Essentially, Bitcoin is a protocol that implements an independent currency and payment system. Other digital money or payment systems (e.g., WebMoney and PayPal) operate with existing (fiat) currencies controlled by government entities (e.g., dollar, euro, pound). Bitcoin is both a separate currency and a payment system that manages its own currency. Note that it is an independent payment system: there is no central entity that controls its operation.
NOTE: We will use Bitcoin to refer to the accounting system or the protocol and bitcoin to refer to the currency or a coin.
When people try to understand Bitcoin, they often turn to Wikipedia, which defines it as a peer-to-peer payment system that uses its own coins as value units, and cryptographic methods are used to ensure the operation and protection of the system. For a person who doesn't have any experience with payment systems, this definition is complex and incomplete—especially if they're hearing about Bitcoin for the first time. Therefore it is necessary to define Bitcoin with more familiar words. The best analogy that appears in publications on this subject is the analogy with "digital gold" (Fig. 2.1).
It is fair to assume that the creator of Bitcoin actually aimed to reproduce all the properties of gold such as a limited supply, mining, independence from a single organization, and the impossibility of artificial reproduction. The fact that Bitcoin reproduces the qualities of a naturally occurring mineral in a digital form can be considered a major breakthrough in computer science.
Using Bitcoin, one can make a payment to anyone and anywhere. All that is required is access to the Internet, a digital wallet, and a receiver's address. Common disadvantages for international money transfers are simply absent. No additional permissions are required to make a payment.
Therefore Bitcoin became well known and well regarded in communities with people who held firm beliefs in anarchism, liberal ideas, and complete privacy; later computer geeks (cypherpunks, hackers) as well as scientists—who did research and conducted experiments on Bitcoin—have joined them. Soon the price of bitcoin attracted the attention of entrepreneurs and speculative investors. Finally, the key motivation for using Bitcoin across the board was the ability for regular people to conduct permissionless payments without having third parties involved and without the need to register.
Payment systems such as PayPal or WebMoney are managed by companies which can be exposed to hackers or government demands, leading to information leaks, server shutdowns, and the freezing of accounts. This is not the case with Bitcoin: there is no, say, Bitcoin LLC which can freeze accounts or individually confirm transactions. Bitcoin transactions are not censored. This property is very important, and we will later discuss how it is achieved.
We do not know who invented Bitcoin, though it is known that it was someone with the pseudonym Satoshi Nakamoto. Perhaps this is an individual, but there are suggestions that it could be a group of people. Satoshi registered the bitcoin.org domain in 2008, released the first article, and published the initial version of the source code of the protocol. Until 2011, messages under the pseudonym of Satoshi Nakamoto appeared on forums and in email lists. Later he wrote that he had decided to focus on other things and ceased public communication.
Nevertheless, it is worth noting that Satoshi's idea of creating Bitcoin didn't come out of nowhere. In his paper "Bitcoin: A Peer-to-Peer Electronic Cash System" [15] (Fig. 2.2), Satoshi mentioned two earlier key projects (previous attempts to create an independent digital currency): Adam Back's HashCash [16] and Wei Dai's B-Money [17]. HashCash first introduced the proof-of-work approach, originally created to combat spam in emails, while B-Money introduced a network model for distributing transaction data, plus the use of cryptographic signatures to send money.
Thus, Satoshi used existing concepts to implement Bitcoin and solved the issues of earlier attempts to create digital money. It is fair to assume that not many would have recognized an embryonic formation of an independent digital currency from the above-mentioned projects.
Background to the invention of Bitcoin
- David Chaum—DigiCash [18] (1989)
- Adam Back—HashCash (1997)
- Nick Szabo—BitGold [19] (1998)
- Wei Dai—B-Money (1998)
- Hal Finney—RPoW as e-money [20] (2004)
Bitcoin is the first successful implementation of a decentralized accounting system. There were other attempts before it: for example, the company DigiCash, founded by David Chaum in 1989, was the first to offer digital payments with a special currency called Ecash. Users of this payment system were anonymous and banks could not track their accounts. The project was supported by several innovative banks in the US and one in Finland; since it was very difficult to convince more banks and merchants to accept anonymous currency, the project was canceled.
Key dates
- Bitcoin whitepaper release—October 31, 2008
- Genesis block creation—January 3, 2009
- First bitcoin exchange—February 2010
- P2SH adoption—January 5, 2012
- Bitcoin Cash fork—August 1, 2017
- Segregated Witness adoption—August 24, 2017
- Lightning Network launch—March 15, 2018
One of the first steps in the development of Bitcoin was the publication of the Bitcoin White Paper on October 31, 2008. On January 3, 2009, the first source code was published and the first block (the genesis block) was created—the first 50 bitcoins appeared. This day can, therefore, be considered as the launch date of the system. Just over a year later, came the first exchange of bitcoins for fiat currency.
Bitcoin Cash fork, which took place on August 1, 2017, was the first splitting of the primary system (for further details, see section 6.1). Another important event was the introduction of a crucial update for Bitcoin, Segregated Witness, which has implemented certain improvements which opened up a number of formerly impossible opportunities for Bitcoin (for further details, see section 4.6). And on March 15, 2018, the revolutionary and transforming instant payment system on top of Bitcoin, Lightning Network, was launched.
Statistics of the Bitcoin network in 2018
- Estimated 10 million unique users
- On average, 300,000 payments in bitcoins per day
- Daily trading volume equivalent to $15 billion
In 2018, Bitcoin is used by millions of people worldwide and hundreds of companies accept bitcoins as a payment method. Many projects are being developed on the basis of Bitcoin, and some countries (most notably Japan) recognize and acknowledge bitcoin as a legal means of payment.
The first reason Bitcoin became popular is that it implements a decentralized financial system independent of governments and banks. It is not subject to inflation in a traditional sense of this term (there is no entity or a particular person who can print more Bitcoins on their own). It does not allow freezing, reverting, or canceling transactions, and it relies only on mathematics and not on the whims of people. In addition, bitcoin payments are more private compared to digital currencies that existed before.
- Financial instrument that operates without restrictions
- No complex registration processes
- Can be used anonymously
- Resistant to censorship
These properties attract a different group of users. For example, businesses can be sure that when a buyer doesn't like the purchased goods, she cannot just automatically demand a refund. Another issue which became very painful for PayPal business users was when their accounts and tens of thousands of dollars were blocked for several months for such reasons as "A complaint was filed against you". This is impossible in Bitcoin, and it is the reason why it became attractive for business.
The non-transparency of the existing financial system is another argument in favor of Bitcoin. History provides numerous cases when governments have issued money without good reason, which led to hyperinflation and a drop in the standard of living. This happened in the 1990s in the countries of the former Soviet Union, where the personal wealth of citizens was devalued to virtually nothing due to reasons beyond their control. Such events clearly explain why people prefer to manage their finances independently of governments or banks, where possible.
In fact, the very first block of transactions in Bitcoin included links to news which described the printing of a large amount of cash as an attempt to deal with the 2008 financial crisis [21]. Non-transparent payment systems caused the dissatisfaction of users during the crisis period. And that is where the conspiracy theory lies: its supporters argue that banks do whatever they want with their clients' money (this actually takes place in some countries). In practice, this happens more "decently": the bank takes fiat money from the client and, in return, gives an obligation to return it at the client's request; a little later the bank may refuse its obligations. The essence of the problem is that for the client proving this refusal is wrong and returning the money is a very complex task.
Issues of existing payment systems
- Users do not control their funds
- Fund transfers may take days or weeks to settle
- Payments can be canceled or voided
It turned out to be very difficult to implement a system in which people could independently manage their own money. However, over time, the demand for this has been increasing, and in 2009, a real solution was presented in the form of Bitcoin. It did not take long for this to capture the attention of the public.
A concise formulation of the basic principle on which Bitcoin functions would sound something like this: each user runs the same version of the software which has the same state, and, as a result, they maintain a decentralized system.
