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CRYPTO EXINITY EBOOK

CRYPTO EXINITY EBOOK

CRYPTOCURRENCIES BITCOIN

Written by

Kingsley

(HEAD of EWEB)

Contents

Satoshi Nakamoto

Decentralisation & The Peer-to-Peer (P2P) Network

Public and Private Keys vs. Public Address

Trust

Proof-of-work

Financial Institutions

Blockchain technology

Cryptography

Double spending

Bitcoin vs. bitcoin

Mining

Block Reward

Digital Signature

Distributed System

Byzantine Generals Problem

The Future of Bitcoin

Trading bitcoin

Altcoins

Regulation

Transaction Fees

About the Author

Satoshi Nakamoto

Emerging from the world of cryptography in the mid-2000s, the mysterious Satoshi Nakamoto is credited as the mastermind creator behind bitcoin the currency, and Bitcoin the network. Is that his real name? Is he Japanese? American? Is he or she, in fact, a lot of people merged under one pseudonym? To this day, no one knows.

As a direct response to the financial crisis of 2008, Satoshi Nakamoto envisioned a new and decentralised digital currency system he called bitcoin. In October 2008, Nakamoto published a paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” which detailed a payment system based on chains of data blocks (later to become known as blockchain) and the removal of third parties between transactions. It came at a perfect time, of course, because a lot of people had lost trust in traditional financial institutions due to the crisis.

Nakamoto’s proposal detailed how the new system would function without financial institutions, how a peer-to-peer network would resolve the issue of double spending and what this new system would mean for transactional privacy.

A few years after his proposal, Satoshi Nakamoto stopped being involved in the development of bitcoin and completely disappeared from all public forums.

 

Decentralisation & The Peer-to-Peer (P2P) Network

The core principle of decentralisation is the removal of a central, controlling body, whether that be an entity in the form of a financial institution (i.e. a bank), a “trusted third party” in the form of a payment provider, or an individual middle-man between the sender and the receiver of a transaction.

One type of decentralised system like this has existed for many decades. Known as peer-to-peer – P2P for short – this network consists of, in its most simplified definition, two or more computers connected to one another and sharing all types of data. Torrent file-sharing, which is widespread and allows users to download music, movies, documents and other types of files, is based on a P2P network.

P2P technology has a long history. As a fault-tolerant network, P2P was initially designed for the purpose of transmitting military messages without any vulnerability to human fatality, natural phenomena or technical malfunction. Its primary feature is its autonomy – in other words, its inherent decentralised nature.

A P2P network has no centralised authority or regulatory entity that monitors, facilitates or controls any of the data that is shared between the two peers.      

 

Public and Private Keys vs. Public Address

To understand bitcoin and its intricate structure, you need to know the difference between three terms whose definitions are often, easily (and mistakenly), interchanged.

Private Keys

In their purest form, private keys are 256-bit numbers that are generated randomly and used to authorise the spending of bitcoins. ‘Bit’ is short for binary digit and always represented by one of the two binary figures: a 0 or a 1.   

Since the number of possible 256-bit combinations is extremely large, a simpler system has been created to represent the private key. A 64-character hexadecimal system using letters a-f and numbers 1-9, like so:

ef235aacf90d9f4aadd8c92e4b2562e1d9eb97f0df9ba3b508258739cb013db2 Public Keys

Derived from the mathematical theory of elliptic curve multiplication, public keys are created from private keys. They are used to confirm that the data sent in the blockchain is authentic; in other words that it comes from the owner of the specific private key.

5Thanks to the public key, the private key takes the shape of a digital signature, without ever being publicly revealed. The receiver, or any peer in the network, will only see the digital signature and public key.

Example of a Public Key:

030589ee559348bd6a7325994f9c8eff12bd5d73cc683142bd0dd1a17abc99b0dc Public Address

Also known as the bitcoin address, the public address is also a major identifier for a transaction and it’s derived from the public key. In fact, this is the information that people need to input if they wish to send you bitcoin.

Each bitcoin transaction carries with it a unique public address, generated by applying the public key into a cryptographic algorithm called Secure Hash Algorithm (SHA).

