In 2008, a white paper published by a pseudonymous person gave birth to the idea of Bitcoin. Bitcoin (BTC) first appeared on the internet in 2009. In its early days, the asset was more of a currency, but it grew in popularity and usage over time.
Bitcoin’s price increased over time, ultimately reaching more than $50,000 per coin, despite the fact that it began off practically worthless in US currency terms. In the crypto sector, the asset is increasingly often regarded as a wealth storage vehicle rather than a currency.
Bitcoin is the only cryptocurrency that has its own blockchain. When explaining how the Bitcoin network works, it’s essential to remember that the system was designed to address a specific set of issues relating to the role of trust in online commerce. Before delving into the specifics of how Bitcoin works, it’s necessary to first grasp what may seem to be a simple concept: accounting.
In the World of Business, Ledgers Are Used To Keep Track of Transactions
The problem of establishing trust between consumers and sellers arose with the emergence of trade in society. How can Alice know that Bob will carry out a previously agreed-upon transaction? The most simple solution is to use a ledger, which is a document that records transactions between different parties so that they can keep track of who owns how much and when.
Single-entry ledgers were the standard for many years. Each person or family would keep its own ledger of credits and debits. Because the duty for maintaining the records rested entirely on each individual, and humans are imperfect, this system was extremely prone to mistake or fraud.
The influential Medici family in 14th-century Florence is credited with inventing double-entry bookkeeping, which built on the system by establishing a two-way link between transactional entities and their respective ledgers. In a double-entry system, everyone uses the same technique to record and audit their debits and credits at any given moment.
The term “double entry” refers to each entry’s two recorded fields: what is possessed (assets) and what is owing (liabilities). Because each column on this balance sheet should always be equal, counterparties may audit the system and detect differences caused by simple errors or even fraud.
In today’s electronic banking world, double-entry is the norm, since banks and payment providers offer the common infrastructure that allows counterparties to trade with one another. A central authority may also prohibit double-spending (spending the same amount of money twice) by rolling back payments if a disagreement arises.
Financial cryptographer Ian Grigg suggested triple-entry accounting as a method for safeguarding trade in digital commerce and creating new digital assets like money, stocks, bonds, and so on in the early 2000s.
In this scenario, Alice and Bob would share a neutral mechanism that would digitally sign and record their transactions, resulting in a chain of verifiable transaction data around a certain contract. A digital asset would essentially be a cryptographic receipt that refers to a chain of digital signatures. Does this ring a bell?
This architecture had the same issue as previous digital currency efforts in that it depended on trusted third parties to run the system. While a central authority can successfully prevent double-spending, there is always one point of failure: the central authority.
Then there’s Bitcoin.
An Electronic Currency System That Works on a Peer-to-Peer Basis
Bitcoin is a self-contained public key cryptosystem that allows peers to exchange digital currency via a series of digitally signed transactions rather than communications. A Bitcoin transaction’s fundamental process flow is similar to that of a series of encrypted messages shown in a diagram of public key cryptography and digital signatures. “An electronic coin is a chain of digital signatures,” Satoshi Nakamoto, Bitcoin’s inventor, states in the white paper.
This is the fundamental method of creating a digital money, which has been utilized in a variety of projects since the 1980s.
Remember that the fundamental flaw in these early digital currency systems was their dependence on trusted third parties to run the central mint and avoid double-spending. Satoshi had to find a method to address the double-spend issue without relying on trusted authority running centralized servers in order to establish a genuinely peer-to-peer, or P2P, transaction system. This is the part when things start to get interesting…
Introducing the Blockchain Technology
Satoshi recognized that in order for a peer-to-peer transaction system to function, all transactions must be auditable by the public through a shared database, or ledger, that contains the history of all previous transactions.
Satoshi’s answer was to create a distributed P2P “timestamp server” that could be used by everyone on the network. This timestamp server operates by constantly hashing blocks of data (messages, transactions, and so on), which are then timestamped and widely distributed throughout the network. Each block’s timestamp refers to the preceding block’s hash, forming a chain of cryptographically secure, verifiable data that grows in security with each successive block. The term “blockchain” was coined by Satoshi to characterize this distributed timestamp server.