- Copy of the database is stored by all users
- Users process transactions themselves
- All users follow the same rules
- Users only trust what they can verify themselves
Connection and disconnection of participants occur independently and do not affect the work of other network members. Everyone keeps and updates the database and the corresponding software independently. All the rules of work are stored by everyone, and all users double-check each other. The Bitcoin network of users can be represented as in Figure 2.3.
A particular user may process any network transactions on her own. By using the software, she may confirm a particular transaction which she considers correct. As a result, each of the users has the set of transactions which he has verified and determined as correct. Based on this, each network node builds the shared database consisting of the transactions agreed on by the majority of users. As soon as the transaction enters this database, it is considered to be confirmed.
Issuance (in the context of money) is the process of putting cash or non-cash money into circulation. Issuance in Bitcoin is different from that in traditional financial systems. Instead, it occurs through the creation of coins by an algorithm. The basic principle is that the entire process is completely decentralized and is based on mathematical algorithms which are publicly published and cannot be manipulated. This is how absolute transparency in the distribution of coins is achieved.
- The process of issuance is decentralized
- Issuance rules are controlled mathematically
- Issuance is performed by the users themselves
- New coins are distributed among active participants
According to the protocol rules, any user can perform issuance, while all the network members verify the compliance with these rules. In short, new bitcoins are distributed among the users who are actively involved in maintaining the accounting system. They are called validators. This means that there can be a lot of participants in the system and each of them can receive new coins.
Rules for the issuance of bitcoins
- New coins appear on average every 10 minutes
- Every 4 years the number of new coins is reduced by half
- Absolute total number of bitcoins which will ever be issued is 20,999,999.9769
The issuance of coins is determined by the rules that are established in the software of the network node (a computer that runs Bitcoin software). Satoshi established that new bitcoins appear on the average every 10 minutes. At first, it was 50 coins, and since then the number of new coins gets halved approximately every 4 years. At the moment, more than 10 years have passed since the launch date of Bitcoin—and the rate of issuance of coins has significantly decreased.
In Bitcoin, it is programmed that the maximum number of coins is about 21 million. Why 21 million? No one knows the exact reason, and it really does not matter; this is what was determined by Satoshi. Each bitcoin can be divided into 100,000,000 parts, the smallest unit being called satoshi (by the pseudonym of the protocol's creator). Therefore, you do not have to have a whole coin: you can own a fraction of one.
1 BTC = 100,000,000 satoshis
According to the calculations, the absolute number of 21,000,000 bitcoins will be reached in approximately 2140. The precise number will be a little bit less than 21 million bitcoin or 2,099,999,997,690,000 satoshis.
Now, let's see how the number of issued coins changes over time. The graph in Figure 2.4 shows the change in the number of coins in existence during a certain time. We can see that it resembles a logarithmic curve. In 2018, the number of mined coins exceeded 17 million BTC.
Properties of bitcoin coins
- Scarcity (limited amount)
- Discreteness (coins are divisible)
- Censorship resistance (independence from any company or state)
- Immutability (inability to forge coins)
Bitcoin allows paying any amount to anyone for anything to any place in the world. In addition, bitcoin as a currency has a number of properties that make it suitable as a means of payment, which at some point can also become a store of wealth.
We believe that the primary reason why many people’s interest is actively drawn by cryptocurrencies is the increase in their price. One of the first questions is how the price is actually determined. The price of bitcoin is determined strictly by the law of supply and demand between buyers and sellers. There is no entity that decides that today the price of bitcoin will be X and tomorrow it will be Y.
For the most part, the price is established on exchanges which allow people to buy or sell coins using an order book, as they do for stocks and other financial instruments. Globally, there are many different trading platforms with different users and order books. Therefore, the price of bitcoin can be different across exchanges because it is determined by the demand and supply ratio created by users of a specific site (Fig. 2.5).
In Figure 2.6, there is the graph of the price of one bitcoin (1 BTC) from the launch date of Bitcoin, namely from 2009 to 2018 [22].
In the early days of Bitcoin, the price of bitcoin did not use to be determined, as there used to be no public exchanges. Later people started exchanging bitcoins for other currencies in a certain ratio. The first purchase of a real product (two pizzas) for bitcoins was made in 2010 [23] at the rate of a few cents per bitcoin. The price began to grow, and in 2011 it reached an early peak of $33 but then proceeded to fall to $2. The record price in 2014 was around $1,100. After another fall to $200, the price was comparatively stable throughout 2015, then began to grow gradually. In 2017, the period of its exponential increase began, and the price reached $20,000.
Concerning the establishment of the price, it is fair to note that bitcoins which cannot be accessed or which are not used for some reason can play a significant role in the overall picture. For example, the fact that by November 2018 about 3 to 4 million bitcoins had been blocked due to key losses has a major influence on the price [24]. It is known that Satoshi has about a million bitcoins, none of which have ever been spent. If evidence were to come to light that the private keys have been destroyed and the corresponding coins are out of circulation, the price of bitcoin could have changed significantly.
We cannot say for sure whether Satoshi has blocked the possibility of spending his bitcoins. If he still has access to those bitcoins, then he can use them, and, if keys have been lost, it is possible that someone else might find and use them. Only Satoshi can prove or disprove it. It remains possible that he may appear tomorrow and declare that he will control the price of bitcoin using his vast supply, similar to the principles used by central banks to manage the supply and value of fiat currencies.
Noteworthy, the price of bitcoin is inessential in some use cases. For instance, if someone needs to transfer money from Ukraine to China, she can use Bitcoin as a transitional “layer”—buy bitcoins in Kyiv for hryvnias (the local currency) and sell them in Shanghai for yuans. Here, it does not matter whether 1 BTC costs $200 or $10,000.
NOTE: It is not always viable to use bitcoins as a payment/settlement method for real business (mostly due to the price volatility), but they can be very helpful in the context of international transactions.
The advantage of Bitcoin is the irreversibility of payments and the ability to “program” behavior. These features are crucial in situations when buyers do not trust sellers. For example, take online auctions: the seller is unwilling to ship the item to the buyer before the buyer’s payment, and on the other hand, the buyer is reluctant to send the money before having his goods shipped.
A simple solution for them can be that instead of paying the full amount using a bank transfer, a buyer makes a partial prepayment in bitcoins (which is instant and supports trustless escrow, see 4.5) and afterward sends the remaining money via bank transfer. Once the seller has received the prepayment in bitcoins (as an option, it may cover the shipping costs), he ships the item. After the item arrives and the buyer makes the bank transfer, the seller returns the prepayment.
In the example above, neither the bitcoin price nor its volatility is an issue. Ultimately, if you imagine a world where many cryptocurrencies provide the same level of censorship resistance and transactions irreversibility, then their price gets irrelevant for people who use them.
NOTE: Censorship resistance stems from true decentralization, and it is what creates real demand for bitcoin as an asset.
It is very easy to copy the Bitcoin codebase and create another cryptocurrency that would also be limited in the issuance or could even have a higher level of anonymity. However, it won’t necessarily be as valuable as Bitcoin because the only distinguishing factor is the level of censorship resistance and not the amount of coins in existence or some additional functionality.
The key feature of Bitcoin is the trustless interaction of all its users. Every single person can verify that the final state of the system is reached with no violations of the protocol rules. Trust between participants of the system is excluded.
Trust only to mathematics is one of the key advances in a cryptocurrency. We will repeat this statement more than once in this book. Nevertheless, it is not comprehensive, and things are slightly more complicated in practice.
Regarding the interaction of a specific user with the Bitcoin network, a number of aspects should be considered which make the user trust somebody. For example, when you trust that your bitcoin wallet balance is correct, this means that you trust:
- Those who recommended you to install this particular wallet (friends, Internet forums, etc.)
- That the wallet you use is developed and implemented correctly
- That your operating system is not hacked
- That hardware of your computer is not hacked
- That your wallet is connected to authentic Bitcoin nodes (you are not connected to malicious nodes)
- That the implementation of a cryptographic library has no backdoors
- That the cryptographic algorithm has no built-in backdoors
All the above-mentioned is not imaginary (there are actually much more possible threats). Behind each of the items, there is a real case that at some point in time happened to somebody. This shows that concepts such as absolute security and full trustlessness in a system are only theoretical. Decentralization is just increasing the probability that the system is not compromised. In the context of Bitcoin, this means that every user can independently verify the correctness of any transaction or block—he does not have to trust the data provided by a third party.
