What is Bitcoin?
Satoshi Nakamoto released Bitcoin to the world on 3 January 2009 ( 1), when the first block of the blockchain was mined. What this actually means will hopefully become clear as we look to explain how this digital currency works and why it might be important. Mysteriously, the name Satoshi Nakamoto has proven to be a pseudonym, with the true identity of bitcoin’s creator remaining unknown ever since ( 2). ‘He’ might be a man, woman, or group of people. In the paper he published a few months previously ( 3), Nakamoto laid out his vision for a peer-to-peer version of electronic cash, that would remove the necessity for a trusted third-party; until this point considered essential for a monetary system. Traditionally, this ‘trusted’ third-party has been financial institutions. His proposal was to use cryptographic proof instead of trust, removing the need for these institutions.
A network of users
Using Bitcoin means being part of a network. A participant in this network requires two keys: one private and one public. The private key secures the participant’s funds and the public key enables transactions to be made on the network. When you set up a means of storage for your bitcoin, these will need to be generated and this normally occurs ‘under the hood’. These keys are a long series of numbers and letters, which are generated using cryptographic mathematics. The generation of this pair of keys is such that, though mathematically related, the private key cannot be determined from knowledge of the public key.
Making a transaction
Consider two participants in the network who wish to make a transaction: Owner 1 and Owner 2. In Figure 1, from Nakamoto’s original paper ( 3), Owner 1 is seen to transfer funds to Owner 2, as part of a sequence of transactions. For a simple way to visualise this, imagine the diagram describing the journey of a fixed quantity of bitcoin from Owner 0 to Owner 3, by way of Owners 1 and 2.
Figure credit: ( 3)
The transaction is seen to involve Owner 1 using their private key to digitally sign a hash of the previous transaction and Owner 2’s public key. The hash, in this context, results from applying an algorithm to create a new value, of a specific format, from this information. This hash is unique and can only result from the input of this exact information. Once the transaction is made, Owner 2’s private key secures the funds, until the funds are eventually paid to Owner 3 and so on. A small transaction fee is paid during this process. Who the transaction fees are paid to will become clear below.
In the transaction described above, there is no way of determining if Owner 1 is spending their funds twice. Some form of verification is required to avoid this, which would traditionally be achieved by a centralised authority, such as a clearing house. An important feature of the Bitcoin network is that it is decentralised. Therefore, to enable verification, the transaction is publicly broadcast to the network and, together with other transactions occurring at the same time, collected into a block. This block, now known throughout the network, will be added to all previous blocks to form a blockchain, which serves as a permanent record of all transactions ever made. Since all transactions are recorded and visible to the entire network, a double-spend is avoided by deciding that the earliest transaction of any double-spend attempts is the one that counts and discounting any others. A timestamp is added to the hash, during the transaction, to allow determination of the earliest transaction.
A new block of transactions is generated approximately every 10 minutes and added to all the previous blocks that have ever been created, in a chain of blocks all the way back to the very first block mined by Satoshi Nakamoto (Figure 2). This first block is known as the genesis block.
Figure credit: ( 4)
A distributed ledger
The creation of a blockchain, which is publicly broadcast across the entire network, is the way that the Bitcoin network achieves what is known as a distributed ledger (Figure 3). This is a fundamental concept common to all cryptocurrencies, with a number of different approaches. Think of a distributed ledger as a record, or a database, that exists across several locations, or among multiple participants. A simple example of a distributed ledger would be if you were to create a spreadsheet of data and email this to a number of people. Perhaps the spreadsheet records a number of transactions. The problem with this simple example of a distributed ledger, though, is how to update everyone’s version of this spreadsheet if a new transaction is made. How is agreement between all keepers of the information arrived at?
Figure credit: ( 5)
Proof of work
Bitcoin uses proof-of-work to ensure consensus across the network. Individuals who choose to participate in this activity, known as mining, set their computers to work attempting to solve a sort of cryptographic puzzle. The first to be successful wins the privilege of adding the next block to the blockchain. In addition, offering perhaps more of an incentive, they also win a block reward of 6.25 bitcoins plus all of the transaction fees paid during the transactions within this block.
The creation of a block involves using a hash function. In this case, it is a mathematical operation that takes all of the information related to the transactions taking place at that time and outputting a hash. This hash is unique and could only result from the exact information which is input. Solving the puzzle, in the mining process, involves making repeated guesses of the hash until one miner is successful. The network possesses a dynamic, self-regulating method for altering the difficulty of the puzzles that miners must solve, such that the average length of time is approximately 10 minutes. This serves to keep the period of block creation constant, despite volume changes in the network.
