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Understanding Bitcoin

Understanding Bitcoin

– What is Bitcoin?
– It’s a digital currency.
– Yeah, I get that, but who is behind Bitcoin?
– Nobody.
– What do you mean by nobody? Somebody must be controlling it!
– Nobody is controlling it, it is an algorithm.
– What? You mean like Terminator? So you say the world is going to be taken over by
machines?
– Well, not the world, but maybe some businesses.
– Right… (rolling her eyes) But who controls the algorithm? Some mad scientist?
– It’s an open source project.
– An open what?
– Yes, free code. You can download it from the internet and do with it whatever you
want.
– So you don’t have to pay for the “program”?
– Well, it’s free as in freedom, not free as in beer.
– What does beer have to do with it?
– The code is not only free in the sense that you can use the program free of charge. It is
also free in the sense that you can take the code, modify it, and release a program of
your own with it.
– Wait a second! If I can do that then I can make my own bitcoins. What value does a
bitcoin have then?
– No, you cannot mint your own bitcoins. What you can do is invent your own currency.
And then you have to somehow make it gain acceptance…
– Oh, but this surely is the end of Bitcoin. If you can make as many currencies as you
want, none of them would have any value.
– Currencies have value because of social convention. Bitcoin has value because people
are willing to give value to it.
– I don’t think you are right. Euros or dollars have value, everybody knows that.
– Well if bitcoins do not have value I will gladly accept your bitcoins (smiling).
– Bitcoins are not backed by anything so they cannot have value.
– Neither euros, dollars nor Bitcoin are backed by anything. You can say that all of
them are the result of consensual hallucination. They have value because people give
value to them. There is not much difference between them in this regard.
– I don’t think so. You can buy things with euros or dollars, but what can you buy with
bitcoins?
– You can buy almost anything with bitcoins. There are companies that will gladly ac- cept your bitcoins in return for regular currency that you can use to buy anything. Converting bitcoins to sovereign currencies is just a technical interface and many companies provide this service. Besides, you can do things with bitcoins that you can- not do with sovereign currencies.
– Likewhat?
– For example, you could launch a crowd-funding campaign, just creating a special type
of Bitcoin transaction.
– That sounds cool.
– There are many more applications that were impossible until now, such as a car which
reads its ownership from the cloud. If you want to buy the car, you just pay the owner with bitcoins and the car knows automatically you are its new owner because it can look it up in Bitcoin’s database. And there might be more applications to come that nobody has thought of yet, as was the case (and still is) with the internet.
– I guess I did not think of it that way.
– As they say, a currency is just the first application. The technology allows transfer-
ring value securely and in a decentralized way and this can lead to many new cool
applications.
– I’m intrigued, I’d like to learn more.
– Great! I believe I have the right book for you…

Opinions about Bitcoin are highly polarized between enthusiasts and skeptics. The au- thor believes that the point of view of the skeptics is easier to grasp for someone not familiar with Bitcoin’s technology. The objective of this book is to present the technology and arguments from both sides of the divide so that readers can form an informed opinion of their own.

What drives the passion of the enthusiasts is that Bitcoin is a technological break- through that creates many new and interesting applications. As is often the case with brand new technologies, many future applications of the technology might not be envisioned today. Who could have imagined the success of video streaming services or social networks in 1994? Enthusiasts feel the technology will yield many unforeseen applications for many years to come. The fact that most of these applications are intertwined with monetary economics makes it even more interesting.

The economic and technical aspects of Bitcoin are so intertwined that, in the opinion of this author, they should be tackled together. Arguing about one of them without understanding the other would be like trying to run a car with only one pedal: just pressing the gas or the brake pedal.

Sure, the driver could descend a mountain with only the brake pedal, but then she could not go much further. Similarly a driver with only the gas pedal could probably ascend a mountain, but she would be better off not trying to descend it. This book covers the technology behind Bitcoin, ranging from cryptography to software engineering to monetary economics.

References to Bitcoin’s source code are scattered throughout the text, especially in the technical sections. These references are intended as clues for readers interested in the implementation of the Bitcoin protocol, but can be safely skipped by other readers.

This book is divided into three parts. The first part serves as an introduction to Bitcoin’s technology and philosophy (Chapters 1 and 2). This part will also cover the economic arguments both in favor of and against Bitcoin (Chapter 3) and some business applications (Chapter 4). This part is designed for the time-constrained readers who are mostly interested in the business and economic impact of Bitcoin’s technology.

The second part covers in detail how Bitcoin works, starting with public key cryptography (Chapter 5), transactions (Chapter 6) and the blockchain (Chapter 7). The last two chapters expand on related topics: wallets (Chapter 8) and mining (Chapter 9). In this line, two additional great resources for developers are the Developer Guide (Bitcoin Foundation, 2014a) and the Reference Guide (Bitcoin Foundation, 2014b) maintained by the Bitcoin Foundation, and the forthcoming book by Andreas Antonopoulos (Antonopoulos, 2014).