The timestamp server has traditionally been a centralized system managed by a trusted authority, such as a bank or other business. Previous attempts at digital money, such as eCash and E-gold, have failed in this area. Even if a business employs the most advanced and secure technologies available, insider fraud is always a possibility. So, how can we protect a distributed timestamp server over a peer network? This is where Satoshi’s creativity shines through.
Mining for Proof-of-Work and the Nakamoto Consensus
There must be a way to fight Sybil attacks (where one entity fabricates multiple identities to corrupt a network) and maintain consensus when nodes freely join and leave the network for this P2P transaction system to stay safe against malicious assaults and defective nodes. To address these concerns, Satoshi developed a proof-of-work (PoW) method based on Adam Back’s Hashcash, which was also used in Bitcoin forerunners B-money and Bit Gold but with significant variations.
Mining is the process through which the network continually verifies broadcasted transactions and stores them in the distributed ledger in the form of linked “blocks” of transaction data, creating a cryptographically secure, verifiable history of transactions over time.
This is where Bitcoin’s architecture differs from prior digital currency versions. The new token standard issued by the Bitcoin protocol works completely differently from previous proof-of-work tokens, which were created and valued according to the amount of work that went into creating them or based on some other set of rules. Instead, Bitcoin miners who solve a proof-of-work are rewarded with a predetermined amount of Bitcoin over time, as the intrinsic value of the currency itself depends on the system rather than on any other metric or resource.
The protocol currency and accumulated transaction fees are rewarded for time, energy, and resources put into securing the network and validating transactions, providing an economic incentive for miners to remain good actors even if certain groups obtain a majority of hashing power and thus become capable of compromising the entire network.
Satoshi not only utilized the proof-of-work method to create a currency, but he also used it to achieve consensus, since the longest chain of verified blocks is always the leader. Nakamoto consensus has been coined as a result of this.
This diagram depicts the Bitcoin network’s entire process flow. This process will continue for years to come, barring the extremely improbable possibility of a widespread, internationally coordinated attempt to shut down and/or capture every single node on the planet.
UTXOs: A Bitcoin Transaction’s Anatomy
“What is a Bitcoin?” you may wonder. Given what has been said so far, this question seems to be straightforward, yet it is not. What is this asset that we’re trading on this peer-to-peer global financial network? What does the number indicate when looking at the BTC balance in a digital wallet?
As we’ve seen, the Bitcoin network’s method of facilitating value transfer isn’t as straightforward as Alice sending a single transaction to Bob’s account and a central server updating their respective balances. Looking beneath the hood of Bitcoin reveals what it really is…
Multiple unspent transaction outputs, or UTXOs, of prior transactions received in the past that may be spent in the future make up the Bitcoin total displayed in one’s public key address, or wallet. Remember how Satoshi defined an electronic money as a “chain of digital signatures.” The entire value of various chains of ownership realized through digitally signed transactions is the total amount of Bitcoin visible and accessible at a given address.
UTXOs are similar to pocket money in that they are made up of different value units such as dollars, quarters, dimes, nickels, pennies, and so on. Similarly, when one conducts a Bitcoin transaction, these outputs become inputs in a new transaction that the sender has approved. The sender will get “change” in the form of extra UTXOs to settle the balance by the time the transaction is verified (minus the transaction fees that incentivize miners to validate the transaction into the next block). Apart from the network fees and the absence of pre-defined units of value, Bitcoin UTXOs are quite similar to cash and coins. In a nutshell, UTXOs are an electronic money abstraction.
The UTXO architecture of Bitcoin transactions is a peer-to-peer application of Grigg’s triple-entry accounting, with the blockchain acting as a neutral method for documenting ownership chains for the digital asset.
The UTXO model is not without flaws. For one thing, the impossibility of a user to change their UTXO set outside of a transaction context provides for more ownership tracing. While the addresses are displayed as public key addresses, blockchain analytics has progressed to the point that it can now accurately map the flow of transactions around an address, perhaps connecting its ownership to a specific service account or other person.
Second, if the UTXO set becomes bigger and larger as the blockchain grows in size, data efficiency may become a problem. The optimization of UTXOs is at the heart of most of the development effort aimed at making Bitcoin transactions more efficient.
