The Bitcoin Trend: How does digital money change the world?

First, of a three-part series of articles, the following commentary discusses the various aspects of Bitcoin.

History of Bitcoin

In 2008, amidst a global financial crisis, a paper was released under the pseudonym, Satoshi Nakamoto. Titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” the paper discussed the convergence of technological changes that allowed for the creation of the first working, digital money[1] framework. Previous iterations of digital money were flawed in many ways, and the following table mentions a few names.

Table 1: Known attempts at creating digital money. Those marked in yellow are likely the ones you might have heard of. Source

One may recognize PayPal. Although its cryptographic payment system was ahead of its time, PayPal was unable to bring it to fruition. As a result, they pivoted the idea and survived. Other names too on the list were early attempts at creating digital money. However, Bitcoin solved a primary challenge that its predecessors failed to address. The challenge was the creation of a decentralized network. Fortunately, each failed attempt was a step closer to realizing a truly decentralized network of digital money, its circulation and at its center was Bitcoin.

But why did the idea of decentralization spawn?

In the late ‘80s and throughout the ‘90s, a movement was born called the cypherpunk movement. It gained momentum as the use of the internet spread across industries and around the world. Cypherpunks believed that the internet would one day become a tool for government surveillance[2] unless a virtual Chinese Wall[3] was erected against it.

Image 1: 1993 Cover of Wired

So, before social media companies started collecting personal data, governments started implementing firewalls, and the big tech started systematically censoring political movements, cypherpunks anticipated the porous boundaries of the digital ecosystem. Their knowledge of cryptography, computer science, mathematics, libertarianism, and Austrian economics[4] became the fuel that drove the Bitcoin revolution.

Following is a list of events that led to the creation of Bitcoin.

1. Cryptographic systems: Public key cryptographic systems were first launched in the 1970s and they allowed for public keys to be used within unreliable communication channels. Although governments attempted to curb its use by invoking the rise in criminal activity, today, public-key cryptography is used in modern technologies for encryption.

- Imagine owning a locker in a bank. You will likely be given a key to access the contents of the locker. However, many banks also issue a key to the administrator in the branch for security. Public key cryptography functions on a similar principle.

- Public key cryptography is a system of encryption where each private key has a corresponding public key that does not allow anyone to determine the private key. Further, data encrypted with one of the two keys can be used to decrypt a file/document using the other.

Figure 1: Basic functioning of public-key cryptography

2. Digital signatures: A digital signature is like a signature on a cheque or a form. Developed by David Chaum in 1989, digital signatures are the virtual equivalent of a physical verification process. Its development allowed individuals to create a signature that proves the association between a private and a public key, without revealing the former. Digital signatures are not necessarily a signature in the conventional form – it may be a few lines of code that allow users to maintain their anonymity while transacting over the internet.

3. Digital scarcity: If we understand digital money as a few lines of code, then any person with enough knowledge would be able to create more (say) Bitcoin. And since money must be scarce to hold fundamental value, then who is to stop people from creating more of it? Adam Beck was able to bring scarcity in a proposal he created for HashCash by utilizing computational puzzles.

- Today, computers have the capacity to solve complex mathematical problems. However, there still exist few problems that can only be solved by guessing.

- Hence, if tie together complex mathematical problems with the creation of digital money, then we can significantly increase the difficulty of solving a problem by guessing.

- Thereby, making digital money scarce and its creation difficult and costly.

- Today, computers have the capacity to solve complex mathematical problems.

However, there still exist few problems that can only be solved by guessing. demanding puzzles” (Yakes, 2021) to create bitcoin.

4. Blockchain: The first working model of blockchain may be found in a paper written by Haber and Stornetta in 1991. The idea by Haber and Stornetta was to allow people to share different editions of a file/document to a server with the ability to access its previous versions. Access to previous versions was given by attaching a hash pointer to each document.

- A hash pointer may be understood as a string of text attached to each file shared. It stores a timestamp (thus, creating a temporal list of the files/documents) and a digital signature that proves that a particular server verified the update.

- For example, assuming one works on Microsoft Word, let us suppose that their laptop crashes in the middle of work. The next time they open Word, a panel on the left side of the application will show them the different versions of the document it was able to recover. Attached to each version will be a date and a timestamp, and they will be able to access any one of them and resume their work. A hash pointer functions on a similar principle.

- If each document added to the blockchain has a hash pointer attached to it, then any change in the current document’s lineage would be evident in its own hash pointer. Thus, any change or tampering in the lineage would be evident in the present document.

Now, let us recap a few things before moving on:

- Digital signatures allow us to verify the virtual identities of senders and receivers without disclosing their real identities. This ensures anonymity.

