Why was it invented?

Electronic commerce must rely on financial institutions serving as a third party processing the transactions and payments. This system works well, except for the inherent weaknesses of the trust base model. These systems cannot do completely non-reversible transactions since they cannot avoid mediation disputes. These mediation processes also increase transaction cost. With the possibility of reversing transaction, the need for trust increases. Merchants also collects more information from customers as they need to be wary. With physical currency payments most of these uncertainties and cost can be avoided. However, in the digital world, a trusted third party is needed (Nakamoto, 2008).

Satoshi Nakamoto published a white paper describing a digital currency based on proof-of-work (PoW) protocols. PoW is a technique or software algorithm used by cryptocurrencies to verify new transactions added to the blockchain. Decentralised applications (DApps) and cryptocurrencies on blockchain and decentralised networks has no central governing authority or any gatekeepers and are making use of PoW to ensure the integrity of the new data. PoW is a consensus mechanism that selects network participants, also known as miners, that are allowed to verify new data. This is lucrative as miners are rewarded with new cryptocurrencies when they have accurately validated the new data (Napoletano, 2022).

In Satoshi’s whitepaper, he explained that a payment system based on cryptographic proof was needed instead of trust. A system was needed that allows any two parties to transact directly without any third party. Transactions that are non-reversable would protect sellers from fraud, and routine escrow mechanisms could be implemented to protect the buyers. Such a digital currency and payment system was proposed by Satoshi Nakamoto in 2008, called Bitcoin. Bitcoin is a new kind of money and an innovative payment system. It is a peer-to-peer version of electronic cash that allows payments from one party to another without going via a financial institution (Bitcoin.org, 2022) (Nakamoto, 2008).

One of the issues with previous digital currency attempts was the issue of double spending. Cryptocurrency is just data, and a mechanism is needed to prevent users from spending the same units in different places before transactions can be recorded. Spending the same one-dollar bill on two purchases would be hard to do but coping a duplicate of a file and data is not so hard. Nakamoto’s consensus mechanism has solved the double-spending issue by PoW. The Bitcoin network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work. The longest chain not only serves as proof of the sequence, but it is also proof that it came from the largest pool of CPU power. This will make it secure for as long as most of the CPU power is controlled by nodes not cooperating to attack the network. These nodes will outpace the attackers. The network itself is very simple where messages are being broadcasted on a best effort basis. Nodes can leave and re-join at any time. When they re-join, they need to accept the longest proof-of-work chain as the proof of what happened in their absence (Nakamoto, 2008).

What is Bitcoin?

Bitcoin is a new digital payment system, using digital money. It’s the first decentralised currency in the world that allows for buying goods and services without having to go via a central authority like a bank. It is a Peer-2-Peer (P2P) payment system. Nobody owns the Bitcoin network. It is controlled by users around the world.

At the time of writing, Bitcoin is the world’s largest cryptocurrency by market cap and was created in 2009 after the housing market crash.

Some basics of Bitcoin are listed below (Karhrman Akademie, 2022):

• Bitcoin was developed by Satoshi Nakamoto; no one knows if this is a person or a group of people under the name “Satoshi Nakamoto”.
  • In Japanese, Satoshi means “clear-thinking” or “wise”.
  • Naka means “inside.
  • Moto means “the origin” or “the foundation” of something.
  • Put together, Satoshi Nakamoto means “Thinking clearly inside the foundation”.
  • Shortly after the white paper was published, Satoshi released the source code and software client to the world; Bitcoin was created and gave birth to today’s cryptocurrency landscape.
• Bitcoin promises lower transaction fees than the traditional online payment methods.
• There are no physical bitcoins, except for the ones made purely as a collector’s item and has no value linked to Bitcoin’s value.
• Bitcoin is not considered legal tender in most countries, however some countries such as El Salvador and Central African Republic has adopted Bitcoin as legal tender.
• Bitcoins are not backed by any bank or government.
• The total supply of Bitcoin is set at 21 million and will never change.
• One Bitcoin is divisible to eight decimal places, each digit is called a Satoshi.

How does Bitcoin work?

In basic terms, users install a mobile application or computer program that serves as a virtual wallet. This wallet allows for sending and receiving Bitcoin.

Sending and receiving Bitcoins is as simple as sending an email. Anyone with a Bitcoin address can send/receive Bitcoins to and from another person. Your address is public and anyone who knows your address can send you Bitcoins. Your Bitcoin account has a private key that allows you to send or access your Bitcoin account.

The how does it work part is a bit technical. Basically, miners create Bitcoins by using computers to solve mathematical algorithms. This same process is also used to verify transactions, the consensus mechanism. The Bitcoin cryptocurrency is traded on exchanges, offering a way in and out of the market for non-miners. Individuals and businesses create wallets that allows them to send and receive Bitcoin. Cryptography secures the network, ensuring all balances and transactions are safe.

