What is Bitcoin. A detailed study.

Bitcoin: 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. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing   them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network,  they’ll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.

Bitcoin History:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments.  While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable.  These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party. What is needed is an 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. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. Bitcoin is a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

At first, anyone armed with an ordinary computer could download and run the Bitcoin software and gather (or “mine”) bitcoins. The more computing power you can dedicate to Bitcoin calculations, though, the better your chances of arriving first at each solution. This feature of the system, by design, resulted in a kind of computational arms race that strengthened the network by rewarding increased computing power. Four years into the Bitcoin project, only very powerful, purpose-built machines have enough muscle to keep pace with existing network nodes.

 

In this way, bitcoins are mined like gold used to be, in quantities that are small relative to the total supply, so that the supply grows slowly. There is an upper limit of twenty-one million new coins built into the software; the last one is projected to be mined in 2140. After that, it is presumed that there will be enough traffic to keep rewards flowing in the form of transaction fees rather than mining new coins. The chain of ownership of every bitcoin in circulation is verified and registered with a timestamp on all twenty thousand network nodes. This prevents double spending, since no coin can be exchanged without the authentication of some twenty thousand independent cyber-witnesses. In order to hack the network, you would have to deceive over half of these computers at the same time, a progressively more difficult task and, even today, a very formidable one.

In 2008, Satoshi Nakamoto, the founder of Bitcoin, whose real identity is not known, cleverly combined existing peer-to-peer network technologies, cryptographic techniques, digital signatures, and the potential power of network effects to design and develop the Bitcoin system. Nakamoto was very clearly motivated in this effort by the fallout from the 2008 financial crisis. When the experiment was launched and the first fifty bitcoins (the so-called genesis block) were mined, in January of 2009, he (or she, or they) included this line of text along with the data: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

The Disappearance and Nakamoto’s theory:

Until his disappearance from the Web, around the spring of 2012, Nakamoto was a visible participant on cryptography forums, where he discussed Bitcoin freely, and published a nine-page paper outlining the details of the project. These posts reveal that even in 2008, Nakamoto was able to respond to concerns regarding the scalability of bitcoin with remarkable prescience; he clearly understood the ramp-up of computing power that would be required for producing bitcoins as the system grew.

Only people trying to mine new coins need to run network nodes And at first, most users ran network nodes, but as the network grew beyond a certain point, mining increasingly became the domain of specialists with server farms of specialized hardware.

A casual review of Nakamoto’s various blog posts and bulletin-board comments also confirms that, from the first, Bitcoin was devised as a system for removing the possibility of corruption from the issuance and exchange of currency. Or, to put it another way: rather than trusting in governments, central banks, or other third-party institutions to secure the value of the currency and guarantee transactions, Bitcoin would place its trust in mathematics. At the P2P Foundation, Nakamoto wrote a blog post describing the difference between bitcoin and fiat currency:

[Bitcoin is] completely decentralized, with no central server or trusted parties, because everything is based on crypto proof instead of trust. The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts… With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.

Much of what has been written so far about bitcoins has centered on the perceived dangers of their relative anonymity, the irreversibility of transactions, and on the fact that they can be used for money laundering and for criminal dealings, such as buying drugs on the encrypted Web site Silk Road. This fearmongering is a red herring, and has so far prevented the rational evaluation of the potential benefits and shortcomings of crypto-currency.

Cash is also anonymous; it is also used in money laundering and illegal transactions. Like bitcoins, stolen cash is difficult to recover, and a cash transaction can’t readily be traced back to the source. Nor is there immediate recourse for the reversal of transactions, as with credit-card chargebacks or bank refunds when one’s identity has been stolen. However, I find it difficult to believe that anyone who has written critically of the dangers of bitcoin would prefer an economy where private cash transactions are illegal.

The Bitcoin Foundation:

Like the Linux Foundation, the Bitcoin Foundation is funded mainly through grants made by for-profit companies, such as the Mt. Gox exchange, Bitinstant, and CoinLab, who depend on the stability and continued maintenance of the underlying open-source code.

