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Bitcoin Explained
Over the last few days, I’ve been exchanging emails with Ricochet’s own Michael Stopa, asking Michael — one of the few people I know who truly understands both technology and the English language — to tell me about Bitcoin. (The background: During the Bitcoin craze with which last year concluded, I finally succumbed to temptation, buying a few hundred dollars’ worth. By the very next morning, I had lost a third of my money.)
Herewith, and with thanks, again, to Michael, the best succinct explanation of the blockchain phenomenon I have yet encountered. My own occasional comments appear [in brackets].
Published in Economics, TechnologyLet me say at the top that the one thing I can’t tell you (and probably the thing you want to know the most) is whether bitcoin value will go up or down and when. Sorry. [Michael knows—I’m sure he knows. He just won’t say.]
That said, the basic innovation of bitcoin is the public ledger of all transactions that allow everyone to see who (or what “wallets” anyway, not the actual human beings) has how many bitcoins and where, over history, have they been moved to; i.e., all the transactions that have ever existed. This is, of course, the blockchain. The blockchain is what is called a linked list. You could think of this like a book where instead of reading the pages sequentially, you find, at the bottom of each page, a line telling you what page to go to next. And when you get to the next page the first thing you find is an encoding (a so-called “hash”) of the page from which you have just come. Thus in some sense each page contains the information of the preceding page, which contains the preceding page, which…
The encoding machine (the hash function, in bitcoin this is called SHA-256) produces codes of the same length irrespective of how long the input is — specifically 256 bits. The technical details of this hash function are not really so difficult, but you do need a little mathematical savvy to work through it. One thing that might occur to you immediately is if we are encoding (or encrypting) a whole page of data into 256 bits (64 characters) then the encoding cannot be unique. It must be possible to find two pages of information that “hash” into the exact same string of 256 bits. This apparent paradox is solved by statistics (it is very unlikely to find two such pages). So far the best source I have found for details of this is on a site called blockgeeks.com.
So, this linked list blockchain can’t be quite that simple, of course. If all we need to do to add a new page to the book is take the previous page, hash it, and put that on the new page with the latest transactions, then anyone could willy-nilly be adding pages all day. So the encryption process also includes a number, called a “nonce,” which has to be “mined.” That number is such that (this is a little subtle) once it is concatenated with the hash of the most recent page and hashed again, then it results in a number with a lot of leading zeros (meaning it is less than some fairly arbitrary target). Just using a 10-digit decimal example, the hash of the hash+nonce would need to give a number less than, say, 0000025000. That result depends on both the nonce and the previous hash (plus other data) obviously. So each time the blockchain gets updated a new nonce has to be found. Once a nonce is found (and the technical details here are to me still somewhat opaque) the blockchain gets updated (and the finder gets some bitcoin for his trouble).
The reason for that is that I am planning to write this all up with copious references on our Harvard Lunch Club page. We will also change the name of the podcast to the Harvard Lunch Club Bitcoin podcast, a la the Ice Tea Company that did the same and saw their share prices skyrocket. (I am kidding a bit here). Maybe we could make it a page on Ricochet, too? [From your lips, Michael, to the Blue Yeti’s ears.]
Anyway, regarding the stability and prospects of bitcoin, what is needed is a genuine calculation of how it will fare in the market. The market, in this case, is the universe of other currencies. Only geeks will use it just because it is cool or democratic. Other folks will use it because it costs less to use it (or else its value is more stable). One thing that mystifies me is how a currency can be useful when its value changes by 30 percent in a day. Surely there must be an expectation that its value will flatten out eventually. [True enough, but in countries where Bitcoin is reportedly unusually popular, such as Venezuela, the native currency is even more unreliable, right?]
Regarding the marginal value of using bitcoins versus other currencies what you are competing against are, of course, the central banks. Transaction costs (e.g., for international transfers) are small but, of course, they add up. These costs are to some extent fixed because the bank has to keep a record of all of the transactions in whatever currency and keep all that information secure. So ultimately the competitive advantage of bitcoin is that they have worked out a system of securing transactions that is cheaper than the old methods. (As I am sure you know, bitcoin transactions are not free. They take computer power and mining costs, etc., that cost money … but they are arguably far cheaper than what the banks need to charge).
Then the question is how will banks compete? They’re not going to take this lying down. Possibly this will force them to innovate their transaction-recording technology (no doubt they are working on it all the time). But I am not sure how, other than becoming cryptocurrencies themselves, governments and banks can surpass bitcoin here.
Lots of other things here, like taxes, for instance. But let me stop there. I hope I haven’t just filled up your inbox with unusable dreck! [No, Mike, you’ve provided a lovely brief education. Thanks.]
There are others..at least a few.
Basically, when your computer finds the current “nonce” (this is just a big number) then that makes your encryption of the current block of the blockchain valid. If it is then sent out to the world, everyone will recognize that validity. It *is* possible for two people almost simultaneously to find a successful nonce and then it gets a little complicated – there are branches in the blockchain that maybe get resolved in time (no further details right now). But omitting that possibility you, the miner, have solved the current problem and the community has recognized that solution as valid.
