Many have heard of bitcoin, but few understand its various aspects… That’s why we have carefully prepared this 60 minute bitcoin crash course. No prior knowledge required! Just read, watch the videos, and in one hour, you’ll know what bitcoin is all about.
Where does bitcoin come from?
The bitcoin paper
Bitcoin was first described in a 9-page research paper posted online in 2008 under the pseudonym Satoshi Nakamoto. The paper, titled Bitcoin: A peer-to-peer electronic cash system, covers a broad variety of topics, such as financial economics (transaction costs, trusted third-parties, money supply), network engineering (distributed decision making, data routing, cyberattacks), and cryptography, a branch of mathematics interested in establishing secure communications to facilitate transactions between users.
How many people do you know who have expertise in financial economics and network engineering and cryptography? Probably none, and that’s because these knowledge domains do not typically intersect (e.g., there is no university degree out there that covers all three). And this is the primary reason why, until today, bitcoin has remained difficult to understand for most of us. If you’re feeling lost, you are not the only one! That’s why we created this bitcoin crash course.
If you want to learn more about particular aspects of bitcoin, you can click the hyperlinks thoughout the text and consult the supplementary materials listed at the end of each section. This is of course optional. You can get a solid overview of bitcoin in one hour without doing any of this.
The 2008 bitcoin paper essentially describes a system enabling people to transact online—a system that can be implemented as software. While bitcoin did start as a paper in 2008, by 2009, Satoshi Nakamoto had already published 30,000 lines of software code to make the paper’s ideas come true.
Satoshi Nakamoto (whose real identity is still unknown) has then progressively withdrawn from the project, and since 2011, it is an international team of developers who regularly upgrade the bitcoin software used by all the stakeholders in the ecosystem.
The impact of the bitcoin paper cannot be underestimated. Even though it was never submitted to a scholarly journal, it has already been cited ~1,000 times, it gave rise to an ecosystem worth several billions of dollars, started a new industry in which hundreds of millions of dollars have been invested in 2015, and it’s become a major topic of discussion for financial institutions, governments, and central banks across the world. In fact, a few years down the road, we may realize that the 2008 bitcoin article has been one of the most influential research papers ever published.
Bitcoin in historical perspective
It should be noted that Nakamoto’s 2008 paper did not come out of the blue. While bitcoin is the first decentralized cryptocurrency ever implemented, several aspects of the bitcoin project have their roots in research conducted in the 1980s-90s. Several companies attempted to create e-currency systems in the 1990s—none of them in a decentralized way—and all of them failed.
Interestingly, Nakamoto recognized earlier influences by leaving a note on bitcoin’s Wikipedia page explaining that
“bitcoin is an implementation of Wei Dai’s b-money proposal on Cypherpunks in 1998 and Nick Szabo’s Bitgold proposal”
Cypherpunks are best described as an online social movement regrouping, since the late 1980s, several hundreds of libertarians and anarchists advocating for the widespread use of cryptography to protect individuals’ privacy and liberty against government and corporate interference. Like bitcoin, Julian Assange’s Wikileaks also has its roots in the cypherpunk movement.
Interestingly, back in 1999, libertarian economist and Nobel laureate Milton Friedman predicted the emergence of an online, “reliable e-cash” free from government interference. This is one of those rare moments in history where a social scientist actually makes an accurate prediction about some significant aspect of the future!
Bitcoin as a payment system
To date, the most prominent application of bitcoin has been its use as a secure decentralized payment system. The following video explains how this works:
By removing the need for a trusted third-party, bitcoin makes it possible to send international payments without relying on banks (e.g. HSBC), credit card companies (e.g. Visa) , or payment processing firms (e.g. Western Union).
But here’s the thing: nothing prevents the technology underlying bitcoin from being used in applications other than payments. In other words, bitcoin can potentially eliminate third-parties (or “dis-intermediate”) other sectors of the economy. To understand how, we need to get a good grasp of the bitcoin technology.