- When digital signatures are mixed with the structure of the blockchain data and the timestamps, it creates a temporal list of immutable data shared between two people.

- “Computationally demanding puzzles” (Yakes, 2021) are used to control the supply of Bitcoin in the digital economy.

Using all these technologies, Satoshi Nakamoto was able to create the world’s first decentralized network of digital money – Bitcoin.

What does Bitcoin do?

In 1999, Nobel prize winner Milton Friedman said,

“I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A.”

Now, what Bitcoin does is diametrically different from why it is valuable. It is valuable because a system of people has adopted it as a means of transaction over the internet, and its supply is scarce. But to understand why they adopted Bitcoin, what Bitcoin does must be understood. It is the difficult part to understand because, as mentioned earlier, Bitcoin was the result of a confluence of technological advancements. Unfortunately, it is beyond everyone’s capacity to understand. Regardless, let us try!

Bitcoin allows anyone to send scarce digital money to another person, anonymously and with very low transaction costs. Suppose you want to transfer 20 lakhs to another person (say, your spouse or brother or sister – does not matter). The amount itself is so large that your transaction will likely raise some red flags[5]. Further, you will also have to comply with (sometimes outrageous) the rules and regulations of the third-party service and the government. Some of the other consequences of third-party services include:

- Sharing proof of identity: One will never guess how it is used and for what purpose.

- Trust they will not misplace sensitive information: If one’s phone can be hacked without a trace, imagine what will happen if one’s basic information was shared with the world?

- Give them control over the money one has stored in their wallet: It is like depositing money in the bank and not knowing how and where it is being used.

So, let us condense these three challenges and call it an ‘issue of trust’. Why would one trust a third party with their hard-earned money?

Bitcoin removes all these intermediate challenges. It gives one the ability to transfer any amount of money – if it can be backed up with sufficient Bitcoin – over a trusted digital network. This means one does not have to rely upon a third-party service to store and transfer money. It is possible because the Bitcoin protocol is a decentralized network of digital money without intermediaries that control it.

What about transaction costs? In 2020, $1.1 billion (161,500 BTC[6]) in bitcoin was moved for which the transaction cost was 68 cents. Large amounts can be transferred over the Bitcoin network in a matter of minutes. Further, these transactions over the Bitcoin network also allow anonymity to be preserved and quick transfer to be conducted, without giving anyone proof of identity to make the transaction. Normally, in any economy around the world, such a large amount cannot be transferred without oversight from a regulatory body or third-party service.

Remember how we mentioned that understanding what Bitcoin does is difficult? This is where it gets highly technical.

1. One-Way Hash Function: A hash function, otherwise known as a one-way hash function, uses an arbitrary line (say the list of transactions) of arbitrary length as an input and converts it into an output of fixed length. Simply put, suppose a message is given, it is easy to create a hash. But if given the hash, it is hard to figure out the message, and if given that message, it is hard to find another message with the same hash.

*The technical aspect of the one-way hash function, which some also call one-way calculation, is below:

BTC makes use of hash functions (otherwise known as hashes) in many ways. Hash functions allow us to produce one-way calculations which means, if A*B=C, then we can find A and B if we know them or for example, if we know A and C, then we cannot divide them to ‘solve’ for B.

Now, in Bitcoin your public key is C, the private key is A, and B is known to everyone.

A = private key (a set of digits chosen by you)

B = this variable is public and therefore, known by everyone but remains change (in Bitcoin, this variable is called secp256k1)[7]

C = public key, otherwise called Bitcoin address (though there is a slight difference between the two – more on this later)

One-way calculations are an important part of the Bitcoin protocol because they are dependent on an unsolvable math problem – a discrete log problem. In its simplest form to understand, a discrete log problem is unsolvable because:

- If we consider finite field math[8] and an unimaginably large prime number, then dividing them would be an impossible task. Much of modern cryptography relies on the discrete log problem for security purposes.

- Of course, as technology improves and we make greater leaps in quantum computing, we may be able to solve the discrete log problem through iteration but that is highly unlikely.

- Imagine this: the prime number used by Bitcoin is 2256 ~ or 1077 digits long. Now, the universe is made up of (approximately) 1080 atoms – which we will consider to be our finite field. This means, a trillion computers working on a trillion computations every trillionth of a second for a trillion years will still be less than 1056 computations.

2. Bitcoin Addresses and Digital Signatures: Hash functions and digital signatures together enable the creation of Bitcoin Addresses, which are then used to transfer files from one address to another. A digital signature, in the process, enables public verification of ownership of private keys that unlock an address without revealing the identity. Bitcoin can do this via a system called Elliptic Curve Digital Signature Algorithm (ECDSA).