NOW, your nonce has been used to validate a whole block of transactions and, here is the punch line, *one* of those transactions is the creation of some bitcoin in your (the miner’s) wallet.
I don’t like Bitcoin or crypto-currency because:
I want no part of any crypto-currency, but I see a day when it will not be a choice but forced –
Yes, and many other countries around the world where people don’t trust the local government fiat currency. Remember when Cyprus imposed currency controls? Or the recent demonetization in India? Of course such things could never happen here…
What do you mean by “the faith and credit of the US Treasury”?
Could you give an example?
My bank charges me a fee if I visit a real teller — but ATM transactions are free, and their ATMs are everywhere and open 24/7. Consequently it’s been at least a decade since I set foot inside a bank branch. I don’t know them and I’m sure they don’t know me.
Bitcoin Explained
Not that complicated. They’re mined. Will o’ the wisps and fae folk mine elvish gold, which is smelted by orcs. The coins themselves are minted by rogue Google engineers harnessing the swarm of a torrent. They’re good for a ferry ride on the River Styx.
Simple really.
I just want to know what happens to bitcoin when the power goes out?
And: who has the nonce 666
Well, when you lose a $1000 bill, that is also up in smoke, passcode or not. People are more careful with cash. And I would have thought a hard drive wouldn’t get tossed.
Car keys, oh, my. That. Is. Another story.
Exactly the arguments governments are making to ban currency. They would love it if every single financial transaction was traceable, and taxable.
The guy who lost the hard drive was a miner. His girlfriend hated the noise his mining rig made and he shut it down and dismantled it. Put the hard drive in a desk and forgot about it, BTC was worth a couple of pennies each at the time….
Or governments trying to ban cash transactions…
I wonder if they’re still together…
I’ve been following Bitcoin for several years – 2017 was the first year I had any disposable $$.
I had to fund my IRA to the tune of $5K – there’s a $20K minimum with the Crypto IRA company. So I took $15 out of Vanguard, $5k of cash and opened a new IRA split between BTC and ETH.
So I’m rolling the dice as safely as I could imagine (all pre-tax money and not the milk money). The $20K at Vanguard wasn’t going to be life-changing; if the Crypto IRA doesn’t grow another penny, it might well be.
My kids think it’s all very amusing but they stopped laughing when for Christmas I gave them some BTC I bought in October.
(On a side note, why am I the only nerd in my family when I spawned four millennials?? I’m the only one who can reset the router and explain Net Neutrality to their idiot peers …)
https://youtu.be/bBC-nXj3Ng4
I still don’t understand the mining. What does mining mean? Where do you look for unclaimed bitcoins or is mining the taking of other people’s but coins?
I can’t wait until the masses figure out what legal tender laws are really for.
You don’t use online bank accounts where most of the money you own is digital anyway?
If physicality is that important to you load your bitcoin onto a USB. It’s as “physical” as paper currency and not counterfeitable.
“Mining” is how new Bitcoins are created, on a set schedule. If there are more miners, then the likelihood of “finding” the next batch of Bitcoin goes down. Thus, as the price of Bitcoin increases, the number of miners increases, and the amount of power consumption increases. Someone I know who is deep into Crypto says if the price of Bitcoin were to suddenly go up in the $100,000 range, there might be a world energy shortage.
Bitcoin currently uses about as much energy as Denmark.
Mike, so someone “releases” new bit coins and they end up belonging to whoever finds them? How does that even make sense?
By the way, it makes me really really happy that so many people are still expressing so much skepticism about Bitcoin. If everyone was a believer then there would be no upside (kind of like US stocks at the moment). The fact that so many people dismiss it and call it a bubble and the newest Tulip Mania means I may not have gotten in too late. I even hope it’s something of a bubble because I want to buy a ton for a cheap price, but every time it dips a lot of people want to call “the death of crypto,” and I take that as an extremely good contrarian indicator.
Someone doesn’t “release” them, it’s done so automatically by the program. It’s random as to whether or not you’ll “hit” by mining the correct “chain” or “hash” (I don’t remember which it is).
It’s basically a low risk lottery, you spend money on energy and you hope to mine enough bitcoin to make it worth your while.
That is really an excellent video explanation, I highly recommend it to anyone who still has questions about the bitcoin protocol and its basic technologies.
It’s complicated, as it’s both based on fairly obtuse math and involves a lot of novel concepts.
Bitcoins are in fact “released,” or granted, as a reward for participating successfully in the bitcoin concept. Specifically, you get bitcoins for adding a block to the blockchain.
The blockchain is, basically, a list of bitcoin transactions, recording how many bitcoins were given by one person to another. (I say “person,” but in fact the identifier is really more of an account identifier, not clearly identifiable with any individual — kind of like a numbered Swiss account, only more so.)
