Bitcoins Simplified - II The Blockchain

This is the second part of the Bitcoin Series. If you haven't already, please refer to Part I.

In the previous part we looked at how ownership and transfer of ownership is implemented in Bitcoin. We left off with the question, how do you ensure that Mark only spends Bitcoin X only once? What is to stop him from sending the same Bitcoin X to multiple people?

When you own an account at a bank, the bank ensures that you can only spend money that you own. The bank in this case acts as the central entity that enforces the correct set of rules on your bank account.

The Blockchain
In Bitcoin, the entire process is decentralized. The bitcoin network is a peer-to-peer network of multiple nodes running the Bitcoin client. All these nodes, in conjunction, maintain and validate a distributed ledger, called the blockchain, to enforce the rules. This is a central part of the innovation behind bitcoins.

• The blockchain is a chain of blocks.
• Each block contains a list of transactions.
• As new bitcoin transactions are generated, they are captured together into a new block and the new block is added to the blockchain.

As can be seen above, each block contains a link to the previous block's hash, thus linking the blocks in the chain. The blockchain, thus, records all the Bitcoin transactions, right from the birth of Bitcoin. This way all the nodes in the bitcoin network know when Mark has spent the bitcoins that he owns, thus invalidating any subsequent double-spend transactions by Mark.

Proof of Work
Now the question is, since any node in the network can add blocks to the chain, how do you prove that someone malicious did not add an incorrect block to the chain? Or worse, fork the blockchain and create their own set of blocks thus misguiding everyone.

This is ensured by enforcing the following simple rules:

1. adding any block to the blockchain takes a significant amount of processing (CPU) power (proof-of-work). While at the same time, validating any block in the blockchain is extremely trivial.
2. if the blockchain is forked, all the nodes in the Bitcoin network pick the longer branch of the blockchain, ignoring the smaller branch.

Assuming that majority of the processing power in the Bitcoin network is controlled by 'good' nodes, this makes it extremely hard for malicious nodes to fork the blockchain. This is because the total processing power of the good nodes, will keep extending the blockchain further, while malicious nodes fail in their race to fork the blockchain since the forked branch will always be shorter. [1]

The process of adding new blocks to the blockchain is called bitcoin mining.


Bitcoin Mining
So all bitcoin miners are always in a race to find the appropriate proof-of-work with other miners in the network. This involves significant computer power. What is the incentive for these miners to expend this computing power?

The miner who added a new valid block to the blockchain gets a reward of new bitcoins. This not only acts as an incentive for miners, but also ensures a steady and predictable supply of new bitcoins in the system. [2]

Isn't all of this fascinating?

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Additional Notes:
1. The proof-of-work algorithm makes the bitcoin miners choose a value for a set of fields in the new blocks header, such that the hash of the generated block satisfies a difficulty target. This criteria is that the hash of the block should be less than a defined target value. This makes the bitcoin miners try all the possible values in the proof-of-work fields and check the hash of the block to match with the current difficulty target, thus expending processing power. The verification process is trivial because all it does is computes the hash of the newly added block with the difficulty target.


The difficulty target of the bitcoin network keeps incrementing to keep up with the advances in hardware of the miners. The difficulty target is so adjusted that it takes an average of 10 minutes to mine a new block.

2. The current reward is of 25 bitcoins. The reward halves after every 210,000 blocks that are mined.

Acknowledgements: Thanks to Danny Hamilton for his corrections.

Bitcoins Simplified - I

For the past few weeks I have been reading up and studying the technology behind Bitcoin. I have found this exploratory activity to be truly exciting, and I have often admired the application of technology to solve this problem.

Here is my take at simplifying the technology behind the working of bitcoin:

Bitcoin is

1. electronic currency: it does not rely on electronic tokens rather than physical tokens to represent money
2. decentralized (peer-to-peer): there is no central authority (like a central bank etc.) responsible for creating the currency, or responsible for managing transactions of this currency

Let's begin by assuming that there is such a currency in an electronic form, then look at the various problems that such a currency would pose.

Ownership
Since the currency is electronic, how do I prove ownership? Anybody could make a copy of my currency and claim that it is theirs.
If your mind is thinking about PKI, you are in the right direction. Digital signatures have been used for a long time now, to ensure the authenticity of the source of a message. The same principle is used for signing transactions. Since I am the only one who has the private key, I am the only one who can sign the transaction. That proves ownership.

In the example above, Mark owns bitcoin X. When he performs a transaction, his transaction will be treated as valid, since he can generated a valid signature. Larry cannot spend Bitcoin X, since he cannot generate a valid signature for bitcoin X.
You may be wondering how exactly would you know what public key should be used to validate the signature. Hold on to that thought, we will come to it in a minute.

Transfer of Ownership
Ok, now how do I transfer that ownership to someone else? What signifies ownership in this case?
I know the answer is forming in your head :).

