Bitcoin & Cryptocurrencies Explained

The circulation of currency in the form of banknotes and coins has long been controlled by centralized governments. Bitcoin, a form of digital currency secured by cryptography, was created out of a need for a decentralized currency that is not controlled by any central entity. Bitcoin is instead governed by a combination of cryptography and the general Bitcoin community, which helps keep the cryptocurrency secure.

This article was written as an assignment for my university writing class, specifically with the intention of trying to explain bitcoin to the average engineering magazine reader.

Introduction

Bitcoin is a form of cryptocurrency, a form of digital currency that people can send and receive over the internet. Bitcoin is currently the most popular cryptocurrency at the time of this writing with 16 million bitcoins in circulation, which is the equivalent of $12 billion U.S. dollars [1]. However, unlike traditional currency, bitcoin does not have a physical form. Instead, they are usually stored digitally on computers or smartphones.

History

The idea of having a digital currency did not begin with Bitcoin. Since the creation of the internet, many have tried to use cryptography to create a digital currency. The earliest cryptocurrency, ecash, was conceived by David Chaum in 1983 but fell out of favor due to the rise of credit cards in the 1990s and the lack of concern for privacy at the time [2].

Bitcoin was first announced by a person under the pseudonym Satoshi Nakamoto, in November 2008, in a paper titled “Bitcoin: A peer-to-peer electronic cash system” [3]. It is currently unknown whether or not Nakamoto exists, or if he is actually a group of people.

Advantages of Bitcoin

Bitcoin popularity and usage have been steadily growing in the past few years. This is because bitcoin, and other cryptocurrencies, have a few distinct advantages to traditional fiat currency. Let’s imagine that you have a distant uncle Bob, located in France. In order to send Bob $1,000 in the traditional way, you would likely have to start a wire transfer, which would certainly take a few days and cost around $10 in fees, depending on the bank you have, the bank Bob has, and each middle bank the money has to go through. That’s a lot of time and a lot of unnecessary middlemen. However, if you were to send the same amount of money to Bob using bitcoin, it would likely to cost you only a few pennies [4]. Not only that, Bitcoin transactions are also very fast, and the transaction will be completed in no longer than an hour. Bitcoin is very much globally accessible, as long as one has a connection to the internet.

Besides transactions, bitcoin has a number of other advantages over traditional currency. First, it is decentralized, which means it is not owned or regulated by any central government. In this way, bitcoin is often compared to the gold standard, since gold also is not dependent on any one government. Another advantage is that bitcoin has low inflation rates because the rate at which bitcoin is released has been predetermined. Every four years, the bitcoin production rate is halved, such that there will only ever be 21 million bitcoins in existence [4]. This may seem like a problem, but bitcoin also has high granularity, in that it can be separated into 1/100,000,00th of a bitcoin. In comparison, the dollar only goes up to 1/100, or one penny. Lastly, bitcoin itself is highly anonymous, since it does not keep track of names or any way that can link ownership of bitcoins to an actual person.

Obtaining Bitcoin

Bitcoin can be obtained in a number of ways. First and most commonly, it can be bought from an online exchange. These exchanges allow you to purchase bitcoin with a credit card or bank account, similar to how you would exchange US dollars for a foreign currency [4]. Another way is to sell goods or service online and ask for payment in bitcoin. Third, you could purchase bitcoin from another person by agreeing to meet up in person and paying them in cash. Lastly, you could engage in the bitcoin mining community, the community which secures the bitcoin network and receives bitcoins as a reward.

Storing Bitcoin

Bitcoins are stored in bitcoin addresses, a list of 25–35 alphanumeric characters, which functions like a credit card number. The bitcoin network keeps track of how many bitcoins are in each account in a public ledger. Figure 1 illustrates a very simple example of the ledger.

Figure 1: Simplified Bitcoin Ledger (Name column included for explanation only)

Information in Figure 1 is publicly available throughout the network, though with a considerably greater number of accounts. Note that the first column of names does not actually exist in the ledger, but exists to make the explanation easier. Thus, even though Alice can see the information above, unless she knows Bob’s specific bitcoin address, she cannot know how many bitcoins Bob has.

A person can have any number of accounts, which can be generated for free [5]. Figure 2 shows an (empty) bitcoin address that was generated from a free online service.