Bitcoin technology and what it can do
It is that time in the bitcoin crash course when we need to take a look at the basic features of bitcoin technology, and based on that outline potential applications beyond payments:
We now begin to understand how bitcoin works under the hood, and how its features offer a distinctive take on the notions of trust and ownership, with potentially far-reaching implications. Bitcoin essentially relies on five interrelated technological building blocks:
- The blockchain, a decentralized public ledger that maintains a transaction history and represents a “single source of truth” shared by all the network users. The bitcoin blockchain is append-only (i.e. past transactions cannot be modified), permissionless (i.e. anyone can join), and transparent (i.e. anyone can examine the entire transaction history). Note that blockchain technology can be used for other applications, independently of the bitcoin currency.
- Cryptographic hashing is a mathematical calculation used to secure, compress, storeand retrieve data in the blockchain. In particular, it is used to create hash pointers that connect each block to the previous one, all the way back to the first block ever generated in 2009 by Nakamoto. Thus, altering a pointer would require altering all the pointers found in subsequent blocks. But since creating each pointer requires massive amounts of computing power, it is virtually impossible to modify old blocks (and that makes the blockchain “append-only”).
- A peer-to-peer network that connects all the bitcoin users and relies on a shared protocol. It allows anyone to broadcast new transactions to the rest of the network and have them verified, executed, and added to the blockchain. Though not hierarchical, the bitcoin network has different types of users. An important type of “power users” are miners, who are in charge of verifying the validity of transactions. Miners do so by lending their computing power to the bitcoin network in exchange for a monetary reward paid out in bitcoin currency. To get a chance at the reward, miners must include a “proof of work” into new blocks as evidence of their contribution to the overall network security.
- Digital signatures are a cryptographic way of proving ownership of digital tokens (the bitcoin currency) to the rest of the network. Miners verify each broadcasted transaction by checking its digital signature and making sure it corresponds to the actual owner of the bitcoin. And this happens without the bitcoin owner having to reveal its secret password (the “private key”), as explained below:
- Bitcoin Script. Scripts are instructions given to a computer. Bitcoin has its own scripting language that allows for programming complex transactions separately for each unit of bitcoin. Around 200 scripting functions are available in bitcoin. A basic transaction sending bitcoin from one account to another only uses 2 scripting functions (1%), one pointing to the recipient’s address (or public key) and one verifying the digital signature of the sender. Most applications of bitcoin (beyond basic payments) described in the previous video tutorial would rely on a broader variety of scripts. Most of bitcoin Script’s potential has remained untapped until this day.
Now, let’s see how these five technological building blocks interact to create basic bitcoin payments. The following video is a little bit technical, and it’s fine if you don’t get every detail the first time. It will still shed additional light on how bitcoin really works, so try to watch it till the end!
So what’s new here?
So far, this bitcoin crash course has shed light on two crucial aspects of bitcoin. First, bitcoin is a network of computers that relies on cryptography, a peer-to-peer protocol, and a scripting language to maintain a shared, transparent, permissionless, append-only, decentralized ledger of transactions. Second, bitcoin allows for transacting digital assets (possibly tied to real-world assets) without trusted third-parties. The bitcoin “currency” can potentially represent anything that people consider valuable. Because of all these feaures, bitcoin is considered the world’s first decentralized cryptocurrency.
Not every feature of bitcoin represents an innovation though. Cryptography, peer-to-peer networking, or digital signatures existed long before bitcoin. So what’s new?
Distributed consensus and trustless transactions
The Fisher-Lynch-Paterson theorem proves the impossibility of achieving consensus about what is “true” in a decentralized (or distributed) network wherein some users are dishonest. Bitcoin offers a practical solution to this theoretical problem.
To bypass this theoretical problem, bitcoin does two things. First, it provides financial incentives for network users to tell the truth—that’s why miners are rewarded in bitcoin for their “proof of work.” Second, it compromises on the timing of the consensus by accepting a latency of 10 minutes on average to process a transaction, and of 60 minutes for the recipient to become close to 100% sure that it can never be reversed or canceled. These are the costs of achieving distributed consensus in a network with no central authority, and wherein some users are dishonest. Put differently, since bitcoin works without having to trust every user in the network, bitcoin is said to enable trustless transactions.
