On-chain or Lightning
An overview of the Bitcoin protocol for beginners
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This article is copied from the original source at Bitcoin Reserve Journal.
Audio by @DelioPera
When I was first exposed to Bitcoin, to me it was just a number on a screen that I could trade. Buy low, sell high, make money. But it is so much more than that. I was treating a miraculous gift to humanity, seemingly with contempt. It deserves much more respect.
During the bear market of 2018, when the excitement of profits vanished, and after the hurt of them being wiped away sunk in, I decided to hold, or “HODL” as the meme goes. I knew I would have to be patient. I had time on my hands. So I decided to learn more about what Bitcoin was. Lucky I did! I was astonished. Since then, I have been continuously learning more, and as I learned, everything was making sense, and my conviction increased. So did my investment.
I asked myself, “Was I blindly going down a path without question?” Due diligence required that I searched very hard for weaknesses in Bitcoin. After 18 months of searching, almost daily, I have not found a satisfactory objection to not aggressively accumulate.
I will first explain what Bitcoin is and how it works. In other articles, I will go through the objections and risks that I, and others, have posed. And I will present the answers I have found to them all, and insights.
Understanding Bitcoin Is Hard, and Then It’s Not
It’s not easy to understand Bitcoin at first. I think it’s better to explain to a newcomer WHAT Bitcoin is, not HOW. What it can do, the problems it solves, and why it’s important. We shouldn’t dive into HOW it works too early. There isn’t a need for this. It doesn’t add to the understanding and appreciation of why Bitcoin is an incredible gift to humanity.
Bitcoin is not easy to explain. There is no one paragraph that can convey all its crucial properties. Every brief explanation is misleading in some way.
That’s partly because nothing like Bitcoin has ever existed before, so there is nothing for people to compare it to. Comparisons are automatically made to help understand concepts, but they are inaccurate and lead to wrong conclusions. It challenges many preconceived ideas about money (that are wrong) and are taken for granted. It challenges world views, and that’s uncomfortable for people.
Another reason why it’s difficult to explain is because it has many different and complicated parts, each with different functions – and only by understanding each part can the whole be understood. These complicated parts are easier to grasp if one has a basic understanding of various fields such as Computer Science, Cryptography, Austrian Economics, History of Money, Social Networks, Game Theory, Human Psychology, and Evolution/Natural Selection.
A Scarce Number
Bitcoin is just a digital number. But a scarce number. How can that be? A scarce number makes no sense at first. There are 21 million of “them”. Each can be broken up into tiny pieces, down to 8 decimal places. You can own an amount as little as 0.00000001 bitcoin. They are not actually “coins” as such, they are just special numbers.
Bits of it can be moved from one place to another, but these pieces can’t exist in two places at once. They can’t be copied. That is very special.
If I have 0.5 bitcoin and send it to someone else, I no longer have that fraction of bitcoin. This is different to an email, such that if I send it, I can keep a copy. Perhaps it might help (at first) to think of a quantity of bitcoin like a uniquely identifiable email containing a number, that can only exist in one place at a time.
No digital item has ever had this property. Also note, without this property, digital money without a central coordinator is not possible.
Let’s increase the complexity a little. Bitcoin is not just the number, but also the digital “book“, or ledger, where it is recorded down. The numbers (the units) are lowercase ‘b’, the book is uppercase ‘B’. The ledger also records down what address the bitcoin are associated with. For now, think of these addresses like bank account numbers that “hold” bitcoin.
The Bitcoin Blockchain, or the “book”, or the “ledger”, contains every address’s (accounts’) balance, and every movement of bitcoin (the transactions) since the beginning of Bitcoin’s creation. Pause and absorb that for a moment – Every transaction for every account, ever. A completely transparent monetary system. Not a transparent bank account, but a transparent monetary system.
Note: addresses have no personal identification associated with them on the ledger, but ownership can be inferred from surveillance. Because of this, privacy is not the default, but can be achieved with good practices. If Bitcoin was completely private, then auditing the monetary system’s integrity as a whole would not be possible.