“The Linux Foundation provides a bit of a center for Linux, and to pay the lead developer, Linus Torvalds, so that he can do nothing but concentrate on the kernel,” Andresen said. “It’s a tricky thing, once you get to be a certain size as an open-source project, how do you sustain yourself? Linux is the most successful open-source project in the world, so we thought it would make sense to use that as a model.”

Gavin Andresen is one of the few people in the world who are known to have corresponded directly with Satoshi Nakamoto. (Joshua Davis tried to track him down for The New Yorker in 2011.) When I said I’d like to know more about Nakamoto, Andresen burst out laughing.

“So would I!” His laughter had a credibly rueful edge to it.

   He was active on the bitcoin forums through December of 2011. He told me he was going to get busy, and then he stopped posting on the forums. A few months later, he disappeared, and as far as I know nobody has heard from him since then.

 

   Whenever I corresponded with him, it was always on Bitcoin forums or e-mail, we never even real-time text chatted. He was always very businesslike, no personal details, always strictly about the project.

Indeed, a casual review of Nakamoto’s writings online reveals him to be unfailingly cool and collected; the only time I noticed him becoming a little heated was in a few forum posts in December of 2010, when WikiLeaks supporters began soliciting bitcoin donations for WikiLeaks. Nakamoto rejected the idea unequivocally. According to Andresen,

   Satoshi just felt the project was still too small to take that much attention. He didn’t want WikiLeaks to jump in at that point, and they didn’t… but a year later they did, and it was fine. I think people realized once I got invited to speak at the C.I.A. that there was no kind of hiding. They, whoever “they” are, already knew about this project. Satoshi was obviously a lot more private, and more worried about what government would do than I am.

I asked Andresen to explain to me the degree to which he and his colleagues are worried about government interference in Bitcoin.

   I think if the U.S. government decided that Bitcoin was a bad thing and told me, “Stop doing what you’re doing,” I’d stop doing what I’m doing, quite frankly. But that wouldn’t be very effective, because there are people all over the world who could pick up and reimplement it, for example in different programming languages; if you browse the Bitcoin forums you’ve seen the enormous chaos and energy there. There’s all sorts of people doing all sorts of things—many of them crazy things that will never succeed, but some of those will be the next big things in Bitcoin.

There are now many thousands of individuals and businesses already doing business in bitcoins. You can buy electronics—including cameras, musical instruments, blood-pressure monitors, and computers—using just bitcoins. There are bitcoin-only casinos, like SatoshiBet, and a bitcoin-based Intrade-style prediction market called Bets of Bitcoin. The infrastructure for implementing the storage and exchange of bitcoins, too, is exploding: vendors, exchanges, facilitators of in-hand trades, dealers in bitcoin debit cards. There are systems for producing “paper wallets” that you can print out for the safe storage of bitcoins, and secure e-wallets for those with a tendency to misplace papers.

The physical bitcoins illustrating most every bitcoin story on the Web are available for purchase, too. They are called Casascius coins, and they are sold by Mike Caldwell through his Web site, casascius.com. These coins contain a private key on a card embedded in the coin and sealed with a tamper-evident hologram.

Caldwell, who lives in Utah, owns a payroll-software business and has about thirty employees. He is not affiliated with the Bitcoin Foundation—he is simply an interested and highly informed participant in the bitcoin market. The name Casascius came from the acronym for “call a spade a spade,” with a vaguely Latinized suffix. The widely adopted Bitcoin motto often appears on Casascius coins: “Vires In Numeris,” which is a rough translation into Latin of the English phrase “strength in numbers.” He is a strong believer in the future of Bitcoin, and has been investing in the currency for a long time. He told me, “After the first crash”—in June of 2011—“there was a panic; people heard that one Web site had been hacked, and erroneously assumed that Bitcoin was a failure. I bought all the way down.”

But Caldwell also thinks the road ahead is likely to be a bumpy one.

