Learning outcomes:
By the end of this article you will understand:
1. What Bitcoin is and how it works
2. The origins of Bitcoin’s blueprint
3. Why Bitcoin was created and the problems it aims to solve
4. The role of the Bitcoin network
What is Bitcoin?
Bitcoin is a digital payment network created by Satoshi Nakamoto, who published the Bitcoin Whitepaper in October 2008 under the Japanese-sounding pseudonym. Bitcoin takes a revolutionary approach to how transactions are recorded and settled, and bitcoin (with a small ‘b’) is the built-in currency it relies on.
The Bitcoin network’s secret sauce is a quality described as decentralisation. A decentralised system functions without a single central authority, like a government, in charge.
As a decentralised payment network, Bitcoin’s users transact directly with each other, and the system logic (the Bitcoin protocol) automatically tracks balances and transactions. This contrasts with the traditional financial system where transactions go through a centralized entity.
Bitcoin isn’t the first attempt to create a financial system without banks; the reason it succeeded where others failed is because it found a solution to the ‘double-spend’ problem.
The double-spend problem.
Almost all the online systems we rely on to make our lives easier are controlled by a central authority, for example, banks who manage our money. The first line of the Bitcoin Whitepaper outlines an alternative.
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.’
For a peer-to-peer system to work, it needs a way to maintain an accurate record of balances. Let’s say Alice and Bob both have £100. If Alice sends Bob £20, their balances need to adjust accordingly.
Without a third-party keeping track, Alice could simply not reduce her balance by £20 and attempt to spend that amount again (double spend).
The Bitcoin Whitepaper sets out to solve a way to keep a decentralised payment system honest without a mediator.
The centralised solution is to trust a money issuer, like a central bank, to keep a tally of money as it changes hands. This is how our financial system works today.
What’s wrong with centralised payment systems?
By finding a solution to the double-spend problem, Satoshi Nakamoto built an alternative decentralised payment system. Bitcoin allows any two individuals living anywhere in the world to transact freely without knowing or trusting each other.
The idea has inspired a trillion-dollar ecosystem of related financial products and services, commonly known as DeFi (decentralised finance).
But, Bitcoin also removes the power of centralised authorities to control the money supply. Bitcoin’s solution is to build into its logic a rule that fixes its supply at 21 million bitcoins, addressing the issue of scarcity.
How does Bitcoin work?
Using the same example of Alice and Bob sending money to one another, they might both record their transactions on pieces of paper that act as a ledger. But they must find a way to reach an agreement on the state of balances and transactions.
That problem increases in difficulty when scaled to thousands of users worldwide who don’t know and trust each other.
The centralised solution would be a single ledger, and a single person or committee in charge.
As Bitcoin is decentralised, it doesn’t have just one instance but works as a distributed database with participants, called Nodes, in the Bitcoin network. Each Node maintains, compiles, and agrees on the correct state of the ledger automatically.
The Nodes stay in sync by following Bitcoin’s rules defined in a piece of software they all run. Satoshi described how Bitcoin maintains an accurate distributed ledger of bitcoin balances with five core concepts: Signatures, Timestamping, Consensus, Network Communication & Incentives.
Signatures
Bitcoin’s whitepaper describes its currency as a chain of digital signatures. This is like banknotes that have serial numbers you can consider as signatures.
Bitcoin’s signatures are cryptographic, to ensure anonymity and security, and combine two keys – one private key known only to the sender (Alice) and one public, identifying the recipient (Bob).
Moving coins forward using signatures can, however, only work with a system for verifying they were spent only once.
Timestamping & the blockchain
If Alice, Bob, and the larger network maintain a record of transactions, the one piece of information that could settle any dispute over valid entries is an immutable timestamp.
A lack of a system that works without a central authority is what stopped Bitcoin’s predecessors from succeeding. But Bitcoin’s whitepaper builds on previous attempts to effectively time stamp a digital document. For example, the work of Stuart Haber and Scott Stornetta (1991).
Haber and Stornetta devised a simple way to time stamp documents that was nearly impossible to fake. What Satoshi did was find a decentralised way of replicating their idea to ensure transaction data was accurate and could be easily verified without the need for trust.
Bitcoin transaction data is grouped together in data blocks, given a timestamp, and hashed (run through a cryptographic algorithm to produce an identifier of uniform length). The timestamp of the previous chronological block of data is included in the hash, creating a chain, now more commonly known as a blockchain.
The next challenge was devising a way to decide which of the Nodes add that block of timestamped data in an honest and accurate way, and incentivising them to do so.
Proof-of-work & block rewards
For a Node to submit a block of bitcoin transactions they must prove that they have done sufficient work to prove their intentions are genuine. If it were too easy, the network would be spammed with fake data.
The solution was to require Nodes to compete in a type of lottery where the winners get to add a new block to the chain. To find the winning lottery number, Nodes use computers designed solely to run a specific algorithm churning through endless permutations. The lottery algorithm adjusts in difficulty depending on the number of participants to ensure a winner is found roughly every ten minutes.
This lottery itself is meaningless other than to prove that any Node has done sufficient work to earn the right to add a new block of data. Logically Nodes would only participate in the lottery for net benefit, so the winning Node gets a block reward of newly created bitcoin, plus fees paid by users to send the transactions. This is why the process is described as bitcoin mining.
And because each block contains the timestamp of the previous block in a chain, Nodes are discouraged from adding fake transactions (double spends). They would have to keep winning the lottery to maintain the false data in the chain, but the network only respects the longest chain.
As it's a random process, the probability of continually winning the lottery is too small to worry about.
How Bitcoin created digital scarcity
The block reward has a double function as mining is the only way new bitcoin can be created. This ensures the quality of scarcity is met as the protocol includes a fixed supply of 21 million bitcoin.
Block rewards have been distributed roughly every ten minutes since the first block – the Genesis Block – was mined in January 2009. The reward for mining a block halves in value every 210,000 blocks or around once every four years. By the year 2140, all bitcoins will have been mined.
