10 Bitcoin Basics Every Crypto Investor Should Know

Investors are fickle, often turning to whatever fad investment offers the most immediate chance to get rich quick. Bitcoin drew in hordes of investors in 2017 as its price soared above the $10,000 mark, but its big declines so far in 2018 have caused the cryptocurrency to lose much of its momentum. Nevertheless, one thing that investors can't deny is that bitcoin has made its mark on the world, both with its huge gains in price and the increase in interest both from investors and advocates of blockchain technology more broadly.

This article originally appeared in the Motley Fool.

As many investors turn to the painful memories of the financial crisis 10 years ago, there's another anniversary coming up. In October 2008, the pseudonymous Satoshi Nakamoto published a white paper discussing the concept of bitcoin. Even a decade later, the paper has a lot to explain about how bitcoin works, and it's required reading for anyone who wants to invest in cryptocurrencies. In honor of bitcoin's 10th anniversary, here are 10 key quotes from the Nakamoto paper.

1. Bitcoin got rid of the middleman

Commerce on the internet has come to rely almost exclusively on financial institutions serving as trusted third parties. ... What is needed is an electronic payment system based on cryptographic proof instead of trust.

Cryptocurrency advocates love the fact that bitcoin doesn't rely on a centralized authority like a bank, especially given the potential for violations of trust. For instance, credit card companies let buyers reverse their transactions under certain circumstances, making it impossible for a seller to be assured of permanent payment. Bitcoin took third parties out of the equation, making payments reliable and irrevocable.

2. Bitcoin's fundamental vulnerability

The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

To work, bitcoin has to be hard enough to crack that those seeking to put together a fraudulent chain of transactions can't outpace the true blockchain. That requires computing power, and it identifies what could eventually be a threat to the cryptocurrency: that enough people trying to topple bitcoin's dominance could come in to threaten its integrity.

3. The basis for trust in bitcoin

We need a way for the payee to know that the previous owners did not sign any earlier transactions. ... The solution we propose begins with a timestamp server.

The biggest threat to bitcoin's use as a payment system is potential double-spending. With a physical currency, double-spending is impossible, because you have to turn over the currency to the seller. Bitcoin's fundamental trustworthiness stems from the idea that everyone knows everyprevious transaction, letting them have confidence in what's come before.

4. Why proof-of-work is essential

Once the CPU effort has been expended to make it satisfy the proof-of-work, the block cannot be changed without redoing the work. As later blocks are chained after it, the work to change the block would include redoing all the blocks after it.

One reason why bitcoin has been so resilient is that it has gotten stronger over time, and proof-of-work is an essential component of that strength. As the blockchain has gotten longer, the effort necessary to attack it successfully has decreased. With proof-of-work difficulty increasing over time, bitcoin further enhances its defenses.

5. How bitcoin keeps growing

Nodes always consider the longest chain to be the correct one and will keep working on extending it.

One issue with bitcoin as it has grown in popularity is that not all nodes of the bitcoin network will always have the latest version of the blockchain. Over time, though, subsequent transactions will spread out distribution of the longer blockchain more widely, allowing the full network to catch up.

6. The incentive to mine bitcoin

By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation.

Bitcoin mining has always been an attractive part of the cryptocurrency movement, and with the rise in bitcoin's price, huge amounts of computing power now go into efforts to unlock new blocks and grab up the small amount of bitcoin that results from success. As the paper notes, mining also gives those with immense computing power an incentive not to seek to subvert the blockchain itself, as they can just claim new bitcoin instead.

7. Dealing with the growing blockchain

Once the latest transaction in a coin is buried under enough blocks, the spent transactions before it can be discarded to save disk space.

Bitcoin processing has gotten slower as its popularity has grown, but bitcoin's founders anticipated the need to prune the growing blockchain. The methodology involves compressing older blocks using shorter hashes that are adequate once enough past transactions have accumulated. However, the theoretical pruning of the blockchain has proven to be more problematic than the white paper anticipated, due in part to the fact that one can't guarantee that any block identified to be pruned doesn't have information that's vital to the rest of the blockchain.

8. Handling bigger transactions

Although it would be possible to handle coins individually, it would be unwieldy to make a separate transaction for every cent in a transfer. To allow value to be split and combined, transactions contain multiple inputs and outputs.

Currencies come in units like 1-euro coins or $20 bills, and bitcoin theoretically could have been set up that way as well, with discrete units. Yet it's more efficient to allow variable-sized transactions. That essentially lets users pay with a "4-bitcoin bill" instead of forcing the blockchain to include four transactions involving a single bitcoin each, as would be necessary for a $4 cash transaction using four $1 bills.

9. Bitcoin privacy

The public can see that someone is sending an amount to someone else, but without information linking the transaction to anyone. This is similar to the level of information released by stock exchanges, where the time and size of individual trades, the "tape," is made public, but without telling who the parties were.

Privacy is a valuable advantage of cryptocurrency transactions over most payments. Bitcoin has turned out not to be as private as some users would like, and that's prompted the creation of even more privacy-focused rivals. Nevertheless, the white paper notes other measures that users of bitcoin can take, including using slightly different key information in each transaction.

10. Bitcoin's defense mechanism

Nodes are not going to accept an invalid transaction as payment, and honest nodes will never accept a block containing them. An attacker can only try to change one of his own transactions to take back money he recently spent.

Lastly, the white paper looks at the chances of an attacker generating an alternate blockchain. To do so, the attacker has to work fast enough so that its false version gains acceptance. Otherwise, if the attacker falls behind other nodes, the chances of reversing a past transaction eventually approach zero.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.