   I believe Bitcoin will have hiccups and issues in the future… scalability limits. And there will be bugs, and times where people experience delays getting their transactions confirmed. These will cause temporary crises of confidence as the developers team up to solve the various issues. But Bitcoin will also evolve and move past them. The day that Hollywood succeeds in using technology to stomp out the music and movie pirates on the Internet, that’s when they’ll stomp out Bitcoin. I think most people know Hollywood will never win. Bitcoin will always win in the long game.

Since mining yields pocket change for most, even if it were technically a violation of the way FinCEN sees the law, mining without registering would be like “laundering” a twenty-dollar bill by taking it to the grocery store and asking for two tens… it’s hardly worth the resources for anyone to care about it, no matter how illegal they decide it should be.

Where he does see an issue, however, is in the anonymity that is prized by bitcoin adherents.

   Mining produces bitcoins that are extremely anonymous. The most anonymous bitcoins you can get, system-wide, are ones you mined yourself. The mined coins have no origin, no history, no nothing. They just appear out of thin air.

This anonymity becomes particularly problematic, from a regulator’s viewpoint, in the context of criminal activity—for example, hacking attacks that succeed in robbing people of their bitcoins. Caldwell’s political views with respect to Bitcoin are connected, like Nakamoto’s, with a belief in the potential value of cryptography. “Until now, society has underutilized cryptography. If people accept it more broadly, cryptography can facilitate many things: the exchange of money, transparent elections, transparent government.”

Bitcoin Price:

Like everything, Bitcoin’s price is determined by the laws of supply and demand. Because the supply is limited to 21 million bitcoins, as more people use Bitcoin the increased demand, combined with the fixed supply, will force the price to go up. Because the number of people using Bitcoin in the world is still relatively small, the price of Bitcoin in terms of traditional currency can fluctuate significantly on a daily basis, but will continue to increase as more people start to use it. For example, in early 2011 one Bitcoin was worth less than one USD, but in 2015 one Bitcoin is worth hundreds of USD. In the future, if Bitcoin becomes truly popular, each single Bitcoin will have to be worth at least hundreds of thousands of dollars in order to accommodate this additional demand.

Bitcoin Exchanges:

There are several ways to buy Bitcoin, but trusted exchanges are a great way to acquire Bitcoin. Because there are inefficiencies in the traditional banking system, exchanges will sometimes have slightly different prices. If the difference is too great, traders will buy low on one an exchange and sell high on another and close the gap. If an exchange constantly has substantially different prices than others, it is a sign of trouble and that exchange should be avoided. As with everything else, do your research and find an exchange you can trust. It’s also a good idea not to use an exchange as a wallet. Move your Bitcoin to your personal wallet so that you have control over your funds at all times. You can view our list of Bitcoin exchanges here.

Bitcoin Isn’t Completely Anonymous:

Because all Bitcoin transactions are stored on a public ledger known as the blockchain, people might be able to link your identity to a transaction over time. Some companies offer various tools such as Bitcoin mixers to help achieve greater privacy, but it takes a huge amount of effort to use Bitcoin anonymously. You may want to follow your country’s tax regulations regarding Bitcoin in order to avoid trouble with the law, but you have the power not to should you choose to take that risk. To improve privacy, most newer Bitcoin wallets will use a new Bitcoin address each time someone sends bitcoins to you.

Unconfirmed Transactions:

Bitcoin transactions are seen by the entire network within a few seconds and are usually recorded into Bitcoin’s world wide ledger called the blockchain, in the next block. While it’s possible that a transaction won’t be confirmed in the next block, in the vast majority of circumstances it is fine to accept a transaction as soon as it has been seen by the network. Unlike traditional payment systems, Bitcoin transactions are lightning fast and can be sent globally. Bitcoin is still relatively new, but with each passing day the technology becomes more reliable. It is more and more unlikely that a major bug will emerge in the system as time goes by, and people can trust the technology more with the passing of time. Each month people transact hundreds of millions of dollars worth of Bitcoin.

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