Bitcoin Blockchain: Components, Mining, Inflation and Algo Trading

8 min read

By Udisha Alok

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

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
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
Bitcoin Mining - Source

Bitcoin Mining and Proof of Work

The Proof-of-Work (PoW) algorithm is designed so that one block is mined every 10 minutes. In order to ensure this time limit, the network sets a difficulty level for the puzzle.

The difficulty level is set by setting a target for the final hash of the block. In the case of Bitcoin, it means specifying the number of leading zeroes in the final hash of the block.

Now each node has the hash of the previous block and the current block of transactions. They need to calculate the nonce (a number used only once), which generates a hash with the given number of leading zeroes when combined with the above values.

Simplified Proof-of-Work diagram
Simplified Proof-of-Work diagram

When one leading zero is added to the target hash, the work is doubled, increasing the problem's difficulty. The Bitcoin network automatically configures the problem so that it takes approximately ten minutes to mine each block.

The first miner who finds a valid nonce (golden nonce) is rewarded, and the nonce is broadcast to the network for validation. The block is added to the Bitcoin blockchain after verification.

Mining a block is computationally-expensive work, so sometimes a group of miners come together and form a mining pool to increase their chances of mining a block.


Transaction fee

When miners mine a block, they receive a reward. They also get transaction fees which is a sum of the transaction fees for all the transactions in the block. The transaction fees incentivize the miners to continue to process the transactions by mining blocks. Else they may not continue to mine the blocks due to the high mining costs.

It is not mandatory for miners to pick up the transactions on a first-come-first-serve basis in the Bitcoin network. So the miners are free to choose the transaction they want to add to a block.

A block can hold only a finite number of transactions- each block size has a soft limit of 1MB. A higher transaction fee will make the transaction more attractive for a miner. Hence, a higher transaction fee block is more likely to get mined and added to the blockchain sooner than one with a lower transaction fee.

Note that a transaction becomes valid only once it is added to the blockchain. You can think of it as a simple money transfer transaction that remains in the processing stage unless the bank confirms it.

Bitcoin transaction fees depend on the network traffic. If more people are using the blockchain, the number of transactions to be confirmed goes up, pushing the transaction fees higher.

Bitcoin transaction fees depend on the network traffic. If there are more people using the blockchain, the number of transactions to be confirmed goes up, pushing the transaction fees higher.

Bitcoin Average Transaction Fee
Bitcoin Average Transaction Fee - Source

Bitcoin and inflation

Nakamoto designed Bitcoin as a deflationary cryptocurrency. The logic behind this was that fiat currencies are in infinite supply as more and more money keeps getting added to the system by the central banks and governments, leading to a decrease in the value of money over time. This is inflation.

To counter this, Nakamoto capped the total number of Bitcoins that will be created at 21 million. So, like gold, Bitcoins supply will decrease over time and hence become scarcer, increasing their price.

After every 210,000 blocks are mined, the block reward is halved until it becomes nearly zero in 2140. It is currently 6.25 coins per block. As the block rewards continue to reduce, the transaction fees may be the primary incentive for miners.

Bitcoin Inflation vs Time
Bitcoin Inflation vs Time - Source

Trading Bitcoin using a crossover strategy

Due to the rise in the popularity of cryptocurrency, Bitcoin is traded on many exchanges. Some decentralized exchanges even allow the users to remain pseudonymous, not asking them to reveal any personal information.

Some of the top exchanges where Bitcoin is traded are:

  • Binance
  • Coinbase exchange
  • FTX
  • Crypto.com exchange
  • Kraken
  • Kucoin
  • Gemini

Bitcoin is a volatile market where there is always momentum. It makes sense to try out a momentum-based strategy in such markets.

We will build a momentum-based trading strategy for Bitcoin using the Awesome Oscillator (AO) technical indicator. AO calculates the difference between a short term (usually 5) and a long term (usually 34) Simple Moving Average.

This SMA is calculated using the mid-point of each bar instead of the closing prices. Here is the code for this strategy:

df.head()
Date Open High Low Close Adj Close Volume
2019-12-31 7294.438965 7335.290039 7169.777832 7193.599121 7193.599121 21167946112
2020-01-01 7194.892090 7254.330566 7174.944336 7200.174316 7200.174316 18565664997
2020-01-02 7202.551270 7212.155273 6935.270020 6985.470215 6985.470215 20802083465
2020-01-03 6984.428711 7413.715332 6914.996094 7344.884277 7344.884277 28111481032
2020-01-04 7345.375488 7427.385742 7309.514160 7410.656738 7410.656738 18444271275
Date Open High Low Close Adj Close Volume ao
2021-10-27 60352.000000 61435.183594 58208.187500 58482.386719 58482.386719 43657076893 6951.021507
2021-10-28 58470.730469 62128.632812 58206.917969 60622.136719 60622.136719 45257083247 6191.566808
2021-10-29 60624.871094 62927.609375 60329.964844 62227.964844 62227.964844 36856881767 5695.694037
2021-10-30 62239.363281 62330.144531 60918.386719 61888.832031 61888.832031 32157938616 5148.665591
2021-10-31 61850.488281 62406.171875 60074.328125 61318.957031 61318.957031 32241199927 4573.736903
Plot for Strategy returns vs Buy and Hold returns
Plot for Strategy returns vs Buy and Hold returns

You can also use other technical indicators like the Ichimoku cloud to trade on Bitcoin. To know more about algorithmic Bitcoin trading, click here.


Conclusion

Diving into the world of blockchain technology, this blog in the series dealt with Bitcoin blockchain. We explored the history of Bitcoin, its various components, Bitcoin mining, and transaction fees. We also looked at a momentum trading strategy using the Awesome Oscillator technical indicator.

I hope you are excited to venture further into the world of cryptocurrencies. In our next blog in this series, we will explore the cryptocurrency that ushered another significant change in the world of crypto - Ethereum. Till then, keep reading!

If you too wish to dive deeper into the world of cryptocurrencies and explore trading opportunities in Cryptocurrency, leverage your knowledge of blockchain, with Quantra's intermediate course on Crypto Trading Strategies. Enroll now!


Disclaimer: Any information regarding cryptocurrency in this article is intended to convey general information only. This article does not provide investment, legal, tax, etc. advice. You should not treat any information in this article as a call to make any particular decision regarding cryptocurrency usage, legal matters, investments, taxes, cryptocurrency mining, exchange usage, wallet usage, etc. We strongly suggest seeking advice from your own financial, investment, tax, or legal adviser. Neither QuantInsti® nor the author of this article accept responsibility for any loss, damage, or inconvenience caused as a result of reliance on information published in, or linked to, from this article.

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