Bitcoin for Dummies

It goes without saying that on a site of a project about Bitcoin an article describing what it is cannot be missing. After all, this is one of our goals: helping people, who have no idea what Bitcoin is, understand the phenomenon, starting from the basis. And if you, my reader, are well knowledgeable about the subject, I hope you’ll bear with me and enjoy a brief refresh of basic concepts. As the title says, this article is about Bitcoin for dummies. I mean no offense whatsoever with it. The point is that Bitcoin is an extremely complex phenomenon, starting especially from its mechanics. Behind them, there is this brilliant algorithm, and giving a detailed explanation of it would require a high level of competence in mathematics, cryptography and informatics, which not everyone possesses. I, myself, am an economist, so I am not exactly the most suited person to lead you through its more insidious technicalities. Fortunately, this doesn’t mean that we can’t understand the Bitcoin protocol at all. On the contrary, keeping things fairly simple and intuitive, we will be able to provide ourselves with the understanding, necessary to be able to form our own and, most importantly, aware and autonomous opinion on the subject. Before I further proceed with my explanation, I’d like to clarify some notation: when I write Bitcoin, with a capital “b” I mean the project, the protocol, the whole phenomenon; when I write bitcoin with a small “b”, I am referring to the coins in particular.

First of all, Bitcoin is a virtual currency, it doesn’t exist physically: every coin is a string of numbers generated inside a computer. More specifically, as you may have heard, Bitcoin is a cryptocurrency. This means that all its mechanism heavily relies on cryptography to work properly. The Bitcoin protocol was created by Satoshi Nakamoto. Nobody knows who he is, this at least untill few days ago, when some reporters claimed to have found him in Temple City, California: a certain Dorian Satoshi Nakamoto, a 64 year-old physicist. It still has to be proved, thogh. In fact, the most accredited opinion is  that the name is just a pseudonym (not his real one) to hide the true identity of Bitcoin’s father, probably more than one, given the tremendous complexity of the Bitcoin algorithm. After publishing an introductory paper on Bitcoin in 2008 - Bitcoin: A Peer-to-Peer Electronic Cash System - and launching the protocol online in 2009, Nakamoto completely vanished into thin air. His mysterious figure and possible identity are still object of fervid discussions.

Nakamoto’s paper is indeed an excellent starting point to define Bitcoin. In the paper, the author presents it as “A purely peer-to-peer version of electronic cash, [which] would allow online payments to be sent directly from one party to another without going through a financial institution”. In Nakamoto’s intention, Bitcoin represents an alternative “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”. Nakamoto, moreover, published his protocol on the Cryptography Mailing List, on the site metzdowd.com, thus showing a connection with the cypherpunk[1] ideology. Being a peer-to-peer network, the Bitcoin system is decentralized, with no central bank or authorities controlling it. In fact, in a peer-to-peer network, all the nodes are equivalent in hierarchy, working both as server and client among each other. Any time a Bitcoin software is installed on a computer, a new node is added to the system, and in just 5 years the Bitcoin network has rapidly expanded, making Bitcoin become a revolutionary phenomenon. One of its main features is anonymity of transactions. As I will better explain later, using bitcoins can allow the transaction parties to remain anonymous, making traceability extremely difficult. And this aspect, together with many others, is source of several concerns. With the general concepts covered, we can move on how this system works in further details.

As I have just explained, in order to become a node of the Bitcoin network, a hypothetical user has to install the Bitcoin software on her computer[2]. This software is basically a bitcoin wallet, which assigns to its user an identity in the Bitcoin system and two digital keys, one public and one private, necessary to perform transactions. The digital identity is in no way linked to the user’s real identity. It’s a numeric pseudonym, which hide the real identity behind it. The two keys, always numeric, can be viewed as “passwords”, and they are used to digitally sign every bitcoin transactions. A digital signature is the virtual equivalent of a physical signature: it links a document or a message to the identity of the one who signs it. Instead of using a pen, the digital signature process relies onto mathematics and cryptography. There are three ways to procure bitcoins:

  1. Buying bitcoins versus real currency on a bitcoin exchange;
  2. Accepting bitcoins as payment for a service;
  3. Mining (I am going to explain later on what this is)

