Network and digital currency
Bitcoin is a decentralized network and a digital currency that uses a peer-to-peer system to verify and process transactions. Instead of relying on trusted third parties, like banks and card processors, to process payments, the Bitcoin technology uses cryptographic proof in its computer software to process transactions and to verify the legitimacy of Bitcoins (Nakamoto, 2008) and spreads the processing work among the network. We make a clear distinction between the Bitcoin system where a capital B is used for the word Bitcoin and that of a Bitcoin, which is a unit of the currency or a digital address created by the Bitcoin system.
With the invention of Bitcoin, payments can be made over the Internet without the control and costs of a central authority (Bitcoin Project) for the first time. Prior to the invention, transactions carried out online always required a third party as a trusted intermediary to verify transactions (Brito and Castillo, 2013). For example, when Alice wants to send $10 to Bob, she would have to use a third-party service like a credit card network or PayPal.
The function of the third-party service is to provide an assurance that the sender, Alice, has the funds to transfer and that the recipient, Bob, has successfully received the funds. This is possible because these intermediaries help maintain a record, or ledger, of balances for their account holders. Here, when Alice sends Bob the $10, an intermediary like PayPal would deduct the amount from her account and accordingly add it to Bob's account, subject to a transaction fee.
However, the currency unit used in payments on the Bitcoin network is Bitcoins, not a fiat currency. Therefore, bitcoins in itself is also a digital currency, in the sense that it exists "digitally" and, for most intents and purposes, satisfies the economic definition of money: it is a medium of exchange, unit of account, and store of value. Conventionally, the uppercase "Bitcoin" refers to the network and technology, while the lowercase "bitcoin(s)" refers to units of the currency. The currency is also commonly abbreviated to "BTC," although some exchanges use "XBT," a proposed currency code that is compatible with ISO 4217 (Matonis, 2013).
Genesis and decentralized control
The first bitcoin was mined, or created, in 2009, following the online publication of a paper by a Satoshi Nakamoto describing the proof of concept for a currency that uses cryptography, rather than trust in a central authority (Nakamoto, 2008), to manage its creation and transactions. Nakamoto left the project in 2010 and his identity largely remains unknown.
However, with the open-source nature of the Bitcoin software protocol, other developers have continued working on it and the Bitcoin community flourishes today. At the same time, although Nakamoto remains anonymous, users need not be concerned that he, or anyone, secretly has full control of Bitcoin. The open-source nature of Bitcoin means that the source code is fully disclosed. This disclosure allows any software developer to examine the protocol and create their own versions of the software for testing or further development, and so far, no red flag has been raised as to the presence of Nakamoto or any other party with secret control.
Furthermore, Bitcoin is designed to operate only with full consensus of all network users. This ensures that software developers who modify the Bitcoin source code in their own versions of the software cannot force a nefarious change in the Bitcoin protocol without breaking compatibility with the rest of the network. The power to change the Bitcoin protocol requires full agreement among Bitcoin users and developers.
Usually, bitcoins may be obtained by buying them at a Bitcoin exchange or vending machine or as payment for goods and services. However, Bitcoin is revolutionary because the double-spending problem can be solved without needing a third party. In computer science, the double-spending problem refers to the problem that digital money could be easily spent more than once. Consider the situation where digital money is merely a computer file, just like a digital document. Alice could send $10 to Bob by sending a money file to him and can easily do so by e-mail.
However, remember that sending a file actually sends a copy of the file and does not delete the original file from the computer. When Alice attaches a money file in an e-mail to Bob, she still retains a copy of the money file even after she has sent and therefore spent it. Without a trusted third-party intermediary to ensure otherwise, Alice could easily send the same $10 to another person, Charlie.
Bitcoin solves the double-spending problem by maintaining a ledger of balances, but instead of relying on a single trusted third party to manage this ledger, Bitcoin decentralizes this responsibility to the entire network. Behind the scenes, the Bitcoin network constantly keeps track of bitcoin balances in a public ledger called the blockchain.
The blockchain is a publicly accessible authoritative record of all transactions ever processed, allowing anyone to use Bitcoin software to verify the validity of a transaction. Transfers of bitcoins, or transactions, are broadcast to the entire network and are included onto the blockchain upon successful verification, so that spent bitcoins cannot be spent again. New transactions are checked against the blockchain to make sure that the bitcoins have not been already spent, thus solving the double-spending problem. Bitcoin extensively uses public-key cryptography to solve the double-spending problem. In public-key cryptography, each transaction has a digital signature and contains a hash that allows for easy tamper detection.
Example of a raw transaction data.
Explanation for the transaction.
