Bitcoin: A Peer-to-Peer Electronic Cash System
Bitcoin (BTC), nowadays most people probably have heard of it at least once. The cryptocurrency gained popularity over the years due to being the first decentralized peer-to-peer cash system based on blockchain technology. Also, the price of bitcoin has risen to astronomical values in the past decade. This price increase is another reason why Bitcoin is so popular. But what is Bitcoin exactly, and how does it work?
In 2008, the mysterious developer and inventor under the pseudonym Satoshi Nakamoto published the Bitcoin whitepaper. This document is a document in which Nakamoto laid out his ideas for a decentralized, peer-to-peer electronic cash system. With this system, people anywhere in the world can send value over the internet without an intermediary. The publishing came at a time of financial crisis and was somewhat of an answer to the unfair traditional financial system.
Nakamoto is a mysterious figure as no one knows who he or she is. It might as well be a group of developers; no one knows. It has long been a debate why Nakamoto stays anonymous. However, a theory is that staying anonymous adds to the degree of decentralization of the Bitcoin network. With Nakamoto being unknown, no one will be able to pressure, contact or influence the original inventor of Bitcoin.
Thanks to blockchain technology, people can send bitcoins to any other Bitcoin address in the world over the internet. Transactions are safely stored on the blockchain, a chronological database stored and maintained by thousands and thousands of nodes worldwide. With the help of encryption, these transactions are almost impossible to manipulate, making Bitcoin a censorship-resistant network. This makes spending a bitcoin just like spending physical money; once you have given away that €10 bill, you can’t get it back and spend it again. Bitcoin is therefore often dubbed as ‘the money of the internet.’
A crash course in bitcoin mining
Bitcoin wouldn’t be as safe and revolutionary without its miners. These are computers that solve complicated mathematical problems to secure the Bitcoin network and process transactions. For many, bitcoin mining is a complex and vague concept. Once you understand it, however, you will realize how genius the mechanism is. So, are you ready for a crash course in bitcoin mining? Here we go.
Let’s start with an example of Adam sending 1 BTC to Maya. After Adam has entered the public address of Maya inside his bitcoin wallet and signed the transaction with his private key, the transaction will start its journey on the Bitcoin network. First, it will enter the waiting room of the Bitcoin network, better known as the “Bitcoin Mempool.” Bitcoin miners will collect transactions that are inside this mempool until they have enough to fill a data block of about 1MB.
A miner has now picked up the transaction that Adam sent. The computer adds the transaction, together with more than 1.000 other transactions, in a block and starts encrypting it. The structure of a block looks like this:
Adam’s transaction to Maya is added in the data section of the block. Other essential parts of a block are the timestamp, the hash key of the previous block, and the nonce. Now we are entering a bit more complicated matter, namely the nonce and the difficulty. And to understand these two, we will first explain how encryption works.
Encrypting is the process of changing data into random letters and numbers. When we take the SHA-256 encryption algorithm, any data size can be encrypted into a 64-character string of numbers and letters that seem completely random. But every time you change even one little bit, the whole output will change. Think of the encryption algorithm as a little machine where you can put a pizza in one end, after which the machine will output a paper with random letters and numbers on the other side. Below you will see how much the output changes after you change just one letter:
Now let’s talk about the difficulty. The difficulty is a parameter automatically set by the Bitcoin protocol. This parameter dictates how many zeroes the hash must start with before the protocol can accept it. After the miner encrypts the transaction data, he or she will get a hash key in return that will most likely not start with the right amount of zeroes. So the miner has to try again, but how does the miner change the output if they cannot change any transaction date? With the nonce!
A nonce is a simple number that a miner can change. So by changing the nonce from 1 to 2, the hash key will change based entirely on the encryption principle explained above. After changing the none to 2, the miner still didn’t find the correct hash, so they try again and change the nonce to 3. Sounds easy, right? Well, not really. Most modern bitcoin mining machines generate more than a trillion of these hash keys per second, and even then, the miner most likely won’t find the right key.
Bitcoin mining is a combination of hard work and a game of chance. Miners try to generate as many hash keys as possible, as fast as possible, which is why they need a lot of energy. Generating so many hash keys increases the chance that they find the hash key that starts with the right amount of zeroes.
Once the miner finds the correct hash, they share the block with the Bitcoin network. Thousands of nodes will check if everything is in order, and if the majority of the network accepts it, the block is added to the blockchain. As a final step, the miner receives their bitcoins!
The unbreakable chain
The miner has now successfully added the block with Adam’s transaction to the blockchain, and Maya will now have 1 BTC in her wallet. But why is it called a “blockchain”? That is because the block with Adam’s transaction is connected to the previous block as the last hash key is included in the new block (as you can see in the illustration of a Bitcoin block above). Miners will add a new block with transactions about every 10 minutes. So let’s say Adam wants his bitcoin back; he will need to do the following.
In this scenario, we assume that since Adam’s transaction, it has been 20 minutes, and thus there have already been two new blocks added to the blockchain. Suppose Adam wants to turn back his transaction. In that case, he will have to take the same data included in the block with his transaction, change his transaction, and redo the whole process the miner did already, changing the nonce and finding the correct hash key with the right amount of zeroes. But that’s not all.
As already two new blocks have been added since the block Adam is trying to alter, he will also have to re-mine those two blocks as the hash of his block will change due to his alteration. With time going on while Adam is trying to mine as fast as possible, new blocks are being added every 10 minutes. The conclusion: it is almost impossible and economically unviable to change his transaction. It will cost Adam more electricity than the value of the bitcoin he is trying to get back.
The advantages of Bitcoin
Hopefully, you have room left in your brain for some extra information after all these technical details! What are the advantages of a network like this? Bitcoin lets anyone with a computer and internet connection send money anywhere in the world. It enables people to truly possess value digitally. And with that, we don’t mean like money in a bank account, more like having a bullion of gold under your pillow (comfort-wise not a good idea, by the way).
Bitcoins are born by the miners who receive them as a reward after successfully adding a block to the blockchain. The amount of bitcoins they receive, however, decreases over the years. This mechanism is inspired by how gold works: the more gold is extracted from the ground, the less there is left; thus, it becomes harder and harder to find new gold. Bitcoin follows the same principles meaning the cryptocurrency becomes scarcer over time. This is another advantage of Bitcoin as the value of 1 BTC will increase over time, assuming the demand on the market stays at least the same. For this reason, bitcoin has been the most successful investment ever and a real monetary revolution that will significantly impact our world.
People without bank accounts can finally participate in the economy without relying on sometimes corrupt governments and financial systems. People in the developed world can, on the other hand, put their money in a truly transparent, scarce, and liquid asset. Bitcoin will shape our future economy, and more and more people are starting to realize this!