Digital scarcity and ownership tracking
Taken together, bitcoin’s properties create the possibility of generating digital scarcity in a secure, decentralized environment. This is quite a big deal because, in a digital world made of 1’s and 0’s, anything can easily be copied. In fact, computer design is premised on the ability to easily copy and transfer digital files. But things that can be copied without constraints are, by definition, not rare, and this affects their value—usually negatively. One of the primary reasons why bitcoin has value is because it is scarce, and that scarcity is protected by design. Besides, the bitcoin blockchain enables tracking who owns what at any point in time. The music industry lost billions in revenues when music files became easily replicable in the digital world (that is, when they ceased to be scarce). Imagine what a technology like bitcoin could have changed in this context! An essential property of bitcoin enabling digital scarcity is that it prevents “double-spending”—that is, copying a bitcoin digitally so it can be spent twice. Here’s how bitcoin prevents “double-spending”:
The bitcoin community
Bitcoin is not a corporation. It does not have shareholders, managers, or even employees. Bitcoin is not exactly an industry either, though the innovations it’s bringing about are giving birth to one (or several). The bitcoin ecosystem is best described as a community. Let’s take a look at the primary stakeholders involved in this community.
Bitcoin users are individuals who use bitcoin to make payments or simply hold bitcoin as a speculative store of value, hoping to make a profit. There are many discussions about whether speculators are a good or bad thing for the community as a whole, but they are beyond the scope of this bitcoin crash course. For now, let’s see how one can use bitcoin to make payments:
This video ends on an optimistic note and claims that “there is no going back”, but this statement needs to be qualified. While it is true that some of the technologies underlying bitcoin have a bright future (e.g. the blockchain), the future of bitcoin itself is uncertain. If governments across the world decide to criminalize bitcoin use, or if better alternatives emerge, bitcoin may well disappear altogether in the coming years.
Interestingly, the video also shows that, while it is possible to use bitcoin without involving any third party, in practice, many users do rely on third-party service providers to buy, sell, store, or exchange bitcoin.
Venture capital (VC) firms invest millions in early-stage bitcoin startups, take huge risks, and play a crucial role in shaping the bitcoin community’s trajectory. In recent months for instance, many have noticed that the bulk of VC investment has shifted from pure-play bitcoin startups to blockchain technology startups—that is, startups not necessarily relying on the bitcoin currency, but instead on potential applications of the underlying blockchain technology.
Third-party service providers
There are many different types of third-party providers in the ecosystem. They are typically private, for-profit firms funded by VCs. For the sake of conciseness, this bitcoin crash course focuses on three that are particularly important in bitcoin’s early years:
- Bitcoin wallets: Many companies offer wallet storage solution with upgraded security or convenience. Some sell hardware wallets to allow for offline storage of bitcoin holdings, which decreases the risk of cyberattacks. Here’s how a basic bitcoin works:
- Bitcoin exchanges: Exchanges are private companies that allow bitcoin users to buy bitcoin (e.g. with U.S. dollars), sell bitcoin, and exchange bitcoin for other cryptocurrencies (e.g. Litecoin).
Note: There are ~500 other cryptocurrencies representing alternatives to bitcoin (called “altcoins”). In terms of market value, bitcoin has always represented more than 90% of the total cryptocurrency ecosystem. Many altcoins are scams (e.g. Ponzi schemes), and to date, none has managed to build a community as globally developed as bitcoin. But this may change in the future. The community is very divided about the need for “altcoins”. Some argue that it’s good to have competition, others that it dilutes people’s effort away from bitcoin.
- Bitcoin payment processors: These companies offer services to help merchants accept and process payments in bitcoin. They typically charge a small fee and offer merchants the possibility of never having to hold bitcoin. To do that, they convert the payer’s bitcoin into local currency (e.g. U.S. dollar) before they reach the merchant’s wallet.
If you’ve reached this point in our bitcoin crash course, the following video should be easy for you to understand:
The community is currently worried about the future of mining pools. First, pooling leads to a concentration of computing (or “hashing”) power in the network, thereby making bitcoin less decentralized, and probably less secure. Today, most bitcoin are mined in China (check this for more on how a mining facility looks like). Second, it is unclear what miners’ incentives to verify transactions will be when the reward they get for their “proof of work” decreases in the future (specifically, the bitcoin software halves the reward every four years, so in 2017, it will go down from 25 to 12.5 bitcoin per block).