Figure 2: Functioning of Elliptic Curve Digital Signature Algorithm

Here is how the ECDSA functions in the Bitcoin protocol:

- Private keys are created as a random numbers.

- The private key function (t) is multiplied with a random coordinate (G) on the Bitcoin elliptic curve to generate a public key (r) that can be shared with anyone without revealing the identity.

- This public key is then hashed to generate a Bitcoin address (a). It is important that users utilize a strong source of randomness to ensure their (a) does not face security issues.

- Finally, the ECDSA algorithm uses the private key to generate a Digital Signature (s). Using the (s) and (a), one can transfer Bitcoins on the peer-to-peer network.

- When one sends Bitcoin to another user, nodes within the network verify the signature and the address to validate that one has sufficient Bitcoin in stock to transfer the amount. If the verification at any step fails to give a positive result, the transaction is dropped from the network.

3. Transaction Mechanics: In Bitcoin, every transaction has an input and an output. An input is considered to be the amount of Bitcoin available to transact, and the output denotes the amount of Bitcoin transferred. Participants of the network keep a log of all the Bitcoin stored within addresses. It is called Unspent Transaction Outputs (UTXOs). UTXO may be understood as the change left in our pockets after spending the original amount of money we had.

4. Blockchain Data Structure: Bitcoin allows anyone to make transactions, which after verification are aggregated into blocks. These blocks are then aggregated to create the Blockchain that remains immutable.

But how do we differentiate between blocks?

Each block has a block header that functions as a verification and identification tool between nodes. A block header includes the following items:

Table 2: Contents of the Block Header

Accordingly,

- Every transaction is aggregated in the form of a tree (otherwise known as the Merkle Tree) which when then combined and hashed further creates one singular hash called the Merkle Root.

- All previous block hashes are the hash of the block headers in the preceding blocks.

- The remaining categories are used in mining – will be discussed in the next part.

Data, when structured in such a form, allows computers to identify and verify the consistency of the blockchain. In this way, all transactions are categorized in a tree form, and the preceding block hash links all the blocks to create the Blockchain.

Further, changes made to any preceding blocks will reflect in the subsequent block (current block). Such a protocol was put in place to ensure that all participants of the network could work on the same chronological order of the Blockchain. It also discourages bad actors from tampering with any of the blocks within the Blockchain.

Finally, to wrap up the chapter on “What Bitcoin Does,” let us examine the concept of memory pools.

Before each transaction is logged into the Blockchain, there exists a period when transactions are recognized by each miner in their memory pools. During this period, each miner attempts to solve the computational puzzle to get the right to log the transaction on the Blockchain thereby, creating the next block. Any transaction dropped within this process will simply have to wait for the next block to be generated.

Hopefully, the structure of the blockchain is now understood. However, this summary of the Blockchain is incomplete without understanding the Blockchain network. The next part will discuss the network and attempt to answer the following questions:

- How do miners hear about the transactions? They are not like your average stock trader that you go to.

- Does everyone agree on the transaction or the changes made to Bitcoin? The network is quite large and universal.

- How is consensus achieved?

Works Cited: Yakes, E. (2021). What Bitcoin does that changes the world? Bitcoin Magazine.

[1] Money is generally understood as a medium of exchange in trading practices. Once it was trinkets, then gold, and today its currency notes and coins. Similarly, Bitcoin too may be understood as a medium of exchange or money.

[2] To some extent, we can see this hypothesis become a reality in India especially with the new OTT rules and regulations. [3] In legal and business terms, the Chinese Wall refers to a virtual barrier erected to block the exchange of information between two departments in a company. Its composition is not physical rather an ethical one.

[4] Austrian economics in many of its holdings dictates how new money emerges and is therefore sometimes intimately connected to the emergence of Bitcoin.

[5] This is the reason why on platforms such as Paytm, the maximum amount that may be transferred in one go is INR 10,000.

[6] BTC is an acronym for Bitcoin [7] Secp256k1 refers to parameters of the elliptic curve y2 = x3 + 7 over the real numbers [8] Finite field or Galois field basically means a field containing a finite number of elements

Cover image: Source

About the author: Aditya Singh is the Technical Head of The JSIA Bulletin. After four years of working in Digital Marketing, Aditya has renewed his passion for Public Policy and International Affairs as a student at JSIA. Previously, as Head of Digital Marketing, Aditya conceptualized and executed marketing plans for PepsiCo, Hackett London, British Council, and Sweden Embassy among others.