Case Study: Bitcoin (BTC)
Background
It’s late 2008, and the global financial crisis is causing shock waves around the world. Anger at the worldwide banking industry, governments and other centralized authorities has reached fever pitch.
Enter a mysterious figure named Satoshi Nakamoto, whose real identity continues to remain shrouded in mystery to this day. Satoshi authors and released a white paper titled Bitcoin: A Peer-to-Peer Electronic Cash System. The paper shared the workings for a new digital currency system that didn’t rely on banks to facilitate transactions or governments to create and disseminate the currency.
Shortly after its release it is studied by members of the Cypherpunk group and found to be extremely promising. In January 2009, the first transaction takes place between Satoshi and Hal Finney, a developer and prominent member of the Cypherpunk movement.
And the rest is history. Today, almost everyone has heard about Bitcoin and its value has skyrocketed. Even more profoundly, the Bitcoin currency along with its core blockchain operating technology has managed to propel a decentralized revolution around the world.
The first user problem: double spending
Satoshi argues that digital transactions are too reliant on financial institutions and other intermediaries due to something called the double-spending problem. This reliance means that digital transactions are expensive and slow. To overcome the double spending problem, Satoshi proposes a new system called Bitcoin which enables people to conduct direct electronic bitcoin payments without needing to rely on costly intermediaries. Namely, peer-to-peer transactions.
Historically, when it comes to transacting money or anything of value, people and businesses have relied heavily on intermediaries like banks and governments to ensure trust and certainty. Middlemen perform a range of critical tasks that help build trust into the transactional process. Things like payment authentication and record keeping. The need for intermediaries is especially acute when making a digital transaction. That’s because the internet today is an internet of information, where information is copied and distributed around the world. Think video, email, any digital file. For example. When you read an email, you are actually looking at a copy of the original. The person who sent you the email has the original email while you have a copy. This may seem obvious, but when you spend money online, you are not sending physical currency notes. Only data, which represents the transaction of currency (USD, YEN, RMB, POUNDS, etc.) is getting sent.
So, money in the digital world is just another piece of data like an email or any digital file. Until now, in this Internet of information, it has been impossible to store, move and transact money or anything of value without relying on an intermediary. That’s because there’s a big problem. Things don’t work so well if you can send someone $100 online, yet still, have that original $100 under your name. That would mean you could just keep spending that $100 as many times as you wanted. The money would become meaningless.
The double spending problem doesn’t exist in the physical world. After a person spends physical currency (paper money), they no longer have it in their possession. They can’t, therefore, spend the same money over and over. The digital world is a different beast. Intermediaries like banks are needed to facilitate transactions and solve the double spending problem thus creating trust between parties. They do this by ensuring the records of who owns what are up to date at any given time. For example, if you spend $100, banks ensure that your account balance decreases by $100 and the account of the person or organization you transacted with increases by $100. No double spending can occur.
The reliance on intermediaries to facilitate online transactions and prevent double spending has two main disadvantages:
Non-reversible transactions are not possible as intermediaries like banks have to mediate any disputes that arise. With the possibility to reverse a transaction through mediation, the need for trust between parties increases as does the need for trusted intermediaries.
The cost of financial institutions to resolve disputes and deal with fraud (mediate) increases transaction costs, thereby, making small or microtransactions impractical. Think about it. Why would anyone digitally transfer or spend $1 if the transaction costs worked out to be even greater than the amount being transferred or spent?
Satoshi proposes a new electronic payment system that relies on sophisticated computer encryption (cryptography) instead of the trust generated by expensive and slow intermediaries. he puts it:
No mechanism exists to make payments over a communications channel without a trusted party. What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
Satoshi's solution: a trustless currency called bitcoin circulates on blockchain
Now we know the basics of the user problem. We're going to introduce the technology that enables Bitcoin to operate: blockchain.
A blockchain is a type of distributed ledger or decentralized database that keeps continuously updated records of digital transactions (who owns what). The Bitcoin blockchain is designed as a write-once and read-only database where records can only ever be added, not edited, or deleted.
Rather than having a central administrator like a traditional database, (think banks, governments), a blockchain has a network of replicated databases, synchronized via the internet and visible to anyone within the network. Plus, the blockchain databases do not have a central administrator to validate the legitimacy of the transactions (it's done through a consensus mechanism called Proof-of-Work which we will talk about later). The intermediaries, hence, are completed eliminated. No more banks, governments, or third parties you need to trust. That's why the trustless currency.