Along with its advantages, Bitcoin also has limitations as compared to the digital currencies which are managed in a centralized way.
- Limited capacity
- High system maintenance costs
- Long transaction confirmation
- Public availability of transaction data
- High fees and their volatility
In the following subsections, we will consider each limitation in detail and describe the respective solutions (see 4.6–4.8).
NOTE: Note. The above-mentioned limitations do not make Bitcoin incomplete. They are the outcome of a tradeoff between properties such as efficiency, security, and censorship resistance. For the same reason, it is incorrect to compare the capacity of digital currencies that operate under different security assumptions (such as Ethereum and Ripple).
So, you now have a basic grasp of decentralization as a notion and also some of the key aspects of Bitcoin operation. This is why, before proceeding to further sections, we would like to repeat some of the specific peculiarities of Bitcoin, namely what does it mean when one says that Bitcoin is decentralized. Essentially, this means that there is no particular party responsible for a particular process in the system.
There is no designated party/organization that is
- Responsible for Bitcoin operation
- In charge of system management
- Collecting fees
- Processing transactions
- Exclusively storing the history of transactions
- Making refunds
- Enforcing court orders
Frequently asked questions
– Are 21 million bitcoins enough for mass adoption?
Some might argue that 21 million coins are not enough for a large number of users. However, each coin can be split into at least one hundred million pieces and, if necessary, it is potentially possible to release an update and increase the coin divisibility.
– Is it possible to "deactivate" Bitcoin?
Theoretically, the possibility exists. In practice, the operation of Bitcoin is maintained by the participants whose equipment is located in different parts of the world. To participate, one needs a computer and Internet access. Therefore, in order to perform a "shutdown", it would be necessary to ban the use of computing equipment and data transmission channels. Moreover, it would also be necessary to enforce this prohibition. This would require coordinated and rapid actions by various political forces, including those opposing each other. This is extremely hard to get done.
– What if I want to modify the Bitcoin protocol?
This is quite common, so there is a conventional way of making suggestions for protocol improvement. The corresponding repository is called "Bitcoin Improvement Proposal" (BIP); in it, members of the community discuss new proposals. Anyone can add their proposal to the repository, and if the community and validators agree with the update, they will switch to a new version of the protocol.
– Does the issuance of coins depend on the demand on them?
There is no such dependency. Here, it is worth mentioning whether the market price of a coin depends on its mining difficulty: in general, it doesn’t. What one can only say surely is that the prime cost of a coin (the price of its mining) will be unlikely to be higher than its market price.
In this subsection, we explore the core properties of digital wallets for utilizing Bitcoin: their types, special aspects of their use, features of their implementations, and the impact of these features on the level of security.
Most common operations with wallets
- Balance check
- User keys generating and storing
- Payment sending and receiving
To illustrate the idea of a digital wallet, see Figure 2.7; here you can see a screenshot of a mobile application running an implementation of a bitcoin wallet. On the main screen (the one on the left in the figure), you can see the current balance, the list of transactions, the amount of each payment, and the state of their confirmation. You can also switch to another view (the one on the right) to accept and send payments.
A bitcoin address is an identifier of the recipient. In order to send a payment, the sender needs to know the destination address. Therefore, it is important for the recipient to provide his address in advance. A regular bitcoin address looks like this:
1BooKnbm48Eabw3FdPgTSudt9u4YTWKBvf
In some sense, a bitcoin address is an alias of a user, which is not tied to any identification data—it (address) is relatively anonymous. This fact, however, does not mean that, when operating with Bitcoin, you stay anonymous by default (to learn more, see section 7.1).
An important feature of Bitcoin is that users create their bitcoin addresses on their own (this also applies to other cryptocurrencies) by launching a special software that generates a new address. The number of addresses that one user can create is unlimited, meaning you can generate even a billion ones and use each for accepting and spending coins.
Each address has a certain confidential data value available only to the owner of the wallet—a private key. It is used to prove ownership of coins at the time they are sent.
An address can be calculated mathematically from the private key, so if someone takes possession of your private key, he can access the coins without even knowing the address.
One key difference of cryptocurrency from the traditional financial system is that the number of addresses is practically unlimited. You can send coins to any of them, whereas in the banking system, accounts always belong to some organization and must have an owner.
A transaction is a set of digital data that initiates the update of the database (the sending of bitcoins from one address to another). It is a simplified definition; the transaction structure is actually more complex (for more details, see 2.3). Note that transaction is created and sent directly by the user's digital wallet, so it is the process which even digital currency developers cannot interfere with. Figure 2.8 shows the screenshots of the interface parts of a particular mobile wallet [25] which allow providing your requisites and send a payment, respectively.
Basic types of bitcoin wallets
- Software wallet
- Hardware wallet
- Centralized storage
Some people use software wallets to store their bitcoins. Software wallets can be launched on a smartphone, laptop, or a desktop computer. A software wallet is an application that processes keys and transactions. This application connects to the Bitcoin network through trusted nodes or centralized services or is a network node itself.
Note that it is recommended to only use the software wallets of developers you trust. This cautionary point is made due to the fact that developers can introduce vulnerabilities into the application code that would allow them to later block or steal the coins. Unintentional mistakes can also be made in their code that hackers can later exploit.
Therefore, it is recommended to use open source software wallets. This solution allows you to audit the wallet's source code and prepare it to run on your device.
However, software developers are not the only ones who should be trusted by a software wallet user. In addition, a user needs to trust the services which distribute this software (application stores, etc.), the developers of the operating system, and the developers of the user's device: backdoors can potentially be implemented at any of these stages.
We pay special attention to hardware wallets. Such a wallet is a computer that can only perform a narrow set of operations and with limited control interfaces. This is done to ultimately complicate possible virus injections into a device as well as eliminate device hacking in general. Typically, the basic functions are as follows: private key generation, private key storing, and transaction signing.
The basic configuration of a wallet does not have any additional interfaces; it is simply a compact device. Most often, it can be connected to a regular PC and operated with via special software. Also, more advanced models are currently available—the hardware wallet may have a screen, a keyboard, a battery, a fingerprint scanner, and modules for wireless communication (Fig. 2.9). In some cases, there is even a camera for scanning the recipient's address. Such wallets minimize the risk of theft of private keys but do not protect the owner from their loss. Therefore, many hardware wallets provide a backup of private keys.
Once there was an interesting story: one person bought on eBay a used Ledger hardware wallet from an unknown seller [26]. In the box with the wallet, there was a sheet of paper (Fig. 2.10) with a recorded mnemonic phrase with the note: "Use this phrase to restore your wallet." The new owner of the device entered the suggested words, and a few days later it turned out that all his bitcoins were gone. How did this happen? The seller of the wallet (the previous owner) knew this mnemonic phrase. Therefore, he could access the addresses that the new wallet owner used. In other words, what the previous owner said was: "Put your money in the vault for which I have a key." Thus, the buyer of the device has irretrievably lost all his coins. The mistake was made as the device buyer did not generate new keys.
In theory, you can imagine a situation where the private key of one user appears to be the same as the one of another user. But in practice, it is extremely unlikely. This is because the amount of possible private keys is 2256. This number is greater than the number of atoms in the universe. Therefore, for a mnemonic phrase with a length of 24 words, the probability of this coincidence is almost zero.
NOTE: If the software that generates private keys is initialized based on some obvious data, such as a user's password or the current time, then the probability of guessing and matching keys increases.
There are online services that implement the basic functions of digital wallets but store private keys on their own servers. Their users have a false feeling that they have a bitcoin wallet, whereas it is actually a particular remote service that performs operations and stores coins instead of the user himself. Obviously, by using such services, you do not control your coins and must completely trust the third-party organization.