A network of nodes
With the incentive of potentially earning a block reward, a network of miners across the globe serves to provide decentralisation and consensus. Each computer involved in mining is referred to as a node. A potential threat to the Bitcoin network is a 51 percent attack, also known as a majority attack. In this situation, a group of people controlling a majority of the nodes in the network decide to construct an alternative version of the transactions that take place in a block. As you might imagine, this version of the transactions would undoubtedly favour themselves. They conspire to create a block that supports these fake transactions and use the mining of their nodes to support this. Now there will be two versions of the blockchain. This is what is known as a fork (Figure 4). When a fork occurs and the blockchain diverges in two different directions, game theory will dictate that it is the longest chain that survives, as eventually all miners will decide to choose this version. Having control of a majority of the nodes in a network would mean that this group would have the power to create the longest chain, since more of the nodes in this group, over time, would be successful in mining. They are said to have more hash power.
Figure credit: ( 6)
It is for this reason that a large network of nodes, run by many different people, in many different places, is of fundamental importance for the security of the network. Any attempt by a group without control of a majority of the nodes in the network would result in an unsuccessful fork of the blockchain and remove the opportunity to claim valid block rewards, thus causing a disincentive to try.
21 million coins
One big difference between bitcoin and ‘normal’ money, is that there is a hard limit to the number of coins that will ever exist. The limit is 21 million and this is written into the code that runs the network. This may sound unusual, given today’s practice of quantitative easing, when central banks can decide to inject new money into an economy with the aim of stimulating spending, but makes a lot of sense when the negative effects of this are considered.
An unfortunate side-effect of quantitative easing is that it leads to a devaluation of the currency, where the buying power of your dollar, pound, euro, yuan, etc. is reduced. You may be old enough to have observed this yourself, but conversations with our parents, or grandparents, about how the price of things has changed over time, clearly illustrates that this is a reality of ‘normal’ money. Bitcoin ensures that an upper limit to the amount of coins is reached by cutting the number of freshly minted bitcoins, that are awarded as part of the block reward, in half after every 210,000 blocks. The original reward was 50 BTC, which was reduced to 25 BTC in 2012, then 12.5 BTC in 2016 and is now 6.25 BTC as of 11 May 2020 ( 7). Each of these events is known as a halving and is repeated until it has occurred 64 times. Satoshi Nakamoto compared this process to the discovery and mining of gold. Interestingly, bitcoin is often referred to as digital gold. It could be said that bitcoin has a lot of advantages over gold.
Benefits of bitcoin
Bitcoin has certain traits that make it attractive as a secure store of value and for making peer-to-peer transactions.
Bitcoin is open
It is available for anyone to use, providing access to financial services for everyone, including the billions of people on the planet who have historically been restricted from banking. Bitcoin enables anybody to be their own bank.
Bitcoin is borderless
It is not controlled by any government, or the banking system. For this reason, it is removed from the shortcomings and corruption that has become so apparent in these institutions and their control of traditional currencies. Bitcoin is truly global, allowing international transactions without inefficient complications, lofty fees, or unnecessary delays.
Bitcoin is decentralised
The Bitcoin network is built upon an immense number of computers, run throughout the world, by many different people, in many different countries. Therefore, Bitcoin is immune to centralised control. It is not merely ‘money for the internet’, but actually ‘the internet of money’.
Bitcoin is censorship-resistant
You have complete authority over your bitcoin. It cannot be seized, frozen, or censored. Transactions cannot be intercepted, or stopped. The blockchain is the glue that holds the network together and serves as a record of all transactions made on the network, while maintaining the anonymity of the parties involved. The blockchain is a historical record of truth, which can be used to register information and thus act as a network of trust.
1. DAVIS, Joshua. The Crypto-Currency [online]. 2011. Available from: https://www.newyorker.com/magazine/2011/10/10/the-crypto-currency/. Accessed: 2020-09-03. Archive: https://archive.vn/tEI54
4. TERRACOIN. What is Genesis Block and why Genesis Block is needed? [online]. 2019. Available from: https://medium.com/@tecracoin/what-is-genesis-block-and-why-genesis-block-is-needed-1b37d4b75e43. Accessed: 2020-10-04.
6. TAR, Andrew. Proof-of-work explained [online]. 2018. Available from: https://cointelegraph.com/explained/proof-of-work-explained. Accessed: 2020-10-04.