It’s also important to clarify that there are no physical bitcoins. They don’t exist, anywhere. There are only records of bitcoin transactions (data) which get stored in a big digital ledger called a blockchain. The ledger history of transactions (i.e., the Bitcoin blockchain) is the actual currency.
A common area of confusion when talking about Bitcoin is the use of the uppercase “B” versus the lowercase “b.” What is the difference, and when do you use each one?
Bitcoin with a capital “B” is typically associated with the Bitcoin blockchain the protocol and payment network. The uppercase form, “Bitcoin,” is also often used to refer to as the ecosystem as a whole. Using Bitcoin with a capital “B” is the common way of referencing Bitcoin when writing about it in general terms.
Bitcoin with a lowercase “b” written as “bitcoin” is usually associated specifically with bitcoin as the currency. When you intend to reference how much of the currency was transacted, or you’re focusing solely on the currency and not the broader payment network or protocol as a whole, you can use the lowercase form, “bitcoin.” Simply put, Bitcoin is the protocol and payment network; bitcoin is the currency
The relationship between Bitcoin and blockchain is best summed up by Sally Davies, Financial Times Technology Reporter:
Blockchain is to Bitcoin, what the Internet is to email. A big electronic system, on top of which you can build applications. Currency is just one.
The lifetime of a transaction on blockchain
To visualize the end-to-end flow for a transaction and how the entire network runs a large number of transactions, the steps involved are as follows :
• New transactions are broadcast publically to all computers (nodes) in the network
• Each node collects new transactions into a block of transactions
• Each node works on finding a difficult Proof-of-Work for its block
• When a node solves the mathematical problem (Proof-of-Work), it broadcasts the block to all nodes
• The network nodes only accept the new block if all transactions in it are valid and not already spent
• Nodes then move on and start creating the next block in the chain
• Repeat above steps
If two nodes broadcast different versions of the next block simultaneously, the network nodes consider the longest chain to be correct and will keep working on extending it. Any nodes that are switched off and fail to receive a new block will be updated when they connect back to the network.
Bitcoin is reliant on a network of nodes and a consensus mechanism (Proof-of-Work) to keep members of the network (nodes) honest and incentivized. By understanding the steps involved in running the network, you can get a better overall picture of how Bitcoin works.
Proof-of-Work (PoW) is a technique to verify the accuracy of new transactions that are added to a blockchain
While blockchain is the ledger (or database), how do we know whether a transaction is legitimate? Proof-of-Work aka mining is performed to facilitate transactions on the blockchain and discourage bad actors from spamming the network by sending out fraudulent or illegitimate transactions. It involves miners (members in the network with high levels of computing power) to prove that a specified amount of work has been completed for the transactions made. Very straightforward naming, right?
The miners must solve complex mathematical puzzles that are difficult to solve yet easy to verify as proof of work. Miners that successfully solve the PoW puzzle and update the blockchain get a reward of bitcoins. Think money supply the central bank issue (or print) currency and inject it into the economy; In a similar fashion, this is how new bitcoins get made.
The PoW puzzle is based on something called a cryptographic hash function. It is an algorithm that takes an input and turns it into an output of a fixed size. It looks like a line of jumbled-up numbers and letters. There are many types of cryptographic hashes. Bitcoin, for example, uses a hashing algorithm called SHA-256.
In Bitcoin, miners put new blocks of transactions through an algorithm that turns a large amount of transaction data into a fixed length aka a hash. The Bitcoin network demands that a block’s hash has to look a certain way. If the hash doesn’t fit the required format, then the puzzle remains unsolved.
Here’s an example:
It usually takes many attempts to find the solution. Every time a miner successfully creates a hash that fits the required format, they get a reward of bitcoins, and the blockchain is updated. Solving these problems demands lots of expensive computational effort (lots of hardware equipment and electricity usage), so fraudulent transactions become infeasible.
Think about PoW as a system that adds a penalty or cost to members who try to present an alternate history of transactions to the network. It's a mechanism the system runs by itself to overcome the user problem. We trust the mechanism, instead of a third-party intermediary to take on the role of central administrator. That's why trustless currency, once again.
