Some of them (like Ethereum) offer smart contracts and many other features.

Scalability issues have split the Bitcoin development camp into two different groups. The path chosen by the Bitcoin is off-chain scaling. It means that small transactions are being processed outside the Bitcoin blockchain. The technology providing this is called the Lightning Network.

The blockchain technology behind Bitcoin means just a distributed ledger. It consists of tens of thousands of nodes all around the world. These nodes take care of all transactions sent to the network.

The Bitcoin network couldn’t function without miners. They are the ones doing the heavy maintenance duties. Miners create each new block of the blockchain. They are rewarded from their work with new Bitcoins.

The bitcoin blockchain is a public ledger – each transaction is visible to anyone. It is showing the public addresses of each sender and receiver. These are like e-mail addresses, but you cannot know who owns each address. A public address can be unlocked with a private key giving access to any funds in it.

Bitcoins are not stored on your computer or in your mobile or in your browser. There are no physical Bitcoin coins or bills either. Bitcoins exist only in the blockchain, where their ownership is always confirmed by the network.

Photo by  André François McKenzie on Unsplash, Tracy Le Blanc from Pexels

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