Currency - a medium of exchange, nothing more
If the day gold died, in what later became known as the Nixon Shock, hasn't stopped the financial world from spinning, why would currency going digital send shockwaves throughout the global economy? Since the beginning of its existence, money has continually transformed and evolved, but at its core it always remained a medium of exchange. Economists see currency as widely accepted legal tender issued by a government and circulating within an economy of a country. But what would happen if "government" and "country" were taken out of the definition? Up until not long ago, that was technologically impractical and scientifically impossible.
And then a mysterious new technology emerged
Seemingly out of nowhere, but actually the result of a few decades of research and development by many unknown computer science scientists around the world. In fact, the first digital currencies, or at least the concept, existed as early as the mid 90s, around the time the Internet was fully commercialized. Essentially, they all suffered from one major drawback that led to their inevitable demise. They all required a central, trusted third party to administer the issuance of new units and reconcile payments at the end of the day.
So how is Bitcoin so different?
Bitcoin emerged in 2009 as the creation of a person under the pseudonym Satoshi Nakamoto. It became the world's first fully operational, decentralized, peer-to-peer, digital currency system. Being decentralized, intrinsically means being self-organizing, a phenomena in which local individuals achieve global goals without central planning or influence. Although decentralized systems can be found in nature, the concept is not easy to grasp in its monetary context, as we are so used to the voice of central governments and financial institutions orchestrating our economic lives.
Computer networks and the Byzantine Empire
From a computer science perspective, establishing trust between unrelated parties over an untrusted network (like the Internet), is part of a set of problems known as the Byzantine Generals Problem. The Byzantine army was chosen to illustrate the problem because it had suffered recurrent treacheries among the high ranks of its military command. Imagine several divisions of the Byzantine army camped around an enemy city, each division is led by its own general. Due to geographic obstacles, the generals can communicate with each other only through messengers. In order to achieve victory, the generals must decide upon a common strategy unanimously. However, some of the generals may be traitors and will try to prevent the loyal generals from reaching consensus. If the traitors succeed the attack is doomed to fail.
Fast-forwarding 561 years to the time of this article
So how did Bitcoin manage to build a trust component that will avert unfair dealing in a decentralized, peer-to-peer network? The simple answer is by successfully implementing and combining two mechanisms known as 'digital signature' and 'proof of work'. The former proves the authenticity of each transaction, so to spend money, you first have to prove you are the rightful owner of the money. The latter manages the issuances of new Bitcoin units (aka "mining") and reconciles all transactions over a fixed period of time (aka "blockchain").
The concepts that lie behind Bitcoin - simplified
- Bitcoin address in its most abstract form is the parallel to a bank account. It is identified by a long sequence of letter and numbers, similar to your bank account number. Each Bitcoin address has its own balance of Bitcoins. But remember, since we're dealing with a decentralized network, there are no centralized entities such as banks in the picture.
- Bitcoin wallet is a piece of software that runs on your computer, mobile device or hosted online. The wallet grants you access to your set of Bitcoin addresses. In a similar way to email addresses, you can use your wallet to "open" as many "accounts" as you wish at no cost. In fact, it doesn't even require an Internet connection to create a new Bitcoin address, as the number of available addresses is almost as high as the number of atoms in the entire world. So the chance someone else already taken your address is nearly zero.
- Ledger balance. At this point you must wonder, if there's no central entity in the picture, who keeps track of the accounts and their corresponding balances? Well, a copy of the ledger is maintained on each and every wallet that forms part of the Bitcoin network. Differently than your bank account, where you have access only to your transactions, your Bitcoin wallet stores all the Bitcoin transactions ever made since it all began in 2009.
- Bitcoin transactions. In order for you to send X units of Bitcoin from your address to a recipient address, all your wallet has to do is broadcast the network that X units should be subtracted from your address and respectively added to the recipient address. Wallets, or "nodes" in the Bitcoin network, will apply that transaction to their copy of the ledger, then pass on the transaction to other nodes, until all nodes in the network are updated.
- Et voilà - this is all there is to it.
The concepts that lie behind Bitcoin - less simplified
Digital signatures 101
As mentioned earlier, in order to spend Bitcoin funds, a sender has to prove his authenticity (rightful ownership of the funds) by adding a digital signature to his transactions. The authenticity mechanism is achieved by implementing a mathematical model called "public-key cryptography." Here's how it works:
- Hash function is a mathematical function that takes an input message of arbitrary length (transaction, in our context) and transforms it into a fixed length output called 'hash'.