Every 10 minutes on average, a new “page” of transactions is added to the ledger, called a “block“. Think of a physical ledger, where transactions are limited to one page every 10 minutes. There is a limit to how frequently the pages will be turned to add new transactions, and the book is continuously growing.
Because data is added in blocks, and each block is connected to the previous block (explained later), the ledger is called a “blockchain” – a chain of ever growing blocks.
The purpose of the Blockchain is not just to put new data in the right chronological order – it is to make the blocks digitally connected, so that any change to previous blocks invalidates future blocks. This makes the history of the monetary system tamper evident. Discussed later, mining makes the system tamper-proof.
Bitcoin started on January 3, 2009, by a person or group of people, pseudonymously called Satoshi Nakamoto. No one knows who “he” is and “he” has disappeared shortly after creating Bitcoin.
On the first page of the ledger, the first block, when Bitcoin first started, only 50 bitcoins were created. What does that mean? It means the first entry in the first block contained a transaction of 50 bitcoins – Just as you might open a new book and write down, “I have $50 dollars.”
Don’t be bothered too much now on the fact that they are created seemingly from nothing – this initial natural objection will be alleviated later.
For every new page added to the “book” of Bitcoin, 50 more “coins” were added. On each of the “pages”, in addition to newly created coins, there also exists any movement of bitcoin from one person to another – called “transactions”.
Every 210,000 pages, or “blocks”, the rate of bitcoin creation halves so that on block 210,001, 25 bitcoin were being created instead of 50. Then on block 420,001, 12.5 bitcoin were being created instead of 25. Then on block 630,001, on May 12 2020, 6.25 bitcoin were being created instead of 12.5. These events are called the Bitcoin “Halvings” (or “Halvenings” – there’s an ongoing debate about that terminology).
In approximately the year 2140, as fewer and fewer bitcoin are created per block, there will come a day when the smallest unit possible (0.00000001 bitcoin, called 1 Satoshi) will be created per block, and can no longer be halved. That will result in a limit of 21,000,000 bitcoin created, and no more will ever be created. Currently, there are about 18.5 million bitcoin in existence.
Nodes: The Blockchain Is Copied, but the Bitcoin Are Not
Importantly, although the units of bitcoin cannot be copied within the ledger, the ledger itself, Bitcoin with a capital “B”, can be copied, and is copied, all the time, and that is crucial to it being resistant to attack or shutdown.
Copies of the ledger sit on thousands of computers all over the world, and they are all connected in a network and synchronised with each other. These computers are called “nodes”.
Anyone can participate in this network of “nodes”. It is just a matter of downloading the software, called Bitcoin Core, from bitcoin.org, and connecting it to other computers via the internet that also run Bitcoin Core (the communication happens automatically).
The new downloaded program then communicates with other computers running the same software, to copy the Bitcoin Blockchain. It maintains these connections to participate as part of the network.
Once a new node is in synchrony with the others, it waits (like all the other nodes) for new blocks to be created (by miners). These get propagated through the network and all the computers update themselves. A node can switch itself off for whatever reason, and return to join the network at any time. It just has to catch up by adding the new blocks it has missed.
The blockchain’s past can not be changed. It is a permanent record of all transactions, and it is distributed all over the world. It can not be eradicated. To shut down Bitcoin, every single one of these nodes needs to be found and destroyed. Because this is virtually impossible, Bitcoin is virtually impossible to stop.
To summarise briefly so far, the Bitcoin Blockchain contains a chain of connected blocks, each with newly created bitcoin (from “nothing”), and any movement of bitcoin ownership (transactions). New blocks are added every 10 minutes on average, and thousands of computers keep an identical up-to-date copy of the entire chain.
Storing Bitcoin: Private Keys
It is interesting to know that you can never actually “own” some bitcoin, as per the general understanding of the word “own”. The bitcoin quantities are just numbers on the many identical Blockchain copies (that everyone can see), associated with a string (letters and numbers) called a Bitcoin “address”.
What you have is the key. A key is like a secret “password” – it is actually a randomly generated, extremely large binary number (zeros and ones), that only you have access to. You can know a number, but you can’t own it. So, you know a key, not own the key. But it’s simple and generally accepted to say “own”.