One of the largest providers of centralized storage is Coinbase. In fact, it is a kind of bitcoin bank, where a user registers as with PayPal (login, password, etc). After that, a user is given an address for the deposit of bitcoins and an application for remote management of her coins. A user in fact only has a promise from the centralized service to keep funds safe. Using centralized wallets, your ability to manage funds is limited: you can only send a request for a withdrawal of bitcoins, and then “hope” that it will be processed.
Most exchanges store coins of users on the principle of centralized storage, hence they require a maximum level of trust from their users.
Since the private key is the only way to prove ownership of coins and spend them, the owner of coins is determined by the knowledge of the private key. All bitcoin wallets implement the following functions: generation of addresses for coin receiving, displaying of balances and transaction history, payment sending, creation of a wallet backup, and wallet restoring from a backup.
There was an interesting incident in the life of a man named James. He had a hard drive storing the keys with access to 7,500 BTC. Since, at that time, the price of bitcoins was low, James threw the hard drive away. When the price of the coin increased, James realized how much money he had lost and started looking for his hard drive at the dump. He even appealed to the municipality, so that the local authorities would allow him to search the dump, but he was refused. Ultimately, James spent a long time pursuing various options to find the hard drive holding his coins, but all efforts proved unsuccessful [27].
We deliberately emphasize the fact that making a backup copy of your wallet is mandatory and something you should carry out even before you receive the first payment. For this functionality, there is a technical specification supported by different developers of the wallet software. A backup copy can generally be restored in wallets from different developers.
If a user is wondering whether or not it makes sense to make a backup copy of the wallet after each payment, the answer will depend on the implementation of a specific wallet. Usually, the wallet generates new addresses and corresponding keys for each payment, meaning that you have to re-transfer them to a backup copy each time. However, there are wallets that use the so-called deterministic key generation (deterministic wallets). In this case, one backup is enough.
For the deterministic wallets, there is the concept of the main secret of the wallet. All new keys are mathematically generated from this main secret. This means that users can make a backup copy of the main secret of the wallet only once and then, using it, restore the access to coins on another device and/or in other software at any time. Usually, special encoding is used by the wallet to allow users to represent the main secret with an easy-to-remember mnemonic phrase.
An example of a mnemonic phrase is illustrated in Figure 2.11. In practice, it is convenient to write a mnemonic phrase on a piece of paper and store it in a very safe place and, when necessary, enter it into another wallet. To store keys conveniently, you can use password managers. They allow a user to remember from 4 to 6 words instead of writing down the entire mnemonic phrase. A user will further need those particular words to open a password manager and access all her private keys.
Common myths
If you store private keys on your device, they cannot be stolen.
The most common way to steal coins is to steal private keys using a software virus. Therefore, it is not recommended to store the private keys which big coin amounts are tied to on unprotected devices.
If you store private keys on a device with no internet access, you need not worry about security.
This approach can actually improve the security of key storage and protect against most remote attacks, but this does not mean that the private key stored in this way is ultimately secured.
Quantum computers can easily hack the Bitcoin encryption system.
In fact, Bitcoin does not use encryption at all. It uses digital signatures and hash functions in a combination that makes them not vulnerable to attacks by a quantum computer (see 3.2).
Frequently asked questions
– Are there any organizations that resolve disputes regarding transactions?
There is no such centralized organization. Disputes regarding transactions are resolved at the Bitcoin protocol level. However, there may be disputes outside the protocol during its usage. To solve them, the so-called escrow agents are used. This means that during a transaction, coins are frozen between the sender and the recipient. The decision on how to distribute these coins is made with the mediator’s participation. In this case, the mediator must be trusted by both parties of the transaction.
– Why can't you personalize a wallet—bind it to a specific person?
Bitcoin as a payment system protocol does not require user identification. Moreover, this is not an exclusive requirement for verifying transactions (for this, a digital signature is enough). The one who generates such signatures is the owner. And so, the signature can be owned by a person, a group of several people, even a robot, etc. As for personalization, there is no identity data in the Bitcoin database, but the entire transaction history is publicly available. This means that if you manage to associate a particular address with a particular person, then you can deanonymize some users with a certain probability.
– If several billion new users get wallets, will Bitcoin slow down?
If you just open a wallet and create many addresses, this will not affect the network and the database. What does matter is the number of transactions. So, it's not about the number of users but the scale of their activity.
- Is it possible to create wallets that work without servers and a center (peer-to-peer)?
Yes, it is possible. However, in this case, the requirements for the mobile device increase: internet connectivity, long recovery on another device, power consumption, and device memory.
In this subsection, we describe some general ideas around the concept of transaction in Bitcoin: what a bitcoin transaction is, how it is verified in a shared database, how a user proves her ownership of the coins that she tries to spend, how fees are determined and set in Bitcoin, and what conflicting transactions are.
As we noted earlier, a transaction is a set of digital data which is used to update a particular database (which reflects coin transferring from one address to another). A transaction is especially what determines the transfer amount and the recipient’s address as well as the terms required to access the transferred coins.
Lifecycle of a transaction
- Creation
- Propagation
- Verification
- Inclusion in a block (validation)
- Rejection (in case the block is invalidated later)
Let's explore what data makes up a bitcoin transaction. Any transaction in Bitcoin contains the origin of coins that are being spent (i.e., references to transactions where these coins were received), proof of coin ownership, addresses of new owners (more broadly, conditions under which the coins can be spent), and the transfer amounts.
Data in the body of a transaction
- Origin of coins that are being spent
- Proof of coin ownership
- Address for the transfer (spending conditions)
- Transfer amounts
NOTE: In the simplest case, an address is associated with one pair of keys (the public and private key), which is used to generate and verify the digital signature. A private key is used to authenticate transactions and is only known to the address owner. The number of all possible addresses is huge, and the number of possible private keys is even greater. Therefore, guessing a private key to someone else's address is almost impossible (given that key generation is a truly random process). It is important not to confuse the concept of address with the concept of account since there are no accounts in the Bitcoin protocol.
The analogy with a usual receipt might help to better understand the idea of a bitcoin transaction. In one sense, regular money is a receipt. Each receipt contains data: who received the payment, from whom, for what, the payment amount, date, and signature (Fig. 2.12).
A bitcoin transaction, just like the lawful receipt, must meet specific requirements to be considered correct. First, it must transfer coins that the sender owns. Secondly, these coins can be spent only once.
Verification is the process of checking the data (transactions, blocks, etc.) according to the protocol rules.
During the verification process, each transaction is checked to ensure that the sender owns the coins that she tries to spend. Usually, the originator of a transaction proves the ownership of coins by using a digital signature. In addition, it is necessary to verify that a transaction spends existing coins for the first time and only once.
The authenticity of the paper receipt is easy to verify, while arguably digital receipts could be copied many times, making it difficult to determine the original. Suppose that Alice has given a receipt to Bob. If Bob turns out to be a fraud, you can assume that he may come with his, say, five friends, all with the same receipts, and all five would demand money from Alice. Thus, if each receipt would have had the authenticity of the original one, then Alice would definitely find herself in an awkward situation. In paper form, it is relatively easy to distinguish a copy from the original; in digital form, it is not. This and similar problems obviously demand their solutions.
In Bitcoin, the solution is that transactions are joined in the structure units called blocks. A block is a unit of data consisting of a header and a body that represents a set of transactions (generally, non-empty). Blocks are linked to each other with hash values (for further details, refer to 3.1) and in this way stored in a shared database. This approach ensures the immutability of a database of all transactions.
Paper checks (Fig. 2.13) are still common in the US and many other countries: people receive their salary in checks, pay for rent, cash them out in banks, etc. On the check, you can see its serial number (12982 as in Figure 2.13), which is unique for each check (you cannot cash out two checks of the same serial number).
How does Bitcoin solve the problem of protection against copying of original "receipts”, in its case called transactions? In the checkbook, each check has an order number, which is its unique identifier. But in a decentralized environment, where Bitcoin functions, it is impossible to enumerate transactions since all participants work asynchronously. Therefore, in order to distinguish one transaction from another, in Bitcoin there is a globally unique transaction identifier (txid/wtxid)—the so-called hash value calculated from the transaction data (for further details, see 3.1). If multiple transactions appear to have the same hash value, only one of them will be considered correct. However, there can be exceptional situations, which will be described separately.
