UNIT II BITCOIN AND CRYPTOCURRENCY

A basic crypto currency

Cryptocurrency comes under many names. You have probably read about some of the most
popular types of cryptocurrencies such as Bitcoin, Litecoin, and Ethereum. Cryptocurrencies
are increasingly popular alternatives for online payments. Before converting real dollars,
euros, pounds, or other traditional currencies into ₿ (the symbol for Bitcoin, the most popular
cryptocurrency), you should understand what cryptocurrencies are, what the risks are in using
cryptocurrencies, and how to protect your investment.

What is cryptocurrency? A cryptocurrency is a digital currency, which is an alternative form

of payment created using encryption algorithms. The use of encryption technologies means
that cryptocurrencies function both as a currency and as a virtual accounting system. To use
cryptocurrencies, you need a cryptocurrency wallet. These wallets can be software that is a
cloud-based service or is stored on your computer or on your mobile device. The wallets are
the tool through which you store your encryption keys that confirm your identity and link to
your cryptocurrency.

What are the risks to using cryptocurrency? Cryptocurrencies are still relatively new, and the
market for these digital currencies is very volatile. Since cryptocurrencies don't need banks or
any other third party to regulate them; they tend to be uninsured and are hard to convert into a
form of tangible currency (such as US dollars or euros.) In addition, since cryptocurrencies
are technology-based intangible assets, they can be hacked like any other intangible
technology asset. Finally, since you store your cryptocurrencies in a digital wallet, if you lose
your wallet (or access to it or to wallet backups), you have lost your entire cryptocurrency
investment.

Follow these tips to protect your cryptocurrencies:

 Look before you leap! Before investing in a cryptocurrency, be sure you understand
how it works, where it can be used, and how to exchange it. Read the webpages for
the currency itself (such as Ethereum, Bitcoin or Litecoin) so that you fully
understand how it works, and read independent articles on the cryptocurrencies you
are considering as well.
 Use a trustworthy wallet. It is going to take some research on your part to choose the
right wallet for your needs. If you choose to manage your cryptocurrency wallet with
a local application on your computer or mobile device, then you will need to protect
this wallet at a level consistent with your investment. Just like you wouldn't carry a
million dollars around in a paper bag, don't choose an unknown or lesser-known
wallet to protect your cryptocurrency. You want to make sure that you use a
trustworthy wallet.
 Have a backup strategy. Think about what happens if your computer or mobile device
(or wherever you store your wallet) is lost or stolen or if you don't otherwise have
access to it. Without a backup strategy, you will have no way of getting your
cryptocurrency back, and you could lose your investment.

ou may be wondering how to buy cryptocurrency safely. There are typically three steps
involved. These are:

Step 1: Choosing a platform

The first step is deciding which platform to use. Generally, you can choose between a
traditional broker or dedicated cryptocurrency exchange:

 Traditional brokers. These are online brokers who offer ways to buy and sell
cryptocurrency, as well as other financial assets like stocks, bonds, and ETFs. These
platforms tend to offer lower trading costs but fewer crypto features.
 Cryptocurrency exchanges. There are many cryptocurrency exchanges to choose
from, each offering different cryptocurrencies, wallet storage, interest-bearing account
options, and more. Many exchanges charge asset-based fees.

When comparing different platforms, consider which cryptocurrencies are on offer, what fees
they charge, their security features, storage and withdrawal options, and any educational
resources.

Step 2: Funding your account

Once you have chosen your platform, the next step is to fund your account so you can begin
trading. Most crypto exchanges allow users to purchase crypto using fiat (i.e., government-
issued) currencies such as the US Dollar, the British Pound, or the Euro using their debit or
credit cards – although this varies by platform.

Crypto purchases with credit cards are considered risky, and some exchanges don't support
them. Some credit card companies don't allow crypto transactions either. This is because
cryptocurrencies are highly volatile, and it is not advisable to risk going into debt — or
potentially paying high credit card transaction fees — for certain assets.

Some platforms will also accept ACH transfers and wire transfers. The accepted payment
methods and time taken for deposits or withdrawals differ per platform. Equally, the time
taken for deposits to clear varies by payment method.

