The Basics!!!

How Bitcoin works

Bitcoin was created by an individual (or group of individuals) who went by the alias of Satoshi Nakamoto. To this day, nobody knows (at least publicly) who Satoshi Nakamoto is – and that’s arguably their biggest legacy to the community.

By vanishing into the ether soon after Bitcoin was robust enough, Nakamoto has done away with the first central point of failure.

If gold had been “invented” by someone, that person would arguably hold great influence over their invention. If, moreover, that someone had kept a key that allowed them to control the gold economy, they would wield an ungodly amount of power.

They would also be vulnerable to pleas, bribes, legal action, punches in the face, and otherwise strong pressure to tweak their invention to benefit one party or another – perhaps a government, or the mafia. Either way, the entire system would be vulnerable at a central point. That’s not Bitcoin’s case.

Also, there’s also no cult of personality around its creator, no one to dictate the rules unchecked. Bitcoin belongs to the world, and no single person or country has jurisdiction over it.

Cryptography & Economics

Bitcoin combines computing and cryptography with a clever system of economic competition and rewards that ensure it’s in everyone’s best interest to respect the rules without the need for a central authority. Instead, the network manages itself, and no single party controls the system.

Bitcoin rewards honest “work” that supports the network (validating transactions, as we’ll see below), while making sure that cheating is prohibitively expensive. This work is also the manner by which new bitcoin are programmatically introduced into the system, making sure the supply can grow in a predictable way – thereby achieving the key quality of scarcity.

These effects grow exponentially as the network grows. In fact, much of the power of Bitcoin comes from its diverse, robust growing network.

Bitcoin participants may have sometimes conflicting interests, but they all share the same ultimate goal – that Bitcoin succeeds. And the more parties are invested in Bitcoin, the more everyone has to lose if it “breaks” – this creates a symbiotic relationship, one where all parties benefit.

So who controls the Bitcoin ledger, and how does it achieve sound money? To answer these questions, it’s necessary to understand how the system is designed.

Bitcoin’s design

Bitcoin is many things, but we’ll focus on the design elements here.

Firstly, Bitcoin is a peer-to-peer network of computers all following a set of rules and instructions (the Bitcoin protocol) for validating transactions and issuing new coins. Any computer running any software that respects these rules can participate in the Bitcoin network. These are called Bitcoin Nodes.

Think of this protocol as the banking laws of a country. Any bank can operate, so long as they obey the laws. The difference is that the Bitcoin protocol is enforced by code, and not by courts – meaning it’s much more reliable.

Second, Bitcoin has a ledger of all the transactions, called the Blockchain. Transactions are recorded in blocks, which are created at set intervals and connect to the previous block to create a chain.

Lastly, there is the mechanism for adding blocks to the Blockchain and reaching agreement (consensus mechanism) that the transactions are valid, and the whole chain accurate. This is called Mining.

Participants don’t need to trust each other; they need only trust the rules and the code.

So how does this work in practice?

The blockchain: trust but verify

The most revolutionary feature of Bitcoin is its ledger – also known as the blockchain – and in the way transactions are validated.

We must trust banks to keep the integrity of their ledgers, but we can’t verify it for ourselves. If one bank sends one euro to another bank, we must trust them to remove that euro from their accounts. That’s because only they can see and update their ledgers. We can’t see if they make a mistake, or if they make poor choices when extending credit. As the 2008 financial crisis has taught us, this isn’t always a good idea.

Banks are incentivised to uphold the law, but history shows that they can go around or even change regulations to their benefit.

In 2008, banks and other lenders exploited the rules to recycle an ungodly amount of debt into “subprime” financial products that were so complex that virtually no one could understand them.

This was made worse by the fact that few people even had access to the books – and the few who did had a hard time understanding the complexity. When these rotten products defaulted, the world economy broke. The result? Trillions in bailout money for the same banks that caused it.

