Grokking Bitcoin

Step 1 of the process (Figure 3) is when Alice asks the network to move 1 bitcoin to Bob. She does this by sending a Bitcoin transaction to the Bitcoin network. This transaction contains instructions on how to move the money and a digital signature that proves it’s really Alice requesting that the money be moved.

The Bitcoin transaction is a piece of data specifying

The digital signature is created from the transaction and a huge secret number, called a private key, that only Alice has access to. The result is a digital signature that only the private key’s owner could have created.

Alice’s mobile wallet app is connected to one or more nodes in the Bitcoin network and sends the transaction to those nodes.

Alice has sent a transaction to one or more Bitcoin nodes. In step 2 of the process (Figure 4), each such node checks that the transaction is valid and passes it on to its peers. It does this by consulting its local copy of the blockchain and verifying that

If all checks pass, a node forwards the transaction to its peers in the Bitcoin network. This is known as relaying. Alice’s transaction will shortly have traveled the entire network while each node verifies it along the way. The blockchain hasn’t been updated yet; that’s the next step.

In step 3, nodes update their local copies of the Bitcoin blockchain with Alice’s transaction. The blockchain contains historic information about all previous transactions; new transactions, such as Alice’s, are appended to it every now and then.

Updating the blockchain with Alice’s transaction isn’t as straightforward as it might seem. Alice’s transaction isn’t the only one going on in the Bitcoin network. Potentially thousands of transactions can be in flight at the same time. If all nodes updated their copy of the blockchain as they received transactions, the copies wouldn’t remain copies for long because transactions can come in different orders on different nodes, as Figure 5 shows.

To coordinate the ordering of transactions, one node takes the lead, saying “I want to add these two transactions to the blockchain in the order Y, X!” This message, known as a block, is sent out on the network by that leader (Figure 6), in the same way that Alice sent the transaction.

As nodes see this block, they update their copy of the blockchain according to the message and pass the block on to their peers. Alice’s transaction was one of the transactions in the block and is now part of the blockchain.

Why would a node want to take the lead? The node that takes the lead is rewarded with newly minted bitcoins and transaction fees paid by the transactions it includes in the block.

But wouldn’t every node constantly take the lead to collect the rewards? No, because to take the lead, a node must solve a hard problem. This requires the node to consume considerable time and electricity, which ensures that leaders don’t pop up often. The problem is so hard that most nodes in the network don’t even try. Nodes that do try are called miners because they mine new coins, similar to a gold miner digging for gold. We’ll discuss this process further in [ch07].

Bob and Alice are Bitcoin network users, and they both need a computer program to interact with the network. Such a program is called a Bitcoin wallet. Several types of Bitcoin wallets are available for different devices, such as mobile phones and desktop computers, and there are even specialized hardware wallet devices.

Before step 4 of the payment process, the nodes in the network update their local copy of the blockchain. Now, the network needs to notify Alice and Bob that the transaction went through, as Figure 7 shows.

Bob’s wallet is connected to some of the nodes in the Bitcoin network. When a transaction concerning Bob is added to the blockchain, the nodes that Bob’s wallet is connected to will notify Bob’s wallet. The wallet will then display a message to Bob that he received 1 bitcoin. Alice also uses a wallet. Her wallet will be notified of her own transaction.

Besides sending and receiving transactions, Bob’s and Alice’s wallets also manage their private keys for them. As described earlier, a private key is used to create digital signatures, as well as to generate a Bitcoin address. Alice created her digital signature with one of her private keys. When Bob later wants to spend the money he received at his Bitcoin address, which he generated from his private key, he needs to create a transaction and digitally sign it with that private key.

People with bank accounts and access to banking services such as online payments or loans are privileged. According to the World Bank, about 38% of the world’s population doesn’t have a bank account (see [web-financial-inclusion]). The numbers are slowly improving, but many people are still stuck in a cash-only environment.

Without a bank account and basic banking services, such as online payments, people can’t expand their businesses outside their local communities. A merchant won’t be able to offer goods or services on the internet to increase its customer base. A person living in a rural area might have to travel half a day to pay a utility bill or top up their prepaid mobile phone.

This segregation between banked people and unbanked people is driven by several factors:

When it comes to electronic payments such as credit cards or bank transfers, traditional money poses several privacy problems. States can easily

You might say, “I have nothing to hide, and the government needs these tools to fight crime.” The problem is, you don’t know what your government will look like in five years and how that government defines crime. New laws are just an election away. After the next election, your government could pass a law that allows it to freeze the funds of people with your political view. In some parts of the world, this is already happening.