The Monetary Policy of Bitcoin
Much of the discussion around Bitcoin depicts it as a ground-breaking technology that aims to decouple money and government. Bitcoin, on the other hand, is evolutionary in the history of money. Money has always been a technical and social phenomena created by and for people, so it’s only natural that it would get a systemic update as part of a global cultural trend toward more digitalization. Before looking at Satoshi’s answer, it’s essential to understand how and why the old monetary system works the way it does.
Current monetary systems are “fiat,” meaning they are supported by the state’s sovereign body via arbitrary edict. Because the state mandates its use as a medium of trade, a store of value, and a unit of account — the three characteristics of money — such currencies have value. The state mandates that taxes be paid in the national currency, which is the most visible proof of its enforcement.
Governments and empires imprinted the face of the current ruler of the area onto the hard metal currency hundreds of years ago, establishing a link between state authority and money. Fiat money is now printed pieces of paper produced by a central mint under the supervision of the state department. Rather than being backed by any commodity, this money is backed by the government.
The US used to be on a gold standard, with banknotes backed by and redeemable for precious metal reserves, but during the Great Depression, capital flight to a safe haven in the form of gold led the government to decouple the dollar from its underlying commodity.
Gold, on the other hand, has its limits. The structural difficulties of a gold-based monetary system would have eventually led to the state progressively abstracting the link to the underlying resource, to the point where, in a way, the scaffolding would have become the building. Fiat currency may be seen as a technological solution to the need to simplify money administration on a large scale.
People put a lot of confidence and responsibility in the government to properly supervise the mint and prevent economic instability since it can produce pieces of paper backed by nothing but the authority it has. Inflation happens when a government creates too much money, depreciating the value of money in the economy dramatically.
Hyperinflation has resulted from serious mismanagement of the money supply by certain governments. It’s not unusual for the price of the dollar to fluctuate by exponential amounts in such volatile circumstances, with the money being more useful as kindling or paper mache than a dependable means of trade.
Is the state now a boogeyman, enslaving the people to arbitrary financial systems from which they have no control? There are undoubtedly many Bitcoin supporters who would agree with that assertion, but one should consider the bigger picture. People consented to the unwritten social compact underlying the money, allowing the state to handle the complexity of such a system, which is why state-managed currencies became popular. This problem of trust is critical to comprehending Bitcoin’s place in the history of money.
Hasu, a pseudonymous cryptocurrency researcher, wrote on Bitcoin’s social contract, claiming that Satoshi’s innovation was in combining an automated, updated social contract with a protocol layer that successfully enforces it. Hasu emphasizes the four fundamental principles of this revised money contract, as stated by Eric Lombrozo, in his essay:
- To spend a coin, only the owner may provide the signature (confiscation resistance)
- Without authorization, anybody may trade and store value in Bitcoin (censorship resistance)
- There will only be 21 million Bitcoins issued, and they will be distributed in a predictable order (inflation resistance)
- The rules of Bitcoin should be able to be verified by all users (counterfeit resistance)
The weaknesses that plagued earlier money systems are addressed in this system via a predictable, globally accessible software protocol that distributes trust and authority outside of a single institution and into an open network of users. This radical experiment in monetary policy and value exchange is still continuing, so we’ll have to wait and see whether this social contract, and the technology that enforces it, can withstand the difficulties that have plagued previous and current systems.
Bitcoin’s Distinguishing Features
Bitcoin is not a single entity, as you may have observed while reading this tutorial. It’s a complex system that may be examined from a variety of perspectives, including computer science, distributed computing, finance, money, record-keeping, and so on. The next sections will look at the Bitcoin network’s distinctive features, as well as the design philosophy underlying them and the difficulties the network faces in maintaining these traits.
Duality of Network Tokens
The difference between the Bitcoin network and the Bitcoin money may be confusing to beginners to Bitcoin. After all, the Bitcoin blockchain’s original purpose was to enable a digital currency system, and it is this use in particular that has become a worldwide sensation. While they are intimately connected by design, distinguishing the two may assist offer a more complete, whole-systems view.
The Bitcoin network is a multistakeholder, open-source system that serves as a worldwide settlement layer and accounting system for borderless, peer-to-peer transactions. Miners, developers, merchants/companies, and users are all stakeholders, and they are all working together to offer security and uptime to the network, enhance the protocol, create services on the network, and, finally, utilize the network.