Bitcoin turns this logic upside down. Instead of a single ledger kept locked away by a central authority, Bitcoin ensures anyone can have a copy of the ledger containing all transactions that ever happened. Everyone can mathematically verify that every transaction in it is legitimate. Transactions that don’t respect the rules are automatically rejected by the software.

Bitcoin transactions are batched approximately every 10 minutes into a block, which is then added to a long chain of blocks containing all previous transactions (hence the term blockchain). This process of adding the new blocks into this shared ledger is called mining.

The problem with a shared ledger is, how do we all agree that the current version is the most up to date one? How can thousands of different computers all over the world reach consensus without someone in charge?

How bitcoin mining works as an incentive

The solution introduced by Bitcoin to this age-old computing problem involves maths, competition, and economic rewards, and goes by the name of mining.

Mining involves a competition for solving a complex mathematical problem, which takes on average 10 minutes and is adjusted every two weeks to account for current computing power. The winner gets to add the current block of transactions and receives a reward for their efforts (as we’ll explain below).

The catch is, everyone can easily verify that the solution is right. If a miner cheats, all other participants will simply discard the block. A cheater would lose not just the reward, but also all the money spent in energy to mine that block. This combined loss far outweighs any expected profits,

Although in theory anyone can participate in mining, the mathematical problem is so hard, and the competition so fierce that you’d need hundreds of specialised computers to even stand a chance today – which is quite an investment.

Despite the cost, mining is a very profitable competitive industry. This competition has so far ensured that no single party controls the majority of the mining power.

Moreover, this is a positive feedback cycle. The more value Bitcoin gains, the more miners in the network, the harder it becomes to cheat, and the more solid Bitcoin becomes.

Money supply and inflation

Mining is also the way by which new bitcoin are released into the system.

Whoever wins the competition for solving the cryptographic problem gets to add the new block of transactions to the blockchain – plus a reward comprising transaction fees and new bitcoin.

Transaction fees are the sum of fees paid for all transactions included in that block, which vary according to demand. These are bitcoin already in circulation.

On the other hand, block rewards also include entirely new coins. In fact, every bitcoin in existence has been introduced into the network via mining. The rate of new bitcoin has started at 50 per block in 2009, but this number is programmatically halved every four years as determined by the protocol.

The current reward is set at 6.25 bitcoin per block until 2024. This process will continue until all 21 million BTC are out there, at which point miners will only receive transaction fees.

There’s no way that anyone can arbitrarily create new bitcoin or mess with the issuance rate unless everyone (or at least an overwhelming majority) of the network agrees to change the protocol. And finding that agreement would be very, very hard.

This programmed scarcity (a combination of fixed supply with predictable issuance rate) completely removes any uncertainty around inflation.

The ultimate sound money?

We’ve just seen how, unlike fiat currencies, Bitcoin achieves reliable digital scarcity with no one in charge. Here’s how it satisfies the remaining properties of sound money:

Durability: the architecture of the blockchain makes it incredibly robust. Since every node has a copy of the ledger, destroying the Bitcoin network would require that all 50,000 nodes distributed around the world (and above) would need to be destroyed at the same time, along with however many backups there are. That’s very unlikely.
Divisibility: Bitcoin’s smallest unit, called a Satoshi, is 1/100,000,000 of one coin. In today’s values, that’s orders of magnitude more precise than even the smallest microtransactions would require. However, due to network fees, that level of precision isn’t currently practical – we’ll discuss this below..
Fungibility: all bitcoin are created equal and have equal value – just like one gram of gold is equal to any other gram of gold.
Portability: Bitcoin is entirely digital and incredibly portable. It can be stored on a computer, mobile phone, and on paper. It can be instantly transferred anywhere in the world with just an internet connection – and even without one..

Bitcoin’s limitations

Of course, no system is perfect, and a decentralised, distributed system such as Bitcoin suffers from limitations that a centralised system doesn’t.

