What is Bitcoin? Get the basics ! Kolin Lukas


What impact does the Bitcoin halving have?

Those that are most impacted by halvings are miners. It makes sense, as the block subsidy makes up a significant part of their revenue. When it is halved, they only receive half of what they once did. The reward also consists of transaction fees, but to date, these have only made up a fraction of the block reward.

Halvings could, therefore, make it unprofitable for some participants to continue mining. What this means for the wider industry is unknown. A reduction in block rewards might lead to further centralization in mining pools, or it could simply promote more efficient mining practices.

If Bitcoin continues to rely on a Proof of Work algorithm, fees would need to rise to keep mining profitable. This scenario is entirely possible, as blocks can only hold so many transactions. If there are a lot of pending transactions, those with higher fees will be included first.

Historically, a sharp rise in Bitcoin price has followed a halving. Of course, there isn’t much data available as we’ve only seen two so far. Many attribute the price movement to an appreciation of Bitcoin’s scarcity by the market, a realization triggered by the halving. Proponents of this theory believe that value will once again skyrocket following the event in May 2020.

Others disagree with this logic, arguing that the market has already factored the halving in (see Efficient Market Hypothesis). It’s not like the event comes as a surprise — participants have known for over a decade that the reward would be reduced in May 2020. Another point often made is that the industry was extremely underdeveloped during the first two halvings. Nowadays, it has a higher profile, offers sophisticated trading tools, and is more accommodating to a broader investor pool.

Contents

  • Is Bitcoin anonymous?
  • Is Bitcoin a scam?
  • Is Bitcoin a bubble?
  • Does Bitcoin use encryption?

Is Bitcoin anonymous?

Not really. Bitcoin might seem anonymous initially, but this isn’t correct. The Bitcoin blockchain is public and anyone can see the transactions. Your identity isn’t tied to your wallet addresses on the blockchain, but an observer with the right resources could potentially link the two together. It’s more accurate to describe Bitcoin as pseudonymous. Bitcoin addresses are viewable to everybody, but the names of their owners are not.

That said, the system is relatively private, and there are methods to make it even harder for observers to figure out what you’re doing with your bitcoins. Freely available technologies can create plausible deniability to “break the link” between addresses. What’s more, future upgrades could massively boost privacy — see An Introduction to Confidential Transactions for an example.

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Is Bitcoin a scam?

No. Just like fiat money, Bitcoin may also be used for illegal activities. But, this doesn’t make Bitcoin a scam in and of itself.

Unfortunately, Bitcoin is used in many scams that you should be aware of. These might include phishing and other social engineering schemes, such as fake giveaways and airdrops. As a general rule: if something sounds too good to be true, it’s probably a scam. Never give your private keys or seed phrase to anyone, and be cautious of schemes that offer to multiply your money with little risk on your behalf. If you send your coins to a scammer or to a fake giveaway, they will be lost forever.

Is Bitcoin a bubble?

Throughout the many parabolic rises in Bitcoin price, it was common to see people referring to it as a speculative bubble. Many economists have compared Bitcoin to periods like the Tulip Mania or the dot-com boom.

Due to Bitcoin’s unique nature as a decentralized digital commodity, its price is entirely dictated by speculation in the free market. So, while there are many factors driving the Bitcoin price, they ultimately affect market supply and demand. And since Bitcoin is scarce and follows a strict issuance schedule, it’s thought that long-term demand will exceed supply.

The cryptocurrency markets are also relatively small when compared to traditional markets. This means that Bitcoin and other crypto assets tend to be more volatile, and it’s quite common to see short-term market imbalances between supply and demand.

In other words, Bitcoin can be a volatile asset at times. But volatility is part of the financial markets, especially ones with relatively lower volume and liquidity.

Does Bitcoin use encryption?

No. This is a common misconception, but Bitcoin’s blockchain doesn’t use encryption. Every peer on the network needs to be able to read transactions to ensure that they’re valid. Instead, it uses digital signatures and hash functions. While some digital signature algorithms do use encryption, that’s not the case for Bitcoin.

It’s worth noting, though, that many applications and crypto wallets make use of encryption to protect users’ wallets with passwords. Still, these encryption methods have nothing to do with the blockchain — they’re just incorporated into other technologies that tap into it.