An important factor to consider is fees. These include potential deposit and withdrawal
transaction fees plus trading fees. Fees will vary by payment method and platform, which is
something to research at the outset.

Step 3: Placing an order

You can place an order via your broker's or exchange's web or mobile platform. If you are
planning to buy cryptocurrencies, you can do so by selecting "buy," choosing the order type,
entering the amount of cryptocurrencies you want to purchase, and confirming the order. The
same process applies to "sell" orders.

There are also other ways to invest in crypto. These include payment services like PayPal,
Cash App, and Venmo, which allow users to buy, sell, or hold cryptocurrencies. In addition,
there are the following investment vehicles:
 Bitcoin trusts: You can buy shares of Bitcoin trusts with a regular brokerage account.
These vehicles give retail investors exposure to crypto through the stock market.
 Bitcoin mutual funds: There are Bitcoin ETFs and Bitcoin mutual funds to choose
from.
 Blockchain stocks or ETFs: You can also indirectly invest in crypto through
blockchain companies that specialize in the technology behind crypto and crypto
 transactions. Alternatively, you can buy stocks or ETFs of companies that use
blockchain technology.

The best option for you will depend on your investment goals and risk appetite.

Preventing double-spending involves a more strenuous verification process and ensures that
the same input cannot be shared over multiple transactions. There are two primary ways to
combat double-spending:

1. Centralized Clearing Counterparty

Centralization can potentially mitigate the inherent risk of double-spending in transacting

digital currency. It is done by implementing a central and trusted third party to verify the
transactions. The added entity would perform a function equivalent to central counterparty
clearing.

In finance, central counterparties are often financial institutions that take on

counterparty credit risk between two parties and ensure that a transaction clears. The services
are commonly applied to facilitate the trading of financial derivative instruments.

2. Blockchain

Decentralized digital currencies, such as Bitcoin, utilize consensus mechanisms that verify
transactions with certainty. The consensus mechanisms are alternatively known as proof-to-
work. Practically, the mechanism ensures that each participant node verifies the transaction.
Therefore, Bitcoin comes with a historical public ledger facilitated through blockchain that
provides empirical verification of property rights and transfer.

In order for a market participant to fraudulently double spend, they will need to use a
significant amount of computing power to eliminate the previous blocks in the chain, and
effectively double-spend the transaction. Additionally, as time passes, confirmations of the
block exponentially grow, further protecting the integrity of the transaction.

Challenges Associated with the Use of a Centralized Authority

One of the notable challenges of implementing a centralized authority is the creation and
maintenance costs. Assigning a bank as a centralized authority will result in commission cuts
on digital currency transactions. It can be expensive, especially in cases were more than two
agents and/or banks are involved in the transfer, processing, and authenticating of funds
being transferred.

Making Use of a Decentralized Approach

Double spending in decentralized systems is more challenging to resolve, as it requires

maintaining a considerable number of servers storing identical and up-to-date copies of
public transaction ledgers. However, transactions that are broadcasted may reach servers at
varying times. A key component of a decentralized system approach is that validity is given
to the initial transaction that is picked up or received by each of the servers.
Hence, in cases where a transaction is duplicated or the same token is used for payment, the
duplicated transaction will be rendered invalid, as the servers will only validate the first
transaction. However, once the servers become mismatched, the validation of true balances
becomes nearly impossible. Such a drawback can be resolved by the use of a consensus
algorithm, which syncs the various servers. Examples of such algorithms include the proof-
of-stake and the proof-of-work consensus mechanisms.

Related Readings

CFI is the official provider of the Commercial Banking & Credit Analyst
(CBCA)™ certification program, designed to transform anyone into a world-class financial
analyst.

To keep learning and developing your knowledge of financial analysis, we highly

recommend the additional resources below:

 Cryptocurrency
 Double Taxation
 Blockchain
 Virtual Currency

This language is not Full Turing because its functionality is limited and cannot
loops. So it is not capable of solving any type of problem such as turing machines.
However, this limitation is intentional as this prevents infinite or endless looping and
error execution. Where malicious parts of the program can be free to create
complicated operations to consume the rate of hash and slow down the Bitcoin
system through infinite loops.