Example of a Public Address: 1J7mdgA5rbQyUHE2NYd5x39WVBWK7AfsLpEo6XZy

 

Trust

You’ve heard the term “trusted third party” before, right? Traditionally speaking, this third party is the mediator between any customer and any merchant. Banks and financial institutions or online payment processors are conventional third parties that help facilitate transactions.

Naturally, any transactions that involve people’s money must be built on trust. After the 2008 financial crisis, this core principle was shaken as the concepts of fraud and disputes became more prominent.

Traditional trust constitutes good faith towards the middle man; should any disputes or claims of fraud arise, it is up to this intermediary to settle them. The system works relatively well, but merchants end up incurring costs, customers are asked for more information, and transactional fees increase.

Coupled with the fact that the traditional trust system took a hit after 2008, Satoshi Nakamoto came up with the Bitcoin Network as a new kind of trust system, based on the P2P network.  

 

Proof-of-work

Integral to the mechanics of Bitcoin, proof-of-work (or POW) is Satoshi Nakamoto’s ingenious workaround for confirming the blocks of transactions. The trust that is traditionally extended to financial institutions is transferred to the decentralised nodes (or computers) on the P2P Bitcoin network.

These nodes validate and group transactions into blocks. In order to include the block in the ledger (blockchain), these nodes need to solve a “cryptographic puzzle”. This is done by hashing the information in the block to satisfy specific conditions. For example, one such condition is that the resulting cryptographic hash has to be less than a specified number. Since this type of proof-of-work involves a lot of trial and error, the approach is called bruteforce - meaning all possible solutions are exhausted until the correct one is found.

The idea behind POW first emerged in the early 90s. By 1999, the first appearance of the official term was documented, and while appearing in various forms, it became increasingly popular when Satoshi Nakamoto integrated it into Bitcoin, amending it to include the decentralised node verification system.

 

Financial Institutions

Financial Institutions, in the context of Bitcoin, are the conventional or traditional entities or companies that deal with monetary transactions within the overall sphere of financial services.

Banks, for example, are the most readily recognisable and referred-to financial institutions. They store clients’ financial data and records, apply their own fees for various transactions, and generally act as the middle man (or “trusted third party”) between a buyer and a seller or, indeed, any two parties (whether individual or group) who enter into some form of financial agreement between each other.  

After the 2008 financial crisis, terms like “bail-in” and “bailout” became popular and threw a very negative light on all standard and regulated financial institutions, especially banks. A popular investment bank famously collapsed in September 2008, prompting a massive banking crisis. With the enactment of the Emergency Economic Stabilization Act of 2008, it has been reported that the US government supplied up to $700 billion to banks in order to bail them out of the crisis.

Nakamoto developed bitcoin as an “antidote” to this loss of collective trust in financial institutions.

 

Blockchain technology

Blockchain technology is at the centre of what makes the entire cryptocurrency system function, including, of course, bitcoin.

As the name suggests, a blockchain is essentially a chain of blocks that contain transactions and other data. In the case of bitcoin, this data is an encrypted form of digital currency. However, the blocks contain more than just the transactions themselves.

Besides the transactions (i.e. the amount for transfer), the blocks also contain the following information:

• A timestamp indicating when the block was created

• A digital signature that is unique to its contents

• A code that links it to the previous block.

To get more detailed, the block header – which is the key identifier of any given block within the blockchain – contains even more data. This includes, but is not limited to, the version of the blockchain, an encrypted summary of transactions, and a number that correctly calculates the digital signature of the block header.

Once a block is included in the blockchain, it becomes permanent and irreversible. Looked at in its entirety, a blockchain consists of every transaction that occurred since the beginning of bitcoin, starting with the very first block known as Genesis.

 

Cryptography

Cryptography has a long history, dating back thousands of years. At its heart, the principle definition has remained the same even while technological advances have radically modernised cryptography.

It is the discipline or science of keeping data and messages secure (or secret) while communicating and/or transmitting them over an insecure route or through a vulnerable medium.

Historically speaking, the use of cryptography heavily influenced the course of action in both World War I and World War II. Since then, cryptography has made huge advances into the digital space. The Bitcoin network uses cryptography as its primary security measure.

