Bitcoin: An Electronic Cash System — A Simplified Version
Bitcoin was created by an anonymous individual with the name of Satoshi Nakamoto back in 2008. It is a “peer-to-peer version of electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution”. What Bitcoin does is that it technically eliminates the trust factor of digital transactions by using a digital representation of cash. In a typical digital transaction, a third party such as a bank or a financial institution is involved that acts as the intermediary and also verifies the transaction. Through the launch of Bitcoin, this is no longer required as bitcoin transactions are encrypted and digitally verified by members of the community, meaning that there is no need for a third party to verify and regulate transactions.
Satoshi Nakamoto launched the Bitcoin whitepaper to establish the framework for Bitcoin. Bitcoin is considered an asset that fulfils functions as a medium of exchange, unit of account, and store of value, functions that currencies and gold also possess. However, Bitcoin has an edge over them since it also has features that include durability, portability, scarcity, and having an intrinsic value. The whitepaper talks about how the entire bitcoin infrastructure operates, with an emphasis on transactions, solving the double-spending problem, proof-of-work, incentive for miners, and privacy to name a few salient points.
Bitcoin transactions take place on the Blockchain network. When person A wants to transfer bitcoins to person B, the blockchain network verifies when the sender first received that amount via the previous block and confirms the amount that they currently want to transfer to the receiver via the future block. To ensure that transactions are verified, they are all made publicly available. All bitcoin transactions are displayed on the blockchain ledger and it contains a ‘timestamp’ that shows where the amount previously existed and where it is now heading, creating a chain of blocks. To avoid the problem of double spending, every transaction in the blockchain ledger is verified by all members of the community, by existing nodes, and by running programs. Since the ledger is publicly available, it can be verified by the sender and receiver as well as other members of the community, making it next to impossible for double spending to occur.
Satoshi implemented a proof-of-work (POW) system to ensure that transactions are functioning correctly. To ensure that a transaction goes through, the sender’s computer must solve a complex mathematical problem and send it to the receiver. Once the puzzle is deemed correct, the transaction is validated and executed. Every mathematical problem solved is added to existing blocks that continue growing as more transactions are performed. It is nearly impossible for someone to reverse a transaction since that individual would need to reverse each and every existing transaction on the block, something that requires quite a lot of computing power.
Bitcoin mining refers to using one’s computing power to verify and process blockchain transactions. Miners are those who generate new bitcoins after solving a complex mathematical problem. They receive a fraction of a bitcoin as an incentive every time they mine new ones. The whitepaper mentions that there is a predetermined number of bitcoins to be mined (21 million). Currently, there are 18 million bitcoins that are in circulation, with the remaining to be mined by the next 140 years. Once this number has been reached, miners will be provided incentives in the form of transaction fees. New strategies can only be implemented on the blockchain network if at least 51% of the network agrees to it.
Privacy was one of the primary reasons why Bitcoin was created. After the 2008 financial crisis, a lot of individuals lost trust in banking and financial institutions. With the invention of bitcoin, the privacy issue is out of question as transactions are encrypted and anonymous. Even though transactions are completely transparent to the public, the blockchain network only uses the addresses of the sender and receiver without linking the transaction to private information. In contrast, in a traditional bank transaction, the names and personal details of the sender and receiver are exposed, making them extremely vulnerable to hackers.
All in all, in conclusion, the Bitcoin whitepaper emphasizes on the fact that Bitcoin was created as a transaction system to ensure that one does not need to rely on third parties to conduct transactions whilst simultaneously preventing double-spending through the use of a peer-to-peer network with a history of all transactions represented on the blockchain ledger that are next to impossible to be reversed. Satoshi Nakamoto, however, mentioned that if the majority (at least 51%) of individuals on the network vote for a change, the network can be modified accordingly. To prevent corruption and defrauding, each node on the network votes with their computing power, and as long as the majority of the network contains honest nodes, the system will not face any corruption issues.
Written by Arhan Parikh (arhan.parikh@xumitcapital.com)
References:
Nakamoto, Satoshi. Bitcoin: A Peer-to-Peer Electronic Cash System. Satoshi Nakamoto, 31 Oct. 2008, https://bitcoin.org/bitcoin.pdf.