Because the number is large, and random, no two people will ever generate the same key.
An example of a Bitcoin private key (they can be twice as long):
This number is hard to write down for a human. So a system was developed, a protocol, in which words can be used to represent that number. Below is the set of words that is equal to the above number:
The private key is used to create a unique set (unique to that key) of seemingly infinite bitcoin addresses using a mathematical pre-defined formula. Below are the first several addresses for the key above:
If on the Bitcoin Blockchain, there is an address noted to have some bitcoin associated with it, and if you are the “owner” of the private key that made that Bitcoin address, then you have the power to remove bitcoin from that address, and send it to any other Bitcoin address you like.
If you move it to an address associated with someone else’s private key, then that person controls where that bitcoin can go to next. You have effectively paid him/her. The balance in your Bitcoin address has gone down, and the balance in his/hers has gone up by the payment amount.
Another way to think of it is that the Bitcoin Blockchain is a public wall of writing that everyone can see. You have permission to make modifications to the wall if you can prove you are the key holder.
That proof comes from using the private key to sign a transaction. This is based on cryptography – you don’t need to understand deeper than that to use Bitcoin. It happens in the background, and your wallet takes care of it. Wallets next…
Storing Bitcoin: Wallets
A wallet is a piece of software that stores your private digital key. The wallet is not part of the Bitcoin Blockchain, it communicates with it. It is privately held software.
The wallet actually has no bitcoin in it per se. It asks the Bitcoin Network, “how much bitcoin is in my addresses?”
Remember it’s the private key that mathematically makes limitless addresses, and controls the “spendability” of the bitcoin associated with those addresses. All the addresses are unique to the key. Because the wallet knows the private key, it can figure out the addresses. You can have many copies of a wallet on various devices, each with the same private key, and each will therefore show the same bitcoin addresses.
A Bitcoin Wallet:
If a key is lost, the bitcoin it controls can never be spent by anyone. The bitcoin still exists on the blockchain but it cannot be spent (moved to another address) and is effectively “lost”, or “unspendable”.
The word “wallet” may confuse newcomers because it is used in two ways: The first usage describes software that holds your keys. The second describes all the addresses that are made by a private key.
Software (called a wallet) –> holds private key –> collection of addresses (called a wallet)
An example of a newly created wallet:
A Bitcoin transaction can be thought of as a small package of data that states an amount of bitcoin to be moved, an origin address, a destination address, plus a signature. Sort of like a bank cheque (amount, sender, recipient, signature).
The transaction is produced by the software wallet of the sender, is signed by the private key contained in the wallet, and then the wallet sends the transaction data to a Bitcoin node. Sort of like a person writing a check, not handing it to the recipient, but directly depositing it to the recipient’s bank account.
That node then checks that the transaction is valid (i.e. not cheating the rules of Bitcoin), which includes checking the signature made by the private key is genuine. Similar to a banker checking the person writing the check has funds in the origin account, and that the signature on the check is real.
The node accepts the transaction if it is valid, and only then passes it around to other nodes. Note that a private key is used to sign a transaction, and it is the signature, not the private key, that gets passed around to nodes and the public blockchain.
Each node that accepts the new transaction, adds it to a waiting list called the “mempool”. Each node keeps its own copy of the waiting list.
Transactions sit in the mempool, waiting for Bitcoin miners to take them, and add them to the next Bitcoin block. (Mining coming up next). A miner finalises the block, and sends it to a node, and after checking it is valid, the node passes it around to all the other nodes which also check it is valid. The block and the new transactions contained within then become part of the Blockchain.
If a wallet has an address that is expecting a payment, it checks that the relevant transaction has been added to the blockchain. The new data on the blockchain is used to update the balance reflected in the wallet.
An example will help illustrate this. Imagine Alice is paying Bob 1.0 bitcoin. I will ignore any transaction fees for simplicity. On the left half of the image below, Alice’s wallet has an address (the 3rd address) with 1.0 bitcoin in it. She makes a payment of exactly that amount to Bob’s 3rd Bitcoin address which has 5.15 bitcoin associated with it. Bob told Alice what his 3rd address was (i.e. provided an invoice), and Alice’s wallet made a transaction that describes the origin and destination addresses, and the amount to be transferred.
