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4 It’s Not Only the Currency, It’s the Technology

4 It’s Not Only the Currency, It’s the Technology

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10



UNDERSTANDING BITCOIN



One such application is autonomous agents. Autonomous agents should not be confused with artificial intelligence. Autonomous agents are just straightforward computer

programs, created for a specific task. One example is a computer program running in the

cloud that rents storage space and offers end users file-sharing services. Up until now

computer programs could not hold value: a computer program presumably could not

open a bank account in its name. With the introduction of Bitcoin, computer programs

can control their own funds and sign smart contracts with cloud service providers to rent

cloud storage and computing power. Similarly a storage agent could enter into smart

contracts with its end users. The storage agent can settle these smart contracts, making

bitcoin payments to the cloud provider and receiving bitcoin payments from its end users

(Garzik, 2013a). A more extensive discussion of autonomous agents can be found in

section 12.4.

Autonomous agents are just one example, and many more innovative ideas are being

devised (Chapter 12). Some of these ideas may turn out not to be practical, but maybe a

few could become mainstream. A decentralized system is an ideal test ground for these

technologies, as innovators do not need the approval of anybody to try out their ideas: a

decentralized system enables permissionless innovation.

Bitcoin is an API (Application Programming Interface) for money and bitcoin the

currency is just the first application. Bitcoin could be used as an open platform for the

exchange of value in much the same way that the internet is an open platform for the

exchange of information. It can be used as a protocol on top of which applications can

be built, much like email, web browsing, or voice-over-IP are built on top of the TCP/IP

protocol. This is where most of the excitement around Bitcoin and related technologies

comes from. Regardless of whether bitcoins have a future as currency, the technology

has shown that many applications are now possible and innovators will continue to push

forward with new ideas. Bitcoin could become a platform for financial innovation.

One of Ronald Coase’s most important economic insights in The Nature of the Firm

(Coase, 1937) was that one factor that contributed to the creation of firms was high

transaction costs. If there were no transaction costs, an entrepreneur could contract any

good she needs in the open market, and this would be efficient, as an efficient market

would always achieve the best price for that good. However, transaction costs, such as information gathering, bargaining, policing the contract, keeping secrets and so on, can be

a significant portion of the total cost of contracting out to the market. For this reason,

it might be cheaper for an entrepreneur to hire some employees to produce the goods

internally, thus starting a corporation. Transaction costs are also at the root of public

goods and government action.

Bitcoin’s technological breakthrough creates an opportunity to lower the costs of

entering and upholding contracts, say through smart contracts. More efficient contracts

thus have the potential to change corporations and government action.



CHAPTER



2



Technology (Introduction)

ntil the introduction of Bitcoin, transmitting money digitally had required the mediation of a third party. The main breakthrough of Bitcoin has been to allow digital

payments with no trusted third party. This chapter serves as an overview of the technology behind Bitcoin.



U



2.1



CENTRALIZED DATABASE



The most straightforward way to try to create digital value is to assign value to a certain

data pattern, basically a string of zeroes and ones. The problem with this approach is

that digital information is easy to replicate at basically no cost. This leads to the doublespend problem, exemplified in Figure 2.1. Say Alice has a digital coin, represented by the

binary number 01000101. She could transfer this value to Bob, by sending him a message

with this number, so that Bob had a copy of the number and thus the value. The problem

is obviously that nothing prevents Alice from sending this same number to another user

or indeed to many other users.

So digital value cannot be represented simply as a number because digital data is

very easy to replicate many times and thus knowledge of the number does not have any

value. As common sense suggests, for something to have value it must be scarce. The

challenge then is how to create scarcity using digital technologies that allow the perfect

copying of information.



FIGURE 2.1 Double-spending problem



11



12



UNDERSTANDING BITCOIN



FIGURE 2.2 Central counterparty holding a centralized database



The next step towards building a digital payment system is to create a central

database, holding a list of the users and the funds held by any of them. This system is

shown in Figure 2.2.

Now if Alice wants to transfer 1 unit of the currency, say a token, represented by

the number 01000101 to Bob, she contacts the server running the central database and

directs it to transfer this token to Bob. The server updates the database, and the token

now belongs to Bob. If Alice tries to double-spend the token 01000101, sending it to

Barry this time, she would have to again connect to the central server and direct it to send

the token to Barry. However, upon checking the database, the server sees that the token

01000101 does not belong to Alice any more, and thus she is not authorized to spend it.

