Bitcoin 101

What is Bitcoin?

Bitcoin is the world’s first and largest decentralized cryptocurrency and payment system. It operates on a distributed ledger (a blockchain), recording transactions without a central authority. Eliminating the need for a middleman, making transactions more efficient and transparent. Anyone can send and receive Bitcoin with a crypto wallet, which are easily accessible through smartphones or computers!

The Start of Bitcoin - An Alternative to Fiat

In October 2008, an individual or group known as Satoshi Nakamoto introduced Bitcoin, publishing the famous whitepaper a year later and remaining anonymous ever since. This whitepaper, Bitcoin: A Peer-to-peer Electronic Cash System, outlined Bitcoin as a decentralized payment network, free from central authority control, serving as the Magna Carta for Bitcoin’s operation. On January 3, 2009, the Bitcoin network became operational with the mining of its first block, known as the “genesis block.” Bitcoin’s significant impact on the financial industry has led to its recognition as a store of value, earning it the nickname “Digital Gold”. Bitcoin is building railways for a global financial system that cannot be censored or stopped by any entities, offering numerous advantages such as high transparency and immutability, borderless transactions and permissionless access for all. The network has the potential to revolutionize how we interact with money, fostering financial inclusion for the unbanked, streamlining international transactions and fundamentally altering the landscape of global finance. Bitcoin’s innovation has laid the groundwork for a future where finance is more accessible, efficient, and empowering for all.

Satoshi Nakamoto created Bitcoin as an alternative to traditional currencies, aiming for global acceptance to facilitate everyday transactions. For example, on May 22, 2010, Laszlo Hanyecz bought two Papa John’s pizzas for 10,000 BTC (then valued at $41), now worth $670 million, this exchange is often celebrated because it is viewed as the first use of BTC in a commercial setting. Bitcoin’s core philosophy centers on decentralization, providing an alternative to government-issued currencies like the US Dollar or Euro. These traditional currencies face issues such as unpredictable monetary policies and geographic spending restrictions. In contrast, Bitcoin is highly accessible and allows direct payments to anyone with internet access and a wallet. Instead of transactions being logged by a central authority, they are verified by computers distributed worldwide through cryptographic puzzles and permanently recorded on the blockchain.

How Does Bitcoin work?

The Double Spending Problem:
The double spending problem is a critical issue in digital currency systems, where a digital token could be spent more than once, risking fraudulent transactions and undermining the currency’s integrity. This mirrors the counterfeit problem in physical currency systems, eroding trust and value. For example, in the first half of 2023, Bundesbank withdrew approximately 26,700 counterfeit Euro notes worth nearly €2.9 million. Similar to counterfeit bills disrupting traditional economies, double spending threatens digital currency stability.

In traditional currency systems, double spending is prevented online through centralized control and trusted intermediaries like banks. For instance, credit card transactions are verified and recorded by banks to prevent duplicate spending. Physical currency also inherently prevents double spending, as you can not spend the same note or coin twice. Bitcoin addresses the double spending problem through decentralization and a public ledger, the Bitcoin blockchain. When a Bitcoin transaction occurs, it’s broadcasted to the entire network of nodes. These nodes collectively validate and record multiple transactions in a block, which are chained together, forming the blockchain.

The key innovation preventing double spending in Bitcoin is the consensus mechanism known as Proof of Work, which will be explained further in later sections.

Transacting with Bitcoin

Bitcoin transactions occur between digital wallets, each with a unique private key for accessing Bitcoin holdings. When transferring Bitcoin, users exchange public keys, acting as addresses effectively like your bank account’s IBAN. Unlike traditional banking, Bitcoin transactions operate without intermediaries, offering pseudo-anonymity and bypassing banking hours. As mentioned, pseudo-anonymity means users’ real-world identities are concealed, but transactions remain traceable due to Bitcoin’s transparent nature.

Furthermore, the blockchain ensures transparency by publicly recording and verifying all Bitcoin transactions. While transactions are pseudonymous, they’re fully traceable, enhancing network integrity and security.

Bitcoin Mining and Security

In the Bitcoin ecosystem, mining is the heart pumping the network’s functionality and security. Bitcoin’s consensus mechanism, Proof-of-Work (PoW), relies on miners using specialized computers to solve puzzles and validate transactions, adding new blocks to the blockchain. This achieves consensus in a distributed and decentralized network.

