Bitcoin: The Monetary Mayhem
“No one can see a bubble. That’s what makes it a bubble.”
— The Big Short
You must be familiar with the above quote if you’ve watched the Christian Bale movie The Big Short. Does that mean Bitcoin is a bubble waiting to burst? I think it has already.
Bitcoin is a decentralized, digital cryptocurrency. Confused? Let’s take an example. Let’s say that you are ordering headphones from Amazon via a seller and you want to know exactly where they’ve been before they were shipped to you. How do you find out? The answer is, you cannot, at least not all the information. You can’t know the exact source of the product and you definitely cannot find out all the transactions related to those specific headphones.
Imagine if there was some sort of a digital ledger that could tell you all that and more? There is. A blockchain is a ledger or database. It is distributed across and maintained by a large number of nodes (computers) in contrast to it being held by a single authority or party. The goal of the technology behind cryptocurrencies such as Bitcoin is to make it possible to reach an agreement (consensus) on the validity of the data in the database and that of data to be added to the database. Data, in this case, refers mainly to online transaction data that determines the ownership of digital assets such as cryptocurrencies or tokens.
The entire distributed ledger is kept up to date and verified, and all participants in the network agree on its validity. Without immediately diving into the technical workings, blockchain protocols such as the one underlying Bitcoin, allow this agreement and validation to be achieved without the need for a third-party intermediary, such as a bank.
In the past, such a party was necessary in order to verify ownership of money (i.e., can this person spend this money). The party also made sure that an online payment was only spent once. (i.e., that particular money is not used in another transaction). The latter issue is what is referred to as the double-spend problem.
This has always been a major issue for transacting digital assets. It is possible to duplicate the code that makes up the asset and use it in multiple transactions.
The name “blockchain” comes from the way the data is stored. Data are collected in blocks that are added to a chain of previously validated blocks.
At the time of writing the Bitcoin whitepaper(the initial ideation), financial institutions were necessary to verify ownership and eliminate the double-spend problem. This, together with the need for transactions to be reversible (financial institutions have to deal with mediation disputes), increases the costs associated with a transaction. This means that there is a minimum transaction size necessary for these financial institutions to execute on it. Their fee needs to cover the transaction costs at least otherwise it does not make any sense. If it has not been clear before: banks really enjoy making money.
“… limiting the minimum practical transaction size and cutting off the possibility for small casual transactions.”
This eliminates the option for a vast amount of transaction opportunities that theoretically exist but are practically not feasible. An amazing application that is not possible due to this minimum transaction size is the micro-consumption of online content, whether these are web articles, videos, music, and so forth. Instead of having to pay a monthly subscription, which may or may not be worth it depending on the usage by the consumer, micro-transactions would allow for a user to make incredibly small automated payments as the content is being consumed.
What Bitcoin aims to accomplish is to, in some way, replicate the simplicity of an in-person transaction in an online environment.
1 Bitcoin costs $57,865.85 at the time of writing this article. Crazy, right? Bitcoin was worth $1 in April 2011 and now, 10 years down the line, it’s worth more than 50,000 times its original value. But, why is the price of Bitcoin so high? Bitcoin’s growing demand and the awareness amongst the public about cryptocurrencies is causing the price of Bitcoin to rise.
People are even purchasing 5% of 1 Bitcoin so that they can sell it off and earn a profit when the price rises again. Various Bitcoin exchanges like Coinome, Zebpay, Unocoin and several others in India are currently allowing the public to purchase and sell Bitcoin also known as BTC.
Warren Buffett, one of the world’s wealthiest individuals and a person who is widely regarded as one of the best investors of his time had this to say about Bitcoin: “It’s a mirage.”
In the world of Bitcoin, those that own Bitcoins have what is called a “wallet”. This functions somewhat similar to a classic wallet in that it “holds” your Bitcoin. Associated with the wallet is a public key. This is an address that can be used to send Bitcoin to, just like somebody has an email address or a bank account number.
Also, there is another (VERY important) key that is associated with a wallet that is called a private key, which sort of functions as its password. Signing with this private key is the only way somebody can prove their ownership of the wallet, and it is what enables them to send the Bitcoins in that wallet. You lose this key (and depending on the type of wallet, your seed words), you lose your BTC.
Note that the order actually goes as follows:
1.When a wallet is set up, that wallet generates a random private key.
2. From that private key (using an Elliptic Curve Digital Signature Algorithm) a public key is generated (note that it is not possible to convert this back to its private key; it’s a one-way algorithm).