- Encryption scheme is the process of turning a readable plain text message into an unreadable ciphered text, using an encryption key that specifies how the message is to be encoded.
- Public key and private key is a mathematically related key pair that possesses an interesting mathematical property; a private key signature can only be verified by its matching public key.
- Bitcoin address (revised) is actually a key pair. The private key is known only to its proprietor and is used to digitally sign transactions. The public address is shared with the network and is used by its members to verify the authenticity of a transaction.
- Alice, Bob and Eve are the three archetypal characters in the field of cryptography. They represent party A trying to send a message to party B while a malicious Eavesdropper attempts to tamper with their message. Below is a breakdown of how math achieves authentication:
- Alice wishes to send one Bitcoin to Bob.
- Alice's wallet calculates the hash for the transaction.
- The hash is encrypted using Alice's private key to create the digital signature.
- The hash and its digital signature are broadcasted to the network as one packet.
- All other wallets on the network decrypt the digital signature using Alice's public key.
- The hash from the received broadcast is compared with the now decrypted hash.
- If the hashes are identical, the transaction has not been tampered with.
- If the hashes differ, the integrity of the transaction has been compromised by Eve.
Transaction validation 101
After verifying the authenticity of a sender, the network must verify that he has sufficient funds in his account to carry out the payment. Remember, there is no central entity that can decide upon this. Here's how the Bitcoin network validates transactions:
- Account Reconciliation is an accounting process that compares two sets of records, the cash inflow and the cash outflow. The account balance is the net cash flow. Yet, wallets in the Bitcoin network never maintain this figure. So how can they all tell whether Alice has sufficient funds to pay Bob?
- Bitcoin transaction (revised) is comprised of two columns, an input column and an output column. The input column contains information about the origins of the Bitcoins in a transaction, while the output column contains information about where to send the Bitcoins of a transaction. The input column of a transaction actually reference the output columns of previous transactions.
- Ledger balance (revised). The validity of a given transaction is dependent on the validity of its previous transactions and on and on until all transactions ever made are validated. So the Bitcoin "ledger" actually consists of a linked list of all the transactions ever made rather than account balances.
- Unspent output is an output of a transaction which has yet to be the input of another transaction. Simply put, it's Bitcoins that have not been spent.
- Transaction validation. To find out whether Alice has sufficient funds to pay Bob, Bitcoin nodes are required to iterate through all the transactions ever made and add up all of Alice's unspent outputs. But remember, all the transactions ever made reside on each and every wallet in the network, in any case.
Proof of work (mining) 101
Now that we know that each transaction depends on its previous transactions, you might be wondering how Bitcoins got into the systems in the first place? The answer in short: by rewarding its members with newly issued Bitcoins in return for solving a complex mathematical problem. However, it is not for the sake of a challenge. The solution for the mathematical problem allows the Bitcoin network to address a serious security loophole associated with transaction order - a problem typically related to decentralized networks.
- Transaction Order. As explained previously, transactions are broadcasted to the network and pass from one node to the other until they reach the entire network. However, there is no guarantee that the different nodes will receive the transactions in the same order as they were created. Again, there's no central entity that can decide upon an agreed order, and it's up to a network to reach that agreement. Failure to do so would inevitably lead to frauds. This is where the Byzantine Generals Problem comes in.
- Double Spending. Imagine Alice has an unspent output of 1 Bitcoin. She sends a transaction to Bob, paying him that 1 Bitcoin. Immediately after this, she sends a second transaction. This time it's to Charlie, paying Charlie with the same 1 Bitcoin. Due to different network capacities at different nodes, it is not unlikely that some nodes would receive the second "double-spending" transaction to Charlie before they receive the one to Bob. Because there is no way to prove which transaction was issued first, the network would reach disagreement on whether it is Bob or Charlie that is the rightful owner of the money.
- Blocks and blockchain are the data structures Bitcoin uses to organize transactions. Transactions that happen at the same time span are grouped together in a block. Each block has a reference to its previous block. The linked blocks are called 'blockchain'. Transactions not yet in any block are called unordered (i.e. not confirmed yet).
- The next block. Any node in the network can choose to opt in and participate in the process of creating the next block in the blockchain. The process is called "mining." What's to be done? Group a set of unordered transactions into a block, and broadcast it to the network as a suggestion for the next block. There will likely be several options to choose from, so the entire network must find a way to decide unanimously which block will be next.
- Mathematical problem. The Bitcoin network will ask its members to find the answer to a special mathematical problem. The block that will contain the answer will be chosen as the next block in the blockchain. The mathematical problem is special due to three vital properties it possesses:
- It lacks an efficient way to solve it and therefore a "brute force" approach has to be used, i.e. trying random values until the answer is found. Statistically, this will take a very high number of attempts.
