A co-founder and contributing editor of Tech.eu, Chief WOWness Officer at Press42.com, co-founder of Tetuan Valley, Global Shaper at World Economic Forum &, Sandbox ambassador ter Madrid
(Editor’s note: This is a four postbode series on Bitcoin, which will voorkant the virtual currency’s protocol and ecosystem spil well spil where Europe stands te terms of Bitcoin innovation, research and opportunities. This very first postbode sheds light on how Bitcoin works and its underlying technology.)
Many are telling Bitcoin is the fresh black. But how many people truly understand what the digital currency means for the future?
I’m tired of reading postbode after postbode on the economic ramifications of Bitcoin, on how this fresh virtual currency is unsafe for trading due to its volatile nature…
Fig. 1: Mt.Gox trading after the attack that made them bankrupt
How about the volatile nature of the current markets after the Crimea incident, which made the FTSE 100 slip by 1.4%, or when NASDAQ halted trading for three hours disrupting the $16 billion Facebook IPO?
Fig. Two: FTSE 100 trading when Russia invaded the Crimea peninsula
It seems very few people writing and covering Bitcoin indeed understand what cryptocurrencies are all about, the genius of its vormgeving and the potential for it to switch the digital landscape.
The problem with digital currencies
To indeed understand Bitcoin, wij have to go back to basics – how does currency work ter the physical world?
Imagine you go to a cafe and buy a coffee. The purchasing of a coffee implies a transaction where two goods have bot exchanged. Te particular, the vendor arms you a beverage and you, the customer, give a token te exchange, which represents an accorded value (be it coins or bills).
One property of physical currency that prevents – to some degree – fraudulent usage is its physical nature. When you pay with a coin or bill, the physical token gets transferred to a fresh pocket, the vendor’s, and there is a zuigeling of validation that you were the true proprietor of the token since it came out of your pocket. The token can also be verified for its authenticity with certain instruments.
Digital currency attempts to replicate the previous transaction but the main difference is that the token exists only ter digital form. For example, imagine wij scanned a five euro bill and named the digital photo ‘five-euros.jpg’. Being digital has many benefits, but also comes with drawbacks, namely, that files are lightly cloned and the copies are indistinguishable from the original.
This poses two big problems for its use spil currency:
Firstly, there can be infinite digital copies of ‘five-euros.jpg’, which means potentially having two (or more) customers possessing the same precies five euro bill pic opstopping and not being able to distinguish who the holder is.
Secondly, since the digital opstopping can be copied many times overheen, theoretically, it’s possible to clone the bill and spend it spil many times spil desired – this is referred to spil dual spending (step Two and Trio).
Fig. Trio: Problems with digital currency transactions
Cryptography to the rescue
Fortunately for us, modern laptop science has figured out a way to overeenkomst with some of the previously-mentioned issues through the use of cryptography. The ownership problem can be solved with the use of what’s known spil public-key cryptography.
It’s a way to protect a digital asset from prying eyes via a ingewikkeld mathematical process called ‘ciphering’, which scrambles the original digital content ter plain text so only the person with the right password, called a key, can unlock (or decipher) it.
One of the most common uses of public-key algorithms are digital signatures, which are the omschrijving of a real-life signature permitting anyone with the right key to sign digital assets and prove they are the rightful owners of it.
The catch about public-key cryptography is that there isn’t a single key but two – the private key and the public key.
The private key, spil its name implies, is kept private and used by the holder to sign any digital verkeersopstopping under their name. The public key, which is mathematically related to the private key, verifies that the digital opstopping wasgoed, indeed, signed with the private key. Additionally, this public key can and should be collective among anyone who wants to verify ownership claims.
Fig. Four: How digital signature algorithms can be used to verify ownership of a digital token
So what exactly is Bitcoin?
Bitcoin is a digital currency that effectively employs cryptography (spil seen above), which is why it’s called a cryptocurrency. Te truth tho’, with Bitcoins, there are neither physical or digital tokens being exchanged.
Instead, the only representation of the currency is an entry on a ledger, which records a monetary transaction. Ter it, Person A sends X amount of Bitcoins to Person B – this is similar to what a typical canap ledger contains.
Te the case of a handelsbank, both Person A and Person B would own a canap account and be identified through a numeric ID. The ownership is clearly stated via ID cards, signed contracts, etc. when you open the canap account.
But ter the case of Bitcoin, any person can generate a pair of public-private cryptographic keys that can be used to create the omschrijving of a canap account, dubbed a ‘Bitcoin address’. It’s essentially an acronym of the public-key and it uniquely identifies the possessor of an account.
Fig. Five: Generation of ECDSA public-key pairs to obtain Bitcoin addresses
At its core, a Bitcoin address is a numbered handelsbank account, but without a handelsbank and or any ties to the identity of the possessor.
Spil you’re most likely figuring out, the fact that anyone with a plain rekentuig (OpenPGP, GnuPG, ssh-keygen, OpenSSL, etc.) can generate a number of sets of keys to use spil Bitcoin addresses with total anonymity is one of the reasons why many banking organizations (te Russia, China and Europe) are banning the crytocurrency.
Delving into transactions
Spil previously mentioned, Bitcoin is not a tangible digital asset, rather, it’s a transaction that gets recorded on a ledger called Blockchain. This transaction basically holds the origin of funds (inputs) spil a Bitcoin address and the destination (outputs) spil another address.
Fig. 6: An example of a ordinary Bitcoin transaction
To ensure the ownership of funds, the entire transaction opstopping is digitally signed with a private key by the user sending the funds (the customer ter our case). Then, the signature along with public key are enclosed te the transaction. This permits anyone to validate the transferred Bitcoins are truly wielded by the sender.