Let us focus on transactions now. Suppose user A wants to send 10 bitcoins to user B. She opens her bitcoin wallet, and write her transaction including all the relevant information: her identity (the Bitcoin network one, not the real one), the number of bitcoin involved in the transaction[3], the eventual transaction fee, and the recipient’s Bitcoin identity. Before sending out this transaction to the network, she signs it with her private key, thus obtaining a fixed length string of numbers, which is now encrypted. When this transaction reaches its destination, B uses A’s public key to verify that this specific transaction actually came from A, and, being that the case, she accepts it. The transaction is public, it means that every node inside the Bitcoin peer-to-peer network can see it. This publicity is exactly what allows the system to prevent a very common problem with online payments, known as double spending. Double spending happens when the user sending the payment in bitcoins, uses those exact same bitcoins in another transaction. In a system with such a high degree of anonymity, as the Bitcoin one, it would appear extremely easy doing so. This, on the contrary, cannot happen. The reason lies in the proof of work protocol, which regulates the entire system. A proof of work protocol is a mechanism, which allows proving the amount of effort a certain user has put into a specific task. Usually, it consists into a complex mathematical puzzle that the user has to solve, spending a considerable amount of time and computational power. The Bitcoin system works in this way. Among the nodes, there are some that are called miners. These nodes have the important task to collect all the transactions occurred within a certain time interval and, by solving the proof-of-work challenge, validate them. So, going back to the previous example, A sends 10 bitcoins to B, how can B trust those bitcoins not to have been spent yet? This is where the miners come in. We can view a transaction as an entry in a public ledger. Once A broadcasts her transaction, also miners sees it, together with all the other transactions broadcasted in the same period. So each miner tries to collect these transactions into a block and attach it to the so called transaction block chain. This chain is made by all the transactions occurred, since the beginning of the Bitcoin protocol. If a block is added to the chain, the transactions inside it are approved and acknowledged by the entire Bitcoin network, and in the event of a fork, only the chain with the greatest amount of effort is considered. In more concrete terms, if the payment received by B is attached to the public chain, B has the guarantee that the received bitcoins are authentic and not already spent. Miners can attach a new block, solving the proof of work challenge. The one who succeeds is rewarded with all the transaction fees, belonging to that specific block, and with newly coined bitcoins. Basically, bitcoin mining is what manages the bitcoin supply. The protocol sets the difficulty of the challenge so that, on average, it takes 10 minutes to add a new block to the chain. This difficulty is constantly[4] calibrated to the network dimension and computational power. After barely 5 years, today the proof of work complexity is such that mining is only possible through specific hardware. From 2013, we can talk about ASIC mining hardware. An application-specific integrated circuit (ASIC) is a microchip designed for a specific purpose. As of today, given the power these technologies consume, compared to other mining technologies, ASIC hardware is the fastest and most efficient way to mine. The amount of emitted bitcoins is fixed, and it halves every 4 years. It began from 50 bitcoins every new block and now miners get 25 bitcoins. This decreasing fixed rate of supply, together with the calibration of the proof of work complexity, is designed so that in the year 2140, the number of bitcoins in circulation will reach 21 million. After that, no more bitcoins will be coined, and miners will be paid only by transaction fees (by that year, the Bitcoin network is expected to have reached a considerable size, and transaction fees won’t be optional anymore, therefore their amount will be relevant and adequate to reward miners). The implications of this fixed supply, as well as the incentive compatibility of the mining system, won’t be discussed in this specific article, but they will be the object of future ones: they deserve a much more detailed analysis.

The above-described mechanism is the core of the decentralization of the Bitcoin system, and probably, it is its most interesting and innovative feature. Bitcoin price[5] (meaning its exchange rate against real currencies) is showing impressive growth rates, attracting more and more investors and enthusiasts. Obviously, scepticism and concerns cannot be avoided. What I want to highlight, instead, is that Bitcoin wasn’t born with the intention of substituting real currency. Even if this were the case, now it’s still too early to talk about that, there are far too many unknowns that still need an answer. To mention just one: taxation. How do we tax bitcoins? The authorities have no idea. However, this doesn’t mean that we have to panic. We should keep our heads cool, study the phenomenon and try to exploit its huge potentials. We are always complaining that our society and our economy need to change, that we need to find new solutions for our problems and offer alternatives. Bitcoin and cryptocurrencies are an alternative. In my personal opinion, or better, in Discover Bitcoin team’s opinion, they are the concrete proof that something is changing. Whether for the better or the worse, it is up to us to determine that. The possibilities are infinite. Discover Bitcoin wants to be a protagonist in this change. And we hope you will give us a chance. Let’s explore together these unknowns.

I hope this article has given you a clear idea of the Bitcoin system on its most intuitive level. In the following articles we are going to dwell much deeper into the Bitcoin universe.  Stay tuned! I just want to conclude with this quote by Appius Claudius Caecus:

“Quisque faber suae fortunae”

Every man is the architect of his own fortune.

 


[1] The cypherpunk movement was born in the late 1980s. Its members are activist that strongly support the use of cryptography, especially on the Internet, as a route to social and political change.

[2] Now there are also phone apps that let you do that. A computer is not necessary anymore, In general, an electronic device should do. For our purposes, however, we shall consider computers as our reference device.

[3] A further clarification needs to be done at this point. In a transaction its the entirety of the bitcoin possessed by the sender that its involved. What I mean is that, assuming user A has a total of 30 bitcoins in her wallet, in the transaction in the example she will specify:

  • 10 bitcoins to B
  • 19 bitcoins to A (herself)
  • 1 bitcoin of transaction fee (optional)

[4] The calibration occurs every 2016. The protocol checks whether the average time needed to mine these new 2016 blocks is more or less than two weeks (two weeks being the average time necessary to mine 2016, with an average of 10 minutes for every block). If it took significantly more than two weeks, the difficulty is reduced; otherwise, if it took significantly less, it is increased.

[5] The following statement can apply also to other cryptocurrencies, like dogecoins or litecoins.

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