What is Bitcoin?
In his original paper, inventor Satoshi Nakamoto calls Bitcoin a “peer-to-peer electronic cash system,” a new and potentially revolutionary form of money. Bitcoins can be viewed as digital units that can be exchanged for the purchase of products, services and/or other currencies. However, what sets Bitcoins apart from traditional currencies is that Bitcoin transactions are not conducted through a central third party, such as a bank, but through a network of nodes, also called the blockchain. This is a big improvement because it eliminates the possibility of “double spending.
Double spending
Double-spending occurs when money that has already been spent is spent again. Normally, a financial organization (third party) functions as the authoritative body that verifies transactions. Double-spending and chargebacks (purchase fraud) are impossible with a system like Bitcoin because transactions take place directly and irreversibly between the two parties involved. Bitcoin uses a decentralized system, meaning that central third-party control is replaced by consensus among the nodes that make up the Bitcoin network. The transaction must receive confirmation from the network instead of being verified by a third party. After confirmation, the payment cannot be undone, as this would require an adjustment of confirmation from the network.
The Bitcoin network
Without getting unnecessarily technical, here is a summary and explanation of the most important aspects of the Bitcoin network:
Transactions and wallets
Bitcoin is an open-source system: there is no owner and it is completely transparent to the public. Anyone can join and become a Bitcoin user. All Bitcoin users have what is called a wallet. In a transaction, a certain number of Bitcoins is transferred from one wallet to another. Installing a new Bitcoin wallet is automatic and creates an initial Bitcoin address, which is needed to receive Bitcoins from others. When using Bitcoin, a so-called “push transaction” takes place, rather than allowing third parties to withdraw money from your account (pull).
Nodes and blockchain
The Bitcoin network consists of nodes. A node can be any person running Bitcoin software. With this software and an Internet connection, the nodes collectively form the decentralized Bitcoin network. All transactions verified by the network are added to the blockchain. A blockchain is a way for the nodes in the network to give the transaction a “timestamp”. Because there is full access to all transactions in the blockchain, wallets can calculate exactly what their balances are and bitcoins cannot be spent that are not owned by the issuer. A transaction is not final until it is confirmed by a given number of blocks. The transaction is then considered secure because the chronological order of transactions is fixed in the timestamps. To guarantee the chronological order and validity of the block, Bitcoin transactions work with cryptographic proof. Each Bitcoin wallet has its own “private key”. This is a unique piece of data that acts as a signature on a transaction.
Safety and verification
Verification of the authenticity of Bitcoin transactions is based on the approval of the majority of nodes in the Bitcoin network. Nodes approve only those transactions for which they can find proof-of-work. This works as follows:
A transaction passes through the nodes of the network to finally receive confirmation of authenticity. A node receives the transactions and collects it in a block. If the node accepts this block, then the node adds a “signature” to the transaction with the condition that the last added signature is correct. This signature is an addition to the end of the code that consists of two parts: a ‘hash’ of the previous transfer and the public key of the next owner. Ultimately, the decision whether to approve the transaction is based on the right of the longest chain. Because it requires a very large amount of computing power, it becomes very unlikely that a fraudulent attacker will override the legitimate network the longer the chain gets.
Mining or buying
The process by which a transaction is confirmed by the network is called mining, but mining is also a way to acquire Bitcoins. This is how Bitcoins are distributed through the network itself. If you are part of the Bitcoin network you are participating in a kind of lottery, where new Bitcoins are discovered. By the way, this is a lottery where the chances of winning are getting smaller and smaller, because there are fewer and fewer Bitcoins left to be discovered. As a result, new Bitcoins are much more frugal and mining new Bitcoins is much less profitable now than it was a few years ago. A great anecdote is that of Bitcoin user Laszlo Hanyecz who bought two pizzas in 2010 for 10,000 Bitcoins (which would now be worth over €7 million). In addition, there are sites where you can buy Bitcoins (for example, via iDeal). Usually the seller of Bitcoins takes a (small) profit margin on the sale.
The future of Bitcoin
Advantages and disadvantages of Bitcoin
Besides the fact that the need for “trust” in an authoritative third party has been replaced by cryptographic proof from within the network, there are more advantages to a payment system like Bitcoin. Because of its peer-to-peer technology, Bitcoin enables very fast transactions with almost no transaction fees. Because Bitcoin does not have to pay attention to national or continental borders, international transactions are much easier. Because transactions are irreversible, one is also protected from fraudulent buyers.
Because Bitcoin is based on a transparent network in which anyone can track every node and every transaction, it may seem contradictory to say that Bitcoin is a highly anonymous method of conducting transactions. The privacy lies in the use of an anonymous public key. To further ensure anonymity, ‘tumbling’ of Bitcoins can also be used in which transactions of Bitcoins are sort of scrambled, this makes it more difficult to trace a ‘path’ of transactions.
Over the years, some weaknesses of the Bitcoin network have also become more apparent. For example, there are technical limitations that stem from the fact that the scale of the network is much larger than originally anticipated. In addition, much of the Bitcoin network’s computing power lies with specialized groups of miners (mostly in Asia), which poses a serious threat to the security and distributed nature of the network.
Conclusion: Future and underlying technology
Given Bitcoin’s technical limitations as well as its association with darknet markets, I don’t see it becoming a more widely accepted means of payment. But the real revolution that Bitcoin has brought about is not Bitcoin itself but the underlying “blockchain” technology, which offers many more potential applications than a public digital payment method. It is best to think of Bitcoin’s distributed consensus system as just one implementation of blockchain technology. Many large companies, primarily in finance and auditing, are investing in the development and potential applications of blockchain technologies ( see, for example, R3 consortium). Blockchain has the potential to dramatically change existing processes and networks. As to whether that will actually happen, we will go into more detail with an upcoming article.
References
[1] Bitcoin.org: Hoe het werkt [2] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System [3] Bitcoin Wiki: Double Spending [4] Bitcoin Wikipedia [5] BitocoinSpot: Wat is Bitcoin? [6] Bitcointalk.org topic 137.0
