On October 31st of 2008, an unknown entity by the name of Satoshi Nakamoto, released a proposal called “Bitcoin: A Peer-to-Peer Electronic Cash System.” This proposal, more formally known as a white paper, offered a way for individuals to send electronic money without having to go through an intermediary. For this system to work, Satoshi Nakamoto utilized ideas from cryptography, computer science, and economics, to create a system that is now known as a blockchain. On January 3rd of 2009, the first block was mined on the Bitcoin network… and… well… the rest is history.
The objective of this guide is to break down all the technical jargon surrounding Bitcoin and blockchain technology so that even a 5th grader can understand it. Albeit, if the show Are You Smarter Than a 5th Grader? has taught me anything… it’s that… we AREN’T! Even in this short introduction, words like “blockchain,” “cryptography,” and “mined,” may seem intimidating if you have no experience with digital currencies like Bitcoin. Have no fear, by the end of this guide you will be in the top 0.1% of the world in terms of knowledge about digital currencies and how they work. Are you excited?! If your answer is yes, keep on reading! If your answer is no, keep on reading (please)!
Why?
Why did Satoshi Nakamoto create Bitcoin? Why does Bitcoin even have any value? These “why” questions are the most common questions about Bitcoin, and other digital currencies (based on the statistical evidence provided by my friends and family asking me about it every other day). So, without further ado… let’s get started!
Why did Satoshi Nakamoto create Bitcoin?
Banks: In 2007-2008, the world went through The Great Recession. Huge banks such as Lehman Brothers were taking excessive risk to make the employees of the bank rich beyond imagine… on behalf of other people’s money of course.
Government: According to CNBC, in 2016, Venezuela’s inflation rate rose to a whopping 800%.[1] Imagine going to McDonald’s and ordering a small fry off of the 8-dollar menu! To combat this increase in inflation, Venezuela decided to print more money… and more money… and even more money… Unfortunately, the more money that gets printed, the less valuable the currency is.
Databases: In 2013, Target had a massive data breach that resulted in more than 40 million customers’ credit/debit card information being leaked to hackers.[2] Moreover, in 2014, The Home Depot had a similar breach that resulted in more than 50 million credit/debit card information being taken.[3] These types of large scale hacks are not uncommon.
In short, you could say that Satoshi Nakamoto had major trust issues with the current financial system and his/her/their way of dealing with them was to create Bitcoin. Unlike conventional currency, with Bitcoin, you can keep all of your money safe without having to store it in a bank. You can send money to your friends and family in a different city, state, or even country, without having to go through an intermediary service like a traditional bank or PayPal. You don’t have to worry about your financial information being hacked into. You don’t have to worry about the Bitcoin network “over printing” money and devaluing your own holding. You are in control of your own money. On to the next “why” question!
Why does Bitcoin even have value?
Arguably, the most puzzling topic about digital currencies, like Bitcoin, is how in the world it even has value. People often don’t understand why Bitcoin is worth anything, let alone roughly $2800 (as of 7/23/2017). So let’s break it down now, shall we? Over time, our idea of what gives money its value has shifted. Before 1971, the US Dollar was backed by gold. Ok… makes sense… but what about gold? Gold’s value comes from the “precious metal” being a scarce resource. We know that someone can’t just make gold from thin air, unlike the current paper money system. Bitcoin works in a similar manner. Bitcoin’s supply caps at roughly 21 million coins distributed over time. Once this limit is reached, there will be no more bitcoin being freely created. Bitcoin is scarce.
If you’re thinking “Is that it? Just because something is scarce doesn’t necessarily mean it’s valuable.” You are correct, that’s not the only reason why. Modern day currency gains its value from usability, dependability, and necessity. The reason why we didn’t just pay people in chunks of gold is that it wasn’t a sustainable way to transfer wealth. Imagine carrying around chunks of gold in your pocket and having to somehow slice it in half to make change. The usability wasn’t there. Hence, we created paper money that was much easier to carry and transact with. Since Bitcoin is all digital, it’s even easier to carry around with you. All you need is a bitcoin wallet, and there are many smartphone apps that can act as your wallet. In addition, Bitcoin’s network is dependable. Since creation, the Bitcoin network has never been “out of service.” Those on the network have always been able to send and receive Bitcoin whenever, wherever, and for whatever they want (assuming they have access to the internet). Now that leaves us with necessity. This is the area that’s been increasing the value of Bitcoin as of late. A currency will never gain value if nobody accepts it as a form of payment in exchange for goods and services. There has been a substantial increase in merchants who accept digital currencies as payments. Dell, Microsoft, and OkCupid are all companies who enable Bitcoin as a payment option (just to name a few).
How?
Now that we have more of an understanding of the origins and ideology behind Bitcoin, let’s take a look under the hood and see what makes this digital currency tick. I will go down the list of all the technical jargon that needs to be understood, define each one, and then bring it all together at the end.
Address: An address is one’s identity on the Bitcoin network. You can think of it as a username. Through this address, one can send and receive Bitcoin. Another name for an address is a public key.
