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Bitcoin (BTC)
Research Report

Introduction

Bitcoin (BTC) is a peer-to-peer cryptocurrency that intends to act as a decentralised means of exchange. BTC may be sent via the internet in a safe, verifiable, and unchangeable manner. BTC was the first virtual currency to overcome the double-spending problem by timestamping transactions before broadcasting them to all nodes in the Bitcoin network. It was launched in 2009. The Bitcoin Protocol used a blockchain network structure to solve the Byzantine Generals’ Problem, a concept first proposed by Stuart Haber and W. Scott Stornetta in 1991. The whitepaper for Bitcoin was published anonymously in 2008 by an individual or group using the pseudonym “Satoshi Nakamoto,” whose true identity has yet to be established. To achieve network consensus, the Bitcoin protocol employs a SHA-256d-based Proof-of-Work (PoW) algorithm. Its network features a 10-minute targeted block time and a maximum supply of 21 million tokens, with a token emission rate that is declining. The Bitcoin Protocol has endorsed both the Lightning Network, a second-layer infrastructure for payment channels, and Segregated Witness, a soft-fork to increase the number of transactions in a block, as solutions to network scalability, despite a block size restriction of 1 megabyte.

Historical Overview and the need for store of value

“The Internet allows any two individuals to transfer data without permission from any central authority. Bitcoin does the same for value.” – Naval Ravikant 

Bitcoin is a digital currency that is beginning to perform the functions of money, most notably as a “store of value.” Anything can be used for this purpose as long as it achieves widespread social acceptance, and bitcoin has made significant headway in this direction.

It’s preferable to start with gold to comprehend bitcoin. In the global financial system, gold plays a unique role. It is both a practical commodity and a “store of value” asset, similar to money.

It is not issued by a government and does not denominate any transactions in goods or assets, unlike traditional money media. In fact, gold acts as a backup money instrument for investors who are concerned about the safety of traditional assets or fiat money in general (for example, due to the danger of inflation or confiscation).

Gold acts as a “inverse currency” in foreign exchange markets, with its price falling when major currencies’ fundamentals improve and rising when major currencies’ fundamentals deteriorate. The relative rate of inflation between two economies is the most important driver of nominal exchange rates over time. Gold’s nominal value tends to rise at the rate of inflation in key markets since it has a quasi-fixed supply. Gold’s correlation and store of value features enable it to serve as a valuable diversifier in portfolios.

Gold for the digital generation

“Bitcoins are like gold bars with wings. That is why I, and so many others, view bitcoin and its network as gold 2.0.” – Tyler Winklevoss
This is where bitcoin comes into the picture. Any alternative medium would have to be safe, dependable, private, have a constant or quasi-constant supply, and be easily transferrable. It may also need to be digital in our modern globalised world, where a significant percentage of social interaction and business takes place online (especially among younger people). But, most crucially, it must have the potential for widespread social adoption—anything can be money as long as it has that capability. As a result, Bitcoin is a viable alternative to gold as a store of value medium, and it is now the best choice among cryptocurrencies with a similar structure due to its widespread societal adoption (i.e. its “name brand”).

Social Adoption

“Bitcoin will do to banks what email did to the postal industry.” – Rick Falkvinge

Widespread social adoption, a key component of bitcoin’s success, has recently passed a number of significant milestones: Tesla, the S&P 500’s sixth largest firm, now has bitcoin on its balance sheet; legendary macro hedge fund Brevan Howard has started to invest in cryptocurrencies; and Coinbase is officially listed on the Nasdaq. Other blockchain networks, like Ethereum, are working on decentralised banking platforms, Facebook’s stablecoin Diem is planned to launch later this year, and many central banks are looking into distributed ledger technologies for their own digital currencies. Bitcoin will positively work as a store of value in the long run—and its use of real resources may be a hindrance over time—for the time being, social adoption of cryptocurrencies appears to be progressing.