The main limitation is the trilemma between security, scalability, and decentralisation. This means that there are trade-offs when designing a network, and you can’t have all three. In other words, you can’t have your cake and eat it.

Scalability is the capacity of the system to execute a higher volume of transactions
Security is the capacity to protect the ledger from cheating, hacks or other attacks
Decentralisation is the system redundancy; it’s what stops any one party from controlling the network

Fiat money, for example, is very scalable and reasonably secure. On the flip side, it’s completely centralised, and controlled by very few people.

Bitcoin, on the other hand, is designed to focus on decentralisation, and it’s incredibly secure. This comes at the price of scalability. Currently, Bitcoin’s maximum speed hovers at around five transactions per second (a fraction of Visa’s purported 50,000+), making it impractical for use at scale.

This explains why right now Bitcoin is popular as a Store of Value and less so as a Medium of Exchange. In the next lesson we’ll look at how that trilemma is being addressed so that Bitcoin and other cryptocurrencies an scale, without compromising on the characteristics of sound money.

Bitcoin’s limitations

An introduction to the Blockchain Trilemma
Why Bitcoin struggles as a medium of exchange
How forks, layer two applications & altcoins attempt to solve the trilemma
The future of Bitcoin

The achievements of Bitcoin’s creator will likely be considered as important as the invention of the internet or personal computer. Not simply a new form of money, but an entirely new way of thinking about money.

As ingenious as the Bitcoin whitepaper was, it wasn’t perfect.

This problem is known as the Bitcoin trilemma; how to achieve the three core functions of an ideal cryptocurrency:

Security – Can it provide a secure, trustworthy & reliable monetary system
Scalability – Can it support increasing numbers of users with no compromise on speed or convenience?
Decentralisation – Can it continue to function without a central point of control.

Understanding this trilemma will give you a better appreciation of the problems Bitcoin solves, as well as those things it isn’t an ideal solution for.

This can then put into context the projects and innovations that have emerged in response to the perceived shortcomings, which fall into one of three distinct groups:

Change the rules
Build on top
Build an alternative/sacrifice one of the pillars

One of the most commonly discussed weaknesses, is that in order to create a new form of scarce internet money, with no controlling authority, Satoshi Nakamoto had to prioritise design features that make Bitcoin unsuitable for low value, high frequency transactions.

The Coffee Shop Illustration

Bitcoin’s design achieves points 1 and 2 – security and decentralisation – at the expense of aspects of scalability (3) for use as a convenient medium of exchange. The most frequently used illustration of this is buying a cup of coffee.

From our previous article we discovered how the Bitcoin network confirms new transactions. Each confirmation takes roughly 10 minutes, with six confirmations being regarded as optimal, to reduce the chances of an incorrect transaction to an infinitesimal level.

Now it doesn’t take a computer scientist to realise that buying a cup of coffee doesn’t take 60 minutes, or even 10 minutes. On that basis, no one is going to use bitcoin where the transaction needs to be instant, especially when there are perfectly good existing services that provide that convenience at the expense of what bitcoin does well.

65,000 vs 7

The number of transactions a second the Visa network can support vs Bitcoin on-chain

Given its centralised design, the Visa Network can support 65,000 transaction messages a second; because of the limitations described, Bitcoin can support seven per second. It sacrifices speed for security, which is achieved through the confirmation process, fundamental to its principle of being managed by a decentralised network.

The proposed solutions to the trilemma have led to a broadening of the cryptocurrency ecosystem as well as tribalism and friction, with each group believing in the value of their approach.

The only true judgement comes from whether people use the system or an alternative. The first real challenge to this open design came in August 2017 when an alternative Bitcoin came into existence, with slightly different rules, known as a Fork.

1 – Change the rules (Fork)

Bitcoin was built to be open source, so anyone that doesn’t like the rules can simply make a copy and create their modified version. This is known as a Fork.

To date there have been 105 Forks, which underlines that in many people’s eyes Bitcoin’s design has flaws. It should also be seen as both underlining the democratic nature of Bitcoin as well as a reminder of a couple of basic human traits.