We’ve seen lots of examples in which these powers are abused to disable someone’s ability to transact. For example, the nonprofit organization WikiLeaks was put under a blockade in 2010 in which all donations through traditional channels were blocked after pressure from the US government on the major payment networks, such as Visa and Mastercard (see [web-wikileaks-blockade]). We’ve also seen how Cyprus seized 47.5% of all bank deposits exceeding 100,000 € as part of a financial rescue program in 2013 ([web-cyprus-seizure]).

Note that bank notes and coins usually aren’t affected. As long as there is cash, people can trade freely and privately. In some parts of the world—for example, Sweden—cash is being phased out, which means soon you won’t be able to buy chewing gum without someone recording your transaction.

Inflation means the purchasing power of a currency decreases (Figure 8).

Most currencies are subject to inflation, some more than others. For example, the Zimbabwean dollar inflated nearly 10²³% from 2007–2008, peaking at 80 billion percent per month during a few months in 2008. That’s an average daily inflation rate of nearly 100%. Prices roughly doubled every day.

Extreme cases of inflation like this are called hyperinflation, and are usually driven by a rapid increase in the money supply. Governments sometimes increase the money supply as a tool to extract value from the population and pay for expenses such as the national debt, warfare, or welfare. If this tool is overused, the risk of hyperinflation is apparent.

A rapid increase in the money supply will most likely lead to a depreciation of a country’s currency. This, in turn, pushes people to exchange their local currency for goods or alternative currencies that better hold value, which further drives down the value of the local currency. This can spiral to extremes, as in Zimbabwe. The result is devastating for people as they see their life savings diminish to virtually nothing. Table 1 shows examples of recent hyperinflations.

Zimbabwe is one of the most extreme cases of inflation throughout history, but even today, some countries suffer from very high inflation. One is Venezuela, where its currency, the bolívar, experienced an 254% inflation rate during 2016 and suffered from about a 1,088% inflation rate in 2017. A staggering 1,370,000% inflation rate is forecast for 2018.

Moving value across national borders using national, or fiat, currency is hard, expensive, and sometimes even forbidden. If you want to send 1,000 Swedish crowns (SEK) from Sweden to a person in the Philippines, you can use a service like Western Union for the transfer. At the time I investigated this, 1,000 SEK was worth 5,374 Philippine pesos (PHP) or 109 US dollars. See Table 2.

If the recipient has a bank account that can receive an international money transfer, you can get away with a 4.9% fee. But a typical remittance recipient will be able to receive only cash, which doubles or triples the cost to 10.5% or 16.3%, depending on how quickly or conveniently they want it.

In contrast with international transfers, moving fiat currency within a nation state’s borders is usually convenient. For example, you can hand over cash directly to the recipient or transfer money using some mobile app made specifically for the currency. As long as you stay within one country and one currency, fiat currencies usually do a good job.

Instead of a central organization such as the US Federal Reserve controlling the currency, control of Bitcoin is distributed among thousands of computers, or nodes. No single node or group of nodes has more privileges or obligations than any other. This equality between nodes makes Bitcoin decentralized, as opposed to centralized systems, such as banks or the Google search engine (Figure 9).

In a centralized system, the service is controlled by a single entity, such as a bank. This single entity can decide who gets to use the service and what the user is allowed to do. For example, an online video service can choose to provide a video only to people in a certain geographical location.

With a decentralized system such as Bitcoin, which has several thousands of nodes spread around the globe, it’s extremely hard to control who uses the system and how. No matter where or who they are, or to whom they’re sending money, the Bitcoin system will treat all users equally. The Bitcoin system has no central point that can be exploited to censor payments, deny users service, or seize funds.

Changing the rules of Bitcoin is nearly impossible without broad consensus. If a node doesn’t obey the rules, the rest of the nodes will ignore it. For example, one rule is that Bitcoin’s money supply is limited to 21 million bitcoins. This limit is nearly impossible to change because of decentralization; there’s no one you can threaten or bribe to change these rules.

Because Bitcoin’s money supply won’t exceed 21 million bitcoins, people can be sure that if they own 1 bitcoin, they will always own at least one 21-millionth of the total supply of bitcoins. This feature isn’t found in any fiat currency, where decisions on supply are made every so often by a company or state. Bitcoin is resistant to high inflation because you can’t increase the money supply at will.