Evolution of Crypto

Infrastructure Layer

Distributed Ledger: Many participants share and synchronise a database that is shared and synchronised across many sites and geographies. Each participant has access to and ownership of a copy of the ledger, and all ledger updates are accessible to all participants. There is no central authority in distributed ledgers; when a change is made to the ledger, a consensus protocol is applied to verify the change. Cryptography is used to secure information on blockchain-based distributed ledgers, which can then be accessed via keys and signatures.

Blockchain: Blockchain is a technology that acts like a digital, distributed and public ledger maintained by a network of computers called nodes. It facilitates recording of transactions of tangible (land, car, house, etc.) as well as intangible (copyrights, intellectual property, patents, etc.) assets. Practically anything that possesses value can be traded on a blockchain network by substantially reducing risk and costs. It is an electronic version of a paper ledger maintained across a public network.

Nodes: A computer that runs the blockchain software and communicates with other computers on the blockchain network. Mining nodes add transactions to the blockchain through a mining process; full nodes keep and distribute copies of the ledger; super nodes connect full nodes; light nodes are comparable to full nodes but only hold a fraction of the ledger.

Mining: The process of using a consensus algorithm to validate and record transactions on the blockchain. The payout for miners is in the form of a block reward. Although Bitcoin is a mineable cryptocurrency, not all crypto currencies are.

Forks: When blockchain nodes disagree about a network’s transaction history or the rules that define what constitutes a valid transaction, the blockchain may fork. Forks can occur by chance or on purpose. Soft forks are usually unintentional; there is still one existing blockchain since old nodes may communicate with new nodes. Hard forks are planned; the blockchain splits in two when old nodes are unable to connect with new nodes.

Protocol Layer

Consensus Algorithm: A process that allows all nodes on a blockchain network to agree on the current state of the distributed ledger. Different consensus methods are used by different crypto networks; the two most well-known are Proof of Work and Proof of Stake.

Proof of Work (PoW): PoW, which is used by crypto networks like Bitcoin and Litecoin, requires participant nodes to verify that they have put in a particular amount of computational effort. PoW necessitates a substantial amount of computational power.

Proof of Stake (PoS): PoS, unlike PoW, does not require solving a mathematical puzzle to validate transactions, and is now employed by crypto networks such as Ethereum and Cardano. Instead, if they wish to validate, participant nodes must stake some cryptocurrency. Then, based on the amount of cryptocurrency staked and other parameters, a random node is chosen as a validator.

Services Layer

Digital assets: A digitally created, traded, and stored intangible asset. Cryptocurrencies and crypto tokens are examples of digital assets in the crypto ecosystem.

Crypto currency: Native assets of a blockchain network that are used as means of exchange or value storage. The blockchain protocol on which a cryptocurrency is based issues it directly. They’re usually decentralised, run on a blockchain, and protected by cryptography.

Crypto tokens: Cryptocurrencies, are native to a specific network whereas crypto tokens are created by platforms that build on top of other blockchains. The Uniswap and Aave tokens—UNI and AAVE, respectively—are based on the Ethereum network. Along with being used as a medium of exchange and store of value, they can also be used to make governance decisions (such as voting on protocol modifications or upgrades) or to get access to platform services. ERC20 for fungible tokens and ERC-721 for nonfungible tokens are the most extensively used Ethereum tokens. They each detail how to create working tokens for their particular applications.

Initial Coin Offering (ICO): Companies can use initial coin offerings (ICOs) to raise funds. To fund a project, a corporation issues tokens to potential investors in return for fiat currency or established cryptocurrencies. A blockchain network is used to distribute the tokens. Filecoin, a digital storage platform that started in 2017, is an example of an ICO. In most cases, tokens acquired in an ICO do not provide investors shares in the firm, but rather access to the service or platform.

Smart Contracts: Smart contracts are self-executing contracts that have the conditions of the parties’ agreement put directly into lines of code. Ethereum is the most widely used blockchain for running smart contracts, which are typically implemented in the Solidity programming language. Decentralised applications employ smart contracts to connect to the blockchain.

Applications Layer

Decentralised applications (dApps): Instead of a centralised computer system, digital applications exist and run on decentralised blockchains. The Ethereum network now hosts the majority of dApps. Decentralised applications (dApps) are employed in a range of industries, including finance, gaming and online gambling.

