Bitcoin Basics

by | Dec 30, 2021 | Cryptocurrency, Resources

By James Allard

The very first sentence in Satoshi’s infamous 2009 Bitcoin whitepaper stated:

‘A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.’

Satoshi is likely cursing in his grave (which is where I believe he rests) at where we are just twelve years on from the birth of his masterpiece. There is little peer-to-peer activity at this point. Every aspect of this new monetary asset has been in intercepted by 3rd party financial institutions. We trade on centralised exchanges, regulated by government regulators. A large proportion of all transactions are made using 3rd party payment processors, again, regulated by government regulators.

Bitcoin and the greater crypto family have merely become regulated commodities, used for speculation and fully exposed to the very system Satoshi intended to disrupt.

Some would argue this is because Bitcoin is flawed, “It’s too slow and expensive” they say, and while this is true, I don’t believe this is the reason for where we are today.

Understanding cryptocurrency isn’t easy. Those of us who stumbled across Bitcoin in its early days have an advantage. We had to learn about the technology and how it worked in order to own it. The easiest way to own some bitcoin back in those days was to either find someone who already had some that was willing to sell (unlikely), or, as it was for most of us – mine it.

It could take days or even weeks for someone new to the space to actually get hold of some, but by the time you did finally get your hands on some, one would have a good understanding of bitcoins inner workings and Satoshi’ vision. Investing in Bitcoin was the precursor to entering a very deep  rabbit hole, one which few ever truly leave.

Today however, it is not neccessary  to understand what private keys are, or how to setup a mining rig, in fact most of those onboarding into the space today will look at you blankly when asked about their private keys, “Huh?” being the typical response.

So for this reason I will introduce Bitcoin to you the old fashioned way, but first let me share a small glimpse of how my path led to bitcoin and ultimately where I am today.

 

Bitcoin in a nutshell

Bitcoin is a peer-to-peer network which anyone in the World can take part in using the networks own cryptographically backed finite token.

Each transaction is time-stamped and ‘hashed’ into the blockchain using a system called proof-of-work(POW).

Proof-of-work is a decentralised consensus mechanism that requires participants of the network to expend effort solving an arbitrary mathematical puzzle to prevent anybody from gaming the system.

These participating workers in the network are rewarded tokens, in this case Bitcoin, for successfully solving a puzzle. Once a puzzle is correctly solved, the latest transactions are hashed into a new block that is then added to the ongoing blockchain and distributed across the entire network.

To avoid an excessive supply of Bitcoin due to the ever-expanding number of participants on the network all competing for the reward, the difficulty of the mathematical puzzle adjusts every 2,016 blocks (roughly 14 days), bringing the block time back to a 10 minute average. Also if the total network hashrate was to decline causing block time to increase and thus transaction confirmation time to increase, the difficulty would adjust accordingly to bring block time back to 10 minutes.

Every transaction that has ever existed on the Bitcoin network can be viewed on the blockchain, allowing 100% transparency on all transactions.

Here you can see the very first transaction ever made

Any attempt to alter the transactional history of bitcoin is prevented by the consensus of the majority. You may have heard the term ‘51% attack’ when the security of bitcoin is discussed. This magic 51% is the hash-rate required by a single controlling entity to maliciously cheat the network through double spending and transaction reversal.

This is why old-school bitcoin enthusiasts are so obsessed with the decentralisation of the bitcoin network. Decentralisation is the network’s ultimate security against such attacks.

Imagine if only 5 network nodes were in operation mining for bitcoin, it would only take 3 of these nodes to join forces to attack the network. But if you have hundreds, or even better, thousands, the ability to hijack 51% of the nodes becomes far less feasible.

Alternatively, someone could, with enough funding, begin a mining operation that was greater than the current hash rate of the network. In the case of bitcoin this would cost someone around $2 million per hour, assuming the equipment was even available to begin such an attack (which off-hand, it isn’t).

But even then, even if one was to first find the computing power (which you cannot) and then spend $2 million an hour on mining, the chance of a successful attack is still far from guaranteed.

 

Hard Forks

A hard fork is when a permanent divergence from a blockchain’s latest version, leads to a separation of the existing blockchain as some nodes no longer meet consensus. The result is two independent blockchains following separate paths, one using the native existing rules, the other following a new set of rules. A hard fork is not backward compatible, so the old version no longer sees the new one as valid.

A prime example of this is when Bitcoin forked to Bitcoin Cash due to a modification in some of the nodes which increased the block size.

 

Soft Forks

Soft forks are minor changes to the code which may add some extra functionality to the chain, without changing the rules. Soft forks do not split the chain into two separate blockchains. After a soft fork, the original blockchain remains valid, and users simply adopt the update.