Since we are using digital signatures, my signed transaction should include the 'public key' of the recipient. Thus the public key of the current owner will be encoded in the bitcoin transaction.

In the example above, Mark transfers Bitcoin X to Larry. He does so by including Larry's public key in the transaction.

So what does this mean for Larry, when he is spending Bitcoin X? He should sign the transaction with a private key that corresponds to the Public key that was encoded in the previous transaction. Only that will allow him to unlock/transfer the Bitcoin to the next recipient. This is shown below.

In this transaction, Larry transfers Bitcoin X to Elon. Larry's signature can be verified by anyone, since it is already encoded in Bitcoin X's previous transaction. After this transaction, Elon now owns the Bitcoin X.

So far so good, but the biggest question is, how do you ensure that Mark only spends Bitcoin X only once? What is to stop him from sending the same Bitcoin X to multiple people? This is where the distributed ledger concept of Bitcoin kicks in. It is a central part of the bitcoin innovation. More on that in a follow-on blog post.

Bitcoin: What's the big deal?

TechTalk Summary: The intention is to understand a topic by raising and answering questions by participants, all of whom are interested in exploring the topic further. Most of the discussion is performed by novices in the field, so most progress is based on first principles. And there could be technical faults in the discussion captured below.

{ This is Part 2 of the Bitcoin TechTalk series. The previous TechTalk about Bitcoin is available here: Bitcoin: A Bubble? }

A: So new currency you say, why do you need a new currency?
B: It is a decentralised network, there is no central authority. So a central authority cannot ask you for a high percentage of commission. A network of miners maintain the network and they are rewarded by new bitcoins for their work.
A: Well, that is for now. Once the transaction volume increases,who is to stop them for charging high commission?
B: Well since anyone is free to participate in the miner network, hopefully economic/competitive equilibrium is reached.
A: Hmm... but if anyone can participate in the miner network, how do you avoid malicious activity?
B: That is the crux of the bitcoin algorithm. It maintains a distributed ledger of all transactions since Bitcoin's birth. Adding transactions to this ledger requires high computing power. And every miner in the miner network is in a race to add transactions to this ledge. On the other hand, validating transactions from the ledger requires very few computational resources. So it is easy for the miner network to identify and discard malicious transactions.
A: While the distributed ledger in itself is useful in a lot of situations beyond currencies, the very low transaction charges implies that you could perform very small transactions without incurring much cost. A slew of new and interesting ideas could be implemented with this. (Ref: Why Bitcoin matters)
B: But the cost of bitcoins is too high, I don't think micropayments is an option at all.
A: Actually, the bitcoin protocol has a nifty feature where you could divide a bitcoin down to as small a fraction as you wish. Currently the smallest unit of bitcoin, also called a satoshi, is 1/100,000,000 BTC

Bitcoin: A Bubble?

TechTalk Summary: The intention is to understand a topic by raising and answering questions by participants, all of whom are interested in exploring the topic further. Most of the discussion is performed by novices in the field, so most progress is based on first principles. And there could be technical faults in the discussion captured below.

[ Please contribute in the comments section, that is the place for most revelations / insights ]

• A: Why does its value fluctuate?
• B: Same reason why the value of any other commodity or equity shares fluctuate.
• A: What is it backed by? Equity shares have the products created by the corporation or its assets as its backing?
• B: I don't think its backed by anything per-se. Even in case of corporations, the perceived value as reflected in the market capitalization wouldn't always match the assets or the created products. 
• A: All currencies are usually backed by gold, aren't they. There is no such backing for bitcoins. Could the energy spent in mining the bitcoins the backing for bitcoins?
• B: True that. That makes it seem like a bubble. I don't have anything to show for it when things are going south. The energy spent is actually energy spent, I still don't have anything to show for it.
• A: Actually, what happens if the price of gold itself goes down, what do we have to show for that? An ornament?
• B: Let's go back to the time in human civilization where only food and wood (shelter) was required for survival. At that point, what would be the value of gold, nothing. I can't eat it, I can't use it for shelter. It's as good as stone. It's price rose only when multiple people were interested in it.
• A: And it was scarce enough. Demand-Supply. As long as you have demand, the value will be maintained. So yeah, apart from food and shelter everything else is pretty much perceived value driven by demand-supply.
• B: The supply is throttled at about 25 bitcoins per 10 minutes for miners, so that addresses the supply side
• A: I wonder what is the number of bitcoin owners. If all of them together dump bitcoin, only then the demand will go down. 
• B: Hmm, that will affect the value of bitcoin, but we could still continue to use it as a medium of currency exchange. 

Some links that I search after this discussion:

• Only once currency is still backed by gold: http://www.businessinsider.com/are-there-any-currencies-backed-by-gold-2012-3?IR=T
• Number of unique bitcoin addresses: https://blockchain.info/charts/n-unique-addresses
• Bitcoin Venture Capital Investments: http://www.coindesk.com/bitcoin-venture-capital/