Bitcoin Blockchain: Components, Mining, Inflation and Algo Trading

QuantInsti

Contributor:
QuantInsti
Visit: QuantInsti

In the previous blog, we explored blockchain technology and its various components. Now, we delve further into a specific application of this technology which is probably the most well-known – Bitcoin. The Bitcoin blockchain has got everyone hooked to this technology.

We will discuss the components of the Bitcoin blockchain, the different exchanges that it is traded on, and look at a Bitcoin trading strategy in Python. So without further ado, let’s get started!

We will be covering the following topics:

  • Bitcoin, the first blockchain
  • Bitcoin components
  • Bitcoin mining and Proof of Work
  • Transaction fee
  • Bitcoin and inflation
  • Trading Bitcoin using a crossover strategy

Bitcoin, the first blockchain

Once upon a time, in a trustless world of paper and plastic money and coins ruled by financial institutions, a blockchain named Bitcoin was born. It vowed to set the world free from the clutches of central power figures and make it a trust-free world where we could transact with strangers without the need for any trust.

Bitcoin is the most popular digital currency created by the mysterious person(s), Satoshi Nakamoto, in 2008, but it was not the first one. Ecash was created by David Chaum back in 1983, and hashcash was proposed in 1997 by Adam Back to counter spam-mail based on a proof-of-work scheme.

In 2004, Hal Finney further developed the hashcash into a reusable proof-of-work (RPOW), the first public implementation of a server designed to allow users throughout the world to verify its correctness and integrity in real-time.

The earlier proposals for distributed cryptocurrencies like bit gold by Nick Szabo (2005) and b-money by Wei Dei (1998) inspired the creation of Bitcoin. And the rest, as they say, is history.

Today exists the modern form of the Bitcoin blockchain, that owes it’s present form to these events.

Bitcoin Timeline – Source

Bitcoin components

The shared ledger

The Bitcoin blockchain contains a very specialized type of data- simple transactional data about who paid whom and how much. However, the data is stored in Bitcoin in a way that the number of Bitcoins in the input of a transaction is equal to the number of Bitcoins in its output.

Each input refers to the previous transaction where the sender of this transaction received the coins. So each input will refer to an earlier transaction keeping track of each Bitcoin. This model is called the UTXO (Unspent Transaction Output) model.

Let us look at how the UTXO model works using this simplified diagram:

Simplified Bitcoin UTXO model

There are some transactions where the coins are generated (‘mined’) by the system. These transactions are called the Coinbase transactions, and they will not refer to any previous transactions as, in this case, the coins have come out of thin air, so to say.

Every block will have one coinbase transaction, which will have a single blank ‘input’. Usually, the first transaction in each block is reserved for the coinbase transaction.

The nodes

Bitcoin is a public blockchain. It means that anyone can join the Bitcoin network and view the entire Bitcoin blockchain. Some of these nodes may take up ‘mining’ by competing to ‘mine’ the blocks for a reward.

The consensus algorithm

As discussed in our earlier blog, a consensus algorithm is simply the decision-making mechanism for a group. As the Bitcoin blockchain is a public blockchain with the largest number of nodes, a consensus algorithm becomes essential.

This is mainly to resolve the following issues:

  • Prevent malicious attacks
  • Solve the problem of double-spending
  • Decide which node will add the next block to the chain
  • Ensure the integrity and consistency of the blockchain

The consensus protocol used by Bitcoin is the Proof-of-Work (POW). Simply put, to add a block to the blockchain, all nodes compete to solve a cryptographic puzzle. This puzzle is computationally extensive, and a lot of energy goes into solving it.

So all the nodes have to ‘work’ on it. It makes it difficult for an attacker to mimic multiple nodes because the cost of setting up another mining node is considerable.

The first node to solve the cryptographic puzzle gets to add the next block to the chain as it shows the ‘answer’ as its proof-of-work and is rewarded with some Bitcoins (coinbase transaction). In the case of two versions of the chain getting created due to two nodes mining a block simultaneously, the longest chain is selected as the valid chain.

Interestingly, Nakamoto mined the first Bitcoin block with a reward of 50 Bitcoins, and Hal Finney (inventor of RPOW) became the recipient of the first Bitcoin transaction of 10 Bitcoins from Nakamoto.

Bitcoin Mining – Source

Visit QuantInsti to read about Bitcoin Mining and Proof of Work and read the rest of the article: https://blog.quantinsti.com/bitcoin-blockchain/.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from QuantInsti and is being posted with permission from QuantInsti. The views expressed in this material are solely those of the author and/or QuantInsti and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.

Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

Disclosure: Digital Assets

Trading in digital assets, including cryptocurrencies, is especially risky and is only for individuals with a high risk tolerance and the financial ability to sustain losses. Eligibility to trade in digital asset products may vary based on jurisdiction.