An interesting feature of Bitcoin is that it is possible in any transaction to show "where" the coins came from (there is a reference to the previous transaction with its hash value). This is how the origin of transmitted coins is verified in Bitcoin. You can schematically see how a new transaction spends the coins received from the previous transaction in Figure 2.14.
Basic stages of transaction verification
- Verification of the condition that the spent coins exist in the accounting system
- Verification of the condition that the coins are spent for the first time and not more than once
- Verification of the proof of coin ownership submitted by the sender (initiator of a transaction)
Here is how it works: in order to spend the coins, a user must indicate where he received them from and prove the ownership. If the origin of coins does not raise additional issues—there is no other transaction that spends the same coins and the user has proved his ownership—then all that remains is to wait for the confirmation of this transaction by other members of the system.
The process of transaction confirmation demands that participants first check them and then mutually agree which transactions they consider correct. This means that a transaction in order to be confirmed should receive a consent of the majority of active participants (see 2.5). Anyone can participate in the process of confirming transactions in Bitcoin (Fig. 2.15).
The transaction model in Bitcoin assumes transaction fees which are paid in bitcoins. Fees are included by the sender during the creation of a transaction and should, by default, be above a certain threshold. Although in practice, users can set a zero fee and such a transaction will be considered correct. The fee is technically an additional reward for the participants who confirm transactions.
With the growing popularity of Bitcoin, the flow of new transactions in the network has increased significantly. In Bitcoin, the block size was limited under the rules of the protocol (the maximum base size of a block is 1 MB). Sometimes there are situations when the flow of new transactions exceeds the capacity in Bitcoin. In this case, each network node arranges all unconfirmed transactions into a queue, where transactions that pay higher fees are at the front. In fact, transactions in Bitcoin can be considered as a data record in a shared database. The price of this data record is the ratio of a fee defined in a transaction and the size of a transaction in bytes (or its size in weight units; see 4.6). So transactions at the end of the queue may remain unconfirmed for longer. Therefore, this provokes a hardly predictable market for adding a unit of data to the Bitcoin database—namely, how much you should pay to have your transaction confirmed within a reasonable time (see 4.7).
The principles of decentralization applied to defining fees in bitcoin transactions can be illustrated by an example: you can compare a potentially confirmed transaction in Bitcoin to a political party that wants to enter parliament. Which of the deputies gets to the upper part of the election list depends on the amount of his "contribution" (unfortunately, such an approach is very popular in many countries). The deputies will be "sorted" by the total of this "contribution"; those who offered less will not succeed. Most likely they will have to wait for the next parliamentary elections and try again. Due to the high volatility of fees in Bitcoin, this became a problem as the transaction sent to the network could remain unconfirmed for a long time (or even forever). However, this problem was later solved (for more details about fee volatility and the solution to this problem, see 4.7).
Transaction pays a fee per each unit of its weight Maximum base size of a block is 1 MB Validators sort transactions by descending price of data records Transactions with a low price of data recording may remain unconfirmed for a longer time (or even forever)
A well-formed chain of blocks contains transactions that do not conflict with each other. You may wonder what a conflicting transaction is. If John transferred 5 coins to Mary in one transaction and later sent the same 5 coins in another transaction to Paul, then it is obvious that both transactions cannot be recorded in one version of history. Therefore, only one of these transactions will receive full confirmation. The question is: who will get these 5 coins—Mary or Paul? Until the point of full confirmation, it is impossible to answer the question as to which transaction will definitely be accepted. You can only suppose that the transaction with a higher chance of confirmation is the one which was distributed over the network first or, even more likely, the one that pays a higher fee.
Common myths
The Bitcoin protocol source code is closed and only the creator can make changes.
Quite the opposite: there are several implementations of one protocol in different programming languages; the source code of most of them is open and available for study, modification, etc.
Ordinary engineers and developers cannot suggest improving the Bitcoin protocol or develop their own wallet.
Anyone can offer a protocol modification and even program his own network client or application. The existing Bitcoin community is open to new proposals and primarily consists of independent enthusiasts. Though, it is generally the more experienced participants who offer the most worthwhile protocol modifications.
Frequently asked questions
– Is it necessary to connect to the Bitcoin network to generate a new address?
No, you do not need a network connection for this. Generation of keys for a digital signature and the generation of addresses is performed locally. This process does not depend on other users.
– What happens if private keys of two different users match?
The probability of such a coincidence is extremely small yet exists, so it is usually neglected. But if due to a generation error or some other unlikely reason this happens, then both users will, in fact, see one amount on the balance sheet and have access to the same coins, which can be spent only once.
– Who establishes the fee for the transaction?
The amount of the fee is specified in the body of the transaction itself. It is determined by the one who creates and signs the transaction. According to the Bitcoin protocol rules, a zero-fee transaction is correct. However, the software of most network nodes will simply ignore the transaction if it is below the necessary minimum (which can change over time).
– Is it true that somehow one can analyze the history of the origin of all coins and violate the privacy of some transactions in Bitcoin?
Yes, there is a practice of creating such organizations that analyze a large number of direct and indirect data regarding the transactions in Bitcoin. And these organizations can with some probability say which coins belong to whom and for what purpose they are used. In turn, services that take bitcoins, for example, centralized exchanges, can apply to such organizations for information. Services that value their reputation, such as Kraken, do not accept payment if the history of the coins origin is doubtful (see 4.1). However, there are approaches that allow increasing the level of privacy in Bitcoin: cryptocurrencies such as Monero and ZCash place greater emphasis on the anonymity of users (see 7.2).
In this subsection, we will cover how Bitcoin works, review the features of a shared database and collective processing of transactions, describe the basic principle of reaching consensus in Bitcoin, and also compare Bitcoin with traditional payment systems.
The architecture of Bitcoin is heavily affected by the need to work in an extremely hostile Internet environment, which is anonymous, where law enforcement barely works, which is full of hackers, and where there are no responsible parties nor any guarantees. Therefore, its launch has proved that it is possible to create a financial system with an open database that anyone can use without registration. The basic principles are as follows: a copy of the database is stored by all users; users follow the same rules and trust only what they can verify themselves. This is the essence of decentralization in accounting systems.
Each user has their local copy of the database organized as a chain of strictly ordered sets of transactions—blocks. In Bitcoin, transactions are considered unconfirmed until they are added to the block. After this block is confirmed by honest participants, it is impossible to modify or remove the transaction from the shared database undetected. Schematically, this data organization can be represented as a chain of blocks, in which each block is a set of transactions (see Fig. 2.16). Satoshi called this format of data storage block chain; later it was called blockchain.
The blockchain technology allows organizing the database in such a way that all the blocks are linked to each other (The green block in Figure 2.16 is a so-called genesis block; for further details, see section 4.3). Since blocks are linked together, it is impossible to change the content of one block without affecting all the subsequent ones.
Who verifies the transactions and how do they get onto the chain of blocks? Any user can create a correct (in terms of the protocol) transaction, send it to the network, and it will be transmitted to all other participants. Then, each validator independently verifies the validity of a transaction and adds it to their block for confirmation; when the transaction has been added to one of the new blocks, it can be considered confirmed. Each new block in the chain is created as a result of parallel and independent work by each participant (Fig. 2.17).
Who creates blocks and chooses which transactions to include in them? In Figure 2.18, you can see that each block is created by one of the users and hence extends the main chain. The creator proposes her block to other network nodes. They verify this block and add it to their database copies if this block complies with the protocol rules. If the majority of participants add the proposed block, it gets to the chain, and the transactions in the block become confirmed. It should be understood that just one block is added to the chain. All the other blocks which have been generated by other participants but have not got to the chain are discarded. The transactions of a discarded block (an orphan block) are not confirmed and are available for future confirmation. This sequence of actions is required to achieve consensus in a decentralized environment.
