The First Currency That is Truly Yours | Fernando Tarnogol
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27 abril, 2017
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The First Currency That is Truly Yours

During the past decade, we have been blind witnesses to an invisible revolution taking place on the internet. Deep below our line of sight, an internet urban legend named Satoshi Nakamoto thought of a way to fundamentally change the way the internet works, to subvert the canons that rule the finance system and ultimately, to enable economic freedom and dramatically decrease costs, bureaucracy and corruption at an unprecedented scale. This “thing” that only a decimal percentage of the world population knows about is called the Blockchain.

Blockchain technology has eluded our radars only because at first sight, the way it works gets obscured by the technology that defines it: cryptography. To understand it, we need to decrypt it. That is the purpose of this story.

If we are to understand Blockchain technology, we first need to understand Bitcoin. Even though both of them were born in the same act of creation, there wouldn’t be a Bitcoin without Blockchain tech, but on the other hand, Blockchain doesn’t need Bitcoin; it is just a use case for the technology.

 

1. Enter Bitcoin

When we are curious to learn about something, usually our first stop is Wikipedia; so that is where we are starting our journey.

   

Bitcoin (BTC) was conceived to be an electronic cash system. It was created by Satoshi Nakamoto, an individual or group of individuals in 2008. This global money system allows people to send or receive money across the internet without being linked to a real identity. The mathematical field of cryptography is the basis for Bitcoin’s security, which among other things, masks the identities of the parties involved in transactions.

We call BTC peer-to-peer because of its decentralized nature. When you make a payment with your credit card, the process is cleared through the issuer’s servers, then this information goes to your bank and finally it reaches the payee. This whole process is centralized. Buying coffee, a transaction that could easily be done person to person, has to bounce on servers across the planet and get back to the cashier in front of you. This costs you.

When you do an electronic transaction using Blockchain, there are no middlemen. It’s between you and the payee. The magic, and what sets Blockchain technology apart, is what happens in between these two points.

Let’s go back to Wikipedia’s definition. It says that transactions are verified by a network of nodes that record this information in a public distributed ledger. Imagine a publicly available Excel spreadsheet posted on the internet where every transaction gets recorded. Now think of thousands of copies of that same spreadsheet, spread across the world and being updated every 10 minutes. Each copy runs on a node. A node is a computer that holds a complete copy of the blockchain. By complete, it means that it holds records of every single transaction made since the moment the first real world transaction using Bitcoin occurred. Behind this mundane event, there’s a story to be told.

 

On October 22nd, 2010 (yours truly’s 20th birthday), Laszlo Hanyecz bought 2 pizzas for 10.000 BTC, worth only a couple of bucks at the time. Today, those pizzas would be worth more than 25 million US Dollars; which led the community to refer to this foundational event as Pizzagate. Follow the link to read original thread on Bitcointalk.org where it has been preserved for posterity.

We call Blockchain technology this way, because it works like that. It consists in blocks of information (containing transactions) that get linked successively one after the other and together configure an always growing chain of blocks that hold a historical record of every transaction.

 

2. Trust

Opposite to the way the banking and financial system works, decentralization is a key component of Blockchain technology.

That $10 dollar bill you hold in your hand, is worth $10 because you and everyone else believes and trusts that $10 is what it’s worth. There’s a central bank behind it that holds assets to back the value of that instrument, so you trust that when you take a loan, the bank will honor that agreement and every time you make a payment towards that loan, the bank will deduce $10 from your debt.

If one day your country’s economy collapses and goes into hyper inflation, the value of that $10 bill will end up being worth a fraction of its former value. So when you go to the supermarket to buy milk, you may need 10 of those bills to purchase it. Which leads to the conclusion that your trust was misplaced and you got rekted by the financial system.

Trust is at the base of our financial system. With Bitcoin, things work differently. That type of trust is gone, since there are no middlemen to place your trust in. Also, since you are making payments to complete, anonymous strangers that you cannot trust, there must be some kind of system in place to guarantee the safety and legitimacy of those transactions. This is where cryptography enters the game to replace trust. Actually, cryptography is the new depositary of trust. We’ll talk about it on the next section when we discuss how bitcoin works.

3. Immutable

Cryptography is not the only thing that makes Bitcoin a secure instrument. One of the main characteristics of BTC is that it’s immutable, meaning that once a transaction has been made, it is crystalised, saved to the blockchain and cannot be edited or reversed and the deeper you go back in time through the blockchain, the more secure the transaction gets. If you sent money to the wrong person, then good luck getting it back.

How does Bitcoin work?

We said that blockchains are chunks of information containing transactions that get linked successively.

I also mentioned that the blockchain is a distributed ledger. But here’s the deal. Unlike traditional ledgers that record balances, Bitcoin’s blockchain doesn’t store account balances. It records transactions.

That means that your Bitcoin wallet (we’ll get there soon), instead of saying “you have X amount of BTC” you will have a historical record of every transaction you ever made with that wallet (account) and its result will be a determined BTC amount.

