Understanding Bitcoin for Complete Beginners

 The gradual deregulation of banks, proved yet again that banks and institutional financial systems, in general, will always go rogue at any given opportunity. The 2008 financial crisis is a classic example. 

 In practice, custodial financial institutions, like banks, have significant room for costly errors in place, that exempts them from whatever flaw or risky experimentation, they may engage in.

This allowance for flaws, which has been abused time and time again, is a practical description of how third-party systems in finance operate. Unfortunately, ordinary savers, with their savings locked-in, get to pay for the mistakes of these institutions. Although, this is usually indirectly. 

Bitcoin— autonomy, and freedom

What Bitcoin offers humanity is an economic system where individuals own and control their money and the economy upon which it is built and exists. From its creation to its circulation, Bitcoin relies totally on mathematical functions embedded in its protocol to function. All of these operate across a shared network of users, through their devices. This shared network allows for its creation, distribution, and documentation. 

In other words, no institution or state can cancel or reverse a transaction, overprint more Bitcoin or freeze any Bitcoin user’s account (that is wallet.) This financial freedom and power to the common man have never been seen in the history of institutional finance. 

The Bitcoin Technology— Blockchain

Traditionally we depend on a central third party or groups, usually banks, to keep a real-time record of what every person owns to help validate transactions as they come. 

So if you issue me a cheque, I depend on your bank to validate the authenticity of the cheque and to also tell me if your account is funded and open to pay.  Generally, we depend on banks to approve cheques for payment, ATM and POS systems to approve card payments, and so on. 

We barely even know what is going on behind the scene, but we trust these institutions to keep the books rightly. 

Unlike these institutions, Bitcoin relies on a decentralized and distributed electronic record called the blockchain to keep the books, across its shared economy. 

With blockchain, the records are collectively approved and stored by everyone. This is such that, you need the approval of the majority of users to validate or make changes to the records. Interestingly, every transaction ever added to the growing list of  Bitcoin blockchain is accessible by anyone and everyone.

With the blockchain, these records are distributed and new batches of transactions, called transaction blocks, are added to the growing chain of blocks every ten minutes.  The process by which these transactions are compiled is what Bitcoin mining is all about. 

All of these processes are totally dependent on a shared economy of users, all connected by the Bitcoin protocol through their devices. The implication of these connections is that to make any change to the network’s database, there needs to be consent from at least a 51% majority of the network, which is almost impossible.  All of these collective interactions are based on mathematically provable rules written into the Bitcoin protocol. 

Bitcoin creation— mining

Like it is with fiat currencies and central banks, the Bitcoin economy is run by a set of macroeconomic rules, in its protocol. However, unlike central banks and their currencies, which do not have a limit to currencies they can ever print, Bitcoin’s creation is limited to 21 million Bitcoins. 

This limitation in its supply is a major reason why Bitcoin’s price has been soaring for years. As at the time of writing, bitcoin just climaxed a new all-time high at $40K. The process of this creation is generally referred to as mining.  

Bitcoin mining explained— Proof of Work (PoW) consensuship  

The idea of Bitcoin creation can be likened to the physical process of digging out ores of precious metals from the ground. The cost, competition, and continuous rise in scarcity, with more ores being mined, is why minerals like gold seem to command significant value, consistently.

Similarly, with Bitcoin, the mining rules are encoded in its protocol. The process involves solving a computational puzzle, in what is called proof-of-work (PoW) consensuship, and anyone who solves the puzzles is rewarded a specific amount of Bitcoin. Approximately every 10 minutes, a specific amount of Bitcoin is given to the first person to solve the PoW puzzle. 

To prove that a member of the network has solved the problem, the other members of the network will have to validate the result of the puzzle, hence the term consensuship. 

This element of competition makes solving the puzzle, all the more, difficult and expensive. Since time is of the essence, the miner (who is anyone in the network for the mining prize) with the fastest computer has the highest chance of winning the mining race. This is why those in the mining business are constantly upgrading their computing capacity to keep up. 

This race also comes with significant energy costs. As of the time of writing, it cost a total electricity consumption of 627.60KWH to include just a transaction into the Bitcoin ledger. Imagine what the cost would be for a block, with sometimes over 500 transactions.

On the flip side, this huge intrinsic cost in mining Bitcoin against its limited and shrinking supply (in what is called Bitcoin halving), is a major reason why bitcoins cost is on the rise. 

Bitcoin halving explained

To understand halving, we must first look at the relationship between a currency’s total supply and its buying power, using the quantity theory of money

This theory simply explains why a currency’s buying power is directly related to its supply. In other words, the more cash the Fed pumps into the economy, the less valuable every bill is worth, making prices go up and vice versa. 

This relationship is an essential tool used by every central bank to execute its economic agenda. Almost every economy has a rate and direction in which they regulate the supply of money in their economy. 

Similarly, with Bitcoin, there is a rate by which new bitcoins are minted into circulation during mining. You can think of it as Bitcoin’s macroeconomic policies. Approximately every 4 years, the rate of reward with Bitcoin mining reduces by half the initial block reward.

Upon its launch in 2009, the block reward was 50 BTC per block and after 12 years it is now at 6.25 BTC per block. This increasing scarcity is a major reason why its value is constantly on the rise, and why it is likely going to continue.

Bitcoin Wallets

With Bitcoin, users can only spend their coins using a digital key —which are alphabets and numbers combined. This key could be translated into a more readable set of words called mnemonic phrases. 

A wallet is basically storage for those keys, not Bitcoin. Bitcoins exist on the network as abstract figures on the blockchain. So any space where a set of digital keys or words can be stored can be called a wallet

This brings us to the two categories of stores, which are Hardware and Softwares wallets, with various variations that allow varying degrees of complexities and ease in usage. 

You can find out more about wallets here.

Getting your first Bitcoin

In addition to mining which was explained earlier, Bitcoin can be gotten from any of the following options:

A centralized exchange

These are centralized markets where buyers and sellers can place their selling and buying prices without getting to see each other. These exchanges use an order-book system, which is a software that merges buyers and sellers at their stated prices. 

It provides ease in sales, although it is not great for high volume trades, since traders relinquish control of their asset to the exchange, and high-volume trades are quickly reflected as high market prices, by the order book algorithm. Some popular examples are Coinbase and Binance.

A P2P market

These are markets where buyers and sellers meet to trade personally. Think of it as the Tinder for Bitcoin traders. There is a review score-card that shows the reputation of traders and in some cases, there is an escrow wallet that helps protect buyers and sellers. 

Generally, P2P exchanges come with the freedom of holding your asset, choosing who to trade with, and sometimes meeting the prospect before a trade. This freedom comes with the responsibility of protecting yourself in every trade. A good example is Localbitcoin.

An OTC market 

Think of it as a hybrid version of a centralized exchange and a P2P exchange. It combines the buyer’s protection features of a regular central exchange with the peer to peer features of a P2P exchange. 

Buyers interact with each other. However, trade is executed with the exchanges escrow features. A good example is Paxful and Luno.

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Views and opinions expressed are solely those of the author and not of The DeChained or any affiliated party. Views or opinions expressed in this article (or any article on the website) are not financial advice. Articles are for informational purposes only. The author and The DeChained may hold positions in assets discussed in this or other articles.
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