Figure 2: Address generated from bitaddress.org

When a bitcoin address (left) is generated, it comes with a corresponding private key (right), which is analogous to the password to your account. When you want to send bitcoin from your bitcoin address, you need the corresponding private key to prove you own these bitcoins [3]. Thus, it is important to keep the private key secret because otherwise, someone else could spend your bitcoins. There are a number of ways to store your bitcoin accounts, including on an online exchange, on computers/smartphones, or even on a piece of paper.

There are exactly 2160 addresses that are valid for bitcoin, which equates to approximately 1 followed by 48 zeroes, a number roughly equivalent to the number of atoms on earth. This makes it so that the software can generate addresses even when offline because the chance of generating an address already in use is astronomically small.

Sending a transaction

Looking at the previous example of Figure 1, Alice and Bob own some number of bitcoins in their bitcoin addresses. If Alice wanted to send 5 bitcoins to Bob, Bob would need to give Alice his public bitcoin address (1F3r5bf…) and Alice would start the transaction. She broadcasts to the network that she is the owner of her account using her private key and wants to send 5 bitcoins to Bob’s address. Figure 3 shows the balances after the transaction is approved, which takes about 10 minutes. As you can see, the process of sending bitcoin is very simple. The next section will explain mining, which is the process of how these transactions are approved.

Figure 3: Example Bitcoin Ledger, after transaction

Blocks and Mining

Before I can explain mining, a process in which new bitcoins are created, we have to talk about blocks. Blocks are a group of pending transactions that must be approved before someone can actually receive bitcoin, and each block contains about 1MB of data [4]. A continuous chain of blocks is called the blockchain, and the blockchain contains every single bitcoin transaction that has happened since bitcoin’s creation. Most of the genius behind bitcoin’s infrastructure, including why it is secure and decentralized, is because of this blockchain technology. Figure 4 shows an illustration of a sample blockchain, with the Alice->Bob transaction in Block 54.

Figure 4: Simple Bitcoin Blockchain [7]

To approve a transaction, it must be grouped into a block and the block must then be approved. So how are blocks approved? This is where miners come in, members of the bitcoin community that dedicate computer power to solving a time-consuming cryptographic problem encoded in each block [3]. These unique problems take into account the transactions of each block and information about the previous block on the blockchain such that each problem is different. In addition, the problem is intricately designed such even a really powerful computer will not a significant amount of time to find a solution.

Once someone solves a block, the solution is publicly announced to the rest of the network and added to the blockchain [6]. The miner who solved the block is rewarded with bitcoins for verifying the integrity of bitcoin transactions. So why does the blockchain go through all this trouble? Basically, by making the problem very time consuming, it makes it nearly impossible to change previous blocks on the blockchain [6]. Since each block’s solution depends on the previous block, attempting to alter one block would invalidate every block after that. In order for a hacker to change the blockchain, they would need to resolve every block after the altered block, while competing against the rest of the network.

To make an analogy on the difficulty of the block problem, it is similar to winning the lottery. Even if you buy a hundred tickets (the equivalent of a hundred computers), you would be competing against the entire mining network. With over a hundred thousand other computers attempting the same problem, the likelihood of you mining the block by yourself is extremely low. Since about 144 blocks are approved a day, a hacker would need to do the equivalent of hitting the jackpot 144 times over the course of 10 minutes, just to modify a block approved yesterday. This process becomes exponentially harder the further back in the blockchain you go.

Concerns

Bitcoin grants anonymity and independence from centralized governments and banks, but these qualities raise concerns regarding the black market and other forms of illegal trade [8]. Money laundering by cycling through transactions across multiple exchanges can make stolen bitcoins and bitcoins spent on illegal purposes very hard to track [9]. Another flaw in bitcoins and most cryptocurrencies is that reversing transactions is extremely difficult. Once a transaction is approved, it is almost impossible to undo, unless the receiver willingly sends the bitcoins back.

There have been numerous occasions where online Bitcoin exchanges have been hacked and had bitcoins stolen. There have been two major heists in which $460 million was stolen from Mt. Gox, the world’s largest bitcoin exchange at the time, in February 2013 [10] and $65 million was stolen recently from Bitfinex in August 2016 [11]. However, this was not a flaw of the bitcoin system, but of companies that allows buying/selling of bitcoin. Because bitcoin is meant to be decentralized, there is no one, not even Satoshi Nakamoto, that can individually revert Bitcoin theft. In addition, the stolen bitcoins were laundered such that the perpetrators have not been caught, and is unlikely for them to be caught either.

Other Cryptocurrencies

Because Satoshi Nakamoto released Bitcoin with an open source license, other developers are free to build upon and modify the original Bitcoin codebase to create other forms of cryptocurrency. Attributes that the developers can change include the hash rate, total coin limit, block size, algorithm, and reward size [4].