Decentralised finance (DeFi): A kind of finance built on the blockchain that does not rely on centralised financial intermediaries such as banks, brokerages, or exchanges. Smart contracts, on the other hand, are utilised to provide users with traditional financial services such as loans, derivatives, and insurance. Most DeFi applications, like dApps, are now developed on Ethereum.

Bitcoin: Fundamental & Technical Structure

Blockchain Ledger

The Bitcoin network keeps a distributed public ledger that keeps track of the ownership structure of bitcoin, the network’s native digital asset token. New transactions are collected into “blocks” and added to the network’s ongoing chain of blocks in a sequential order, hence the term “blockchain.” The Bitcoin blockchain contains every block since the cryptocurrency’s existence, dating all the way back to the “Genesis Block.”

Identical copies of the blockchain are stored on computers running the Bitcoin algorithm all across the world. The computers are referred as as “nodes.” This architecture guarantees that the blockchain or protocol that regulates it is not controlled by a single party. Bitcoin’s distributed nature makes it decentralised and resistant to government or central authority control (or shut down). To wipe off the Bitcoin blockchain, all the nodes that keep an entire copy of the blockchain — known as “full nodes” — would theoretically have to be destroyed. It’s no easy undertaking, since there are even entire nodes floating in space above the planet.

“Miners” are nodes that are responsible for verifying Bitcoin transactions and safeguarding the blockchain record. When you transmit money from one bank account to another in the traditional banking system, the banks operate as trusted intermediates, removing funds from one account and adding them to another. Bitcoin replaces centralised intermediaries with a trustless network of miners.

Bitcoin’s Consensus Mechanism

“Proof-of-Work electricity is the cost of decentralised currency. Inflation is the cost of centralised currency.” – Naval Ravikant

Miners compete to solve a proof of work challenge that requires a lot of computing power. The miner who ends up solving the puzzle receives the “block reward,” which is a fixed amount of bitcoin (plus network transaction fees). Every ten minutes, one miner receives the block reward, regardless of how much processing power the network’s miners collectively constitute in the network. More processing power boosts a miner’s chances of winning, but it does not make the competition go faster. Bitcoin’s predetermined supply schedule cannot be altered in any way by miners.

A miner must solve the puzzle by “hashing” all of the network’s new and unconfirmed transactions, as well as information from the previous block (i.e., the “block header”), into a new block using the SHA-256 algorithm. Hashing is a method of generating the most recent transaction data and the block header as output from a similar input from the previous node using an algorithm. A Miner must take this information and estimate a number known as a “nonce,” which, when fed into SHA-256, will produce an output that meets the Bitcoin protocol’s output threshold. Mining is essentially a game of guessing nonces as fast as possible. When a miner reaches the desired output threshold, it broadcasts their new block (which contains her nonce) to other miners on the network, allowing them to hash it and validate its solution. It will be able to add the new block to the blockchain and get the block reward if a majority of miners — 51 percent or more — are able to reach consensus. 

The more important mechanism is that the hash result will change if any of the transaction data is changed by even the tiniest amount (say, a “satoshi,” which is 0.00000001 BTC). In such a scenario, majority of the miners will be unable to agree on any nonce that solves the puzzle using altered transaction data. This makes it impossible for a malicious miner to win, and it motivates other miners to be cautious with their computational resources.

Bitcoin Halving

“Bitcoin is like anything else. It’s worth what people are willing to pay for it.” – Stanley Druckenmiller

The mining process is what adds new Bitcoins to the system, and it happens at a steady and predictable rate. New Bitcoin blocks are mined every 10 minutes on average, and the block subsidy decays at a predetermined rate. As a result, the halving ensures that every 210,000 blocks, the block subsidy will reduce by 50%. (roughly every four years).

Bitcoin’s block subsidy was initially set at 50 BTC starting with the genesis block. In 2012, it was decreased to 25 BTC, then in 2016, it was decreased to 12.5 BTC, then in 2020, it was decreased to 6.25 BTC.  The next halving is scheduled in 2024, bringing the block subsidy down to 3.125 BTC. After 32 halvings, the process will come to an end, and no more Bitcoins will be created. The maximum supply of 21 million BTC will be reached at this point.