3.From that public key a wallet address is generated.
Owning Bitcoins does not mean you actually have coins sitting in your wallet. A Bitcoin is not a piece of code you own or that is stored somewhere. The value of the BTC associated with a wallet (let’s call it ABC123) is based on how many transactions on the blockchain say “Address ELONGATE890… sends x amount of BTC to address ABC123” as well as how many say “Address ABC123… sends x amount of BTC to address ELONGATE453”.
In other words, the Bitcoin blockchain stores an incredible amount of data that specify who sent how much to what address. This data (who sends, what amount, who receives) is stored in individual transactions. The ownership of Bitcoin is calculated by looking at all the transactions coming into an address and those that go out.
Now, if address ABC123 wants to spend the BTC that has been received from another address, it has to prove it is allowed to do so by signing the transaction with its private key (that conditional data — you can only use it if signed with the correct private key — can be found in the previous transaction that is called upon). A new transaction is generated, the BTC is sent, and we start again.
The idea here is to collect the transactions that have been publicly broadcast into blocks, timestamp them (adding a time value ), adding some more relevant data and then running it through a SHA256 hashing algorithm.
What this basically does is it converts the block and its data into a string of characters that can be used to uniquely identify that block (only that combination of data will get you that hash value). Each new block (before being added and run through a SHA256) can now refer back to the hash of the previous block in the chain, creating a chain of blocks in chronological order. This way, everybody can see which blocks (and its transactions) have taken place in the past and what order.
“To implement a distributed timestamp server on a peer-to-peer basis, we will need to use a proof-of-work system…”
What is needed is a system that demands some work to be done before being able to add or suggest a new block to the blockchain. Just like the infamous CAPTCHA on the web, the goal is to create a barrier where it becomes harder (and infeasible) to spam the system (or in Bitcoins case, suggest false data). Bitcoin does this as follows.
I mentioned above that transactions are broadcast to the entire network. At this point, they are not yet added to the chain. Miners (those that are going to perform the “work” to add the block to the chain) are going to perform the previously mentioned hashing. They collect these transactions and put them in a block (as Merkle Root) together with the aforementioned timestamp, previous block hash, and some other relevant data like block height (what block # in the chain), and more.
Having collected all this data in a block, they run it through the SHA256 hashing algorithm. Again, what this basically does is that it converts all that data into a string of characters that uniquely identifies that block and its data. Change a tiny thing in the block’s data and the entire hash changes (there is no known pattern for this but it is not random; change it back and you will get exactly the same hash).
Why would miners go through all that effort and pay a lot of money to obtain the computational power to mine?
Once the block is agreed upon, an extra transaction is added to the beginning of the block (often referred to as the ‘coin base transaction’) which allocates newly created BTC to the winning miner’s wallet address, rewarding them for the work put in and providing a way to distribute coins into circulation. On top of that, each transaction in the block has a small — at least that was the goal — transaction fee associated with it which also goes to the winning miner.
The idea here is to keep the public key anonymous. As long as people cannot associate a public key with a particular person, there is no way to reveal its identity.
How do miners get that hash? They need to add a number to the block’s data which is called a ‘nonce’ (they add it just like I added the “1”). Nobody knows what number is needed to find the correct hash. The only way to find it is through trial-and-error: guessing.
“… we implement the proof-of-work by incrementing a nonce in the block until a value is found that gives the block’s hash the required zero bits.”
This process, guessing the right nonce, is what is referred to as ‘mining’. The miners with the largest CPU resources (most computational power) have the highest chance of being the first to find that correct nonce.
As long as more than 51% of the CPU power is in the hands of honest nodes, it will be impossible for a malicious miner to consistently win the mining process and add false data to the chain. The longest chain is always the chain that is taken as the truthful chain.
“… the proof of work difficulty is determined by a moving average targeting an average number of blocks per hour. If they’re generated to fast, the difficulty increases.”
This process of adding a new block to the blockchain happens every 10 minutes or so. This is kept stable by the protocol adjusting the mining difficulty— also called “difficulty bomb” — accordingly as computational power grows over time.
So, this is a brief description of how a bitcoin transaction works according to the whitepaper published by Satoshi Nakamoto in 2008 and has hence become one of the most reliable and credible technology to date. This is just the beginning of a new world of microtransactions and the elimination of third-party intermediaries.
To know more about Blockchain, check out this article:
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