Miners compete in a lottery-like process, expending computational resources determined by their power to solve puzzles, similar to physical labor in gold mining. When a solution is found, the block is broadcasted and verified by other nodes, ensuring consensus and network security. This is similar to how everyone can see edits made on a Google Doc. This process ensures consensus regarding the state of the ledger and secures the network against bad actors. Miners are rewarded with new BTC for their efforts, incentivizing network participation and maintaining security and decentralization.

The mining process maintains a consistent block production rate, adding a new block approximately every 10 minutes. Puzzle difficulty adjusts to account for changes in computational power, ensuring predictable block mining, while maintaining a level playing field to keep nodes challenged in an equitable manner. Bitcoin’s decentralized peer-to-peer transactions rely on Proof-of-Work for validation, securing the blockchain’s integrity. Mining incentivizes participation and ensures the issuance of new bitcoins in a secure, decentralized manner.

Bitcoin Supply

Bitcoin’s supply side policies revolve around a fixed maximum supply of 21 million BTC and a predetermined supply schedule embedded within its protocol. Unlike traditional fiat currencies, where central banks can adjust the money supply as they see fit, Bitcoin operates on a fixed model. Scarcity is built into the system to mimic the properties of precious metals like gold, preventing inflationary pressures over time.

New BTC is introduced into circulation through mining. Initially, miners were rewarded with 50 BTC per block, but approximately every four years, this reward undergoes a “halving event”. During a halving, the reward is cut in half, reducing the rate of new BTC entering circulation and therefore slowing inflation. The next halving, expected in April 2024, will further reduce the block reward to 3.125 BTC per block, reinforcing Bitcoin’s scarcity. To learn more about bitcoin halving, please see our report: Bitcoin Halving & Beyond.

Bitcoin’s scarcity stemming from its supply dynamics, combined with increasing adoption, contribute to its value proposition as a digital store of value, often referred to as ‘digital gold.’ Understanding these supply mechanisms is crucial for newcomers to grasp Bitcoin’s unique monetary properties and its potential as a hedge against inflation.

How Can I Buy Bitcoin?

As mentioned earlier, in order to transact Bitcoin you’ll need a wallet, a secure place to store BTC. Think of it as your own virtual personal safe. Once you have a wallet set up, you can choose where to buy Bitcoin. Two main options are available: centralized exchanges and decentralized exchanges.

Centralized exchanges (CEXs) function like marketplaces, allowing you to buy, sell, and trade cryptocurrencies. In this case, Know-Your-Customer (KYC) in the form of identity verification is necessary. Keep in mind, these exchanges often offer built-in wallets, with the drawback being, they have custody of your Bitcoin which often tempts users to find alternative solutions. Popular centralized exchanges include Coinbase, Binance, and Kraken.

On a CEX, you’ll place an order specifying how much Bitcoin you want to buy and at what price. The exchange will match your order with someone selling Bitcoin, and the transaction will be completed. After buying Bitcoin, it’s a good idea to transfer it to your own wallet for added security. You can do this by withdrawing your Bitcoin from the exchange to your wallet address.

On the other hand, decentralized exchanges (DEXs) operate without a central authority, enabling direct peer-to-peer transactions and offering more control over your funds. You’ll typically connect your own wallet to the decentralized exchange without needing an account. Examples include Uniswap, PancakeSwap, and SushiSwap. With a DEX, you simply choose the amount of Bitcoin to buy and approve the transaction using your wallet. The trade is executed directly on the blockchain.

Bitcoin & Beyond

In an ever-evolving industry, Bitcoin continues to adapt and expand its utility as the digital assets space matures. Beyond its role as a store of value and payment method, Bitcoin introduces innovations like the Lightning Network for faster transactions, Oracles for real-world data integration, and BRC-20s for tokenized asset creation. These advancements broaden Bitcoin’s appeal and utility, fostering growth and adoption in the digital assets ecosystem.

Lightning Network

As Bitcoin’s popularity surged, its rising transaction fees and slower processing times became apparent, prompting the need for solutions to improve scalability and accessibility for everyday users. In response, the Lightning Network was conceptualized in 2015 as an additional layer on top of Bitcoin, designed to expedite and economize transactions by conducting them “off-chain.”

To illustrate, imagine being at a coffee shop. Using the Lightning Network is similar to running a tab instead of paying individually for each purchase and waiting in line each time. This allows for seamless, continuous small transactions, with the final settlement occurring at the end of a defined period. Similarly, Lightning Network users establish channels, preload them with Bitcoin, and engage in multiple transactions off the main blockchain, settling the total balance when necessary at the end on the main Bitcoin blockchain.

