Bitcoin, a cryptocurrency and payment system that was invented by a person or a group of people by the name Satoshi Nakamoto, whose identity in real world is still unknown.
It is the first cryptocurrency that solves double-spending problem and thus introduces blockchain, a distributed ledger managed by a P2P network that removes the reliance on a single authority for trust and establishes a trustless payment system that depends on cryptographic proof using proof-of-work (PoW).
MINERS :
No central authority is issuing Bitcoin. It is the miners who maintain the blockchain and the Bitcoin system in general. And they are the ones who create/mine all the bitcoins and own them upon creation. Others buy from them. Yes, all the bitcoins out there were first owned by some miner when they were first created or mined.
However, anybody can buy computers and become a miner by joining the network. It is as simple as installing certain software and running it. However, mining bitcoins is like winning a lottery, depends on your computing power. If you (or your mining pool) have the most powerful computer and a bit of luck, you will possibly be able to mine. However, whether that will be economically viable or not is a different matter. How miners generate bitcoins will be clearer later.
How many miners are presently working on the Bitcoin blockchain?
Limited Supply: Bitcoin protocol stipulates that there would be a maximum of 21 million Bitcoins (BTC) created by 2140, at a diminishing rate. Every 4 years the number of bitcoins mined will be halved. Thus bitcoin production will be slowed down and at some point it will be stopped. We will do some math on it later.
This is the limited supply of bitcoin that convinces people to treat it as some kind of gold whose value, they think, will gradually appreciate.
Well, this limited supply is an artificial construct. We will have a short discussion regarding this at the end.
Apart from the limited supply there are few more things that make Bitcoin attractive to people.
PRIVACY : Within Bitcoin network, you are represented by a number – your public key, to be precise. When you are sending some coins to somebody else – everybody knows it. After all, the ledger is public, everybody can see everything. But they don’t know who you are in the real world. It is different from using our usual debit card/credit card payments where the bank and the merchant know who the buyer is. However, it is not entirely untraceable; it is just hard. But it is not very obvious as buying something using a credit card.
NONREVERSIBLE TRANSACTION : As we will slowly understand that once a transaction gets into a block and that block is accepted in the blockchain, it becomes permanent and virtually impossible to reverse. It gives confidence to people who receive money that they will not be cheated later.
This is important. As there is no reversal, the merchant does not need to trust you. That in turns allows a system where the two parties can remain anonymous.
TRANSPARENCY : As mentioned, all the transactions are open in the public since the beginning and no central authority is managing them. It is the miners and nodes (what is a node, we will see later) who are managing them. It will be clearer that it is in their best interest to remain honest and manage it properly. It sounds like a transparent system.
Wallet: Suppose I want to have some bitcoins. I will then need to have a wallet. There are different wallet providers like Mt. Gox exchange. A wallet can manage multiple cryptocurrencies. Note that, Bitcoin is the first cryptocurrency but there are 1000+ out there.
A wallet can have multiple addresses. Each address is essentially a private-public key pair. More precisely, it is actually the public key that is called an address. However, with each public key there exists an associated private key that secretly stays with the owner, behind the scene.
While doing transactions, we use these keys. A public key is used to receive bitcoins and the corresponding private key is used to spend them.
By using multiple addresses, I am trying to hide my aggregate balance that I own in the blockchain. This is because everyone can see how much bitcoins an address (like an account in real world) owns. But they don’t quite completely know as to what all addresses belong to a certain person behind the curtain. Well, if you are spending some coins from multiple addresses at one go then one would know that all these addresses belong to you.
Public-key Cryptography: As we have mentioned, public-key cryptography plays an important role in Bitcoin/blockchain. Especially, digital signature is an integral part of it. Even if we forget the P2P network that is built at the top of a secure channel.
Digital signature employs asymmetric cryptography – usually, based on RSA or Elliptic-curve Cryptography. Bitcoin uses Elliptic Curve Digital Signature Algorithm (ECDSA) based on elliptic-curve cryptography, possibly because for the same level of security, it requires much smaller key than Digital Signature Algorithm (DSA) based on RSA. That saves bandwidth on the blockchain P2P network.
Public-key cryptography provides two keys – a private and a public. A private key is never to be exposed to public and remains a secret with the owner. On the other hand, public key is known to all. When the owner wants to send some information, she will take a hash, say, SHA-256 of the information, called digest, “decrypt” it with her private key and send that signature along with the original information.
The recipient would take the same hash, SHA-256 in this case, of the information and compare it to the signature after “encrypting” it. If the two match then the recipient knows for sure that the information came from the person who claims to have sent it and that it has not been altered on the way.
Bitcoin Transaction: Continuing with the previous example, I want to pay 3.01635 BTC to Bob. I have two coins – one worth 3 BTC and another 1.01635 BTC. These two coins of mine will go as inputs into the transaction. There will be two outputs: one to Bob, 3.01635 BTC and the second to myself, 0.8 BTC – the change. The rest, 0.2 BTC, will be used as transaction fee.