Miners are nodes that verify transactions broadcast to the network and store them on a cryptographically safe and verifiable distributed ledger of transaction data. This computationally intensive procedure not only protects the network from different threats, but also acts as the Bitcoin money minting process in the form of block rewards.
Bitcoin Core is an open-source software project that has been developed by a number of different teams and people all around the globe. Some of these programmers are paid members of established teams, while others contribute to the protocol on a volunteer basis. The Request for Comments proposal method that created the protocols that make up the internet today is mirrored in the Bitcoin Core development process. Anyone may submit a Bitcoin Improvement Proposal to the open-source community for feedback. If there is widespread societal agreement that a suggestion should be adopted, the program will be updated at a later date.
Many businesses have developed to offer services to Bitcoin’s users, just as many have formed to provide services to the bundle of protocols we call the internet throughout the years. Wallets that enable users to transact Bitcoin via an intuitive user interface, exchanges that allow users to swap Bitcoin for fiat and other cryptocurrencies, Bitcoin-based escrow systems for P2P commerce, secure document timestamping, and more are examples of these services. Asset custody, non-repudiation, data immutability, and other issues that businesses that use Bitcoin in their technological stack confront are typically unique difficulties and dangers that conventional IT enterprises do not encounter.
Users include everyone from the most die-hard cypherpunk hodler to the day trader to the newbie who just wants to see what the buzz is all about. Because all of these stakeholders are essential to Bitcoin’s success, it’s vital that the incentives be aligned throughout the ecosystem. In this case, a cryptocurrency is very beneficial.
The fact that Bitcoin is a financial infrastructure in the form of globally accessible commons created, maintained, and utilized by a network of peers is part of its innovation. Because it is also an independent network that mints the Bitcoin digital money, the system’s economic incentives enable it to develop and survive in the future.
When it comes to Bitcoin and other crypto/blockchain networks, decentralization isn’t a one-size-fits-all notion. It is, in many respects, an abstraction of an ideal state of affairs: a future in which the essential systems that support our existence, such as the present financial system, are maintained by a robust, competent network of peers rather by trusted administrators. It is, for many, the whole purpose of systems like Bitcoin and other blockchains – their raison d’être.
Despite its abstract nature, decentralization has become a key component of the bitcoin industry’s message and is often one of the first things a newbie meets while exploring the sector. Yet, paradoxically or fittingly, there is a lack of clarity and agreement in vision and practice about what the word really implies. For the sake of this tutorial, we’ll deconstruct the complicated concept quickly in order to offer some context for Bitcoin newbies.
To begin, it’s critical to recognize that decentralization includes both technological and social components, which are often intertwined. A thorough examination of Bitcoin’s decentralization, for example, would have to consider the entire protocol stack from top to bottom, including the various subsystems within it, how the network adapts over time, the distribution of power among the various stakeholders, and the influence of external forces such as corporations and governments.
Given that the network has yet to be hacked since its creation, evidence suggests that Bitcoin is technically decentralized from a basic architectural standpoint. In terms of social resilience, the network is highly resistant to excessive internal or external impact. While many people have tried to use the network to gain power or influence for their personal gain throughout the years, the system has remained credible, impartial and durable.
Externally, if a government or ad hoc agency really intended to shut down the network, it would not be impossible to monitor the energy usage of mining operations and prohibit the use of Bitcoin in trade. The currency’s sustainability as a widely accepted monetary system would be jeopardized without a strong network of stewards to maintain it and the inability to utilize it as intended. Despite the skeptics and the hypotheticals, Bitcoin has survived. Despite the fact that China has banned Bitcoin at least five times, the nation accounts for a significant portion of the network’s hashing power. Bitcoin has died approximately 400 times, according to 99Bitcoin’s curated collection of Bitcoin obituaries.
A generally recognized methodology for measuring the decentralization of these distinct techno-social systems has yet to emerge. This is likely to change in the future, not just for the advantage of having industry standards, but also to protect Bitcoin and other value networks from changing legislative regimes. The continuing decentralization of Bitcoin is essential for it to survive in any meaningful manner, whether in recognition of or in spite of the world’s regulatory systems.