Ultimately, the Lightning Network solution was designed to help Bitcoin realize its vision of being a financially inclusive payments system that anyone can use. In line with this, the Lightning Network’s channel capacity has grown from 2200 BTC, in terms of available liquidity in August 2021, to 4750 BTC in August 2023. Further, the Lightning Network’s estimated monthly routed volume grew by a factor 8 in BTC terms, growing from 303 BTC to 2950 on a monthly basis, as seen in figure 1.

BRC-20, Ordinals, Runes

Bitcoin underwent an exciting development with the introduction of Ordinals, by bringing new functionality to Bitcoin. Ordinals leverage a Bitcoin protocol upgrade called SegWit (Segregated Witness), which separates transaction signatures from main transaction data, freeing up space for Ordinal inscriptions. Essentially, they allow Satoshis (the smallest unit of Bitcoin) to be inscribed with data (such as images, videos or texts) directly on the Bitcoin blockchain, which remain immutable and verifiable by anyone. This development brings non-fungible token (NFT-like) features to the Bitcoin network, which has gained momentum evidenced by $790M in NFT volume being seen in the last month on the network, overtaking both Solana and Ethereum. However, they come with certain drawbacks. The fixed block size on Bitcoin can lead to heavy competition for block space, potentially increasing transaction fees. Extensive use of Ordinals could bloat the blockchain, impacting speed and efficiency, negatively affecting user experience.

To address these challenges, BRC-20 tokens emerged as a standard for creating fungible and non-fungible tokens on Bitcoin using Ordinals, inspired by the ERC-20 token standard on Ethereum. Unfortunately, while BRC-20 tokens were a pioneering effort, their reliance on Ordinal inscriptions means they still inherit some of their limitations. Trying to cram all information about a token (such as total supply, individual ownership details and fungibility status) into a single inscription becomes a data juggling act. To represent these token properties, BRC-20 utilizes nested data structures within the inscription. Think of it like Russian dolls – each layer adds complexity and increases the overall size of the inscription data. This additional data contributes to larger transaction sizes, leading to higher fees. Further, transferring a BRC-20 token isn’t as simple as sending Bitcoin. Due to the way inscriptions work, transferring ownership might require multiple transactions because the data representing the token might be spread across multiple inscriptions. These additional transactions further strain network efficiency and add to the overall cost of using BRC-20 tokens. While they offer functionalities such as token creation and management on Bitcoin, it comes at the expense of increased transaction sizes and inefficiencies, potentially hindering wider adoption.

This paved the way for alternative solutions like the Runes protocol which launched in early-April this year, aiming to further streamline tokenization on Bitcoin. Firstly, the Runes protocol breaks free from the drawbacks of Ordinals, as it doesn’t rely on Ordinals for its functionality, operating as a separate protocol specifically designed for token issuance and management. This eliminates the need for complex data structures within inscriptions, and also introduces a concept called Unspent Transaction Outputs (UTXO) consolidation. Instead of creating separate UTXOs for each inscribed token (like in BRC- 20s), Runes condenses information about multiple tokens into one UTXO. Essentially, all tokens can be stored in one neat wallet instead of having them scattered across multiple locations, significantly reducing blockchain clutter leading to faster transaction processing and lower fees.

By minimizing the number of UTXOs, Runes helps keep the blockchain leaner, more scalable and accommodating to future growth. One of the biggest drawbacks of BRC-20s was the need for multiple transactions to transfer ownership. Runes streamlines the process, allowing the transfer of any number of tokens within a single transaction, simplifying the user experience and reducing the overall cost associated with transferring tokens. Runes essentially takes a more minimalist approach, separating token management from data storage, leading to a more scalable and user-friendly tokenization experience.

The emergence of Ordinals, BRC-20s, and the Runes protocol signifies a period of rapid innovation in the Bitcoin space. While Ordinals offer exciting possibilities, their impact on scalability needs careful consideration. BRC-20s provided a foundation for tokenization, but their overall complexity paved the way for more efficient solutions like Runes. As the technology matures, developers will likely continue to refine these protocols and explore new ways to leverage Ordinals for unique applications on the Bitcoin network. It’s important to remember that this is a rapidly evolving field, and the long-term impact of these advancements on Bitcoin’s functionality and scalability remains to be seen.

Figure 1: Estimated Growth of Lightning Network Transactional Volume

Estimated growth in monthly routed lightning transaction volume (Lower bound estimates as private transactions are excluded)