- It is very easy to verify. Think of Sudoku, hard to solve, but trivial to verify if a given solution is correct.
- The solution for the current block is based on the solution of the previous block.
- Proof of work proves that a node participated in the total network effort of finding a solution to the mathematical problem. On average, it will take a single node several years of computing power to solve a block on its own. Since it is statistically improbable for a node to solve a block on its own, it's unlikely that a node which solved a block would be an adversary node.
- Solved blocks. The entire network achieves consensus by accepting the first solved block to be the next in the blockchain, thus verifying all its transactions. Since the solution for the current block is built upon the solution of the previous block, agreement on the current block actually strengthens the agreement for the previous block as well, and so agreement is built upon as the blockchain continues to grow.
- Mining (Bitcoin issuance). The process of solving a block is rewarded by issuance of new coins into the system and granting them to the block-solving node. This is why it is called "mining". The mining process addresses two central aspects of the system:
- It verifies transactions and safeguards the financial integrity of the system.
- It gradually issues and randomly distributes new coin units. The process is equivalent to a central bank's monetary policy of regulating money supply.
- Block chain branches. Sporadically, more than one block is solved at the same time span, therefore the network has different blockchain branches to choose from. When this happens the network reaches agreement by immediately accepting the longest valid branch. Why? Because block solving is built upon previous block solving. The longer the block branch, the harder it is to solve all its elements, and subsequently the less likely a malicious node will archive it.
- Transaction Order (final). Within the Bitcoin network, the "real" order of transactions is recorded within the blockchain.
So what is the mathematical problem the network is asked to solve?
If you truly dislike math skip this section, curiosity is more important!
- Hash function (revised) is, as explained above, a function that takes an input of arbitrary length and produces a fixed size length output called hash. A fascinating mathematical property of hash functions is that even the slightest change to the input will result in a totally non-predictable drastic change to the output, though the length will remain fixed in size.
- SHA-256 is a cryptographic hash function developed by the U.S. National Security Agency (yes, the one who's on the news quite often recently) which Bitcoin utilizes for solving blocks.
- Cryptographic nonce is nothing but an arbitrary number used to slightly modify the input of a hash function, which will result in an unpredictable hash value as output.
- The mathematical problem all miners in the network are asked to solve is as follow:
- Input = previous hash value + current block + nonce
- SHA-256(SHA-256(Input))? hash value with X number of leading zeros
- The mathematical problem (simplified to words) look for the nonce that when hashed twice with SHA-256 will result in a number that begins with X number of zeros.
- The X number of leading zeros sets the difficulty of the problem. The required computational power to solve the problem increases exponentially as the number of leading zeros is set higher and decreases exponentially as the number of leading zeros is set lower.
- Bitcoin heartbeat. The X number of leading zeros is set by the network, in such a way that it will always take the entire network exactly 10 minutes to solve a problem. If there are more computers in the network, the problem will get harder, if there are less computers in the network the problem will get easier, but it will always take 10 minutes. Therefore the "heart" of the Bitcoin network beats 6 times per hour.
- Hacking the system. On average, a skilled hacker would need a computing power greater than the total computing power of the entire network to be able to solve a block before anyone else does. In capital terms, today it is estimated at USD 500 million for one block.
Economic truths and untruths - deflationary currency
How generous is the Bitcoin network in rewarding newly issued coins to its miners, and subsequently, to its total economy? Bitcoin is based on a predictable issuance rate of 50 Bitcoins for each solved block (that's every 10 minutes). Every four years that issuance rate gets reduced by half.
In 2012 the issuance rate went down to 25 Bitcoins for each solved block. In 2016 it will be further reduced to 12.5 Bitcoins and so on until 2140, when all 21 million Bitcoins are projected to be issued. Up until the time of this article around 12 million Bitcoins are in circulation and roughly 250,000 blocks have been solved. This growth model approximates the growth pattern at which commodities like gold are mined.
If you're concerned that the low number of issued Bitcoins would limit its usability, keep in mind its almost infinite divisibility. One Bitcoin is divisible down to 1/100 millionth of a Bitcoin. That equates to one Bitcoin being 100,000,000 Satoshis, the smallest fraction of a Bitcoin. At present, the number of Satoshis in circulation is 10-fold higher than that of US cents in circulation.