She then adds a digital signature for the transaction and publishes the transaction to the Bitcoin Network (sends the transaction to a node’s mempool, a miner includes the transaction in a block, the block gets sent back to a node, the new block is distributed to all the nodes). Both of their wallets update themselves based on the data on the blockchain (by asking a node via the internet).
On the right-hand side of the diagram is the status of the two wallets after the transaction is finalised. Alice’s third address in her wallet has zero bitcoin. Bob’s receiving address now has 6.15 bitcoin instead of 5.15 bitcoin. Bob has been paid.
You don’t need to understand the inner workings of mining to understand how Bitcoin works. You probably should not consider attempting to mine bitcoin as an individual. It is generally not profitable anymore. Mining is mainly profitable for big business with access to extremely cheap (below retail price) electricity. Below is an image of a small mining “farm”:
Only a basic understanding of mining is needed to understand how Bitcoin functions – In the same way that a gold accumulator doesn’t need to know how gold is mined.
Mining is done block by block, and miners are all competing to mine the next block. It involves spending computing power to search for a special number, by repeated trial and error attempts. There is no “calculation” involved per se, although it is commonly described that way. It is brute force and costs electricity.
When the number is found for the next block, the miner is rewarded bitcoin within that block. Apart from including other peoples’ transactions, every miner makes one transaction that effectively says “My address has 6.25 newly created bitcoin”. All other transactions in the block are movements of bitcoin, not the creation of bitcoin.
This reward is how bitcoins are regularly created each block. Because the miner found the special number, he/she proves that computer work was done, so that when the block is passed to the nodes, they will all accept this creation of bitcoin as valid. Whoever does this first (per block), wins. Coming second is fruitless. Once there is a winner, all miners start working to win the next block.
Anyone trying to cheat will fail because they will not have the right number. The number is very difficult to find, but it is easy and quick for nodes to check that it is valid.
This computer effort is NOT WASTED energy. It is a defence mechanism. The miners spend this energy, seeking a reward in bitcoin. Any attacker, someone who wishes to tamper with the blockchain, must compete by spending more energy than the entire world mining power combined, and potentially receive NO REWARD if they fail. The more energy spent by miners, the more expensive it is to attack Bitcoin.
All the mining computer power all over the world COMBINED, is protecting the integrity of the entire Bitcoin system. It protects the blockchain, so no one can make edits against the Bitcoin rules, or steal funds.
In addition to this overall security, there is personal security. When you control bitcoin with a private key, your “control” is protected by you keeping your key safe and secret. If someone has your private key, they can steal your funds, and do so without breaking the rules of Bitcoin.
Why Can Bitcoin Be Money?
Bitcoin can be money because it has all the desirable features of a good money. It is divisible, portable, durable, recognisable, transferable (medium of exchange), measures value (unit of account), and is easily verifiable. Crucially, it is not dependent on the honesty of humans, or central coordination, and it can not be debased by creating more.
A counterargument (to be explored in a future article) is that money needs “intrinsic value” – In fact, nothing has intrinsic value. The argument would better be phrased: “It needs to have value for something other than money.” – This is not true either. Money needs no alternative value. It is a language. The language of value:
Compare it to the English language: The purpose of English is to “store” and communicate MEANING. English has no “intrinsic meaning”. The words themselves are just abstract symbols or noises. People don’t speak English because they believe there is something intrinsic to it. They do so because the people they communicate with also speak the same language. The network of people speaking the language started small, and grew.
For free market money (not government enforced money), people speak the language of value with other humans that accept that language. In the same way that English needs no intrinsic value to be accepted as a language, money needs no intrinsic value to be accepted as a language.
Any alternative value for money is just useful for the initial stages of adoption of the language. Once it is adopted, alternative value becomes irrelevant – it could even disappear and it wouldn’t matter. This is how gold grew as the language of money. Its usefulness for other purposes is nice, but irrelevant. It was its superior monetary properties and relative scarcity that grew its dominance as free-market money, not its alternative uses or alternative value.