A central database solves the double-spend problem. However, there are issues

associated with a central database. For a start, all users must have previously registered

with the central server in order to operate. Thus the central database knows the identities

of all the users and collects their financial history1. A central database is also an easy

target to attack, either by insiders or by outsiders. If an attacker gets control of the

central database, she could change the ownership of any funds, thus stealing them from

their legitimate owners. Or she could create new funds (tokens) and assign them to herself.

Perhaps the main drawback of a central server is that it constitutes a single point

of failure, as portrayed in Figure 2.3: the payment system can be easily taken down by

shutting the central server.

Some early digital payment systems were based on the idea of a central database

holding the positions of all the users. Two famous examples are e-gold and Liberty

Reserve. E-gold ceased operations in 2009 (Wikipedia, 2014h), and Liberty Reserve in

2013 (Wikipedia, 2014i).

Figure 2.4 shows the analogy between BitTorrent and Bitcoin. Both are systems

where the coordination of information is done in a decentralized way. In BitTorrent (the

1

Technology exists to implement a payment system based on a central server where users retain

their anonymity. This technology is based on blinded signatures and is the subject of section 10.1.



Technology (Introduction)



13



FIGURE 2.3 Central counterparty single point of failure



FIGURE 2.4 Analogy between BitTorrent and Bitcoin



protocol) any user can create a torrent descriptor and seed the file into the network. Other

users in possession of the torrent descriptor can then connect to the network and retrieve

the file (Wikipedia, 2014d). Bitcoin’s ledger database is distributed and maintained by

many computers called nodes. Bitcoin users can send new transactions to this distributed

database, where they are recorded. Both systems are resilient, even in scenarios where a

large portion of the network is forced down.



2.2



ADDRESSES, TRANSACTIONS



At the center of the Bitcoin network is a decentralized ledger that contains the balance

of every Bitcoin user. Bitcoin identifies users by large strings of letters and numbers

such as “13mckXcnnEd4SEkC27PnFH8dsY2gdGhRvM”. The address is the public

part of a public–private cryptographic key2. The private part of the key is under the

2



Bitcoin addresses are not exactly public keys, but are derived from public keys (section 5.6).



14



UNDERSTANDING BITCOIN



FIGURE 2.5 User sending funds. State of the database after the transaction has settled



control of the user. Figure 2.5 shows how a user (Alice) sends some funds to another

user (Bob): Alice uses her private key to sign a message saying “I want to send 1 bitcoin

to 1gr6U6...” that she sends to the network. Note that Alice does not identify the user

she wants to send funds to, just the address to receive the funds. Thus Alice must find

out Bob’s address through other means.

Upon receiving Alice’s message, nodes in the network follow these steps:

They verify that the signature is correct. If it is not they reject the message.

They check that the sending address has enough funds to honor the transaction.

If there are not enough funds credited to the address, the transaction is considered

invalid.

Finally, they update the database, subtracting the funds from one address and crediting them to the other.

An important detail is that nodes in the network do not know the identities of either

Alice or Bob, as users are identified only by their addresses. Bitcoin users are identified

by a pseudonym: Bitcoin provides pseudonymity.

Another important detail is that addresses are not granted by the network. They

are created inside the users’ devices when it runs the Bitcoin software that generates the

cryptographic public and private keys. As the public and private keys are intimately related

(Chapter 5), they have to be generated jointly and locally on the user’s device. The address

generation process is straightforward and can be performed almost instantaneously by

any device such as a laptop or a smartphone. There is also no restriction on the number

of addresses that a user can create. Indeed, it is recommended that users generate many

addresses to enhance privacy (Chapter 13).

No prior registration is necessary to use Bitcoin. In fact, new users do not even have

to communicate their addresses to the network to be able to receive funds. A user, say Bob,

can generate an address and communicate this address to Alice through other means, such

as an email or the pairing of two smartphones. Alice can now send funds to Bob’s address

and the network would accept the transaction even though it has never encountered that

address before.



Technology (Introduction)



15



In a centralized system the funds are held by a central entity, which also holds the

means to control those funds, say by changing the registries in the ledger. In contrast, in a

decentralized system, the private keys that give access to the funds are solely in the hands

of the end users.

Addresses, public–private keys and transactions are discussed in more depth in

Chapters 5 and 6.



2.3



DISTRIBUTED DATABASE, THE BLOCKCHAIN



Bitcoin’s distributed database is called the blockchain. Transactions are grouped in blocks

of transactions roughly every 10 minutes. These blocks of transactions are then recorded

one after the other in a chain of blocks, hence the name blockchain. This may seem

a strange way to record information, compared to, say, a regular relational database.

The blockchain was designed to be resilient in the presence of attackers in the network.

Blocks are linked to create a record of the history of transactions that cannot be altered.