Bitcoin by definition is a deflationary currency. Assuming Bitcoin continues to do well, the demand will grow faster than its fixed rate supply. Each unit of its currency will then have to encompass a bigger portion of its economy, thus propagating further the persistent deliberate deflationary effect. Moreover, if Bitcoin, like other fiat currencies, would turn to have its M0, M1, M2, etc., then the value of Bitcoin would be much greater than the number in circulation.
We are taught to fear deflation more than inflation, believing it depresses economic growth. Does MV still equal PQ? Perhaps it is easier to perceive Bitcoin as gold or other type of commodity, with its scarcity and a worldwide free market determining its value. Differently than fiat currencies, Bitcoin is not tied to any country's GDP, government debt, debt-to-GDP, and the likes. It might even be better than gold, a sort of a virtual gold, as any Satoshi of it can be sent to the other side of the planet in a second, person to person, with no financial intermediaries.
By the time of this article, around 100 alternative digital crypto currencies (aka Altcoins) have emerged, all inspired by and technically identical to Bitcoin. All will be judged by their ability to achieve the aims they set out to accomplish. Unlike fiat currency exchange rate, which is influenced by a country's economic performance and political stability, crypto currencies compete directly against each other for market share based solely on their fitness function.
The road that lays ahead of Bitcoin
In a world of accelerated technological changes, it would be unwise to predict what tomorrow may bring. There are many factors that may come into play in the evolution of Bitcoin. If it will run into severe obstacles, it will rapidly be displaced by another crypto currency that will overcome the obstacles. In the contrary case, the network effect will carry Bitcoin to dominance. Whether or not it's Bitcoin, crypto currencies are here to stay as an intriguing concept and a groundbreaking technology.
Statutory and regulatory frameworks in some countries are stacking against Bitcoin, yet there is no evidence so far to think that Bitcoin could not coexist alongside other fiat monetary systems. In fact, they may address different market needs and even complement each other synergistically, like the coexistence of commodity money and fiat money.
Another factor that mustn't be disregarded is that Bitcoin is an early stage technology, where millions of dollars constantly exchange hands, making it a dream target for faceless international hackers, hostile intelligence services, or just about any group of hippie coders.
What history has taught us - the music industry
In 1999 Napster was among the first networks that facilitated file distribution across the Internet, namely MP3 music files. The technology was based on a central server and proprietary software and a legal structure of a registered corporation. Within the first six months of its operation, the Recording Industry Association of America filed a lawsuit against Napster over copyright infringement, leading to the their demise.
The next generation of file sharing was KaZaA. Unlike Napster, this time it was a decentralized peer-to-peer network. Nonetheless, the legal structure was still of a centralized registered corporation. A similar fate awaited them, as the Motion Picture Association of America filed a lawsuit for copyright infringement, leading to their shutdown.
Then Gnutella appeared. The initial protocol was developed by a small company acquired by AOL. It was erroneously released to the internet for just one day, before AOL discontinued its availability due to legal concerns. One day was all it took. In less than a week, the protocol had been reverse engineered and released for download as a free open source software under the Gnutella name.
At that point, there were no legal entities to sue, so the music industry started suing individuals. The action proved to be not very viable and casted a negative image on the music industry. The end result was that, the more governments and the music industry fought it, the more they cultivated its use.
Eventually, the music industry took a new approach to the situation. It started to commercialize file sharing technologies, charging reasonable amounts via services like Spotify and the new edition of Napster.
Shattering a myth or two
Criminal activity and money laundering. There have been claims that Bitcoin is a safe haven for criminals and terrorists to transfer money anonymously. As explained previously, every transaction in the Bitcoin network is permanently logged and available for all to see. As a result, it is considerably easy for law enforcement bodies to trace down any sort of allegedly illegal financial activity.
Bitcoin is a Ponzi scheme. Bitcoin is occasionally accused of being a Ponzi scheme, a scam where money from new investors is used to pay off early investors until it all goes bust. Bitcoin's protocol is open source available for anyone to investigate, a transparency that dispels this myth. However, there is one alarming aspect, if interest continues to grow steadily, those who invested very early in Bitcoin could become the world's first trillionaires. If, despite all, Bitcoin proves to be an ultra sophisticated fraud, it will be marked in history as the most spectacular scheme, without a shadow of a doubt.
Thoughts of liberty and freedom
With the ever greater flows of information across the globe and now a wiser world currency, political idealists might start dreaming openly about a different kind of sovereignty for the whole of humanity. Perhaps a withdrawal from the nation-state actuality towards a larger democratic order for all. While it is undeniably captivating to contemplate money independent of governments, corporations, and other corrupting influences, it is sadly not even foreseeable in the faraway future. Still, it's pretty good material for political romanticism.
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