As mentioned earlier, everybody knows that I own that two coins. At two separate occasions, those two coins came to my address 7. They came to my address means, in each of those occasions, my public key 7 was mentioned in a transaction as output. Hence, these two coins are the output of those two transactions. And as of now, those two transactions have not been spent. Hence, they are unspent transactions. This can be verified as all records are public. That is why it is still valid to use those two transactions as inputs, to a new transaction.
INPUT : To spend these two coins, I have specified the two transactions as input into a new transaction. How exactly I do that? I get the hash for each of the two transactions and list them in the new transaction. Anybody can look at a hash and figure out which transaction it is referencing to.
THE REAL OWNER IS SPENDING : I then create a digital signature by combining that hash with the new owner’s address (Bob’s public key, say 9 that I know). Why do I do that? Well, since I have digitally signed this with my private key, anybody can verify that it is none other than the private key of the corresponding public key 3 (that is 7 and owned by me), who is saying that the two transactions be included as inputs, meaning the coins be spent.
To be more specific, there are two things happening here: 1) everybody knows which address (address 7) that two coins belong to, and 2) everybody can verify the digital signature using my public key (that is 3). Nobody else’s digital signature could have been verified using my public key, right? So it is verified that the rightful owner of the coins is now instructing to spend it.
Well, all is good. It is my coins that I am spending. And I also included Bob’s address, who is the recipient, in the signature.
OUTPUT :In addition to the input section, I also have an output section, where I have listed two addresses: one is Bob’s, who is specified to be receiving 3.01635 BTC and one is my own address – it can 7 or a new address associated with a new private key of mine that I have already generated (note that I am using multiple addresses). The transaction fee 0.2 BTC will go to a miner that we will explain later.
Double Spending: If we pause for a moment and think, we will realize that all is not well. It is all fine that I am paying my valid unspent coins to Bob. But what if I also create another transaction, just like the one above and instead of Bob, this time, I pay to Alice. Wait, so I am paying the same coins to two persons? Yes, and it is perfectly fine as no central authority is checking this. So far what we have discussed, the only thing we can do is to confirm the owner and that at this moment the coin is still unspent. But it cannot stop one to spend the same coins twice at the same moment.
Blockchain :
Bitcoin came up with a solution for the double-spending problem using a timestamp server combined with PoW. This is called blockchain. It serializes transactions by putting them in a permanent, irreversible blockchain by taking majority votes from the nodes.
At this point, it can be stressed that even though blockchain was invented for Bitcoin by the inventor of Bitcoin, blockchain is an independent technology on its own that can be used for many other applications. Bitcoin needs blockchain, not the other way around.
BLOCK :
So far we were discussing about transactions. Now we will talk about block, where a number of valid transactions are packed together. Such a block would also include the hash of its previous block and then it would be added to the existing chain of blocks.
Thus a blockchain is a chain of blocks. Keeping the hash of the previous block inside a block makes sure that no arbitrary block fits in the blockchain.
Suppose, at this moment we have 500,000+ blocks in the Bitcoin blockchain. If we change a little history in say, 10,234th block then 10,235th block would become invalid. After all, 10,235th block takes into it the hash of 10,234th block. As 10,235th block becomes invalid, the next one will also become invalid and so on, all the way till the most recently created one.
We can think this relation as a parent-child genetic relation. A block can be thought as a child of its previous block where some genes from its parent (previous block) are propagated to it. Now if the parent’s genes change, child’s genes will no longer match to its parent. Now child’s genes also have to be changed to fit its parent’s ones. But we are not talking about only two generations. We have to change all the descendants of the altered parent, till the last generation, to keep the lineage valid.
NODES : Bitcoin implements blockchain using a P2P network. Blockchain, as mentioned, is the single version of history. It is essentially a ledger that is maintained by the participating computers in the system. A node is such a participating computer that maintains a ledger.
We already saw what a miner is. To repeat, miners are a subset of nodes who actually creates blocks. As we have seen, miners are the ones who create the block and earn/mine bitcoins in that process.
Non-miner nodes are plain volunteers. Why does a node want to be a volunteer? Well, a node can be maintained by a merchant, who is accepting bitcoins to sell his/her products. Well, there were 100, 000 merchants as of Feb 2015. A merchant would feel comfortable to maintain a ledger on her own before accepting a payment by doing certain verification herself.
A node has a voting right. When a miner creates a block, and broadcasts the same to the network, hoping that it would be added in the blockchain and she would get the reward. The onus is on the nodes to decide whether it can be so done. If the majority nodes accept that to be a valid block only then it would be added.
How many nodes are there?
Each of the nodes would verify on its own that the transactions are all valid inside the block. For example, the money that a person wants to spend really belongs to her and that it is not already spent. And that the input value is higher than (the additional money goes to the miner as transaction fees) or equal to the output value etc.
There is one more thing that a node will check – PoW.
Proof-of-Work : Creation of a block, as we have already seen, takes no time. Well, that’s a problem. As mentioned earlier, at this moment, we have 500,000+ blocks in the Bitcoin blockchain. That is the Bitcoin history. If a block can be created very fast, an attacker can create the history in no time. If something can be changed so fast then that is anything but history.
We need to create the blockchain in a way so that it resembles a true history in the sense that it cannot be altered so easily.