Bitcoin’s money supply isn’t fixed today. It’s increasing, at a diminishing rate, according to a predetermined schedule and will eventually stop increasing around the year 2140. See Figure 10.

Because Bitcoin is a system run by ordinary computers connected to the internet, it’s as global as the internet. This means anyone with an internet connection can send money to other people across the world, as Figure 11 illustrates.

There is no difference between sending a bitcoin to someone in the same room or sending it to someone on another continent. The experience is the same: money is sent directly to the recipient, who sees the payment nearly instantaneously. Within about 60 minutes, this recipient can be sure the money is theirs. Once settled, the transfer can’t be reversed without the recipient’s consent.

One interesting Bitcoin feature is that you keep your money safe by storing a set of private keys: the secret pieces of information you’ll need when you want to spend your money. You choose how those private keys are stored. You can write them on paper, or you can store them electronically with a mobile app to have easy access to them. You can also memorize your private keys. These keys are all anyone needs to spend your money. Keep them safe.

Savings is an attractive use case for Bitcoin. A simple way to save is to create a private key and write it down on a piece of paper that you store in a safe. This piece of paper is now your savings account, your savings wallet. You can then send bitcoins to your wallet. As long as your private key is kept safe, your money is safe. You can choose from a lot of different saving schemes to find the right balance between security and convenience. For example, you can keep your keys unencrypted in your mobile phone for easy access or store them encrypted on paper in a vault with armed guards.

As noted, moving money from one country to another is expensive (say, 15%), especially if you move money to a poor country, and the recipient doesn’t have a bank account. It’s becoming increasingly popular to use Bitcoin to circumvent this expensive and slow legacy system. It’s usually cheaper to exchange Swedish crowns for bitcoins in Sweden and transfer the bitcoins to your friend in the Philippines. Your friend will then exchange the bitcoins locally for Philippine pesos.

Some companies offer services so that you pay Swedish crowns to the company and the company pays out Philippine pesos to your friend (Figure 12). You won’t even know that Bitcoin is used under the hood. Such companies typically charge a few percent for the service, but it will still be cheaper than traditional remittance services.

Of course, if recipients can make good use of Bitcoin where they live, there’s no need for a middleman that takes a cut of the money. You can send bitcoins directly to your friend. This is what Bitcoin is all about. Exchanges and other such service companies are just bridges between the old legacy world and the new Bitcoin world.

The most obvious use case for Bitcoin is shopping. Bitcoin’s borderlessness and security make it ideal for online payments for goods and services.

In traditional online payments, you send your debit card details to the merchant and hope the merchant will withdraw as much as you agreed on. You also hope the merchant handles your debit card details with great care. They probably store the details in a database. Think about that: for every debit card purchase you make, your card details will be stored in that merchant’s database. It’s likely that one of the databases will be hacked and your card details stolen. The more merchants store your details, the higher the risk.

With Bitcoin, you don’t have that problem because you don’t send any sensitive information to the merchant, or anyone else. You transfer the amount of money you agreed on and nothing more.

The world is full of people wanting to get rich quick. Bitcoin can be alluring to them because of its price volatility, or tendency to change. Looking at the history of bitcoin’s price, as shown in Figure 13, it’s tempting to try to buy when it’s low and sell when it’s high.

Sometimes a government or big corporation makes a negative statement about Bitcoin that creates fear in the market, but those events tend to have a limited effect on bitcoin’s value.

Bitcoin’s price volatility seems contradictory to the claims of it having a non-inflationary property; a 50% drop in market value appears pretty inflationary. Bitcoin is still relatively new, and lots of short-term speculation causes this volatility. But as Bitcoin grows and more people and institutions start using it to store their wealth, it will probably stabilize in the long run, and its deflationary property will emerge over time.

Bitcoin is digital cash, but this form of cash can be used for things beyond money. This section covers two common uses, but there are others, including those not yet invented.

As you read in the Section 1.5.4, a bitcoin’s price can fluctuate dramatically. But where does this price come from? Several Bitcoin exchanges exist, most of them internet-based. They resemble stock markets, where users wanting to sell bitcoins are matched with users wanting to buy bitcoins.

Different markets can have different market prices depending on the supply and demand in that market. For example, in countries such as Venezuela, where the government tries to hinder the Bitcoin market, the supply is low. But the demand is high because people want to escape their hyperinflating currency. These factors drive the Bitcoin price up in that market compared to, for example, the US and European markets, where people can trade more freely.

Bitcoin is nice and all, but it’s not suitable for all financial activity. At least, not yet.