 A programming language is necessary because it allows us to write programs and that

computers execute our wishes. In BitcoinIn order to communicate our wishes,
the opcodes (OP CODES), which serve various functions. Like memory
manipulation, math, loops, function calls, among many others.
 Therefore, Bitcoin Script is essentially a set of programmed instructions that are
recorded with every transaction made. These instructions describe how users can
access and make use of the bitcoins available on the network.

Bitcoin uses a scripting system for transactions. Forth-like, Script is simple, stack-based, and
processed from left to right. It is intentionally not Turing-complete, with no loops.
A script is essentially a list of instructions recorded with each transaction that describe how
the next person wanting to spend the Bitcoins being transferred can gain access to them. The
script for a typical Bitcoin transfer to destination Bitcoin address D simply encumbers future
spending of the bitcoins with two things: the spender must provide

1. a public key that, when hashed, yields destination address D embedded in the
script, and
2. a signature to prove ownership of the private key corresponding to the public
key just provided.
Scripting provides the flexibility to change the parameters of what's needed to spend
transferred Bitcoins. For example, the scripting system could be used to require two private
keys, or a combination of several keys, or even no keys at all.
A transaction is valid if nothing in the combined script triggers failure and the top stack item
is True (non-zero) when the script exits. The party that originally sent the Bitcoins now being
spent dictates the script operations that will occur last in order to release them for use in
another transaction. The party wanting to spend them must provide the input(s) to the
previously recorded script that results in the combined script completing execution with a
true value on the top of the stack.
This document is for information purposes only. De facto, Bitcoin script is defined by the
code run by the network to check the validity of blocks.
The stacks hold byte vectors. When used as numbers, byte vectors are interpreted as little-
endian variable-length integers with the most significant bit determining the sign of the
integer. Thus 0x81 represents -1. 0x80 is another representation of zero (so called negative
0). Positive 0 is represented by a null-length vector. Byte vectors are interpreted as Booleans
where False is represented by any representation of zero and True is represented by any
representation of non-zero.
Leading zeros in an integer and negative zero are allowed in blocks but get rejected by the
stricter requirements which standard full nodes put on transactions before retransmitting
them. Byte vectors on the stack are not allowed to be more than 520 bytes long. Opcodes
which take integers and bools off the stack require that they be no more than 4 bytes long, but
addition and subtraction can overflow and result in a 5 byte integer being put on the stack.

Peer-to-Peer (P2P) technology is based on the decentralization concept, which lets network
participants conduct transactions without needing any middle-man, intermediaries or central
server. Peer-to-peer technology is how Bitcoin

BTC

$42,685
operates; no administrator is required to maintain track of user transactions on the network.
Instead, the peers in the network cooperate to handle deals and manage the BTC.

Peers refer to the nodes or computers that perform the same tasks and have the same power
within a blockchain network. Blockchain is a P2P network that acts as a decentralized ledger
for one or more digital assets, which refers to a decentralized peer-to-peer system where each
computer keeps a complete copy of the ledger and verifies its authenticity with other nodes to
guarantee the data is accurate. In contrast, transactions at a bank are kept secret and are only
overseen by the bank.

The security of the underlying consensus algorithms and the privacy of transactions are all
closely tied to its implementation, making the P2P network a crucial component of
blockchains. However, no common P2P protocol for blockchains has been suggested.
Instead, different cryptocurrencies have developed and adapted their own peer-to-peer
protocols.
How do P2P networks work?

As mentioned, there are no central in peer-to-peer blockchain networks. Instead, all nodes
(peers) are connected to one another. A mesh network with a “flat” topology connects the
network nodes and there is no hierarchy. In a peer-to-peer network, nodes simultaneously
give and consume services with reciprocity serving as the motivation for participation,
making P2P networks open, decentralized and robust by nature.

A transaction is a transfer of Bitcoin value on the blockchain. In very simple terms, a

transaction is when participant A gives a designated amount of Bitcoin they own to
participant B.
Transactions are created through wallets: either on mobile, desktop or specialized hardware.

Bitcoin makes use of public-key cryptography to ensure the integrity of transactions created
on the network. In order to transfer bitcoin, each participant has pairs of public
keys and private keys that control pieces of bitcoin they own. A public key is a series of
letters and numbers that a user must share in order to receive funds. In contrast, a private key
must be kept secret as it authorizes the spending of any funds received by the associated
public key.