Audit of the accounting system Validation of transactions Update management (governance)
Audit is the process of verifying that the current state of the database fully complies the conducted transactions.
Validation of transactions (also known as mining or the process of block creation) is the process of verifying transactions for the compliance with the protocol rules and of adding them to a block (and subsequently to the database of the system).
Update management (governance) is the process of affirming the functionality of the system and, at best, transforming all nodes of a system to a uniform operation model.
Bitcoin allows every participant to manage the above-mentioned processes and hence perform any of the below roles.
User Auditor Validator Developer QA engineer
Another feature of Bitcoin is that every system participant decides himself (in a permissionless manner) which role he will perform.
As described above, before making any changes to the general state of the chain of blocks, participants must come to an agreement. If participants have checked the block for correctness, and everyone agrees to add it to their chain, then the block is added, and all the subsequent blocks will be created on its basis. Coming to an agreement is very often difficult yet a crucial task. Without a solution, you wouldn't achieve reliable operation of a decentralized accounting system. Therefore, one of its crucial components is the consensus mechanism.
Consensus is the state of users' agreement regarding the transactions that they consider correct, which is developed during the "discussion" (exchange of messages about transactions, blocks, state of nodes). Reaching consensus is the goal of all honest participants in Bitcoin, but obviously, you wouldn’t blindly rely on the fact that most Bitcoin participants are honest. For this reason, the Bitcoin protocol is designed in such a way that consensus can be reached in the system even under the following conditions.
Number of network nodes is unknown Participants can be anonymous Validators can be anonymous System participants do not trust each other There is no single governing authority Number of malicious nodes is unknown
Ideally, everyone should agree with the list of confirmed transactions. However, in practice, there are a number of difficulties during the reconciliation. As we have already stated, Bitcoin is designed to securely operate in an extremely hostile Internet environment. Here, all participants are anonymous and do not trust each other; their number is generally unknown and is very likely large; each user's vote can be easily forged (if you consider the traditional approach to voting). Directly on the network, there is a computer program which is usually controlled by a person. However, it may be that particular software isn't run by an honest participant but rather is a bot controlled by a malicious person. Moreover, it may even happen that for a hundred or a thousand users there will be only one real person.
Having determined the complexity of the task—reaching overall consensus in the environment which is trustless and where any participant may potentially be malicious—we can cover the key question, how.
The principle of reaching consensus in a decentralized accounting system can be explained in the following example. Imagine playing a card game. In this game, there is no "dealer" responsible for controlling the game: all participants know the rules and are obliged to adhere to them. All moves (in our case, transactions) are public and checked by all participants of the game. In case one player cheats, this will be immediately noticed by other players, and the cheater will be excluded (Fig. 2.19). The distribution of new cards from the deck is carried out by the same principles. Rules determine the order in which players pick up cards as well as the number of these cards.
Let's draw a consensus schematically (see Fig. 2.20). All users store their local copy of the database, which is organized using blockchain technology. The state of unanimous approval means that copies of all honest users are identical after they have been synchronized (i.e., database copies of all participants have the same blocks of data forming identical chains).
NOTE: In the context of Bitcoin, the concepts such as shared database, chain of blocks, and transaction history have the same meaning.
Bitcoin does not require registration Transaction does not contain any users’ personal data Payment address can be used only once
Very often people wonder how confidential their bitcoin transactions are. In fact, everyone can see all the transactions between all the addresses, but it is difficult to identify who is behind each bitcoin address as well as track the transaction history of a specific user. For a better understanding of privacy in Bitcoin, let's draw an analogy with traditional financial systems (Table 2.1).
Table 2.1 — Traditional payment systems as compared to Bitcoin
| Traditional payment systems | Bitcoin |
|---|---|
| Non-transparent transaction history and limited access to audit | Transparent transaction history; all changes are evident to everyone |
| Centralized decision-making regarding the changes (governance) | Collective update of the database with transactions |
| Requires full trust to the responsible organization | Trust only to mathematics and the program code |
| Possibility to restore access to an account | Self-management of access keys |
| Risk of bankruptcy and denial of service | Each user bears all the risks related to their keys and software management |
The bank performs the functions of storing and accounting. It takes money and valuables from customers and in return promises to remember how much and to whom it owes. Generally, this approach is convenient since access to money is performed through a credit card, and only the owner has the ability to use this card. This saves the customer from having to carry cash, while the lost cards can easily be replaced. However, the funds of customers are managed entirely by the bank and subject to their centralized decisions. A client will have problems in the case that a bank "forgets" how much and to whom it owes the money. This is a typical example of a trade-off between convenience and security.
Before Bitcoin, this was essentially the only possible way to perform financial relations in society—users could only hope that banks would fulfill their obligations. So banks have been increasingly adopting this specific scheme and over time developed a lot of different implementations of it.
Bitcoin operates without the restrictions common in traditional payment systems. In one sense, Bitcoin complements an established financial system; it shows that alternative architectures are possible as well as an accounting system without any managing authority.
Common myths
The creator of Bitcoin can change the currency rules or steal users' coins.
This is not true. The creator of Bitcoin has the same capabilities as other users.
To send and receive payments in Bitcoin, you need to register.
In Bitcoin, there is no database of registered users and no decision-making center. Each transaction is validated separately, and anyone can verify a digital signature. Typically, centralized systems use session authentication, which means that once a user is verified, he does not need to redo this process for each next action. Meanwhile, in Bitcoin, a user is assumed to generate a new address for each new payment.
Frequently asked questions
– What does the bitcoin coin look like?
Bitcoin coins do not have a physical representation but are defined abstractly. This abstract concept quite clearly indicates the properties of the digital currency because the shared database has the record of all actions performed in it—the need for physical coins is simply absent.
– What happens if a transaction is disputed in court, and it orders the transaction to be canceled?
There is no any global jurisdiction on Bitcoin, as there is no law which rules over the open source protocol. Since decisions in Bitcoin are taken in a decentralized way through a consensus, a single action will not affect the overall state of the database. The court, of course, can decide to cancel the transaction but most likely will not be able to implement it. The only exception is the case in which the majority of participants would support the court order. Though, such an arbitrage practice can hardly be imagined nowadays.
We have mentioned heretofore that Bitcoin can work reliably, given the anonymity of participants and the potential presence of an unknown number of cybercriminals. In this section, we will try to describe in detail how it is made possible. In addition, we will explain the issues related to full confirmation of transactions (namely, how the transaction that has been previously confirmed can then again become unconfirmed) and why finality of transactions is impossible to attain in such conditions [28]. Also, we will consider how Bitcoin implements transaction confirmation in a decentralized environment.
Among the unconfirmed transactions, any user can choose those that she considers correct, then merge them into a block, and offer this block to all other nodes of the network. The block can be adopted or rejected by the decision of the majority. If the validator worked honestly, verified transactions according to the protocol rules, and proposed the next block of the general chain earlier than the rest, then other honest participants will accept this block.
A correctly created block consists of transactions that have not been confirmed in the previous blocks and do not conflict with each other. Each block necessarily contains the hash value of the previous block. In this way, each new block confirms that not only are the transactions in it correct and confirmed but also those in the previous blocks to which it refers. Another feature is that the protocol regulates the difficulty of a resource-intensive problem for block creation in such a way that a new block is added to the shared database on average every 10 minutes.
A correctly created block
- Contains correct transactions which have not been confirmed so far and do not conflict with each other
- Contains a hash value of the previous block
How is the new block created? A particular user's computer stores the entire chain of blocks that has been verified using the Bitcoin software and is considered correct. Coin transfers between users in the system occur constantly and new unconfirmed transactions are propagated across all nodes. Each user's computer verifies the flow of new transactions and adds to the block those it considers correct (Fig. 2.21). Further, it refers to the previous block by indicating a link to it, so that the operational history is clear—and this is how the integrity of the database is maintained. Next, the computer suggests its created block as a continuation of the general chain to other nodes.