This section contains information from Satoshi’s whitepaper, with the aim to make it a bit more understandable. There is a network, the Bitcoin Blockchain, with nodes decentralised all over the world containing a copy of the blockchain. In addition, it consists of mining nodes that are responsible for approving transactions and adding them to the blockchain. Lastly, there is a timestamp server that records every transaction on the blockchain.

Transactions

An electronic coin is defined as a chain of digital signatures. Each owner transfers the coin to the next one by digitally signing the hash of the previous transaction and the public key of the next owner and adding these to the end of the coin. The recipient of a coin can verify the signatures to verify the chain on ownership (refer to the figure below) (Nakamoto, 2008).

Timestamp Server

As mentioned, one problem with digital currencies is double spending. A way was needed for a payee to know that the previous owners did not sign any earlier transactions. The earliest transaction is the one that counts. The only way to confirm the absence of a transaction is to be aware of all transactions. To achieve this without a third party, transactions are publicly announced and can be viewed on blockchain explorers. In addition, a system is in place to agree on a single history of the order in which transactions were received, called the blockchain (Nakamoto, 2008). The blockchain begins with a timestamp server, by taking a hash of a block of items to be timestamped and widely publishes the hash. The timestamp proves that the data must have existed at the time to get into the hash. Each timestamp includes the previous timestamp in its hash, forming a chain, with each additional timestamp reinforcing the ones before it, as shown in the figure below from Satoshi’s White paper.

Proof-of-Work (PoW)

A distributed timestamp server is implemented on a peer-to-peer basis, by means of a PoW system, which works like Adam Back’s Hashcash (Nakamoto, 2008). The PoW involves scanning for a value that when hashed, such as with SHA-256, the hash begins with several zero bits. The work required in the number of zero bits is exponential and can be verified by executing a single hash. For the timestamp network, the PoW is implemented by incrementing the nonce, a random value, in the block until a value is found that gives the block’s hash the required zero bits. When the CPU effort has been expended to make it satisfy the PoW, the block cannot be changed without redoing the work. As blocks gets added to the chain, the work to change a block would involve redoing all the blocks after it.

The PoW also solves the issue of determining the majority decision making in the blockchain technology. PoW is essentially one-CPU-one-vote. The majority decision is represented by the longest chain. If most of the CPU power is controlled by honest nodes, the honest chain will outgrow and outpace any other competing chains. If an attacker wants to modify a past block, he/she would have to redo the PoW of the block and all blocks after it and then catch up and surpass the work of the honest nodes. As blocks are added, the probability of a slower attacker catching up diminishes exponentially over time (Nakamoto, 2008)

Network

The steps on how the network runs is as follows:

1. New transactions are broadcast to all nodes.
2. Each node collects new transactions into a block.
3. Each node works on finding a difficult PoW for its block.
4. When a node finds a PoW, it broadcasts the block to all nodes.
5. Nodes accept the block only if all transactions in it are valid and not already spent.
6. Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.

Nodes always consider the longest chain to be the correct one.

Privacy

In traditional banking models, privacy depends on the trusted third party. With Bitcoin, all transactions are announced publicly, but privacy is maintained by keeping the public keys anonymous. The public can see someone is sending BTC to someone else, but there is no information that could link it to any person. There is also an additional firewall, a new key pair should be used for each transaction to keep them from being linked to a common owner (Nakamoto, 2008).

Security

The future of Bitcoin is still uncertain. However, it is predicted that it might be the safest to use on the network since credit theft is a major issue on the Internet.

Since all transactions are recorded publicly, it is extremely difficult to copy Bitcoins, make fake ones or spend coins you do not own.

It is however, possible to lose your Bitcoin wallet or delete your Bitcoins and lose them…forever.

If you store your Bitcoins remotely or on an exchange, you are at risk of possible hacks to the exchanges and lose your Bitcoins due to theft.

Bitcoin is very volatile and investors could lose a lot of money.

Why does Bitcoin have value?

A lot of things in life other than money are considered valuable such as gold and diamonds. Basically, Bitcoin has value because people have bought into the concept and are willing to exchange Bitcoins for cash, goods and services.

Bitcoin is scarce, there is only 21 million in total supply.

Bitcoin is decentralised. Bitcoin is borderless.

Bitcoin is freedom. Certain people like the fact that Bitcoin is not controlled by the government or banks, which gives adds more value to the coin.

Bitcoin is fungible.

Bitcoin it is transparent. It can be spent fairly anonymously. All transactions are recorded, but no one can link a person’s identity to the transactions, unless the person reveals his/her identity.

Elon Musk, the world’s richest man, announced in 2021 that he is a big supporter of Bitcoin, which added tremendous value to the digital asset. He even changed his Twitter bio to #bitcoin. He has also showed his interest and support in other cryptocurrencies, such as Doge-coin, which caused major big movements in the value of the cryptocurrencies.