Buying and storing Bitcoins
Typically, a user who wishes to spend bitcoins obtains it by exchanging real-world currency for bitcoins. This can be achieved by purchasing bitcoins from a vending machine, from an exchange, or simply from another person. Bitcoin vending machines, often called "ATMs," are the most convenient way to buy bitcoins, because one can easily insert cash into a machine to obtain bitcoins instantly (Ulm, 2014).
Bitcoin exchanges are also a popular means to obtain bitcoins, but users often face a time delay while waiting for bank transfers to clear (Ulm, 2014). Trading real-world cash for bitcoins is also a possibility but it is inconvenient if bitcoins are needed on the spot. However, marketplace websites like LocalBitcoins have sprouted up to connect people interested in buying and selling bitcoins to enable them to do so privately, whether in person or online (LocalBitcoins).
This option is more likely to be used in countries with restricted or no access to Bitcoin vending machines or exchanges. Bitcoins are typically stored in a wallet, so a user needs to have a wallet available to buy and sell bitcoins. Specifically, it is the private keys that are stored in a wallet (CoinDesk, 2014).
These keys are used to access the Bitcoin addresses and sign transactions and therefore must be kept securely. There are various types of Bitcoin wallets, including desktop, mobile, webs, and hardware wallets.
Users who choose to install a desktop wallet on their computer can create and keep wallets on their computer. The original Bitcoin client software, known as Bitcoin Core, which is still in use today, includes the functionality of creating a bitcoin address to send and receive bitcoins and to store the corresponding private key for that address. There are various other wallet software in which users may elect to install on their computer, like the cross-platform MultiBit and the security-conscious Armory (Bitcoin.org).
The different wallet software have varying additional features, although the most basic function of a wallet in storing the private keys for corresponding bitcoin addresses remains the same. While the user maintains control of his desktop wallet at all times, such wallets, like any other computer file, are vulnerable to theft by malicious users or software. Desktop wallets are not the be-all and end-all of wallets, even if they were the first.
When transacting at a physical store, a mobile wallet is often the most convenient way to spend some bitcoins. Mobile wallets are simply an application that provides for Bitcoin wallet functionality in a mobile phone. There are apps like Bitcoin Wallet and Mycelium that only exist on the mobile platform, while some desktop wallets like Blockchain.info also have mobile versions (Bitcoin.org).
However, in the early 2014, Apple removed Bitcoin Wallet apps like Blockchain.info from its App Store (Southurst, 2014), although unofficial versions and mobile browser-based wallets continue to exist. Another convenient type of wallet is the online wallet, which is generally accessible from anywhere through a browser with an Internet connection, regardless of the device used (CoinDesk, 2014).
The private keys for a user's Bitcoin addresses are kept and stored by the service provider of the online wallet, which may present a risk of the service provider or a third party absconding with the bitcoins, if security was not implemented properly. Blockchain.info also has a popular web-based online wallet and some online wallets offer extra encryption and two-factor authentication for additional security.
Finally, there is small but growing interest in hardware wallets, which are specialized devices that can hold keys electronically and are also able to send and receive bitcoins. An example of a dedicated Bitcoin device is the Trezor, a single-purpose token-sized device for making secure Bitcoin transactions (SatoshiLabs).
Mining to create new bitcoins and process transactions
The verification process is a computationally intensive process that ensures that only legitimate transactions are verified and recorded onto the blockchain. It is the network that provides the computing power for the transactions to take place and for the transactions to be recorded. What happens during mining is actually a mathematical process. A real-life analogy to bitcoin mining would be the search for prime numbers: while it was easy to find the small ones, it became increasingly more difficult to find the larger numbers, leading researchers to use special high-performance computers to find them.
The Bitcoin protocol is designed to generate new bitcoins progressively, at a predictable but decreasing rate. To ensure a progressive growth in new bitcoins, the reward for solving a block is halved automatically every 4 years, and the difficulty of solving increases over time. These two effects work together to produce an effect that over time, the rate at which bitcoins are produced will be similar to the production rate of a commodity like gold
There will be a point in the future when the hard limit of bitcoins will be reached and the incentive for miners will instead be transaction fees. The arbitrary number chosen to be the limit in number of bitcoins is 21 million. Once the very last bitcoin, or to be specific, the very last satoshi-- 0.00000001 of a bitcoin--is produced through mining, miners who continue to contribute their computing power to verify transactions will instead be rewarded with transaction fees.
This may be a less desirable situation for people and businesses relying on bitcoin payments, which will have to pay a transaction fee, but it ensures that miners will still have an incentive to keep the network up and running even after the last bitcoin is mined. Every new block that is successfully added onto the blockchain references the previous block, making it exponentially difficult to reverse previous transactions in previous blocks. Because changing a block on the blockchain will require recalculation of the proofs of work of all subsequent blocks (Bitcoin Project), it becomes more and more infeasible for an adversary to manipulate a block after more blocks have been added after it, and the Bitcoin protocol is accordingly designed to prefer longer chains.