Say that Jenny sent Alan 5 BTC. In order for this to occur, Jenny should have received -and not spent- 5 BTC from previous transactions in order for her to be able to send those 5 to Alan. So, since Peter sent 2 BTC and Terry sent 2 BTC to Jenny, she has 5 BTC available to send to Alan. As Alan receives these 5 BTC, he will then be able to send BTC to someone else.

4. Identity verification

This is where cryptography enters the scene and things might get a bit murky for the uninitiated. So hold my hand and I’ll take you through it.

In order to understand how cryptography is at the core of Blockchain technology, we’ll use the analogy of a padlock and a key. For now, there’s one thing we need to learn about cryptography: public and private keys.

Imagine you have a lock to secure your luggage and that padlock is opened by a master key. As long as you have the master key, you will be able to unlock it. The problem is that if you make copies of that key, there will be as many people able to unlock your luggage as key holders. This is symmetric cryptography’s main drawback.

At the beginning of World War II, the Polish Cipher Bureau, which cracked the encryption of the German Enigma machine years earlier, shared the key to decipher German messages with their British allies. The information gleaned from this source was named Project Ultra and signified a substantial aid to the war effort.

To solve the problems that symmetric cryptography had, asymmetric cryptography was developed. This type of cryptography uses public and private keys to encrypt and decrypt a message (in Bitcoin’s case, transactions). In our lock example, Jenny -the luggage owner- holds both a private and public key. Jenny can lock her bag using either key, but the padlock can only be opened using the private key. That key is almost statistically impossible to be copied so it ensures that Jenny is the only one that can unlock the padlock.

Either of the keys can be used to encrypt a message; the opposite key from the one used to encrypt the message is used for decryption.

In the case of the 5 BTC transaction between Jenny and Alan, Alan sends the payment (message) to Jenny, which is encrypted using Jenny’s public key (this would be Jenny’s wallet address). As the encrypted message reaches Jenny, since she is the only one that has the private key, she will be the only one who can decrypt the message, thus receiving the transaction’s payment. If Jenny loses her private key, her bag will be locked forever.

5. Wallets

A Bitcoin “wallet” is basically the Bitcoin equivalent of a bank account. It allows you to receive bitcoins, store them, and then send them to others. A wallet consists in both a public and a private key. Both are generated at the same time upon wallet creation. In practice, you may not ever see your private key since dealing with private and public keys is usually handled by software or your online wallet account.

Wallets come in different flavors. You can install wallet software to run offline on your computer, smartphone or a pen drive, you can have it printed or written down on a piece of paper or you can have an online wallet. Each one has a different degree of safety.

This is what a public address looks like -if you want, you can send me a Bitcoin tip to it ;)-: 1MFtyDKKJbvHyuYaKpmf244PzztUiPSVBu

There is no risk in sharing my public wallet, since in order for anyone to steal what I have in it (or more precisely, the history of transactions that led to my current balance on that wallet) they must have my private key which honestly, I don’t know what it is because I trusted it to the online place where I have it.

By doing this I’m forfeiting one of Bitcoin’s security advantages as I am trusting a third party not to divulge my private key, risk losing it during a hack to their website or simply running away with my coins. If I had my wallet offline, it would be unreachable for hackers. In my case, if I were to hold it myself I am more likely to lose it while moving, in a house fire, flood or if I get robbed. Remember that there’s no 1–800 to call if you lose your private key or make a mistake making a transaction.

Now, what if I just slammed my palm on the keyboard like this rf4frnijowh2480ifh234fh28jeui8de3d and came up by chance with a possible private key that unlocks a wallet?

Let me tell you about chances. These are the possible number of keys both in real numbers and scientific notation (1.46 x 10⁴⁸).

The estimated number of grains of sand on this planet -if you live on the same one I do, it’s Earth, third one from the Sun if you are coming from that side of the solar system- is:

So that doesn’t cover it. So let’s take one of those grains of sand and pretend this little guy is another Earth (think about Andromeda’s necklace in Men in Black I) and multiply that for 7.5.

So, even the combined grains of sand of 7.5 earths (10³⁶) wouldn’t account for 1 possible BTC address, we are still missing 10 exponentials. That is the chance of someone randomly finding or appropriating your private key. Good luck to them!

6. Mining

A common question from people getting into the cryptosphere is about where Bitcoin (or for that matter any other cryptocurrency) come from and how it’s created. Which places us right into mining territory.

Mining is the process of solving mathematical problems -called hashing-, which is at the core of Bitcoin creation. But let’s step back a little and once again use an analogy to visualize what mining is about.

Travel back to the wild west’s gold rush and picture Billy Bob, a long bearded miner with his pickaxe smashing stones from the mine hoping to uncover some gold. His brother Rufus, who works outside the mine, pans sand to find precious gold.

In Bitcoin, this is basically what miners do, minus the physical effort. Instead of hitting stones with a pickaxe, BTC miners use computers to solve mathematical problems. There is also effort involved but instead of spending kinetic energy (moving muscles), electrical energy is consumed to solve these math problems.

