Bitcoin for Dummies


Background:Some of my readers might have noticed that starting in the last year I have become more interested in Bitcoin and Cryptocurrencies. Don’t worry, I will not
invest gamble with them but I do think it is important to understand what is going on in this area as this could change many things especially within financial services. As this blog functions primarily as my own diary, I have decided to do a few posts about my own learnings so far.
Bitcoin explained (maybe wrongly) in 10 Points:

  1. In order to incentivize miners to actually perfom this task on an ongoing basis, they are rewarded a certain amount of Bitcoins if they succesfully post a verfied block onto the blockchain
  2. At its core, Bitcoin is (only) a network software protocol which defines the way the potential  members of the network communicate via cryptographic techniques
  3. Based on this protocol, the network then runs many copies of a transactional database which records each and every transaction since the beginning of Bitcoin
  4. The database itself consist of blocks of transactions which are “chained” together by clever cryprocraphic “trees” and pointers (“blockchain”), allowing relatively easy verification if the database has been retroactively changed
  5. The main challenge of this structure ist to avoid “double spending” or what one would call counterfeiting for normal currencies. How does the Bitcoin network  make sure that no one is able to spend his Bitcoins more than once ?
  6.  This problem has been solved cleverly by decentralizing the verification process to the socalled “Bitcoin” miners. Bitcoin miners in principle collect transactions into a new “block” and then verify each transaction if it is valid or an attempt to doublespend
  7. As the Bitcoin network is totally open (anyone with a computer can join, open an account or become a miner) , it is important to defend this process against malicious members who might verify for instance their own double spending attempts
  8. For this reason, the protocol contains a  competition feature. The miners compete against each other for posting a block (and reaping the Bitcoin reward) by solving a cryptographical puzzle which resembles to a certain extent a traditional lottery but requires significant amounts of computational power (“Proof of work method).
  9. Interestingly, this combination of reward and puzzle is the truly innovative feature of Bitcoin. So far this mechanism has ensured that the integrity of Bitcoin has not been compromised, without any control of a central authority. Up until Bitcoin was invented, no one really succeded in establishing such a decentralized verification process.
  10. Finally, Bitcoin cointains a feature which also makes it a truly electronic currency: If one sends Bitcoins via the protocoll, one can embed a set of instructions attached to the Bitcoin which then gets executed at the recieving end. In Bitcoin this is rarely used, mostly for a kind of trust account, but within Ethereum, this feature has been expanded to what is now called a “smart contract”.
Some Myth busting:
A) Bitcoin is fully anonymousThis is not true. Although anyone can open an account without verification and transfer Bitcoins, it doesn’t seem to be too difficult to track for instance IP addresses. Plus it is really easy to track back Bitcoins as all transactions are recorded forever. Only in combination with other tools (Tor etc.) , some sort of anonymity can be insured. In my opinion, cash bills still provide better anonymity than Bitcoin.
B) There are only 21 mn Bitcoins
This is just a number set in the current protocol and could be changed at any time. However this depends on the consent of the miners. Plus, every “hard fork” of the protocol automatically creates 21 mn new Bitcoins (or something similar) as it has happened with “Bitcoin cash”
C) Bitcoin is great for Micropayments as there are no transaction feesThere are several types of fees within Bitcoins. Indirect Transaction fees are currently mostly paid by issuing new Bitcoins to the miners.  Direct transaction fees need to be paid if fore some reasons the transaction should be executed quickly, as miners prefer transactions that offer them fees. One of the big issues is what will happen if no new Bitcoins can be created anymore and then miners are only compensated by fees. Or if the Bitcoin price falls significantly and the significant electricity consumption cannot be refinanced by the block award alone
D) Bitcoin works without Trust or a central authorityIt is true that no central authority decides what is going to happen with Bitcoin. But as a normal user for instance you have to trust either the Bitcoin Exchange if you buy Bitcoins or the programmers behind your Bitcoin Wallet Software that they don’t rip you off. There is also a small Group of people who are responsible for developing the “Bitcoin Core” which is the central protocol software. However their power is limited as the miners can decide which version of the protocol they want to run. Theoretically, a very large mining pool could influence Bitcoin (and even try to double spend) but then trust in the system would vanish quickly and the miners have achieved exactly nothing. Personally I would describe Bitcoin as a relatively well-balanced system with different authorities. Not unlike the power distribution of a country where the power is divided between the legislative, jurisdictive and executive branches. As Bitcoin is relatively new, it needs to be seen how stable this will be.
E) Bitcoin could replace theoretically any currency in the world
In its current form, Bitcoin has no chance to replace any currency. The main reason is that the transaction volume on the Bitcoin Blockchain is very limited. Due to its limited Block size, one Block can contain only around 1500-2000 transactions. As new blocks can only be created every 10 minutes, this limits the amount of transactions to around 12.000 per hour. Visa in contrast for instance claims to be able to handle 56.000 transactions per second. Technically it seems to be possible to improve Bitcoins transaction speed, but so far the Bitcoin “community” seems to have problems to agree on how to do this. So independent of any price fluctuations, Bitcoin in its current form is not a very good payment device from a technical point of view. It will be interesting to see if Bitcoin evolves quickly enough or if other crypto currencies will steal the thunder.Ethereum for instance is a lot quicker as they create blocks at a much faster rate.
F) Bitcoin is a fraud
Just a few days ago, Jamie Dimon called Bitcoin “a fraud”. Acccording to Wikipedia is defined as follows:
In law, fraud is deliberate deception to secure unfair or unlawful gain, or to deprive a victim of a legal right.
The founders of Bitcoin clearly didn’t intend anything in this way. They wanted to create a peer-to-peer payment system which cannot be hacked and I think they were succesful. That Bitcoin now is worth ~70 bn USD is clearly the result of a lot of speculation, but so far I see no intentional fraud.Many things are worth something because people believe it is worth something. When an old painting is sold for 180 mn USD, it is clear that this is a price that is not justified by the cost of the underlying material etc. but that this is the value that the buyer thinks it is worth.
In contrast, some (or all ?) of the hundreds of Initial Coin offerings happening at the moment do have all features of a typical fraud. My favorite coin is PonziCoin which clearly states its true nature. Bitcoin in contrast never did an “ICO”, it just developed the way it is. In a few years time we will see what value then will be assigned to Bitcoin, personally I think that this is not predictable.
More material:
For those who are more interested in the topic, I can highly recommend the Princeton lectures