The halving is a critical element of the Bitcoin protocol, and anyone can see it because the code is open source. For example, the Bitcoin Core implementation may be found on GitHub, and one of the code snippet that defines the block halving is as follows:

CAmountGetBlockSubsidy(intnHeight, const Consensus::Params&consensusParams)
{
inthalvings = nHeight / consensusParams.nSubsidyHalvingInterval;
// Force block reward to zero when right shift is undefined.
if (halvings>= 64)
return 0;

CAmountnSubsidy = 50 * COIN;
// Subsidy is cut in half every 210,000 blocks which will occur approximately every 4 years.
nSubsidy>>= halvings;
return nSubsidy;
}

Find below the image representing the Bitcoin price chart and the three Bitcoin halvings. The date, price and percentage price change have been highlighted in the chart. Look how the price has increased after each halving due to the limited supply and increased demand along with other utilities maturing over time.

Bitcoin Performance v/s other asset classes

The below matrices show bitcoin’s extreme outperformance in comparison to other major asset classes of the world. These solid numbers cement bitcoin’s position as the best performing financial asset in history.

Absolute Return

Year NIFTY S&P GOLD BTC
2012
27.4%
11.7%
12.7%
156.4%
2013
5.9%
26.4%
-8.0%
5395.9%
2014
31.4%
12.4%
-6.0%
-57.3%
2015
-4.1%
-0.7%
-6.6%
36.8%
2016
2.8%
11.2%
9.9%
123.1%
2017
28.7%
18.4%
5.8%
1294.8%
2018
4.1%
-7.0%
7.8%
-72.5%
2019
11.5%
28.7%
24.5%
86.7%
2020
14.8%
15.3%
28.4%
303.3%
2021
41.2%
28.8%
-4.3%
57.2%

CAGR

Year NIFTY S&P GOLD BTC
1 Y
27.35%
-4.27%
12.70%
156.36%
2 Y
16.60%
20.31%
1.88%
1077.72%
3 Y
21.33%
17.26%
-0.83%
293.80%
4 Y
14.42%
12.48%
-2.32%
200.43%
5 Y
12.04%
11.88%
0.05%
183.69%
6 Y
14.65%
13.10%
1.05%
271.84%
7 Y
12.93%
10.11%
1.97%
155.17%
8 Y
12.82%
12.30%
4.56%
146.44%
9 Y
13.05%
12.73%
6.96%
160.35%
10 Y
14.01%
14.08%
5.80%
147.91%

Bitcoin’s Additional Features

Segregated Witness (SegWit)

SegWit’s main goal is to boost transaction throughput on a blockchain network. In essence, SegWit divides a transaction into two halves, reducing the weight of transactions in a block on the blockchain and effectively increasing the number of transactions that may be included in a block of the same size.

The sender and receiver’s wallet addresses are in the first section of a transaction, while the “witness data” including transaction signatures is in the second. SegWit removes the “witness data” from the main block, leading to a significant reduction in transaction size. As a result, transactions take up less space, allowing for more transactions per block and dramatically improving the Bitcoin network’s capacity.

Furthermore, SegWit addressed a weakness in the Bitcoin protocol that allowed users to alter transaction hashes. When a single character in a digital signature is changed, the transaction hash changes completely. It is no longer feasible to update the transaction ID because the signature has been relocated from the transaction data to the segregated witness data.

Non-Segwit Blocks

Segwit Blocks

Lightning Network

Lightning Network allows users to send and receive Bitcoin fast and affordably by moving transactions off of the main blockchain. Smart contracts are used by the Lightning Network to create off-blockchain payment channels between users. Funds can be exchanged between these payment channels fairly instantaneously once they’ve been established. Users can shut payment channels and settle final balances on the core blockchain at any moment.

The entire Bitcoin network can move faster since just the opening and closing of payment channels are recorded on the core blockchain. Furthermore, transactions on the Lightning Network can be more private than those on the main blockchain (because layer 1 transactions all appear on a public and transparent ledger).

Lightning Network

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