Now, for the first time, there is something vastly better than gold. It just needs time for people to learn the language.
A candidate for money needs not only the right properties, it also needs social acceptance, and in a free market, it needs to start off as the best. Once it is in the lead for acceptance, it no longer needs to be the best. It can be good enough as money, and any new competitor that is only slightly better cannot catch up.
To illustrate with the language example, if there was a new language just like English, but a bit more beautiful sounding, we can say it is slightly better, but English will not be overtaken. English will remain dominant because it already is dominant. This is a property of networks.
Conversely, the reason Bitcoin will overtake gold is not that it is slightly better – but because it is vastly better. It is likely to overcome the dominant free-market money because it fixes gold’s greatest weaknesses.
- Is not easily divisible for small payments
- Is not easily portable (try taking several kilograms overseas)
- Is not digital
- Final settlement is very slow and expensive (physical delivery).
- It is expensive to store securely
- It is centralised
- It has been confiscated by governments (Order 6102)
To overcome many limitations, currencies backed by gold were created. This allowed people to trade value more portably, of small values, and later digitally, but it introduced new limitations – Trusted Third Parties. Bitcoin overcomes gold’s flaws, without a trusted third party. This is truly amazing.
Since President Nixon’s complete removal of the backing of the US dollar by gold in 1971, the dollar became money, not a currency. Easy money, not hard money. Not sound money.
We now have multiple government paper currencies backed by nothing – we can conclude that gold failed. If the world impossibly ever returns to the gold standard, the exact same thing can happen again later. We need a better solution, and there is one. But it is unlikely governments will voluntarily adopt Bitcoin (although it is possible). Instead, as the famous Austrian Economist put it, now a well-known quote in Bitcoin circles:
“I don’t believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can’t take them violently out of the hands of government, all we can do is by some sly roundaboutway introduce something they can’t stop.” – Friedrich Hayek in 1984
Even though it is vastly better than gold, Bitcoin won’t actually be money until it is accepted by most people as money. That takes time to develop. Nearly everyone in the world doesn’t need to OWN some for it to be money, but nearly everyone in the world needs to WANT it. That is the final hurdle for Bitcoin.
Why Is Bitcoin Important?
Bitcoin is important because we don’t have free-market money. Our money is created by and controlled by governments and central banks, and that control allows them to extract human time (savings) from us against our will – via money creation. This is a humanitarian disaster, and to find out more about this injustice throughout human history, I encourage you to read Robert Breedlove’s incredibly well-written article, “Masters and Slaves of Money.”
There are many other reasons Bitcoin is important, but this is by far the most. There are those that can envision (myself included) that a world with free-market money, and eradicated central banks, will be a world of peace and prosperity. That is the dream.
Free Market Money vs Barter
In a free market, there will eventually only be one money. If there are multiple monies, that is just adding friction, and is moving towards barter. Money solves the problem of barter. If free-market money works, barter will eventually disappear. Note that most countries have government money, which is required by law, to use for exchange, write contracts, and pay tax. It is not free-market money, and that is why many can exist, and also why foreign exchanges are necessary for international trade.
When storing one’s wealth, an individual has an incentive to store it in the money that is most accepted – not the second most accepted. This pressure eventually results in the leading money to absorb all inferior stores of wealth. But it takes time.
Hopefully, this can help you understand what Bitcoin actually is, and why it is not just a worthless token “backed by nothing” that governments can easily stop. This is a natural first impression, but as you scratch the surface, you’ll realise it is something breathtaking. In future articles, I will write about peoples’ typical objections (there are many), and my responses to them. I will also write about concerns that surface after understanding Bitcoin for a while – they also have excellent counter-arguments.
This article was “not too technical” by design. When you are ready for the next step in technical understanding, I strongly recommend this superb lecture by Andreas Antonopoulos. There is nothing else like it.
I am also available to answer questions and can be contacted on Twitter – @parman_the.
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