The blockchain is a long list of blocks of data, each of which links back to the previous block in the chain, all the way back to the first block — the so-called “genesis block” — created by the anonymous inventor of bitcoin. Because every block contains a reference to the preceding block, all of the blocks are linked together. Because every block has a numerical hash value attached to it, a value computed from the contents of the block itself (that SHA-256 code described in the original post), it’s virtually impossible to insert a fake block somewhere in the chain; it would invalidate all subsequent blocks, and the distributed bitcoin network would reject such an attempt.
Here’s where the bitcoins, the actual money part, comes in.
The blockchain is really just a distributed (i.e., not centrally managed) record-keeping system, keeping track of, and guaranteeing the legitimacy of, transactions. To create bitcoins, bitcoin “miners” earn the coins by doing something computationally difficult — something that also, as it happens, contributes to the management of the blockchain. They have to take the accumulated list of bitcoin transactions that haven’t yet been attached to the block chain, and they have to add that block of transaction to the end of the blockchain.
To do that, they have to modify the block so that it generates a hash — a 256 bit number — that has certain statistically improbable characteristics. In the case of bitcoin, that means that the hash has to begin with a certain number of zeros. (Any other digit or digit pattern could have been chosen and would have worked equally well.) In order to modify the block to generate a hash meeting that restrictive criterion, the miner generates a number — that nonce Michael describes in the post — that, when appended to the block (actually, to the hash of the block, but it’s conceptually similar), causes the hash to come out as desired.
It takes a lot of tries to find a number that makes the hash come out right. How many tries? Many hundreds of quadrillions — and perhaps more. And the number of tries continues to increase, going up by a factor of about 25 over the last two years. It takes about ten minutes for each new block to be approved by someone and added to the chain, at which time a few bitcoins are created for the miner of the block.
It takes longer because the bitcoin system pays attention to how long it takes to successfully mine each block — to generate the statistically unlikely hash value — and, every couple of weeks, adjusts the requirements of the next block’s hash value accordingly. The bitcoin system tries to maintain a mining — block generation — rate of about six blocks per hour. As computers get faster and more people participate in the mining, the system continues to make it harder to generate the next block.
It also periodically reduces the number of bitcoins awarded to each successful miner, halving it about every four years. Eventually, no more bitcoins will be given to miners, and the 20-some million bitcoins in circulation at that time will be all there will ever be. I’m not sure how the blockchain of bitcoin transactions will be managed when that day is reached; I assume the computational cost of successfully adding a block will get quite low, and will be covered by transaction fees.
While I know a fair bit about cryptography, the details of bitcoin and the blockchain technology are new to me, but I think I’ve described it accurately.
First of all, great explanation @henryracette, and I agree with most of it except this bit. Saying that bitcoins are “released” suggest they exist somewhere in a pool to be granted as a reward.
My understanding is that new bitcoins are simply created out of thin air. As a reward for adding a new block to the blockchain, the “miner” is permitted to add to the list of new transactions one additional transaction that says essentially “and I hearby credit myself with 0.0001 BTC.” Whereas the other transactions all need to balance, this one does not. One wallet gets credited, but no one gets charged the 0.0001 BTC (or whatever the actual amount is).
This sounds a bit alarming, until you realize the Federal Reserve does the exact same thing all the time. See: quantitative easing.
Joseph, you’re absolutely right. I use “released” and “created” interchangeably. What is important is that a new bitcoin transaction is added to the blockchain ledger without depleting the sum of bitcoins previously recorded. They are created.
Except that the people you know may not be ones that decide to give you your money.
Are you familiar with the process by which bank failure is handled?
Hopefully you don’t have the following products with the bank:
As they are not covered by FDIC and may not survive the weekend.
And there is an upper limit on the number that can be created. This is why it is called “mining” the bitcoin exists as a potential until it is “mined”. There are only 20 million -ish total bitcoin (existing + potential) ~ 20 million.
This is very good on Bitcoin.
The question is why do people want “harder” money and can the various governments permit freedom in this area?
Europes banks are broke. The FDIC is nothing in reality for us, it’s the taxpayer and our ability to issue debt in reality. Is anyone’s debt to GDP anywhere ever going to improve? How are all of the Western entitlements going to get paid? Why won’t more and more labor get outsourced to the rest of the planet and robots– i.e. deflation (our system can’t hack deflation, bitcoin is deflation same for gold).
I’m not clear though if there’s anything truly immutable about that limit. Bitcoin is an open-source software project, if the developers that maintain it got together and decided to raise the limit to 30 million bitcoins, then I think the question would be whether the existing miners are willing to upgrade to the new version or not. If there’s resistance, it might result in another “fork” with multiple resulting currencies as we saw not so long ago with Bitcoin Cash.
But ultimately, isn’t the upper limit just an arbitrary number that Satoshi pulled out of a hat when he wrote the white paper?