Satoshi recognized that non-repudiable — i.e., non-reversible — payments had to be a fundamental element of the protocol in order to establish a peer-to-peer transaction system that did not depend on trusted third parties. While such capabilities are part of the established financial system to manage inter-party disputes or rectify human or technological mistakes, the administrative power to alter a transaction record will eventually be abused. To be sustainable and resistant to seizure, censorship, and fabrication, a digital money system without central authority must be immutable.
Bitcoin’s immutability is achieved via a continuous proof-of-work consensus mechanism. Every successive block strengthens the confidence and legitimacy of a transaction by exponential orders of magnitude after it has been processed by miners and added to the blockchain data structure.
Cryptocurrency pioneer Nick Szabo compares the process to “a fly trapped in amber” in a conversation with Tim Ferriss, with the fly representing the transaction and the amber representing the collected proof-of-work. Bitcoin relies heavily on the connection between time and transactional assurance. While a new block is verified approximately every 10 minutes, it is recommended that a transaction be fully confirmed after waiting up to six more block cycles. This is sometimes referred to as “finality.”
Large-scale information and communication systems need a high level of security. The internet was designed from the start to be a communications network that could survive nuclear war. Bitcoin was intended to function in an aggressive, unstable environment, despite the geopolitical background and fundamental objectives being very different.
Decades of study and development into ensuring the integrity and uptime of distributed systems inspired the network’s security architecture. Because there are no central administrators who can be trusted to right the ship, truly peer-to-peer computer systems pose particular difficulties and dangers in this field. Because the Bitcoin network supports a whole monetary system with enormous value at risk, robust security is critical.
Bitcoin’s proof-of-work consensus mechanism protects the network against Sybil assaults (the creation of a large number of false accounts to swarm and overload the network) and sporadic or malfunctioning nodes (due to power outages or poor maintenance), resulting in a fault-tolerant Byzantine system.
The ability of a distributed system to sustain consensus in the face of faulty information, partial network failure, or even malevolent actors is known as byzantine fault tolerance. The phrase refers to a scenario proposed by Leslie Lamport, Robert Shostak, and Marshall Pease in their famous work “The Byzantine Generals Problem,” in which they use the example of a number of army generals cooperating in a combat setting with restricted communication options.
How can the generals agree and execute a common plan with faulty information and situational awareness, or even trust that another general would not turn traitor and single-handedly change the tide of battle? Their conclusion: The endeavor will not be self-defeating as long as at least two-thirds of the generals remain loyal.
Bitcoin’s decentralization is enabled through a smart alignment of incentives among the network’s stakeholders: miners, developers, merchants, and users, as previously mentioned. Simply stated, any deliberate effort to seize the network or restructure the chain will cause the currency’s value to fall, making any intended gain useless.
The expense of being a poor actor much exceeds any potential benefit. As a result, it is in everyone’s best interest to simply follow the rules and work together to further the Bitcoin ecosystem’s maturity and acceptance.
The Bitcoin network has never been hacked at the base layer and has had virtually 0% downtime since its inception in January 2009, making it one of the most secure computer systems on the world.
One of Bitcoin’s most distinguishing features is that it abandons the account-based approach of identifying network members in favor of a public key cryptosystem in which entities are represented by cryptographic key pairs rather than given names. Bitcoin addresses are alphanumeric sequences of 26 to 35 characters that begin with either 1, 3 or bc1. While there are services that allow users to map their public key addresses to their names to make them more user-friendly, interacting with these cryptographic key pairs is already integrated into the Bitcoin user experience.
Cryptographic keys are critical to online privacy and have long been a foundational component of privacy-preserving systems ranging from digital currency to email and routing protocols like Tor. They’re everywhere in the plethora of information and communication technologies that pervade our lives, yet many systems abstract the experience by having the keys handled and coordinated by trusted third parties rather than by users directly.
The cypherpunks significantly inspired this focus on cryptographic keys as a primitive for private online conversations and transactions. Timothy May’s manifesto, in particular, emphasizes the revolutionary potential of allowing people to trade and communicate anonymously over communications networks using just digital signatures as a means of verification — no identities required.