ActionSoft ForkHard Fork
Backward Compatible?YesNo
Block SizeSmallerLarger
SpeedSlowerFaster
SecurityLowerHigher

 

Private Keys and Public Keys

“If you don’t own your private key, you don’t own bitcoin”

Understanding keys in crytpocurrency is one of the most important things you need to understand. Being unaware of what they are, and how they should be used could be the greatest mistake of your life.

Private key

A private key is a secret alphanumeric password/number used to spend or send your bitcoins to another Bitcoin address. It is a 256-bit long number which is picked randomly as soon as you make a wallet.

The degree of randomness and uniqueness is well defined by cryptographic functions for security purposes.

Public key

This is another alphanumeric address/number which is derived from private keys only by using cryptographic math functions.

It is impossible to reverse engineer and reach the private key from which it was generated.

This is the address you give to someone else so that they may send you bitcoin.

Seed key

A seed key is a more human friendly way to display private keys. It is a combination of 12, 18 or 24 words that are used to generate the private key. This same set of words used in the correct order will always generate the same private key. Storing the seed key is as important as holding a private key, it is your private key.

 

Hold your own keys

If you and only you hold your own keys, only you have access to your bitcoin. It is as secure as the method in which you store the keys. There are, of course vulnerabilities, for example, most hold their private key on a computer device connected to the internet. Hackers could obtain your private key through the internet using malware.

Or if someone else was to gain access to your device, they could steal the private key.

There are better ways to store private keys such as paper wallets or, in my opinion, the best and most practical method, hardware wallets.

A hardware device such as the Ledger Nano devices store the private keys on a small chip within the device, so even when connected to the PC a hardware security mechanism protects the key from intrusion.

All of our Nano hardware wallets possess a certified chip, designed to withstand sophisticated attacks. They are called Secure Element (SE), and are cryptographically protected, similar to the ones used in the likes of passports and SIM cards. Unlike the generic chips used in remote controls or microwaves, your private keys stay safe and isolated inside the Secure Element chips. – Ledger

All you need to access the hardware wallet is a pin number. However, as with the paper wallet, this method is still only as secure as the seed key that a new ledger nano device generates upon its first startup. The seed key is a combination of 24 words that backup the private key held on the ledger device.

You need to store this seed key in a safe place in case of hardware failure or loss.

There are secure ways to backup paper wallets or seed keys from hardware wallets. A method I use is splitting the key into multiple parts. Then I distribute these different parts of the keys in different places that are accessible to you.

The fifth part should be stored in your mind, if possible. There are a number of elaborate ways to store the different parts of the seed key. How you do this exactly I’ll leave up to you, as suggesting a particular method would weaken the security of the method.

Today, most people do not hold their own keys, they keep their cryptocurrency held on centralised exchanges such as Binance or Coinbase. These people do not own their crypto. The exchange owns the cryptocurrency and owes you the amounts held on account if, and when, you decide to withdraw. It is little more than a contract of trust, much the same as we have with the old banking system.

This little setup is everything Bitcoin was designed to end, it was designed to remove the need for trusted third-parties and make you the banker of your own wealth. We’ve seen exchange run offs time and time again, beginning with the most famous, MtGox. We’ve seen exchanges seize user accounts due to state intervention and dozens if not hundreds of alleged exchange hacks.

There is a time and a place where using centralized exchanges might be necessary, but storing crypto for long periods of time, is not it.

Bitcoin is a trustless decentralized monetary solution which enables anyone in the world who has access to a smartphone and the internet to transact freely across borders. No government body can seize your funds, no 3rd party can halt the transaction. You send, and another receives.

The only time your funds are at risk are when you interact with centralised exchanges, second layer options or any other 3rd party. Maybe you want to cash out some crypto to fiat, or maybe you want to exchange one crypto for another.

There are ways we can do this to minimize exposure, but first I’d like to quickly talk about fungibility.

 

Fungibility

A fungible asset should be replaceable like-for-like for another of the same asset. A £20 note is as functional and has identical value to another £20 note. Bitcoin is advertised as being fungible, however this is not entirely true.

Because every transaction ever made on the bitcoin network is viewable to the public, it has given rise to something being duped ‘Dirty Bitcoins’. These are bitcoins that have been at some point in their history been involved in suspected shady transactions. Exchanges often black-list these coins and report those trying to deposit them on to an exchange.

It maybe you have no idea you are holding ‘dirty bitcoins’, it may be dirty from a transaction that had nothing whatsoever to do with you 5 years ago when it was in someone else’s possession, but regardless your bitcoin could be tainted forever. This growing issue destroys this idea that bitcoin is fungible.

You can check how clean your Bitcoin is using antinalysis.org, the service is commonly used by dark web traders, but can also be a great tool for anyone wanting to check the health of their bitcoin.

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