The other factor in play is luck. Just like Billy Bob needed some of it to find gold, a miner needs luck to achieve the reward.

What is a miner’s job?

A miner has basically three jobs:

  • Performing computations to process the transactions that are constantly generated
  • Assembling blocks by putting those transactions into them
  • Adding, time stamping and linking blocks successively on the block chain

The miner gets rewarded when:

  • Transactions are processed, the miner takes a fee off of that transaction
  • The miner creates a new block, he is entitled to generate a transaction to himself with a block reward measured in X amount of BTC.

But here’s the thing. Let’s get back to the brothers ten years after our last visit. Two things have happened. The first one is that since gold is a finite resource, in 10 years they have mined most of the surface of the mine so nowadays it’s more difficult to find the precious metal. The pan and pickaxe are no longer profitable in terms of effort versus gain.

The Wild West grew in these 10 years and as word got out that there were riches to be found, big corporations moved over with their heavy machinery, hired the brothers to work for one of them and took over the mining operation.

Something similar happened to Bitcoin. When Satoshi Nakamoto created Bitcoin, he/she/they capped it at 21 million. That means that Bitcoin, like gold is a scarce resource. There will be a maximum of 21 million BTC available on the planet. So far, there is around 16 million BTC in circulation, with more being created every day. It is estimated that the last Bitcoin will be mined by the year 2140.

Due to the above, the nature of Bitcoin is deflationary. Supply is limited -and some is lost due to lost keys and invalid transactions-. Also, as more people hold it, there is less available BTC on the market, which makes its price rise over time.

Moore’s Law states that computing power doubles every two years. In order to maintain balance and avoid reaching the 21 million cap overnight -and also making miners rich overnight in the process-, mining difficulty is increased at predetermined intervals.

This forces miners to upgrade their mining hardware to keep up with their profit margins.

In 2010, you could mine several Bitcoins in a single day with a home computer. In 2017, to mine the same amount of BTC you need a wharehouse full of specialized hardware.

For the average Joe -or the miner brothers of our story- this situation cornered them and forced them to make a difficult decision. They either found other ways to make a living or join the big corporation to be able to make ends meet.

In Bitcoin, if you decided to mine the coin, you can join a mining pool, which is a network of computers managed by a central server that takes all the hashing (computational) power of each individual computers and coordinates them to mine Bitcoin. When a block is created the reward is distributed among the pool members proportionate to the computational power that each member has supplied to the pool.

7. Recapping

By now you should have a fairly good idea of what bitcoin is and how it works.

You know that it’s secure because it is based on cryptographic digital signatures to safeguard the money, the history of ownership for each BTC or fraction of a BTC is stored in an immutable chain of blocks, it’s anonymous (up to a degree), enables lower costs for transactions at a global scale by cutting off middlemen and it is not controlled by any government or organization due to its open source and decentralized nature.

Still, since nothing is perfect, there are some pitfalls and caveats. First of all, for the average person, Bitcoin is currently difficult to exchange since it is not yet a mass market commodity and getting acquainted with the inner workings of the technology is still within the realm of the tech savvy. Moreover, only recently user friendly services have appeared to ease the learning curve. Another factor that Bitcoin detractors use is that due to its security and anonymity features it is used for illegal activities. Lastly, exchanging it is not instantaneous.

This last variable is the focus of current debates around Bitcoin. A Bitcoin block (which contains 1MB of data) is generated every 10 minutes. Each block has to propagate through the network to be validated and confirmed by miners and nodes, which initially took around 1 hour. These days, with more and more people and organizations using it as a safeguard against a potential -traditional- financial market crash the network has gotten saturated and some transactions could take up to a couple of days to be validated, when they don’t bounce back. This has brewed a huge debate -sometimes not very amicable- within the community with parties proposing different solutions to these scalability woes since a solution for some -users- signifies worse conditions for others -miners who would receive lower fees per transaction-. This is a whole other story so if you want to know more about it, here’s a brief rundown (in spanish) of the situation.

As you can see, and especially if you have read the linked post from above, you will see that Bitcoin is not exempt from human politics.

Almost a decade has passed since Bitcoin and Blockchain technology were created. During these past few years a blockchain ecosystem has arisen. New cryptocurrencies -some derived from Bitcoin’s original code- designed to patch BTCs limitations, such as enhanced anonymity or faster transaction times have entered the scene.

For now, you have enough information to chew on for a couple of days. Just know that today we’ve only touched the tip of an iceberg that hides a second iceberg underneath. Stay tuned for our next entry where we will explore the true potential -beyond financial uses- of Blockchain technology through current and upcoming real world applications.

Now, I’m sure your question is “Should I invest in Bitcoin?”. Glad you asked yourself that, and if you haven’t, now you have. The answer to your question lies within the 3000+ words that precede this sentence; and only you know it. Let us know what you think or ask away in the comments section!

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