Cryptographic key pairs are not only a replacement for identification in the context of Bitcoin, but they are also a value in and of itself. These keys are digital bearer assets that give the possessor exclusive ownership of the underlying assets. They are often referred to as wallets since they enable one to transfer and receive Bitcoin between other public key addresses. “Not your keys, not your crypto,” as the slogan goes. The achievement of full ownership and control of one’s assets without depending on custodial services supplied by trustworthy third parties is one of Bitcoin’s most innovative features.
But, in comparison to modern-day alternatives, how does Bitcoin’s privacy approach fare? While Bitcoin’s anonymity has long been a distinguishing feature of the currency and a source of contention with authorities, data analytics of blockchains has progressed to the point where casual usage of Bitcoin has essentially been de-anonymized.
Because all transaction data is public, advanced analytics methods may be used to connect public key addresses to different external accounts, such as exchanges and other fiat on/off-ramps, using a transaction graph. Cryptocurrency mixers, for example, may assist obscure transaction flow and avoid connection to external accounts and real-world identities, but these tools have started to face aggressive government closure. Much of the future development of the Bitcoin protocol is focused on improving its privacy features.
The characteristics of Bitcoin as both a (largely) privacy-preserving system and a transparent one may catch the Bitcoin newbie off surprise. Isn’t it true that these two qualities are mutually exclusive? Certainly not. Indeed, it is the balance of these two characteristics that makes Bitcoin and blockchain so successful and beneficial as an open financial system.
We’ve shown that Bitcoin’s privacy model is based on the substitution of cryptographic key pairs for names and accounts. These key pairs are the instruments that allow users to safely transact on the network using digital signatures. How can we believe that the records we’re dealing with are accurate if we don’t know who we’re dealing with?
These transaction flows, as well as the ownership chains of these precious bits, are maintained in a shared ledger of cryptographically verified, secure data using blockchain. One of blockchain’s key value propositions is data verification, which is achieved by combining a mutual ledger of secure but open data with a consensus mechanism that enables network members to constantly agree on the ledger’s legitimate state.
Participants in the Bitcoin network can rely on the ledger’s validity rather than on each other or on a trusted third party if all peers on the network share a transaction record dating all the way back to the genesis block as well as the cost of returning previously timestamped transactions exponentially outweighs any benefits.
While the Bitcoin network places a lot of focus on financial transactions for obvious reasons, the blockchain has also proved to be beneficial for other uses. The proof-of-existence technique of utilizing the Bitcoin blockchain to date documents and other digital items is the first non-financial use of the Bitcoin blockchain.
From the recording and enforcement of legal contracts to the provenance of data around a digital or physical asset to the establishment of a worldwide, automated notary public, the application cases are many.
There is a crucial difference to be made when discussing Bitcoin’s speed. Is it the number of transactions Bitcoin can handle in a certain period of time or the time it takes to execute a single transaction that we’re talking about? These are two separate but connected findings in evaluating Bitcoin’s value proposition over time.
Transactions per second are a popular metric for determining a cryptocurrency’s performance and scalability. The Bitcoin network averages just 4 transactions per second at the time of writing this book, a pitiful figure when compared to Visa’s 1,700 transactions per second. This figure is often used in discussions about Bitcoin’s scalability and feasibility as a digital currency.
How long does it take Alice to transfer Bitcoin to Bob, on the other hand? The typical block duration is approximately 10 minutes, with transaction finality guaranteed after 6 blocks, or 60 minutes, depending on the amount of transaction fees paid by Alice to encourage priority validation by miners.
While Bitcoin’s transaction throughput and confirmation times might be improved, it’s essential to remember that these are peer-to-peer transactions that are performed and protected by a worldwide network that operates across borders. This is crucial to understanding the value proposition of Bitcoin. While it lacks sheer speed at the moment, Bitcoin avoids the need for central clearinghouses to process Visa and ACH bank transactions in favor of an ultra-secure global settlement layer. Millions of dollars in worth may be transferred across the globe in less than an hour and confirmed with little costs and without the need of trusted third parties.
In the short to medium future, developing layer-two scaling solutions like Lightning will offer a trust-minimized way to execute high-frequency Bitcoin transactions off-chain while maintaining the Bitcoin blockchain’s integrity.