There are also other currencies that are not cloned from Bitcoin’s original source code, such as Dash (Digital Cash) that allows for complete anonymity in transactions [12]. Ether is another form of cryptocurrency that is gaining popularity [13]. However, unlike bitcoin, ether is not meant to be a globalized currency, but specifically a currency for the Ethereum platform. The decentralized platform will host a number of applications that will require the use of ether as payment.

The future of Bitcoin might not even be limited to currency. The concept of the blockchain can be applied to more than just money. Having a publicly managed ledger can solve disputes with property ownerships, patents, and other kinds of information that needs to be kept track of, eliminating the need for a trusted third party.

Conclusion

Although cryptocurrencies are not yet widely adopted, they are rapidly gaining in popularity. Like the value of gold, the value of bitcoin is not reliant on any one country’s economy. Decentralization and privacy are concepts that are becoming increasingly important to people living in the digital age. And since the validity of transactions is managed by the entire network, bitcoin transactions are much more secure than anything that is managed by a smaller organization, including banks. Many stores and businesses are starting to accept bitcoin payments, and this number will only continue to grow. It would not be surprising to see bitcoin payments, or at least the blockchain technology, popularized in the next few decades.

References

[1] “Bitcoins in circulation”, Blockchain.info, 2016. [Online]. Available: https://blockchain.info/charts/total-bitcoins. [Accessed: 03- Dec- 2016].

[2] D. Chaum, Blind Signatures for Untraceable Payments, 1st ed. 2016.

[3] S. Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System”, Bitcoin.org, 2008.

[4] Bitcoin Project, “How does Bitcoin work? — Bitcoin”, Bitcoin.org, 2016. [Online]. Available: https://bitcoin.org/en/how-it-works. [Accessed: 28- Aug- 2016].

[5] Bitcoin Address Generator, Available: http://www.bitaddress.org. [Accessed: 28- Aug- 2016]

[6] R. Grinberg, “Bitcoin: An Innovative Alternative Digital Currency”, Hastings Science & Technology Law Journal, vol. 1, 2016.

[7] Y. Brikman, Bitcoin Block Chain Verified. 2016.

[8] F. Reid and M. Harrigan, An Analysis of Anonymity in the Bitcoin System. New York: Springer, 2016, pp. 197–223.

[9] A. Ogunbadewa, “The Bitcoin Virtual Currency: A Safe Haven for Money Launderers?”, SSRN Electronic Journal.

[10] R. McMillan, “The Inside Story of Mt. Gox, Bitcoin’s $460 Million Disaster”, Wired, 2016. [Online]. Available: http://www.wired.com/2014/03/bitcoin-exchange/. [Accessed: 31- Aug- 2016].

[11] J. Horwitz, “The $65 million Bitfinex hack shows that it is impossible to tell a good bitcoin company from a bad one”, Quartz, 2016. [Online]. Available: http://qz.com/753958/the-65-million-bitfinex-hack-shows-that-it-is-impossible-to-tell-a-good-bitcoin-company-from-a-bad-one/. [Accessed: 31- Aug- 2016].

[12] E. Duffield and D. Diaz, Dash: A Privacy­Centric Crypto­Currency, 1st ed. 2016.

[13] T. Piotrowski, “White Paper”, GitHub, 2016. [Online]. Available: https://github.com/ethereum/wiki/wiki/White-Paper. [Accessed: 06- Sep- 2016].

Related Media and Further Reading

[1] S. Molyneux, Bitcoin vs. Political Power: The Cryptocurrency Revolution. 2016.

[2] D. Morris, “At the Speed of Money: How Cryptocurrency Will Transform Everything”, TEDxTampaBay, 2016.

[3] Khosla Ventures, Bitcoin 101 | Balaji Srinivasan. 2016.

[4] “Everything you need to know about Bitcoin mining”, Bitcoinmining.com, 2016. [Online]. Available: https://www.bitcoinmining.com/. [Accessed: 03- Dec- 2016].

[5] “Choose your wallet — Bitcoin”, Bitcoin.org, 2016. [Online]. Available: https://bitcoin.org/en/choose-your-wallet. [Accessed: 03- Dec- 2016].

[6] “The Best Bitcoin Exchange of 2016 | Top Ten Reviews”, TopTenReviews, 2016. [Online]. Available: http://www.toptenreviews.com/money/investing/best-bitcoin-exchanges/. [Accessed: 03- Dec- 2016].

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