Private Key: A private key is essentially digital currency passwords. The private key is used to prove to the network that you do in fact own the digital currency associated with a certain address (or public key).
Wallet: A wallet is where one stores their Bitcoin. Every wallet has an address associated with it. There are many forms of wallets ranging from cold to hot storage. A cold storage wallet is a wallet that remains offline and only connects to the Bitcoin network when needed to be used. Think of this as an external hard drive. On the other hand, a hot storage wallet is one that is always online. For example, there are many websites that you can go to that provide wallet services using the cloud.
Transaction: A transaction on the Bitcoin network is the exchange of value between any two addresses.
Block: A block on the Bitcoin network is a collection of transactions. Transactions aren’t updated to the Bitcoin network immediately when they are placed. Transactions first get bundled up into these blocks, and then the blocks are what gets sent to the Bitcoin network.
Blockchain: A blockchain is a collection of blocks in sequential order based on when they were added to the network. The strength and security in a blockchain is that you cannot change a specific block within the chain without having to change every block that comes after it. For example, if I wanted to try and deceive the network and reverse a single payment I sent for pizza yesterday, I would have to change all of the blocks of transactions today.
Decentralized: Bitcoin is a decentralized network which means that no one entity controls the network. There is no central leadership that forces others to follow what it does. At any time, a person is allowed to alter the Bitcoin code and make their own version if they do not like how the current version is operating (this process is called forking the network).
Mining: Mining in Bitcoin refers to the process of securing the validity of the blockchain at all times. Miners verify all transactions, create blocks, add blocks to the blockchain, and validate blocks that other miners propose to the blockchain.
Proof-of-Work: Bitcoin’s mining protocol is based on a Poof-of-Work algorithm. What this means is that not everyone can submit new blocks to the network. The person who’s allowed to submit a new block to the blockchain is the person who solves a mathematical puzzle using computational power. This shows that that person used up natural resources (computational power and electricity) to create this block. This Proof-of-Work algorithm is used to keep the network secure because “hackers,” and those who want to hurt the network in general, have to use up a lot of computational power and electricity to accomplish this. In theory, an attacker would need over 50% of the computational power on the network to do serious damage. The current computational rate on the network is roughly 6.5 million terahashes/second (Th/s for short).[4] So. one would need to be able to produce over 3.25 million Th/s to own more than 50% of the network. However, once the attacker adds 3.25 million Th/s to the network, now the total is 9.75 million Th/s and the attacker still doesn’t own 50% of the network! An attacker can then proceed to add more and more until they own over 50%. The current state of the art Bitcoin mining rigs can produce roughly 5 Th/s per $500.[5] So, based on that logic, an attacker would need to spend roughly over $600,000,000 to own more than 50% of the network… talk about secure…
Cryptography: Cryptography is defined as “the art of writing and solving codes.” In terms of the Bitcoin network, cryptography is used in the Proof-of-Work algorithm to make the process secure and fair for all. In addition, cryptography is used to generate the public and private keys (individuals’ usernames and passwords). Cryptography is used in many other aspects of digital currencies as well, but generally speaking, it is used to keep the network safe and secure.
Ledger: Often one may hear that the Bitcoin network is simply a distributed ledger. A ledger is where one can store and track transactions. In the case with a blockchain, this ledger is distributed to all who would like to keep track of it. This means that you can see every single Bitcoin transaction ever made since the first block. No more secret black boxes that result in the general public having no clue of what is happening at all times. Everything is open for everyone to see. However, your privacy is still safe because public keys (essentially one’s username) look like this:
1NkHC5mcNTkDJz7XYULwG1BTmcJznufWbU
Unless you can tell that address belongs to me, my privacy is safe. Note, please don’t send any bitcoin to that address… I generated it randomly and did not save the private key. All bitcoin sent to this address will be gone forever and no one benefits.
The genius of Satoshi Nakamoto was that he was able to bring all of these ideas together to create Bitcoin. The network allows people to store their bitcoin safely in their wallets, and then use them to transact directly with anybody. It is no longer necessary to have middlemen as a part of the process when sending payments. You can send money instantly to anyone, anywhere. In addition, you can trust that the transaction is cryptographically secure and permanent due to all the computational effort spent on creating and adding blocks to the blockchain. Moreover, the Bitcoin network lets everyone keep track of the ledger to see all the transactions at all times. You don’t need to wait and see if PayPal, Venmo, or Visa processed your payment correctly and that everything went smoothly on their end. You can see, and verify, every transaction you make occurs and processes correctly. Lastly, since it is decentralized, no one person can force you to do anything. There is no central bank that owns Bitcoin and can change protocols at their will that everyone else must follow. Bitcoin truly does bring the power back to the people and allows them to take control of their own money.
Congratulations! You are now more knowledgeable than a majority of people on the history, ideology, and inner workings of Bitcoin and blockchain technology. However, with that said, this guide is a VERY quick primer and there is so much more about Bitcoin and blockchain technology that is not touched on in this guide. Please feel free to reach out with any questions, concerns, and comments about this guide. We will be posting more about this subject in the future and will be building up from this framework you now have!
- Jeremy Liu
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