Tho’ the origin of funds address is derived from the enclosed public key, te theory, no one knows the true identity of the possessor of that public key. The same goes for the destination, which is represented by another Bitcoin address, and doesn’t even have a public key to match with the possessor.
To keep it plain, wij’ve shown the point of view of the two parties involved te the transaction. If wij eyed this transaction from the outside, wij would only see random Bitcoin addresses and have no idea who possessed them.
Transactions, tho’, don’t exists on their own. Each transaction input is a pointer to a previous transaction. Te other words, the input used te a transaction wasgoed the output of a previous transaction. Blockchain stores this linked list of transactions so any Bitcoin can actually be traced to its origin.
Fig. 7: An cxample of two linked transactions
The Bitcoin transactions stored te the Blockchain can be very plain (above), or become very ingewikkeld with numerous input and output sources (below).
Fig. 8: A single input-multiple output Bitcoin transaction
Fig. 9: A numerous input-multiple output Bitcoin transaction
Why would wij want numerous inputs or outputs for a transaction? Because Bitcoin transactions don’t specify how much you transfer from the inputs, which means it will transfer all the Bitcoins associated with an address. It’s similar to attempting to pay a three-euro coffee with a 20 euro bill.
To prevent this from happening, it’s possible to add reserve output pointing to an address wielded by a customer where the ‘switch’ will be received (Fig. 8). Likewise, because there might not be enough Bitcoins ter a single address, it’s possible to add numerous inputs possessed by a customer to match the desired output (Fig. 9).
The original Bitcoin paper highlighted two major goals behind the vormgeving of the cryptocurrency: 1) To create a digital currency preventing the dual spending problem Two) To achieve the very first objective without a centralized third-party financial institution.
Ter previous attempts to build digital currencies, the ledger wasgoed always stored by a centralized third-party. Bitcoin circumvents this by deploying a peer-to-peer network of collective ledgers.
Every client ter the Bitcoin network wields a copy of Blockchain, which is public and accessible to anyone ter the network permitting unprecedented transparency to the currency.
Fig. Ten: A broad overview of the Bitcoin network
The Bitcoin network is made out of interconnected clients, called total clients or knots, that are te charge of validating any transactions received. Once validated, the clients broadcast the transaction to neighbouring until each one ter the network has a copy of it.
Instead of storing the transactions spil they are, Blockchain bundles them into what is dubbed a ‘Bitcoin block’. Once a block is created, it will be broadcasted to all the other knots so everyone can update their Blockchain. Each block is then linked to the previous block, creating a chain that can be traced to the very first block everzwijn created – the ‘genesis block’.
Fig. 11: Bitcoin Blockchain recreation since the ‘genesis block’
Users ter charge of creating thesis blocks are called ‘miners’ and the process, unsurprisingly, is called ‘mining a block’.
Te the early days, every client te the network wasgoed a miner. Presently, miners have dedicated clients that connect to the Bitcoin network with specific protocols. Once a transaction gets bundled into a block and is accepted by a large majority of the network, it is considered official.
Fig. 12: Bitcoin simplified block mining process
Once a knot receives a block from a miner, it will add it to its local Blockchain and broadcast it to the surplus of the network. Spil wij can see below, each block can contain any number of transactions.
Fig. 13: Bitcoin Blockchain live gegevens from Blockchain.informatie
So how does a miner select which transactions to bundle into a block? Mostly, it depends on how much money the parties are willing to pay the miner to process their transaction.
Te theory, every transaction is processed for free. However, Bitcoin permits its users to ‘peak’ the miners for validating their transaction.
Thesis tips are called transaction fees and taken when the sum of all the inputs of the transaction is fatter than the outputs. The difference inbetween inputs and outputs will be cashed by the miner that processes the transaction into a block.
Fig. 14: Example of transaction fees
By default, many of the Bitcoin software clients will automatically add transaction fees if certain criteria are met.
Of course, there’s still a trust punt with the Bitcoin network. If miners are the real validators of the transactions, then any single entity wielding enough miners could potentially subvert the Blockchain. With ownership of the network, old transactions could be manipulated and even open up the possibility of dual spending.
To avoid this, Bitcoin introduced a safeguard mechanism called Proof of Work (PoW), a puny mathematical problem every miner has to solve before sending a block back to the knot. PoW is designed so it takes miners, on average, Ten minutes to accomplish.
Fig. 15: Bitcoin’s Proof of Work
The computing power and randomness required to obtain the solution of the problem prevents having rogue agents fully controlling the Blockchain. Essentially, the more rekentuig power you own, the quicker you can compute the PoW.
But there’s a catch: Every 2016 blocks (around two weeks), the network checks how quick the miners have worked. If they’ve mined blocks quicker than expected, it means the miners have enlargened their computational power.
To prevent this from happening and tipping the balance, the network modifies the difficulty of the PoW and increases it so the average time to solve it remains at Ten minutes.
If mining a block costs computational power, then why would anyone want to do it? Well, miners are rewarded with Bitcoins.
Originally, for every block, miners would be awarded 50 Bitcoins plus any transaction fees. This prize is called a coinbase transaction.
Coinbase transactions introduce fresh Bitcoins into the system, control the inflation of the currency and, at the same time, deter any attempt to subvert the network. The system is designed under a managed supply – this means that every four years, the mining prize gets halved.
Be sure to check back for more
For the sake of clarity, wij’ve omitted many details about the Bitcoin protocol. That said, wij encourage you to ask any extra questions you may have so wij can update this postbode and make it spil accomplish spil possible.
Don’t leave behind, more advanced concepts (and their ramifications) are covered te the next postbode of the series.
Te true Bitcoin style, you can also donate Bitcoins if you’re liking the series: 13kbYPnPbhPALfCpSeMgairFYj3W7etRTx