While transacting bitcoin, cryptography comes into play when describing the role of the Secure Hash Algorithm (SHA). This is a cryptographic algorithm designed by the National Security Agency (NSA). In order for a user to obtain his or her public keys, the corresponding private key is fed into SHA-256. This generates the public key, which is then fed back into the SHA-256 to generate the public address. The SHA- 256 algorithm takes a string of data of any length and transforms it into exactly 256 bits – that is, a series of 256 1s and 0s.

Another innovation of Satoshi Nakamoto is the digital signature, which is actually not only unique to every block but also contains links to the previous blocks that make its transactions irreversible. Digital signatures are another example of the kind of cryptography used in the Bitcoin network.

 

Double spending

Even though a form of P2P technology has been available since the 1960s, it has proven very difficult for an independent online payment system such as bitcoin to appear. The reason for this can be summed up in two words: double spending.

The best way to explain what double spending is to imagine a bitcoin transaction as a text file:

Imagine that each text file represents €10.

A customer only has €10 to his name and needs to buy a product online that is worth €20.

If he takes the text file, and copies it 10 times, all of a sudden he has €100.  

If the customer buys 5 products with these €100, he would be double spending. In the bitcoin world, if someone were to copy a digital file that represents €10, and send €10 to two different merchants at the same time, this would be an act of double spending.

Nakamoto figured out a workaround for double spending, by registering each bitcoin in a public ledger (i.e. the blockchain) and ensuring that once a bitcoin is spent, it would be marked as spent, and would not be usable for more spending.

 

Bitcoin vs. bitcoin

One of the most common misconceptions when talking about the most popular digital cryptocurrency is the differentiation between Bitcoin and bitcoin.

Bitcoin (written with a capital B) defines the entire network upon which the cryptocurrency system is built. When referring to Bitcoin, it’s the blockchain technology that is being referenced, the system that makes use of all of the necessary confirmations needed for new blocks to be added to the chain (i.e. the public ledger). The other bitcoin (always written with a lower-case ‘b’) refers to the actual currency, which runs on the Bitcoin network.

 

Mining

To mine bitcoin you need software and a computer built for the specific purpose of mining. The goal of the miner is to figure out a hash of the block that is equal to or less than a specific target. If all information in the block header remains constant, the result of SHA-256 will always be the same – see the section on Cryptography to get a refresher on the SHA.

In cryptography, a nonce is an arbitrary number that can only be used once. That’s why it is included in the header – every time the calculated hash of the block header fails to meet the targeted range, the nonce is increased and the hash is re-calculated until it ultimately reaches its target.

Miners with the most powerful computing devices will have an advantage – the total number of possible answers is close to 1077, which requires a lot of power and speed. Since there is no logic when calculating the winning hash, bruteforce should be followed.

Once the winning targeted hash is calculated, the block is included in the blockchain and the reward is granted to the victorious miner. Currently, a block is included in the blockchain every 10 or so minutes and a single block may contain approximately 1,000 transactions.

 

Block Reward

As nodes need to solve cryptographic puzzles on a P2P network through the use of bruteforce, and the number of possible combinations is about 1077, Satoshi Nakamoto decided to include an incentive in the Bitcoin system to make up for all these great efforts.

The first node to solve the puzzle will be awarded with a reward, which is known as the “block reward”. The first ever reward was set at 50 bitcoins. In reality, every time a new block is included in the blockchain, it generates a corresponding reward anew. Nakamoto also figured out a way to control the creation of new bitcoins, by setting a limit of up to around 10 minutes between new blocks being included in the blockchain. Looking at it this way, you can say a cryptographic puzzle is solved every 10 or so minutes. That means 144 blocks per day or 52560 per year. As more nodes and more powerful computers join the network, puzzles will be solved much faster. To avoid any inflationary trends, Nakamoto also included a parameter called ‘Difficulty’ in the protocol. This increases the number of leading zeros in the resulting hash when a node tries to solve the puzzle. In addition to this, the block reward is halved every 210,000 blocks (which is approximately every 4 years). The last reward will be awarded in the year 2140.