The link between blocks is a cryptographic link that cannot be forged unless the attacker

has vast computational resources at her disposal. The blockchain is discussed in greater

detail in section 7.4.

Aside from the blockchain, nodes keep an additional database called the Unspent

Transaction Outputs cache (UTXO) (Chapter 6). The UTXO is a ledger that records

the funds available for every address, in essence working as a cache for the blockchain.

As new transactions come, the UTXO is updated: funds from the sending addresses

are subtracted and added to the receiving addresses. The UTXO is more similar to the

central databases at the heart of most centralized systems. Figure 2.6 shows a, sometimes

useful, abstraction for Bitcoin: a distributed ledger with entries for the funds available



FIGURE 2.6 Bitcoin as a distributed ledger



16



UNDERSTANDING BITCOIN



FIGURE 2.7 Bitcoin issuance theoretical schedule

to every address, which roughly corresponds to the UTXO. Every node in the network

holds a copy of the distributed ledger. Furthermore, copies of the ledger are consistent

across nodes, and new transactions have the same effect in all these copies.

Bitcoin achieves consensus in the distributed database using several cryptographic

constructions. The details can be found in Chapter 7, but roughly speaking, consensus

is secured applying large amounts of computational power. This computational power

serves the purpose of providing protection against attacks and is rewarded with the

issuance of new bitcoins. The protocol encodes a schedule of new bitcoin creation, and

all the newly created bitcoins are distributed among those who secure the blockchain,

called miners. Miners compete to create blocks of transactions that are appended to

the blockchain. A miner who creates one of these blocks is granted the block reward,

consisting of a certain number of newly minted bitcoins. A native currency is essential

to the design of Bitcoin, as the issuance of new currency is used to pay for the cost of

securing the distributed ledger.

Figure 2.7 shows the schedule of bitcoin creation. The pace of new issuance is halved

roughly every four years, so that eventually the total number of bitcoins will reach a total

of roughly 21 million. The number of bitcoins in circulation, as of the time of writing,

is around 13 million. Bitcoins’ value stems from their scarcity, as the number of bitcoins

that will eventually be issued is fixed.

Miners also collect fees from the transactions that are published in the blockchain.

Fees are still a small fraction of total miners’ compensation, currently below 1% of their

total compensation. It is expected that as the issuance of new bitcoins shrinks, transaction

fees will take over as the principal compensation to miners.

During the end of 2013 and beginning of 2014 there has been an investment boom

in Bitcoin mining equipment. It is estimated that over USD 200 million were invested

in Bitcoin mining equipment in 2013 (Luria and Turner, 2014). This investment rush

has been fuelled by the increase in the price of bitcoins and by technological evolution



Technology (Introduction)



17



in mining equipment (Chapter 9). This investment trend will likely ease in time, barring

another large increase in the price of bitcoin, with the future decrease in issuance of

new bitcoins and the mining technology catching up with state-of-the-art semiconductor

process technology.

An attacker who wished to subvert the distributed database to perform a doublespending attack must enter a race with legitimate nodes3. The result of this race is

determined by the amount of computational power. A straightforward attack would

require a computational power as large as the power of the legitimate network. That is,

the attacker would need to control more than 50% of the combined power of the network.

This type of attack is called a 51% attack. Other types of attacks, requiring somewhat

lower fractions of computational power, are possible. In any case, an attacker would have

to devote a significant investment to be able to mount an attack against the blockchain.



2.4



WALLETS



The software that helps a user manage her funds is called a wallet. The functions of the

wallet software are to hold (securely) the user’s private keys, create transactions that are

sent to the network, and collect incoming and outgoing transactions to show the balance

of available funds to the user. As a user can own many addresses, most software wallets

are ready to manage multiple addresses, aggregating the funds across them.

All wallet software can create new addresses, for instance when it is run for the very

first time. To create a new address a key generation algorithm is executed (Chapter 5).

Creating a Bitcoin address is straightforward and instantaneous.

The wallet software also implements the cryptographic protocol to sign a transaction

with the private key. Private keys are usually kept in the device. Losing these private keys

prevents a user from accessing the funds. The funds are still in the distributed ledger, but

without the private keys there is no way to correctly sign a transaction to spend them and

therefore they are considered to be lost. Thus it is highly recommended that backups of the

private keys are created. Most wallet software assists the user in creating digital backups.

Another risk for wallets is for an unauthorized person, say a attacker, to get hold of

the private keys. If an attacker gains access to the private keys, she can send the funds

in the associated addresses to some addresses under her control. Thus it is important to

properly secure the private keys stored in devices connected to the internet. Many wallets

offer encryption of the private keys4 before they are stored locally. This decreases the

convenience for the user, who has to type the password to decrypt the private keys before

using them, such as when sending a transaction. However, if the device is compromised,

the attacker would only be able to get a copy of the encrypted private keys. She would

then have to brute-force them, a time-consuming process, especially if the encryption

password is well chosen. Technologies to securely handle private keys are explored in

more depth in Chapter 8.