The Bitcoin network operates purely with incentives and disincentives to replace central intermediary
Bitcoin mining is an expensive and time-consuming task. To incentivize members to support the network a reward is given in the form of bitcoins. The first transaction in a block creates a new coin which is owned by the person (node/miner) who solved the puzzle and subsequently created that particular block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them.
Unlike traditional currencies, Bitcoin doesn’t have a central bank to "print" or produce more currency. To introduce more bitcoins into the network and motivate people to keep the system honest, miners are rewarded with new bitcoins.
Transaction fees which are additional charges added to transactions are also used to incentivize miners to keep the network operating smoothly. Once a predetermined number of coins (21 million to be precise) have entered circulation, the incentive will then transition entirely to transaction fees.
Therefore, the term "crypto-economics" is coined.
It refers to the study of economic interactions in adversarial environments. It’s all about incentives and disincentives. In adversarial P2P environments like Bitcoin, where there are no central intermediaries to keep bad things from happening, there needs to be a set of incentives and penalties to keep things running smoothly. Without a way to incentivize members, the Bitcoin network would not be able to operate.
The second user problem: privacy and security concerns
As the world digitizes at a rapid speed, data privacy has become a significant concern. Data breaches have impacted companies and government agencies around the world. Sophisticated hackers are stealing highly sensitive data on an unprecedented scale. If a breach of the Bitcoin network occurs, your address and transaction information cannot be easily linked to your identity.
When people hear that all transactions are publically announced, a typical response is - that’s an abuse of privacy and security. People don’t want their transaction history and identity presented to the world.
In the traditional banking model, privacy is achieved by limiting access to transaction information to the parties involved and the trusted third party. In Bitcoin, however, there is no central intermediary like a bank.
Satoshi's solution: a trustless currency called Bitcoin circulates on blockchain with cryptography based on Proof-of-Work
Do you see the components of the solution stack upon each other like laying bricks?
Let's take a look specifically at how public-key cryptography comes to the rescue. Cryptography is just a form of encryption that involves the creation of codes to allow information to be kept secret. It is the cryptographic element of Bitcoin which turns a transaction message into a format that is unreadable to an unauthorized user. While it’s true that all transactions are publicly announced, transactions use cryptography instead of relying on centralized intermediaries to provide security and privacy.
Transaction information is encrypted so members of the network only see a random bunch of letters and numbers. No party that intercepts a transaction message will be able to read it. Only the holder of the private key can make sense of the message contents.
Example: Transaction information in the eyes of the holder of private key
Example: Transaction information in the eyes of the network memberss:
So even though bitcoin transactions can be viewed by anyone on the network, they are pseudonymous. When you send and receive bitcoins, it’s like writing under a screen name, pen name, alias or whatever you want to call it. This alias which comes in the form of a jumbled bunch of characters is not linked to your identity.
A bitcoin transaction is a signed piece of data that allows a transfer of ownership of a specified amount of bitcoin to an assigned address. Transactions do not get signed in a traditional sense with a pen and paper. Instead, transactions are authenticated through the generation of some code that is unique to each party and transaction. Bitcoin digital signatures are like mathematical mechanisms that authenticate transactions. They use something called public key cryptography which is a system that uses pairs of connected keys. A public key is publicly visible on the network, and a private key is known only to the owner of a Bitcoin. It is these paired keys or digital signatures that ensure transactions are secure, authentic, and private.
Here’s a look at the transaction process in a nutshell: A sender generates a private and a public key. They then digitally sign a transaction message which ensures the transaction is authentic and non-repudiable and send their public key along with the signature and message to the Bitcoin network.
But what happens if members of the network use different transaction timelines? Members are spread around the world so won’t people be able to double spend their bitcoins? How do participants in the Bitcoin network agree on a single history of the order in which transactions were received?
To avoid these issues, members of the network agree to a single transaction timeline and process transactions according to their timestamp. And it's where the timestamp server comes into play.
Satoshi's solution: a trustless currency called Bitcoin circulates on blockchain with cryptography based on Proof-of-Work and timestamp server
Timestamp server is a specific software that is used to digitally timestamp data.
Even though the majority of the network agree to run on a single timeline, for a decentralized system like Bitcoin to operate without any central intermediary, there needs to be a way for the network to agree about which order transactions are generated. That means each transaction needs to get stamped with a precise time on it.