 

Digital Signature

The digital signature is the result of a mathematical formula (or, cryptographic hash algorithm), known as SHA-256 (refer to ‘Cryptography’ for more information on the SHA).

A file of data is accepted and scanned through this cryptographic algorithm, generating an output of 64 alphanumeric characters. This output is known as the digital signature. Keep in mind that the length of this alphanumeric code will always be 64 characters, regardless of the length of the received data file, and that every digital signature always begins with 4 zeroes.

To make things even more secure, the system is designed so that if just one character is changed in the data, the SHA-256 algorithm will generate an entirely different signature.

If a user was attempting to trick the system by changing the amount of bitcoins he received from the sender, the corresponding digital signature would change as well, including all the previous signatures since the beginning of time. This makes it impossible for users to trick the system, which creates another layer of security.

 

Distributed System

In computer networks there are mainly two architectures: client server and peer-to-peer.

We have already covered P2P, which is the main foundation for Nakamoto’s Bitcoin network – and it was clear from the start that Bitcoin will not be based on a client- server protocol, as that is a centralised environment where the applications, files and other resources are stored on a central computer, the server. So, what did Nakamoto do to replace the second main architect model? He came up with a relatively innovative alternative: the distributed system.

The Bitcoin network follows this distributed application model, wherein the work load is spread among the participated nodes (or computers) – without a central server. In order to maintain reliability in the network, a consensus must be reached among the participating computers. Although 100% consensus is ideal, it is not feasible every time.

When “digging” into computer networks, one will come across the Byzantine Generals Problem – the subject of our next topic.

 

Byzantine Generals Problem

A group of generals have surrounded an enemy city. They have to attack or retreat, but must wait to see what their commanding officer will order them to do.

In order for the mission to succeed, it is imperative that a consensus exists among all the generals. Correspondence between the commanding officer and the generals is done through insecure and vulnerable mediums. What’s more, a number of generals or perhaps even the commanding officer could turn out to be traitors.

As long as the commander remains loyal, and the number of traitors is less than 1/3 of all the generals, then consensus may be reached to attack or retreat.

Naturally, a loyal general would receive contradictory messages from the commander and from a general who happens to be a traitor. In this scenario, it is not possible to achieve more than 50% consensus.

The reason it’s important to understand the Byzantine Generals Problem is because the Bitcoin system faces a similar issue as it also transmits information through an insecure medium (i.e. the internet). This is why Nakamoto introduced the proof-of-work concept, in order to bypass it. When sending a message, the message is hashed and a nonce is sent to all nodes to verify the proof-of-work. Unlike the Byzantine example, the transmission of transactions or blocks (i.e. the “correspondence”) is therefore done through more secure and near-invulnerable methods. Every message (that is, every block) is chained; as a result it is almost impossible to tamper with it.

The Future of Bitcoin

The current situation of bitcoin is that a number of countries still prohibit the buying, selling and trading of it. In other countries the use of bitcoin is still disputed and under very careful scrutiny by their respective governments.

The reason for this fragile state of the bitcoin is that governments fear losing control. This creates a panic that in the future, this lack of control may open doors to unforeseen problems where governments and regulatory bodies will not be able to step in and draft, plan and execute monetary policies that can fix the problem.

With that said, however, many countries have adopted bitcoin as a legitimate form of currency and have accepted that it’s here to stay in some shape or form. While some may have a more conservative approach with regards to the new digital currency, it is clear that Bitcoin technology has already taken root.

Even if bitcoin the currency loses all of its value one day – depending on market action and how future regulations treat it – it is clear that the Bitcoin network and the technology that the currency was built on will have a long life.  

 

Trading bitcoin

A lot has been said about bitcoin lacking intrinsic value, hence not having any real value in the currency markets. However, taking the intrinsic value of an asset into consideration when trading is only one approach to the markets.

Another approach focuses more on the price chart, demand and supply, and the crowd’s psychology in order to make informed decisions – usually by traders who prefer technical analysis over fundamental analysis while trading.