The third part completes the cryptocurrencies landscape. First, digital currency technologies preceding Bitcoin are discussed (Chapter 10). Then alternative cryptocurrencies based on Bitcoin (alt-coins) are covered (Chapter 11) and new applications of crypto- currencies beyond payment systems are explored (Chapter 12).

Most of the action in the cryptocurrencies community is focused on these new applications and Chapter 12 will introduce several of the brand new projects that are being built. Bitcoin is not anonymous, and Chapter 13 explores techniques that can be used to de-anonymize users, as well as technologies that are being built to enable users to counter these techniques and enhance their privacy.

The chapter concludes with an introduction to the technology, based on zero-knowledge proofs, to create fully anonymous decentralized digital currencies. The book concludes (Chapter 14) with a discussion of some additional technical topics and the latest developments being discussed in the community.

 

Part One – Introduction and Economics

CHAPTER 1 Foundations

There has been ample media coverage of Bitcoin, and many public figures have been compelled to state their opinion. As Bitcoin is a complex topic, covering cryptography, software engineering and economics, it is difficult to grasp its essence and implications with only a superficial look at it.

Thus some commentators might not have a clear picture of how it works and the implications. It is the goal of this book to equip the reader with the knowledge to evaluate the merits of this technology.

Figure 1.1 summarizes some misconceptions around Bitcoin.

Understanding Bitcoin Figure 1-1

Bitcoin is a decentralized digital currency. This means there is no person or institution behind it, either backing it or controlling it. Neither is it backed by physical goods, such as precious metals. This might seem counter-intuitive at first glance: how could it exist if no one controls it? Who created it then? How did the creator lose control over it?

The answer to this seeming paradox is that Bitcoin is just a computer program. How exactly this computer program works is the subject of the second part of this book. The program has a creator (or creators) but his identity is unknown as he released the Bitcoin software using what is believed to be a pseudonym: Satoshi Nakamoto. Bitcoin is not controlled in a tight sense by anyone. The creator did not lose control of it because he (she?, they?) never owned the code. The code is open source and thus it belongs to the public domain, as will be further explained in section 1.2.

One of the most innovative features of Bitcoin is that it is decentralized. There is no central server where Bitcoin is running. Bitcoin operates through a peer-to-peer network of connected computers. Bitcoin is the first digital currency built in a decentralized way, a technological breakthrough. The decentralized nature of Bitcoin will be further explored in section 1.1.

Bitcoin creates its own currency called bitcoin, with a small b. The creation of a currency is integral to how the system operates, as it serves two simultaneous purposes. First, it serves to represent value. Second, issuance of new bitcoins is used to reward operators in the network for securing the distributed ledger. These two functions cannot be unbundled without significantly changing the design.

The heart of the Bitcoin network is a database holding the transactions that have occurred in the past as well as the current holders of the funds. This database is sometimes called a ledger, because it holds the entries representing the owners of the funds. Bitcoin is not the first distributed database to be created.

However, the requirements of a financial database are different from those of other applications, such as file sharing or messaging systems. In particular, financial databases must be resilient against users trying to double-spend their funds, which Bitcoin solves elegantly. This is explored in the following sections and in Chapter 2.

Some critics have argued that Bitcoin is a Ponzi scheme. It is not. In a Ponzi scheme there is a central operator who pays returns to current investors from new capital inflows. First of all, in Bitcoin there is no central operator who can profit from the relocation of funds. Second, there is no mechanism to deflect funds from new investments to pay returns.

The only funds recognized in the Bitcoin protocol are bitcoins, the currency. Transfers of bitcoins are initiated by the users at their will: the protocol cannot deflect funds from one user to another. Third, a new investment in Bitcoin is always matched with a disinvestment.

Investors who put money into bitcoins usually operate through an exchange where they buy the bitcoins from another investor who is selling her investment. There is simply no new investment flowing into bitcoins: the amount of sovereign currency that has flown into bitcoins exactly matches the amount that has flown out of bitcoins.

However, bitcoin, the currency, can be a bubble. Whether the value of bitcoin crash- es, holds, or increases depends on whether bitcoins will be used in the future for different applications. There are several interesting applications for Bitcoin, of which the most straightforward (but not the only) are to serve as a medium of exchange and a store of value. It is too early to tell whether any of these applications will become important in the future. The merits of bitcoins as medium of exchange and store of value are explored in Chapter 3.

Finally, Bitcoin is not just a currency but a whole infrastructure that can be used to transfer value digitally: see section 1.4 and Chapter 12.

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