ECON120 Study Guide

Unit 6: Bitcoin (2009–Present)

6a. Summarize the goals of the Bitcoin software 

  • What did Satoshi Nakamoto intend to create, according to the Bitcoin whitepaper?
  • How were financial institutions eliminated in their role within the Bitcoin network?
  • How does Bitcoin draw some inspiration from gold though its network characteristics?

Satoshi Nakamoto's worte "Bitcoin: A Peer-to-Peer Electronic Cash System" was an attempt to describe a "peer-to-peer" electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution. Bitcoin was intended to mimic gold as a first-layer, counterparty-free money.
To review, see Bitcoin.

6b. Summarize proof-of-work, Bitcoin mining, and Bitcoin's difficulty adjustment 

  • What is the difference between the Bitcoin protocol and the monetary unit, also known as Bitcoin or BTC?
  • What type of encryption does Bitcoin use?
  • What does the Bitcoin blockchain describe?
  • How does a block get mined?
  • How does proof-of-work contribute to the process of mining bitcoin?
  • Why does Bitcoin require a difficulty adjustment, and what does the difficulty adjustment help to accomplish?
  • How is Bitcoin mining comparable in some ways to gold mining?
  • Why did Satoshi Nakamoto link Bitcoin mining and gold mining by metaphor?
  • How do private keys and addresses contribute to the functioning of the Bitcoin network?
  • What are some of the ways one can store private keys, or numbers, that control balances of BTC?

The word "Bitcoin" refers to two things, the Bitcoin software protocol and the monetary unit within that software. It uses a Secure Hash Algorithm 2 (SHA2) as an attempt to create a secure system with gold's monetary properties but in the digital world. Its rules built a mechanism called a "chain of blocks", or blockchain, which is a distributed database of transactions in the network.
This database is maintained by Bitcoin nodes, which are computers running the Bitcoin software. These operate in a trustless way, meaning they rely on their software to verify settlement of BTC transactions. However, most people rely on some form of provider to interact with Bitcoin, such as smartphone applications for wallets and exchanges for trading and custody. Using the Bitcoin software should only be done by people with a high degree of proficiency, as it is impractical for most everyday users.
A block is a set of data that includes the details of unsettled Bitcoin transactions that people are trying to complete. Blocks become chained together, and unsettled transactions get confirmed when a block is mined. Bitcoin miners compete over the new supply of BTC and expend energy that awards them the currency within the Bitcoin software. Bitcoin miners are awarded BTC when they find a random number; consider it a lottery. They expend energy to perform trillions of computations every second to find that number. That makes Bitcoin mining virtually one giant random-numbers game, and only the fastest and most powerful computers can compete. Today, supercomputers called ASICs (application-specific integrated circuits) are required to mine BTC successfully.
Miners are financially motivated and dedicate energy and computing power toward adding blocks to the chain. This is commonly referred to as hashpower, with the word "hash" coming from SHA2. Bitcoin mining is also called performing proof-of-work, which is expending resources to add BTC to circulation.
The Bitcoin protocol mandates that blocks occur on average ten minutes apart, but the actual time between blocks can take seconds or hours depending on how long it takes a miner to win each BTC lottery. The algorithm that adjusts the computational lottery every two weeks to make sure blocks occur ten minutes apart is called the difficulty adjustment. No single peer has control over the entirely automated difficulty adjustment. A miner can win an outsized proportion of block rewards with superior mining ASICs, but Bitcoin regularly increases in mining difficulty as a security mechanism. This attempts to prevent fast computers from running away with block rewards.
Addresses used to receive BTC are generated from numbers called private keys. Private keys are 256-character strings. The private keys generate an address used to receive BTC, but the address cannot be reverse-engineered to reveal the private key behind it.
To review, see Bitcoin.

6c. Summarize Bitcoin's legal precedent and standing in the US 

  • How did the IRS rule on Bitcoin ownership, and when did it issue that ruling?
  • How does the US commodities regulator view Bitcoin?

Bitcoin officially gained recognition in the United States government in 2014, when the IRS determined that ownership of BTC was to be treated as property and that gains realized in USD terms were subject to capital gain taxes. The US commodity futures regulator ruled that Bitcoin was a commodity and not a currency. It compared Bitcoin to gold in its research process and concluded that ownership of BTC is possession of a numerical commodity due to the software's reliance on private keys. Despite being difficult to define in the traditional context, Bitcoin was starting to morph into its own asset class.
To review, see Bitcoin's Denomination.

6d. Describe the evolution of Bitcoin as an asset class, including the introduction of Lightning Network 

  • How have Bitcoin futures traded on the CME changed Bitcoin as an asset class?
  • How has investment demand for Bitcoin evolved since the start of the pandemic?
  • What does the Lightning Network allow users to do?

CME Bitcoin futures help financial market participants translate between BTC and USD, which has contributed to Bitcoin adoption. Bitcoin futures offer a second-layer BTC to participants that operate within the dollar pyramid and want exposure to changes in BTC price, not possession of Bitcoin private keys. In 2020, several hedge fund investors acknowledged ownership of BTC. Investment management companies and payment processors started to give customers the ability to purchase BTC on their platforms.
The Lightning Network allows Bitcoin transactions to happen more quickly through smart contracts, which are agreements written in code. Smart contracts attempt to provide escrow and multiple-party coordination. The smart contracts in Lightning Network, Hashed TimeLock Contracts (HTLCs), allow the Bitcoin network to process more transactions per second via Bitcoin Improvement Proposals (BIPs) that did not change any of Bitcoin's fundamental rules.
To review, see Layered Bitcoin.

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • Bitcoin
  • block
  • difficulty adjustment
  • hashpower
  • Lightning Network
  • node
  • private keys
  • proof-of-work
  • smart contracts
  • trustless