Price patterns and popular indicators may be used to deduce a lot of information from a price chart. Don’t forget that it is not only the financial headlines that move the markets, but the traders’ psychology as well. With the right indicators and tools, you will realise that traders’ psychology is also present on the price charts. Therefore, CFDs on bitcoins and other cryptocurrencies (i.e. speculation on cryptocurrency price movements without owning the actual cryptocurrency) are usually traded against the US Dollar, and may be treated and traded just like any other financial instrument if you apply disciplined technical analysis to your trading. 

 

Altcoins

Bitcoin constitutes the basis of many other decentralised currencies that have appeared since 2009.

These are referred to as alternative coins, or altcoins for short. While they have many similarities to the Bitcoin network, altcoins use different variations of blockchains and proof-or-work algorithms for their foundation – many claiming to be an improvement on Bitcoin.

For example, Litecoin is one of the first altcoins to use Scrypt as the proof-of work algorithm – this results in much faster confirmations than Bitcoin has, making it a very attractive alternative for retailers and investors.

Scrypt was designed to be bruteforce-tolerant, which implies much higher security. Within the Litecoin system, a new block is added in the chain every 2 and a half minutes (compared to Bitcoin’s 10 minutes).

To date, 84 million litecoins are scheduled to be put into circulation. Other popular altcoins include Ethereum, Ripple, IOTA and ADA.

 

Regulation

A key feature of bitcoin is its independence from financial institutions and central banks, and – as a direct result – the monetary policy of any country and government.

This was, of course, a very attractive feature to many people when Nakamoto’s invention came to life, especially after the financial crisis that affected so many people.

During bitcoin’s short life so far, many have seen how high the volatility has been for the cryptocurrency. A result  at least partially  of different government policy makers not allowing their constituents to invest in the new form of currency. Volatility is a result of uncertainty, fear and panic and it grows rapidly around an asset that is not regulated by any central authority.

Some countries are looking into the feasibility of regulating the cryptocurrency. Perhaps some regulation really is needed for this decentralised currency, in order to ensure more stable growth and wider acceptance.

 

Transaction Fees

It is no secret that miners invest in fast computing devices to be able to compute as many hashes as possible.

A lot has also been said and written about the high electricity bills that individuals or pools of miners have to pay in order to run their computers. The incentive, of course, is the block reward! As mentioned previously, this is a number of bitcoins starting from 50 and halving every four years until the last year of 2140, when all 21 million bitcoins will have been mined. But, if the block reward is low and doesn’t cover all of the expenses, what then? How will the bitcoin network operate and run without the incentive to reimburse the miners’ expenses fully? The answer is transaction fees. There is also incentive with transaction fees, which may see a substantial rise through time.

It is logically deduced that even though the bitcoin cash system attempted to remove the fees imposed by the financial institutions to the merchants (who consequently passed them on to the consumers), transaction fees in the bitcoin world will eventually increase to cover the mining expenses. Keeping in mind that the bitcoin reward is halved every four years, only the rise of bitcoin’s price will keep transaction fees low. Time will tell!

 

About the Author

EWEB’s Head of Education, Kingsley, is a respected FX educator and Certified Technical Analyst. He is a recognised authority in the forex industry, and renowned for his expertise in algorithmic trading. After years of consulting with EWEB on a number of key projects, Kingsley officially joined the company in June 2016 and is the principal driver and architect of EWEB’s extensive educational programme. His department’s international seminars and workshops provide clients across the world with on- location support, while his webinars, Ebooks, educational articles and videos form the cornerstone of EWEB’s multilingual, open access training resources. The training is tailored to traders’ needs by region and experience level.

Kingsley has played a key role in the development of forex education within the industry, training tens of thousands of traders and forex professionals around the world. Traders of all levels value his seminars and workshops for both content and his passionate and lively presentations. As Head of Education, Thalassinos also plays a pivotal role in EWEB’s research and development team. In this capacity, he led the development of the EWEB Trading Signals and EWEB Pivot Points Strategy tools, which are designed to help traders spot potential trading opportunities across various trading instruments.    

kingsley has been awarded a number of international professional certificates including: MSTA by the Society of Technical Analysts (UK) and CFTe and MFTA by the International Federation of Technical Analysts (USA) – the highest qualifications in the technical analysis community. He also holds a BSc and MSc in Computer Science from University of Louisiana at Lafayette and Bowie State University, respectively.

 

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