Think about it. Without the network running on a single timeline and each transaction getting timestamped, how does a new recipient of bitcoins know and trust that the previous owner did not sign any earlier transactions? In the Bitcoin network there is no central intermediary to confirm if a transaction or previous transactions have been double spent. The timestamp server timestamps transactions when they occur. It takes a small section of the transaction data and digitally timestamps it to create a hash.
• The timestamped hash is, in turn, made publicly available for everyone in the network to view.
• The Bitcoin network processes each transaction in order of their respective timestamped hash.
• The hash serves as a complex computer problem that needs to be solved by miners before a transaction can be added to the blockchain for eternity.
• Each timestamp includes the previous transaction timestamp thus forming a chain of transactions aka a blockchain.
If the same coin is sent to multiple recipients only the first recorded transaction will be accepted. The transactions with later timestamps are rejected. Because the entire Bitcoin network agrees to the same transaction timeline, there are no discrepancies.
Eventually, the bitcoin in the simple wallet
In the earlier chapter What Makes Money Money, it illustrates the nature of money, and by all means, bitcoin has the necessary features as a form of money. It can be split up, so it’s not only possible to transact in full bitcoin denominations.
Think about it like dollars and cents. When you go to the local store, it’s possible to pay for an item in a variety of ways, right? 10 or 20 cent coins for example. You don’t just have one dollar coins or notes in your wallet. Just like traditional currencies such as the dollar, bitcoins can be split into ‘cents.’ What's more, they can also be combined to form larger transactions.
For example, you walk into a store and want to purchase something for $50. It would be inefficient for you to hand over $1 coins/notes to the shop attendant. It would also be inefficient for the store owner to individually process each of these $1 transactions independently 50 times. It’s much easier to just hand over a $50 note in one quick and easy transaction. In Bitcoin, a coin can be both split into multiple parts before being passed on and combined to make a larger amount, thus ensuring practicality and efficiency in the network.
On the other hand, you also don’t have to be a miner that helps verify transactions to make bitcoin transactions. It’s possible to just send and receive bitcoins with a simple Bitcoin wallet. Most members of the Bitcoin network around the world do not operate full payment verification nodes and don’t have massive supercomputing power at their fingertips.
Most people just own a simple light wallet as a simplified payment verification node.
Whereas Full Payment Verification wallets, also called thick or heavyweight wallets, require a complete copy of the blockchain and can verify transactions, Simplified Payment Verification wallets, also called thin or lightweight wallets, do not have a full copy of the blockchain and cannot check whether transactions are valid. They can however securely determine whether or not a user has received transactions.
You don’t need to be a computer geek with thousands of dollars of equipment to get involved in the crypto-economics. Because Bitcoin inherited the core money features.
Key takeaways
To overcome the double spending problem which results in reliance on intermediaries and a whole new set of problems (inability to make non-reversible transactions, increased costs, etc.) Satoshi proposes a new electronic payment system that relies on complex computer encryption (cryptography) instead of the trust generated by intermediaries.
A blockchain is a type of distributed ledger or decentralized database that keeps continuously updated records of digital transactions (who owns what). It is the underlying technology that enables Bitcoin to operate.
Instead of relying on centralized intermediaries to provide security and privacy, Bitcoin transactions use cryptography. Transaction information can’t be linked to any identity because it is encrypted. Members of the network only see a random bunch of letters and numbers.
For a decentralized system like Bitcoin to operate without any central intermediary, there needs to be a way for the network to agree about which order transactions are generated in (to prevent double-spending).
Proof-of-Work aka mining is performed to facilitate transactions on the blockchain. It involves miners (members in the network with high levels of computing power) to prove that a specified amount of work has been completed.
To incentivize members to support the network and carry out the expensive and time-consuming task aka mining, a reward is given in the form of bitcoins.
To keep the entire history of the Bitcoin blockchain intact, the Bitcoin network keeps a trace or root of transaction data.
You don’t have to be a miner that helps verify transactions to be involved in the Bitcoin network. It’s also possible to send and receive bitcoins with a simple Bitcoin wallet.
A bitcoin can be split into multiple parts before being passed on and combined to make a larger amount, thus ensuring practicality and efficiency.
Last updated