Nakamoto believed that transaction fees would progressively replace block rewards, that is, bitcoin users would have to pay miners (fee <1%) to have them verify transactions and add them to the blockchain. The problem is, mining is costly (in hardware, electricity, and rent) and thus only profitable when the bitcoin price is high enough to cover these costs. In other words, a collapse of the bitcoin price can start a wave of bankruptcies among miners, and leave the bitcoin network insecure.
Bitcoin core developers
Bitcoin core developers are real people who give their time to maintain bitcoin’s “core” software (e.g. fix bugs), improve it, and help the network to scale. What do they do exactly and how can one join the team? Listen to a core developer talk about his job:
Now, you may be wondering… How many core developers are there? Less than fifty developers in the world are in charge of major developments. That’s quite a responsibility…but how do they get paid for their work? Well, they don’t (at least not directly), because bitcoin is not a corporation, and its developers are not employees.
The Bitcoin Foundation was created in 2012 to raise funds and pay the developers, but its lack of transparency as well as several scandals destroyed its reputation. Some core developers are now paid by private companies, which is great, but raises another set of issues, such as potential conflicts of interest. Recently, core developers have had a strong disagreement on how to scale the bitcoin network going forward. This disagreement led to the departure, in January 2016, of a core bitcoin developer who believes bitcoin governance problems to be insurmountable.
Merchants accepting bitcoin
Merchants have several incentives to start accepting bitcoin. First, the bitcoin user demographics are quite attractive—they tend to be tech-savvy people in the higher income brackets. Second, settling bitcoin payments at the point of sale is mobile-friendly, transaction fees are between 1 and 2.5 percent lower than those charged by Visa or Mastercard, and there are no charge-backs. Third, settlement takes seconds (including internationally) when using the services of a bitcoin payment processor, which is faster than credit card payments.
Is bitcoin regulated? Yes and no. As long as bitcoin payments remain private, no specific regulation applies (in most countries), though tax offices have provided guidelines on how to declare capital gains realized in bitcoin. But as soon as third-party businesses are involved (which is most of the time), bitcoin is actually heavily regulated and a number of enforcement agencies are involved. Some would argue that bitcoin regulation in the U.S. is actually a “nightmare”. Here’s how it works:
Note that national regulators differ greatly in their approach to bitcoin. The U.K., for instance, has acquired a reputation for being “bitcoin-friendly”, whereas China or Russia have taken steps to criminalize or ban bitcoin.
Supplementary material: Bitcoin regulation in selected jurisdictions
Wrapping up the bitcoin crash course: The future of bitcoin
There is disagreement in the community about where bitcoin is going. Some say it is doomed to fail, and the true potential resides in private blockchain applications. But private blockchains are not transparent, permissionless, or even append-only, so they don’t really need incentivized miners, because in this context distributed consensus can be achieved by other means. Private blockchains, thus, are very different from the bitcoin blockchain, and far less innovative.
Therefore, others argue that it is the bitcoin blockchain that’s truly revolutionary—and bound to thrive. But recent governance issues among bitcoin core developers and miners question the soundness of this belief.
Some say the future lies somewhere in between. One possible path ahead is the development of colored coins, which attach external assets to small bitcoin units, as if one was marking a one-dollar bill with a special stamp saying “this bill gives its owner the right to go to the next Lady gaga concert.” Another possible path is the development of sidechains, which are external blockchains with advanced features that are pegged to the bitcoin blockchain (in the same way traditional currencies were pegged to gold, between 1944 and 1971).
Supply and demand for bitcoin, as well as the ongoing development of the bitcoin ecosystem, will drive the price of bitcoin going forward. Bitcoin may be worthless a year from now, or its $5bn market capitalization may triple. The truth is, no one knows for sure where this is going. The only thing we know for sure is that the innovations that came to the spotlight thanks to bitcoin are here to stay, with or without bitcoin.
Supplementary material: A fascinating discussion about the future of bitcoin and blockchain technology involving leading experts.