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How Bitcoin works

WikiBit 2022-04-13 15:05

Abstract:We’ll explore how Bitcoin achieves sound money in an entirely digital form, and with no one in charge.

  The history of bitcoin started with its invention and implementation by Satoshi Nakamoto, who integrated many existing ideas from the cryptography community.

  In this lesson, well explore how Bitcoin achieves sound money in an entirely digital form, and with no one in charge.

  As stated earlier that Bitcoin was created by an individual (or group of individuals) who went by the alias of Satoshi Nakamoto. To this day, nobody knows (at least publicly) who Satoshi Nakamoto is - and thats arguably their biggest legacy to the community.

  By stepping into the ether soon after Bitcoin was robust enough, Nakamoto has done away with the first central point of failure. If gold had been “invented” by someone, that person would arguably hold great influence over their invention. If, in addition, that someone had kept a key that allowed them to control the gold economy, they would wield an ungodly amount of power.

  They would also be exposed to pleas, bribes, legal action, punches in the face, and otherwise strong pressure to tweak their invention to benefit one party or another - perhaps a government, or the mafia. Either way, the entire system would be vulnerable at a central point. That‘s unlike the case of Bitcoin. Besides, there’s also no cult of personality around its creator, no one to dictate the rules unchecked. Bitcoin belongs to the world, and no single person or country has jurisdiction over it.

  Cryptography & Economics

  The two words are different Economics and Cryptography, as Bitcoin combines computing and cryptography with a smart system of economic competition and rewards that ensure it‘s in everyone’s best interest to respect the rules without the need for a central authority. Instead, the network manages itself, and no single party controls the system.

  Bitcoin pursue honest “work” that supports the network (validating transactions, as well see below), while making sure that cheating is prohibitively expensive. This work is also the manner by which new bitcoin are programmatically introduced into the system, ensuring the supply can grow in a predictable way - thereby achieving the key quality of scarcity.

  These effects continuously grow exponentially as the network grows. In fact, much of the power of Bitcoin comes from its diverse, robust growing network. Bitcoin members may have sometimes conflicting interests, but they all share the same ultimate goal - that Bitcoin succeeds. And the more parties are invested in Bitcoin, the more everyone has to lose if it “breaks” - this creates a symbiotic relationship, one where all parties benefit.

  But here is a questions, who monitors the Bitcoin ledger, and how does it achieve sound money? One thing to know before we answer this question is how The system is designed.

  Bitcoin's design

  Bitcoin Design is a free open-source community resource that helps designers and developers working on bitcoin-products to create better experiences. Bitcoin entails many things, but well focus on the design elements here.

  Firstly, Bitcoin is a digital currency which operates free of any central control. It is a peer-to-peer network of computers all following a set of rules and instructions (the Bitcoin protocol) for validating transactions and issuing new coins. Any computer running any software that respects these rules can participate in the Bitcoin network. These are called Bitcoin Nodes. Now, Think of this protocol as the banking laws of a country. Any bank can operate, so long as they obey the laws. The difference is that the Bitcoin protocol is enforced by code, and not by courts - meaning its much more reliable.

  Secondly, Blockchain which store datas in block is the ledger of the Bitcoin for all transactions. Transactions are recorded in blocks, which are created at set intervals and connect to the previous block to create a chain.

  Finally, there is the mechanism for adding blocks to the Blockchain and reaching agreement (consensus mechanism) a fault tolerant mechanism used in a blockchain to reach an agreement on a single state of the network among distributed nodes, that the transactions are valid, and the whole chain accurate. This is called Mining. Bitcoin members dont need to trust each other; they need only trust the rules and the code.

  So how does this work in reality?

  The blockchain: trust but verify

  The most throughgoing feature of Bitcoin is its ledger - also known as the blockchain - and in the way transactions are validated. We must trust banks to keep the integrity of their ledgers, but we can‘t verify it for ourselves. If one bank sends one euro to another bank, we must trust them to remove that euro from their accounts. That’s because only they can see and update their ledgers. We can‘t see if they make a mistake, or if they make poor choices when extending credit. As the 2008 financial crisis has taught us, this isn’t always a good idea. Banks are encouraged to uphold the law, but history shows that they can go around or even change regulations to their benefit.

  In 2008, banks and other lenders exploited the rules to recycle an ungodly amount of debt into “subprime” financial products that were so complex that virtually no one could understand them. This was made worse by the fact that few people even had access to the books - and the few who did had a hard time understanding the complexity. When these rotten products defaulted, the world economy broke. The result? Trillions in bailout money for the same banks that caused it.