To better illustrate how value is transferred in the Bitcoin network, we will walk through an
example transaction, where Alice sends .05 bitcoin to Bob.
At a high level, a transaction has three main parts:
1. Inputs. The bitcoin address that contains the bitcoin Alice wants to send. To be more
accurate, it is the address from which Alice had previously received bitcoin to and is
now wanting to spend.
2. Outputs. Bob’s public key or bitcoin address.
3. Amounts. The amount of bitcoin Alice wants to send.
Bitcoin mining is the process of validating the information in a blockchain block by
generating a cryptographic solution that matches specific criteria. When a correct solution is
reached, a reward in the form of bitcoin and fees for the work done is given to the miner(s)
who reached the solution first.

Over time, the reward for mining Bitcoin is reduced. This reward process continues until
there are 21 million bitcoin circulating. Once that number is reached, the bitcoin reward is
expected to cease, and Bitcoin miners will be rewarded through fees paid for the work done.

At the heart of Bitcoin mining is the hash. The hash is a 64-digit hexadecimal number that is
the result of sending the information contained in a block through the SHA256 hashing
algorithm. This part of the process takes little time to complete—in fact, you can generate a
hash in less than one second, pasting some content into an online SHA256 hash generator.
This is the encryption method used by Bitcoin to create a block hash. However, decrypting
that hash back to the content you pasted is the difficult part: a 64-digit hash can take
centuries to decode with modern hardware.

Bitcoin mining requires the mining program to generate a random hash and append another
number to it called the nonce, or "number used once." When a miner begins, it always starts
this number at zero. The nonce changes by one every attempt—first, it's 0, then 1, 2, 3, and
so on. If the hash and nonce generated by the miner are more than the target hash set by the
network, the attempt fails, and the miner tries again.

Every miner on the network does this until a hash and nonce combination is created that is
less than or equal to the target hash. The first to reach that target receives the reward and
fees, and a new block is opened. Once that block fills up with information (about one
megabyte), it is closed, encrypted, and mined.

The Bitcoin network is made up of thousands of devices that mine 24 hours per day.
Because the mining reward goes to the first to solve the problem, they are all competing.
This competition led miners to create pools to gain an advantage over other miners because
they needed more computational power to increase their chances of winning.

The Bitcoin network mining rate fluctuates, but it averaged 448 exa-hashes per second on
Oct. 11, 2023—that's 448 followed by 18 zeros. If it takes roughly 10 minutes for a block to
be mined, that's about 268 zeta-hashes (268 followed by 21 zeros) to open a new block.4

Proof-of-Work

The mining process is what you hear called proof-of-work (PoW)—it takes a lot of energy
and computational power to reach the goal of less than or equal to a target hash. The work
done is viewed as the validation proof needed, so it's called proof-of-work.

Confirmation

Each block contains the hash of the previous block—so when the next block's hash is
generated, the previous block's hash is included. Remember that if even one character
changes, the hash changes, so the hash of each following block will change. This secures the
blockchain.

However, the block you closed and received a reward for isn't yet confirmed. The block isn't
confirmed until five blocks later when it has gone through that many validations. With that
said, it is possible to alter information in a block before reaching six validations, but it is
highly unlikely because the network must be controlled by someone attempting to change
information for it to work.

Mining difficulty is how much work it takes to generate a number less than the target hash.
Mining difficulty changes every 2,016 blocks or approximately every two weeks. The next
difficulty level depends on how efficient miners were in the preceding cycle.

It is also affected by the number of new miners that have joined Bitcoin's network because it
increases the hash rate or the amount of computing power deployed to mine the
cryptocurrency. The more miners there are competing for a solution, the more difficult the
problem will become. If computational power is taken off the network, the difficulty adjusts
downward to make mining easier.

The difficulty level for mining in October 2023 was 57.3 trillion. That is, the chances of a
computer producing a hash below the target is 1 in 57.3 trillion. To put that in perspective,
you are about 170,000 times more likely to win the Powerball jackpot with a single lottery
ticket than you are to pick the correct hash on a single try