What happens if one user runs a network node that is cheating and offering fake blocks to other users? Even worse, what if it were an organized group of intruders launching a whole botnet of modified network nodes that ignore the protocol rules? How can honest users achieve consensus in such a situation? This obvious risk was solved by Satoshi Nakamoto, and we will explain how, next.
Consensus regarding the new transactions
- Any user can choose among the unconfirmed transactions the correct ones and add them to a block
- The proposed block will be accepted or rejected by the decision of the majority of validators
The solution to the potential problem of fake blocks is as follows: the block is considered correct if a given amount of computing resources was spent on its creation. This means that a user must provide a solution to a resource-intensive task so that all other participants can check and accept his block.
In this way, a bad actor cannot trick the rest of the participants with a large number of fake blocks. The task which needs to be performed also addresses two other considerations: how frequently new blocks should appear and how to prioritize the order in which blocks are added to the shared database. It works like this: everyone starts creating a new block, yet only the one who solves the resource-intensive task first gets the right to offer his block to the rest.
So, the more computational power a user has, the more often she becomes the first to finish the task. The probability for a particular participant becoming the first to complete is the percentage of the total system computational resources which a particular participant has.
Block creation flow
- A solution to a resource-intensive task must be provided
- The one who has solved the task first notifies everyone else by sending them his proposed block
- The probability of being first depends on both the share of participant's resources as compared to all resources
- Involved in the system and delays in data transmission channels
That's how we come to the very essence of mining in Bitcoin, which in practice means the solving of a resource-intensive task. This task is the same difficulty for all nodes in the network. Mining is essential for Bitcoin: honest users are involved in mining to maintain the reliability of the transaction confirmation process. Those who control more computing power create blocks more often. Let’s see how it works in the example below.
Suppose that there are 10 validators operating in the system. Each of them has one mining computer, which calculates the same number of hash values per one unit of time (Fig. 2.22). Let's take this computing power as 1, and thus the total power of the system will be 10. Each validator, accordingly, controls 1/10 of this capacity and has a 0.1 probability of creating the block first.
Now, let's assume that Alice has noticed that mining appears to be more beneficial than ever before and therefore buys a couple more computers (Fig. 2.23). After that, the total power of the system will be 12 (10 + 2 = 12). Her share is now 3/12 (or 1/4), while each other validator’s share remains equal to 1/12. Therefore, the probability that Alice finds the new block first is 0.25, while for the other validators, it will be equal to 0.08(3). In this way, even with a smaller fraction of processing power, a validator can nevertheless create the new block first, but the probability will be lower.
However, what would happen if an attacker solves the resource-intensive task? What if his block contains transactions which are correct in terms of the protocol, yet honest users will still disagree with this block? Sounds confusing, right? After all, members of the network are anonymous and you cannot say in advance who is honest and who is malicious.
Before we answer how disagreements regarding a specific block are solved, let's observe how blocks are propagated over the network. So, one of the network nodes finds a solution to the problem and creates a block. Then, a block is broadcast to the network. That is, the node which has created a block transmits it to all the nodes to which it is connected.
After that, the nodes which have received a block verify whether or not it matches the protocol rules. There are two possible scenarios. In the first one, a node agrees that the block is valid and can be added to the chain of blocks; it saves a copy of the block and propagates it further over the network. What happens in the second scenario, in which a node disagrees that a block received is valid?
To answer the above question, we will consider how disagreements regarding confirmation of transactions are solved. If one participant does not agree with the block of the other, it is possible, according to the protocol rules, to create an alternative block at the same height of the chain of blocks.
Disagreed participant creates an alternative block Alternative blocks can include the same transactions Network nodes keep both alternative versions Each of the participants creates blocks, extending one particular version of the chain The longest chain "wins" (the one which has taken the largest amount of work to be created)
The height of the block is the sequence number of the block in the chain starting from the genesis block (Fig. 2.24).
Genesis block is a block with a zero height.
Therefore, a disagreement between at least two participants may entail a situation where we have two blocks created both
referring to the same previous block. Such blocks can include the same or conflicting transactions. In this case, all
the other nodes of the network can save both suggested options if they consider both blocks correct, but each of them
should nevertheless determine which block is the basis to start creating the next one. In this way, different
participants make their choice, creating subsequent blocks on top of one of the existing blocks, and specifying a link
to it in their new block to extend a particular version of the chain. The rules of the protocol state that out of the
two correct versions, the priority should nevertheless be given to the one for the creation of which more computational
resources have been spent (i.e., the version which is supported by the majority of participants).
The process of resolving disagreements can be shown schematically (Fig. 2.25). There is a network of nodes. These nodes, in their local database copies, may store two alternative blocks at the same height. Let's say that users on the left (in the figure) have decided to select the top block as the main one, and users on the right selected the bottom one. Everyone continues to work on creating the next block supporting different versions.
Then, a certain user has created and proposed a new block that refers to the block which is at the top of the two alternative blocks (according to the above figure). Her proposal was accepted by all other participants of the network. Even those who originally chose another alternative block, have checked and accepted a longer chain (Fig. 2.26).
This is the so-called rule of the longest chain. It says that among all chains a participant considers correct, he must choose the longest one. In other words, he chooses the chain where more work has been spent on its creation.
Furthermore, an honest participant will switch to the longest chain only if it was created according to the protocol rules. This means that anyone trying to disrupt the chain is prevented from violating the Bitcoin rules, even when having a lot of computational power.
Probably the most important matter in Bitcoin is the process of confirming transactions. A transaction can be considered fully confirmed if it is included in the longest chain and there are 5 blocks after the block in which this transaction is contained. In other words, you need to wait for at least 6 confirmations, not 1. Since a new block is created on average once every 10 minutes, full confirmation of a transaction takes approximately one hour (however, in some situations, one may want to wait much longer to reduce the risk of an attack).
The answer to the question why exactly is it 6 confirmations lies in the mathematical calculation: if there are two alternative chains and one is ahead of the other by 5 blocks given that the same amount of processing power was invested in both chains, the probability that the shorter chain outruns the longer one is very small. In his article [15], Satoshi Nakamoto mathematically proves this on the basis of the following proposition.
where p is the probability that the next block will be created by an honest node; q is the probability that the next block will be created by an attacker; and qz is the probability that an attacker will someday catch up with the main chain if he started his, alternative chain z blocks back.
For example, if an attacker possesses 10% of the processing power of all validators, the probability of a successful attack is less than 0.1% (on the assumption that honest nodes operate on the network with an equally fast message delivery).
Another important issue is the motivation for users to solve resource-intensive tasks, create new blocks, and confirm transactions, thus leaving no chances for intruders.
We have already described the processes such as block creation, coin issuance, and the imposition of fees for transaction confirmation. In Bitcoin, these processes are very closely related to each other. The fact is that, according to the rules of the protocol, the creator of a block can send to her own address a certain number of coins, which she literally took from nowhere, meaning that these coins did not exist previously—this is how coin issuance works. The total amount of a reward is calculated as the issued coins plus the fees for all transactions included in the block.
reward = new (issued) coins + fees
In 2018, the reward for creating one block is 12.5 coins plus fees. Note that, for security reasons, a validator does not receive this reward immediately after the block is created. There is a special parameter called coinbase maturity [29]. It indicates the minimum number of transaction confirmations for which the validator was rewarded. In Bitcoin, this parameter has a value of 100, which means that after the block is created, the reward (fees + issued coins) becomes available only after 99 further blocks confirm this block.
As noted earlier, a new block appears on average every 10 minutes regardless of the total computational power of the system. This is achieved by using the difficulty parameter, which is calculated by each node independently by the known algorithm and used to specify the requirements for solving the resource-intensive task. Over time this parameter is recalculated according to the change in computing power of the system.
All network nodes create a new block collectively in 10 minutes. For an individual participant, creating it may take hours, days, or even years. But according to the theory of probability, one block will be created on average every 10 minutes provided that all validators work on one chain of blocks. This also means that turning off half the power of the system at some moment will increase the average block creation period to approximately 20 minutes. It will remain extended until the difficulty parameter is recalculated.