  As the Bitcoin comes, it turns this logic head over heel . Instead of a single ledger kept locked away by a central authority, Bitcoin ensures anyone can have a copy of the ledger containing all transactions that ever happened. Everyone can mathematically verify that every transaction in it is legitimate. Transactions that dont respect the rules are automatically rejected by the software. Bitcoin transactions are distributed approximately every 10 minutes into a block, which is then added to a long chain of blocks containing all previous transactions (hence the term blockchain). This process of adding the new blocks into this shared ledger is called mining.

  But one of The issues with a shared ledger is, how do we all agree that the current version is the most up to date one? How can thousands of different computers all over the world reach consensus without someone in charge?

  How bitcoin mining works as an incentive

  As a results of Bitcoin existence the solution it gives to this age-old computing problem involves maths, competition, and economic rewards, and goes by the name of mining. Mining involves a competition for solving a complex mathematical problem, which takes on average 10 minutes and is adjusted every two weeks to account for current computing power. The winner gets to add the current block of transactions and receives a reward for their efforts (as well explain below).

  The idea behind this is, everyone can easily verify that the solution is right. If a miner cheats, all other participants will simply discard the block. A cheater would lose not just the reward, but also all the money spent in energy to mine that block. This combined loss far outweighs any expected profits, even though in theory everyone can participate in mining, the mathematical problem is so hard, and the competition so fierce that youd need hundreds of specialised computers to even stand a chance today - which is quite an investment.

  Irrespective of the cost, mining is a very profitable competitive industry. This competition has so far ensured that no single party controls the majority of the mining power. In addition to that, this is a positive feedback cycle. The more value Bitcoin gains, the more miners in the network, the harder it becomes to cheat, and the more solid Bitcoin becomes.

  Money supply and inflation

  Mining is also the way by which new bitcoin are released into the system. Whoever wins the competition for solving the cryptographic problem gets to add the new block of transactions to the blockchain - plus a reward comprising transaction fees and new bitcoin. Also Transaction fees are the sum of fees paid for all transactions included in that block, which vary according to demand. These are bitcoin already in circulation.

  Alternatively, block rewards also include entirely new coins. In fact, every bitcoin in existence has been introduced into the network via mining. The rate of new bitcoin has started at 50 per block in 2009, but this number is programmatically halved every four years as determined by the protocol. The current reward is set at 6.25 bitcoin per block until 2024. This process will continue until all 21 million BTC are out there, at which point miners will only receive transaction fees.

  By any means, no anyone can arbitrarily create new bitcoin or mess with the issuance rate unless everyone (or at least an overwhelming majority) of the network agrees to change the protocol. And finding that agreement would be very, very hard. This programmed scarcity (a combination of fixed supply with predictable issuance rate) completely removes any uncertainty around inflation.

  The ultimate sound money?

  We‘ve just seen how, unlike fiat currencies, Bitcoin achieves dependable and reliable digital scarcity with no one in charge. Here’s how it satisfies the remaining properties of sound money:

  • Durability: the architecture of the blockchain makes it incredibly robust. Because every node has a copy of the ledger, destroying the Bitcoin network would require that all 50,000 nodes distributed around the world (and above) would need to be destroyed at the same time, along with however many backups there are. Thats very unlikely.

  • Divisibility: Bitcoin‘s smallest unit, called a Satoshi, is 1/100,000,000 of one coin. In today’s values, that‘s orders of magnitude more precise than even the smallest microtransactions would require. However, due to network fees, that level of precision isn’t currently practical - well discuss this below..

  • Fungibility: all bitcoin are created equal and have equal value - just like one gram of gold is equal to any other gram of gold.

  • Portability: Bitcoin is entirely digital and incredibly portable. It can be stored on a computer, mobile phone, and on paper. It can be instantly transferred anywhere in the world with just an internet connection - and even without one.

  Bitcoins limitations

  Surely, there no faultless system , and a decentralised, distributed system such as Bitcoin suffers from limitations that a centralised system doesn‘t. The main limitation is the trilemma between security, scalability, and decentralisation. This means that there are trade-offs when designing a network, and you can’t have all three. In other words, you cant have your cake and eat it.

  • Scalability is the capacity of the system to execute a higher volume of transactions

  • Security is the capacity to protect the ledger from cheating, hacks or other attacks

  • Decentralisation is the system redundancy; its what stops any one party from controlling the network

  Fiat money, for example, is very scalable and reasonably secure. On the flip side, it‘s completely centralised, and controlled by very few people. Moreover ,Bitcoin is designed to focus on decentralisation, and it’s incredibly secure. This comes at the price of scalability. Currently, Bitcoin‘s maximum speed hovers at around five transactions per second (a fraction of Visa’s purported 50,000+), making it impractical for use at scale.

  This elaborate why right now Bitcoin is popular as a Store of Value and less so as a Medium of Exchange. In the next lesson we'll look at how that trilemma is being addressed so that Bitcoin and other cryptocurrencies an scale, without compromising on the characteristics of sound money.

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