3



A resourceful attacker could perform a double-spending attack over accounts under her control,

but she cannot change the balances of other accounts, as these are protected by public-key

cryptography.

4

Using a symmetric cypher (section 8.1).



UNDERSTANDING BITCOIN



18



Private keys could also be kept on physical media—such as a piece of paper—or

digital media not connected to the internet. This is called cold storage, as the private keys

are not accessible from the internet and are thus safe from electronic attacks. These keys

can be subject to physical theft, though, and must be secured appropriately.

Some wallet implementations run a full Bitcoin node. A full node keeps a complete

copy of the distributed database, the blockchain. These wallets have the advantage of

not having to rely on any third party server, at the cost of having to store and process the

whole transaction database.

Lightweight wallet implementations are also available. These lightweight wallets rely

on third party nodes to feed them the information they need, such as the balances for

the addresses in the wallet. They also rely on third party nodes to relay the transactions

created by the wallet. Lightweight wallets are more suitable for devices with limited

memory and processing/battery capabilities, such as smartphones. The technology

behind lightweight wallets is explored in more depth in section 8.8.

It is recommended that a wallet with an open source implementation is used (section

1.2). A proprietary source wallet can constitute a security risk, if the author of the

wallet decides to include a backdoor into the binaries5. There are several open source

implementations of both full node wallets and lightweight wallets.

A third type of wallet is web wallets. In a web wallet the funds are transferred to a

third party, often a website, which then manages the funds on behalf of the user. The

user experience is similar to that of existing online banking services. Web wallets offer

convenience for their users, as the service takes charge of managing the private keys.

However, the user is open to the web service stealing her funds, or the service being

attacked and robbed. In both cases, the user could lose all her funds, as the private keys

are entirely controlled by the web wallet service. Following many episodes of theft or

attacks on these services (McMillan, 2014), there have been calls to use already available

technology (multisignatures) to create web wallet services where the service operator (or

an attacker) cannot take control of the client’s funds. These technologies are explored in

sections 8.3.



2.5



THE DIFFERENT MEANINGS OF BITCOIN



Bitcoin is an overloaded word, as it can mean several things:

The protocol. The protocol is the specification of how to construct the distributed

database (the blockchain), how to parse it, how transactions should be assembled,

what constitutes a valid transaction, and so on.

The network. This is the peer-to-peer network to which nodes connect. Nodes in this

peer-to-peer network exchange messages containing new blocks being added to the

blockchain and new transactions being published.



5



A backdoor can also be included into the binaries of an open source wallet, and these binaries

offered as a download in a website. However, in the case of an open source wallet, the user always

has the option of downloading the source code, reviewing it, and compiling it herself (or paying

someone to do it for her).



Technology (Introduction)



19



The currency. A bitcoin, usually spelled with lower case “b”, is a unit of the native

currency of the Bitcoin network. There will be a total of roughly 21 million bitcoins

issued. Although bitcoin is the main unit of account, each bitcoin is divisible to

100,000,000 pieces, called satoshis6.

The open source implementation. This is the original open source project, written

in C++, implementing the protocol. The project was recently re-branded to Bitcoin

Core, in part to avoid confusion between the different meanings of Bitcoin. Both the

source code and complied binaries can be freely downloaded from bitcoin.org/en/

download.

Bitcoin Core is a single computer program but it includes two different services:

Bitcoin Core Wallet, also known as bitcoin-qt, is the default implementation for a

wallet. The wallet is a full node wallet as it requires a full node to run. Bitcoin Core

Wallet presents a GUI to the user using the qt framework, hence the name bitcoin-qt.

Bitcoin Core Server, also known as bitcoind, implements a network node. It can be

run in headless mode, i.e. without a graphical user interface, as a daemon, hence

the name bitcoind. Bitcoin Core Server is used to connect to the Bitcoin network,

interchange messages with it, interpret the blockchain, handle new transactions in

the network, and so on.

There has recently been some interest in the community in dividing the Bitcoin Core

project into two separate standalone programs, as the target users for the wallet and the

node software have been diverging.



6



Further divisibility could be achieved with a change in the protocol. Currently the protocol

represents amounts using 64-bit integer numbers that hold the amount of satoshis. To achieve

further divisibility, the protocol could be changed to another representation. Note that this change

would require coordination of all users of Bitcoin to upgrade their software.



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