Miners therefore perform a vital task as they verify transactions and ensure that the blockchain cannot be tampered with. While bitcoin transfers are broadcast instantaneously over the network, there is, in practice, a 10 min delay for a transaction to be confirmed. This is the result of the 10 min delay for a block to be created and added onto the blockchain. Having a confirmation ensures that the network (of miners) has verified that the bitcoins are valid and have not been already spent.
Typically, most users wait for six confirmations, that is, an hour, before considering a transaction to be "confirmed," but each user has the freedom to decide how long they wish to wait before they consider their transaction confirmed.
Security and Cryptography
There is no need for suspicion against the NSA because the SHA algorithm is part of the public domain and has been extensively analyzed to be secure (Pacia, 2013). SHA-256 is an upgrade from the SHA-1 series and is presently used in Bitcoin for the digital signatures that secure the transactions and blockchain and it forms the basis of the proof-of-work mathematical problem.
Central to Bitcoin technology is public-key cryptography, which with the SHA-256 hash function is used to generate Bitcoin addresses, sign transactions, and verify payments. Public-key cryptography is a technique of reliably determining the authenticity of Bitcoin transactions using digital signatures. It uses an asymmetrical algorithm that generates two separate but asymmetrically linked keys: a public key and a private key.
The keys are asymmetrical in the sense that the public key is derived from the private key but it is computationally impossible to obtain a private key from a public key. In such a system, the public key is used to verify digital signatures in transactions while the private key is used to sign transactions to produce those very digital signatures. The public key is publicly accessible; in Bitcoin, it is used as the Bitcoin address to and from which payments are sent.
The private key, on the other hand, must be kept secret and safely. The beauty of such a system is that transactions can be easily verified using the public key without sharing the private key used to sign the transactions.
Pseudoanonymity
For example, when Alice makes a transfer of $10 using PayPal to Bob, PayPal will have a record of the transfer. In addition, their PayPal accounts are likely to be linked to their respective credit cards or bank accounts, which will provide information as to their identities. On the other hand, if Alice gives Bob $10 in cash in person, there is neither an intermediary nor a record of the transaction. If the two of them do not know each other, then the transaction can be said to be completely anonymous.
Bitcoin is somewhere in between these two extremes. Bitcoins can be said to be like cash in the sense that when Alice gives bitcoins to Bob, she no longer has them, while Bob does. Since there is no third-party intermediary, nobody knows their identities as well. However, unlike cash, the transaction is recorded on the blockchain.
Some ofthe information recorded includes the public keys of the sender and recipient, the amount, and a time stamp. Every transaction in the history of bitcoin has been recorded and will be recorded on the blockchain and is publicly viewable. While there is some privacy, the blockchain is a public record of all transactions and it may be possible for anyone to identify the parties behind them, especially if a person's identity is linked to a public key. While bitcoins may be anonymous like cash in the sense that parties can transact without disclosing their identities, it is also unlike cash because transactions to and from any Bitcoin address can be traced.
Therefore, Bitcoin is pseudonymous, not anonymous. It is not particularly difficult for anyone with the right tools and access to join the dots between a pseudonymous Bitcoin address and a real-world identity. Some personally identifiable information is often captured during a transaction on a website, like an IP address. To make it more difficult to connect an identity to a Bitcoin address, one would have to use software methods that obfuscate or shield such personally identifiable information from being tied to Bitcoin addresses.
Early studies have already shown some potential analyses that could erode the pseudonymity of Bitcoin. For those who are persistent in connecting Bitcoin addresses to realworld identities, their work should begin with the blockchain. In a simulated experiment, a study found that up to 40% of Bitcoin users within the experiment could be personally identified using behavior-based clustering methods (Androulaki et al., 2012). The statistical properties of the transaction graph could also, with the relevant analysis, reveal the activity and identity of Bitcoin users (Reid and Harrigan, 2013).
Even the use of multiple public keys may not defend against such transaction graph analysis (Ober et al., 2013), as an observer may gradually be able discern patterns in user behavior to link the public keys together, using a process called entity merging (Brito and Castillo, 2013). Besides the technical aspects of Bitcoin, it is important to also consider the pressures faced by Bitcoin intermediaries from regulators.
Bitcoin regulation is evolving, and should Bitcoin intermediaries become regulated, it is expected that anonymity will become less guaranteed (Brito and Castillo, 2013), often with KYC and reporting requirements requiring these intermediaries to collect personally identifiable information from their customers.
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