You’ll never please all the people all the time.
Greed is often the biggest driving force rather than innovation.

What matters in the end is whether the Forks are supported by Miners who act only in their own economic interest. Miners earn from creating new blocks and from fees, but without anyone using or buying the underlying coin, neither provide value, and the Fork fails.

Over four years since Bitcoin forked to created Bitcoin Cash, which itself split to create Bitcoin SV, and those two off-shoots represent less than 1% of the value of Bitcoin.

The next lesson will explore Forks in more detail, looking at the successes, failures and what they mean for the overall health of the wider ecosystem.

2 – Build the missing functionality on top (Layer 2)

As you read more about Bitcoin you’ll probably come across the term ‘layer 2’. The concept of layers sees Bitcoin as the base layer, with transactions recorded in blocks connected across an ever-increasing chain.

What happens on the base layer is often referred to as happening ‘on-chain’. Transactions that happen on-chain are subject to the consensus rules and with Bitcoin, the limitations of the trilemma.

However, using a second layer that can interact with the base but isn’t subject to its restrictions can enable a solution to the coffee shop use case. This comes in the form of the Lightning Network (LN) which we discuss in the next article.

In summary, LN gives the transaction speed of Visa, at a fraction of the cost. The technology exists, what is missing is the usability and network effects, though the Lightning Network is growing steadily, helped by adoption in El Salvador where it is used for remittance.

3 – Sacrifice one of the concepts (Altcoins)

The two options so far for addressing problems of Bitcoin scaling as a convenient medium of exchange have looked to either adapt the Bitcoin design, or build on top of it. The third area of innovation retained Bitcoin’s basic concepts but compromises on how it is implemented, creating what are now known as alternative coins, alt coins for short.

A commonly used term to refer to cryptocurrencies that came after Bitcoin; literally alternative coins, i.e coins that are designed to work differently from Bitcoin.

The most important cryptocurrency after Bitcoin is Ethereum. Though there are some similarities in their use as digital currencies, Ethereum has a much grander ambition – as a world computer – has a visible creator, in Vitalik Buterin, and less clarity on the crucial aspect of its money supply.

We’ll look in detail at Ethereum in a later lesson, but its relevance here is that – whether you agree with its design and approach to the trilemma – its function as digital money enables much faster transactions.

Beyond that, the ‘world computer’ concept means – in very simple terms – that Ethereum enables any application, which can be reduced to mathematical terms, to be built on top of it and supported by a decentralised network, not servers in New York or London.

Ethereum quickly inspired a wave of cryptocurrencies which were able to use it as a launchpad, along with a simple standard for generating new coins called ERC20. This enabled rapid innovation, opening the door to different approaches to the trilemma.

One of the crucial aspects of Ethereum was the way that it raised its initial investment. The team – based in Switzerland – established what is known as the ‘Initial Coin Offering’ or ICO. It was a shortcut to the traditional way of raising investment for a new business. Anyone with bitcoin, an email address and a willingness to take the risk could invest.

Once Ethereum was up and running, and increasing in price, the ICO approach (across 2017-19) saw insane amounts raised, for what amounted in some cases, to nothing more than ideas.

Some of those ideas never materialised, but many have established themselves providing potential solutions to the blockchain trilemma, as well as innovative new uses for decentralised networks beyond internet money.

The Trilemma & the future

Knowing that Bitcoin has limitations may feel a bit like realising your favourite Super Hero has a weakness, but this was always part of the design. On-chain bitcoin transactions are best suited for high value, infrequent payments; in other words, the Store of Value use case.

From previous lessons we know that money must also function as a Medium of Exchange, and that is where solutions to the trilemma come in.

With this context now in mind we can delve further into each of the potential solutions – Forks, Lightning Network and Ethereum – and how this relates to the wider cryptocurrency ecosystem with the huge range of coins and services that are emerging.