It is believed that only those who control more than 50% of the capacity can influence the processing of transactions. Bitcoin can be considered secure when most of the computational power of the system is controlled by honest validators. The confidence in Bitcoin as an accounting system, therefore, depends on the fact that thousands of people are unlikely to collude against a particular user (the opposite of a centralized system where censorship is easy to implement and hide). This means that trusting Bitcoin, a user is confident that thousands of people will not disagree with him at the same time. An attack in which an adversary controls more than half of the computational power of the system is called a 51% attack (for more details, see 4.2). Bitcoin has never been exposed to this in practice (as of 2020). However, there are striking examples of 51% attacks in several digital currencies such as Bitcoin Gold and ZenCash, which cost more than 18 million US dollars in total.
Let's start by imagining the following fictional situation. One day, the sea beavers got drunk with pirate rum and cut all the fiber-optic cables, which passed on the bottom of the oceans and connected all continents into a global network. Data transmission channels between continents refused to operate, but nodes on each continent continued working correctly in their subnets. However, users of different subnets could not synchronize in order to exchange transactions and blocks. Therefore, on each continent validators formed different versions of the chain of blocks.
It is obvious that the majority of Bitcoin network nodes use a global network to communicate with each other, while the population of entrepreneurs-miners is unevenly distributed on the surface of the continents (Fig. 2.27). What can happen to Bitcoin if the Internet fails between six continents?
While Dr. Powderpill was grinding the teeth of all the sea beavers to prevent them from breaking the cables for a second time, and Inspector Gadget was mending the fiber optic cables with his electrical tape, validators continued creating blocks (Fig. 2.28). Since the computational power of validator groups on different continents is different and the difficulty parameter had not yet been updated, the period of block creation for each subnet significantly exceeded the default parameter, which is 10 minutes. Moreover, this period was different for each continent, which led to the creation of alternative chains of different lengths.
By the time Dr. Powderpill and Inspector Gadget finished their work and data transfer channels were restored, the Bitcoin network nodes from different continents started synchronizing with each other. Then it turned out that there are several different versions of the chain of blocks, all with a different length (Fig. 2.29). Moreover, different chains now contained different transactions, and only the subsets of these transactions could partially intersect.
In accordance with Bitcoin protocol rules, all nodes will eventually choose the longest chain and consider it as the primary one (the mainchain). Another interesting fact is that the transactions that were already confirmed but included in alternative chains have lost their confirmation status. Nevertheless, full nodes of the network continue to store and synchronize them, and validator-nodes, as always, are interested in including them in their blocks and receive the rewards, provided that these transactions do not conflict with those already confirmed in the mainchain.
Therefore, transactions of the orphan blocks get to the list of unconfirmed transactions but will very likely be confirmed later. And even though some of the validators will not receive a reward for solving the resource-intensive task since there is a possibility that the transaction from the orphan block (which they created) will be confirmed in the mainchain by a different validator. Thus only one validator will receive a reward even though both worked with the same diligence.
In the situation described, there are risks of losing coins not only for Bitcoin validators (who lose both the reward for created blocks and transaction fees) but also for regular users who accept payments in bitcoins. These risks are due to the fact that the computational power of Bitcoin was used just partially to maintain the reliability of the currency. For example, users may not notice the split of the global network into subnets and continue receiving payments in bitcoins, which means that there is a risk that they will later find out that their balance is zero.
Pirates of the Caribbean Sea could well carry out a similar deception. Suppose that Captain Jack Sparrow somehow obtained a representation of a private key. On the address controlled by this private key—even before pirates taught beavers to drink rum and be mad—someone sent some bitcoins, which remained unspent. Once the beavers had turned the global network into six local ones, Captain Jack, without wasting time, decided to install a diesel engine on his Black Pearl in the port of the closest continent and arrange this payment in bitcoins. Then the ship, under a favorable wind, swiftly sailed to the second continent to refill with diesel fuel.
Pirates don't have a lot of time for their deception to work before communication is restored; on the second continent, no one knows about the first transaction by Captain Jack Sparrow. Arriving at the second continent, Jack again uses the private key to pay for refilling the pirate ship with bitcoins (Fig. 2.30). The local tanker waits for the first confirmation and accepts the coins that were actually spent on the first continent, buying the diesel engine.
Meanwhile, Dr. Powderpill and Inspector Gadget are promising to eliminate the threat and solve the communication problem very soon. Knowing how persistent Dr. Powderpill and Inspector Gadget are at their work, the pirates have in advance prepared the schedule for a swift around-the-world travel. Having a representation of a private key and a fast ship with a full tank of diesel fuel, they are ready to visit other continents to fill the hold with rum and buy a manual on studying quantum computing.
Obviously, after the nodes were synchronized, only one of Jack's transactions was confirmed—the one which paid the merchant from the continent with the biggest part of the Bitcoin computational power. The pirates had given the deceived traders a good lesson—check the network healthiness before accepting a transaction. The captain and his team are analyzing the events and think about improving their strategy—now they consider using a quantum computer.
Common myths
Creation of a block in Bitcoin always takes 10 minutes.
In practice, a block can be created in a split second or in an hour and a half. Time of creation of the next block is almost unpredictable. However, there is an algorithm that adapts difficulty so that blocks appear on average every 10 minutes.
If someone controls the majority of mining power, then he may violate the rules of the protocol.
The greatest harm that the owner of most of the power can inflict is actually a successful attempt to double-spend his coins and also filtering or blocking someone else's transactions upon confirmation. This is only possible when an attacker has appropriate equipment. He cannot steal coins or perform an arbitrary issuance.
Frequently asked questions
– What is the minimum number of confirmations a transaction should receive to be added to the chain of blocks?
One confirmation. But in order to consider a transaction fully confirmed, there has to be more: 6 confirmations by default. Some services accept payments with two or three confirmations. In general, the number of confirmations depends on the amount of payment (and a risk of a double-spending attack; for further details, see 4.2) and can even exceed 100.
– What is the probability that a correctly created transaction will be confirmed after it is sent to the network?
The probability that a correctly created transaction is confirmed is close to 1 if it includes a sufficient fee and the process of creating new blocks is truly decentralized (is not censored).
– Is it required to set up a full node and in what cases is it necessary?
A full Bitcoin node is required if you want to accept and send payments and see the current version of the database without having to trust other nodes. Light clients, web wallets, mobile wallets, which do not store the entire chain of blocks, use trusted nodes to obtain up-to-date data. In other words, a node launched by a service itself keeps track of the current state of all transactions and current distribution of coins, while the light client (that trusts this node) receives this state to make the payments. In some cases having trustees is unacceptable; therefore you will set up your own full node, make an audit of its software, and no longer depend on the third-party services.
– What is a fork? What kinds of forks are there?
There are two different meanings of fork: the branching of the chain of blocks and the copying of the source code. In the context of blockchain, forks can either be planned or unplanned. Forks of the source code are usually performed either for the development of a separate project or in order to make some changes to the protocol for the purpose of testing them. At the same time, forks should not be confused with concepts such as softfork and hardfork: these are types of protocol updates (for further details, see 6.1).
– Who in the Bitcoin system makes the decision to increase or decrease the difficulty?
No one does. The difficulty is determined by the same rules, which are laid down in the software of each node of the network. Each participant updates the difficulty parameter in her software according to these rules. As a result, this parameter will be the same for all; the decision center is not required. This is the most important principle in the work of decentralized systems.
– If 1 hour is initially set in the system for transaction confirmation, how could Bitcoin be used as a means of payment?
In fact, 1 hour is only a recommendation that is better to adhere to by default. If you go deeper into detail, it turns out that the waiting time before accepting payment is determined by the recipient. And the larger is the transaction amount, the longer the recipient is interested in waiting. According to a rough estimate, one transaction confirmation is sufficient for accepting a payment of $1; for the amount of $1,000,000, it is 16 confirmations (for further details, see 4.2) [30]. In addition, there are methods for making payments through the so-called payment channels, where they are confirmed much faster than usual (on-chain) transactions, and the confirmation time does not depend on the amount of payment and the established fee (for more details, see 4.8).