Contents

  • What is scalability?
  • Why does Bitcoin need to scale?
  • How many transactions can Bitcoin process?
  • What is the Lightning Network?
  • What are forks?
  • Soft forks
  • Hard forks
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What is scalability?

Scalability is a measure of a system’s ability to grow to accommodate increasing demand. If you host a website that’s overrun with requests, you might scale it by adding more servers. If you want to run more intensive applications on your computer, you could upgrade its components.

In the context of cryptocurrencies, we use the term to describe the ease of upgrading a blockchain so it can process a higher number of transactions.

Why does Bitcoin need to scale?

To function in day-to-day payments, Bitcoin must be fast. As it stands, it has a relatively low throughput, meaning that a limited amount of transactions can be processed per block.

As you know from the previous chapter, miners receive transaction fees as part of the block reward. Users attach these to their transactions to incentivize miners to add their transactions to the blockchain.

Miners seek to make a return on their investment into hardware and electricity, so they prioritize transactions with higher fees. If there are a lot of transactions in the network’s “waiting room” (called the mempool), fees can rise significantly as users bid to have theirs included. At its worst, the average fee was upwards of $50.

How many transactions can Bitcoin process?

Based on the average number of transactions per block, Bitcoin can manage approximately five transactions per second at the moment. It’s much lower than that of centralized payment solutions, but this is one of the costs of a decentralized currency.

Because it’s not managed by a data center that a single entity can upgrade at will, Bitcoin must limit the size of its blocks. A new block size that allows 10,000 transactions per second could be integrated, but it would harm the network’s decentralization. Remember that full nodes need to download new information roughly every ten minutes. If it becomes too burdensome for them to do so, they’ll likely go offline.

If the protocol is to be used to payments, Bitcoin enthusiasts believe that effective scaling needs to be achieved in different ways.

What is the Lightning Network?

The Lightning Network is a proposed scalability solution for Bitcoin. We call it a layer two solution because it moves transactions away from the blockchain. Instead of recording all transactions on the base layer, they’re handled by another protocol built on top of it.

The Lightning Network allows users to send funds near-instantly and for free. There are no constraints on throughput (provided users have the capacity to send and receive). To use the Bitcoin Lightning Network, two participants lock up some of their coins in a special address. The address has a unique property — it only releases the bitcoins if both parties agree.

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From there, the parties keep a private ledger that can reallocate balances without announcing it to the main chain. They only publish a transaction to the blockchain when they’re done. The protocol then updates their balances accordingly. Note that they don’t need to trust each other, either. If one tries to cheat, the protocol will detect it and punish them.

In total, a payment channel like this one only requires two on-chain transactions from the user — one to fund their address and one to later dispense the coins. This means that thousands of transfers can be made in the meantime. With further development and optimization, the technology could become a critical component for large blockchain systems.

For a more detailed explainer on the scalability issue and its potential solutions, take a look at Blockchain Scalability — Sidechains and Payment Channels.

What are forks?

Since Bitcoin is open-source, anyone can modify the software. You could add new rules or remove old ones to suit different needs. But not all changes are created equal: some updates will make your node incompatible with the network, while others will be backward-compatible.

Soft forks

A soft fork is a change to the rules that allows updated nodes to interact with old ones. Let’s take block size as an example. Suppose that we have a block size of 2MB and that half of the network implements a change — from now on, all blocks must not exceed 1MB. They would reject anything bigger.

Older nodes can still receive these blocks or propagate their own. That means that all nodes remain part of the same network, no matter which version they run.

In the below animation, we can see that the smaller blocks are accepted both by older and updated nodes. However, newer nodes will not recognize 2MB blocks, because they are already following the new rules.

Bitcoin’s Segregated Witness (or SegWit) is an example of a soft fork. Using a clever technique, it introduced a new format for blocks and transactions. Old nodes continue to receive blocks, but they don’t validate the new transaction type.

A hard fork is messier. Suppose now that half of the network wants to increase the block size from 2MB to 3MB. If you try to send a 3MB block to older nodes, the nodes reject it as the rules clearly state that 2MB is the maximum they can accept. Because the two networks are no longer compatible, the blockchain splits into two.



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