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].

Let 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 108 comments.

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  1. Member

    Peter Robinson: 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.

    It sounds like there’s no such thing as a private financial transaction with Bitcoin. Even if the owner of a “wallet” isn’t named in the ledger, is that information not knowable by someone (or government)?

    • #1
    • January 14, 2018 at 8:40 am
    • 3 likes
  2. Inactive

    Peter Robinson: You could think of this like

    Using this phrase is supposed to make things easier to understand, not harder.

    • #2
    • January 14, 2018 at 8:51 am
    • 2 likes
  3. Podcaster

    Give me physical currency. Privacy is the foundation of liberty. What is more fundamental than being secure in one’s self and one’s possessions? Turning commerce into a completely electronic transaction will rightfully turn us all to paranoia.

    • #3
    • January 14, 2018 at 8:54 am
    • 9 likes
  4. Member

    I’m grateful, although I lost a lot of my initial hope when you said we’d need a little “Mathematical savvy”. I don’t got that.

    2 questions: so Bitcoin is UNLIKE cash, in that transactions are NOT private, every one will be recorded, and the record of it retrievable?

    And–what backs Bitcoin? What takes the place of the faith and credit of the US Treasury or the EU?

    • #4
    • January 14, 2018 at 9:35 am
    • 2 likes
  5. Coolidge

    What is lost on me is why one needs to “mine” and “nonce.” Is it money or is it work?

    • #5
    • January 14, 2018 at 9:46 am
    • 1 like
  6. Member

    Peter Robinson: ne thing that mystifies me is how a currency can be useful when its value changes by 30 percent in a day.

    Presumably the price of the coin would have to be fixed. Just as the price of gold was fixed in the 19th-century gold standard and Bretton-Woods. The free-floating price of gold can go nuts under the right conditions (think about how the price of gold looks to a holder of Zimbabwean currency, although only in an ever-upward direction so far. The price-action in USD v Gold in the aughts and early teens and 1970s and 80s (post Bretton-Woods), while not that spectacular, was pretty spectacular.)

    Another possibility is that with a large enough market and enough arbitrage vehicles, the sinusoidal fluctuations converge to a steady hum. A chicken/egg problem, but I increasingly believe that speculators and Goldman Sachs serve useful purposes and that this may be one of them.

    Buckminster Fuller’s idea that currency should be based on electrical current (electrical power, more precisely) seems to be coming. Interesting, considering I thought it was an idea worthy of a pile of bricks when I first heard it. May still be, but it also may slide into reality soon nonetheless.

    My 2 cents, anyway. No, wait, $4372. No, wait, 0.000000035 Swiss Francs. No, wait …

    [Edited to end with a joke.]

    [Edited again to reflect the brain-restorative power of a hot shower.]

    • #6
    • January 14, 2018 at 9:51 am
    • 4 likes
  7. Member

    It needs to be kept in mind that “bitcoin” and “blockchain” are not identical. Bitcoin is just a particular instance of an implementation of the blockchain technology. There are many others, including many other cryptocurrencies. But anything in principle can be accounted for with a blockchain ledge.

    With respect to @hypatia and what backs bitcoin, there is nothing that backs it. But then nothing backs the dollar, either, which is one of the reasons we can get to $20 trillion and counting in national debt. Dollars are valuable, however, because the government requires us to pay taxes in dollars and our court system will only resolve contract disputes in dollar terms.

    Bitcoin is valuable because, right now, because there are still people out there willing to pay you more for it than you did in buying it. (At least, that’s the hope). Bitcoin is a textbook case of a bubble mania. Peter Robinson didn’t buy bitcoin because he thought it had any intrinsic value; he bought it because he thought it would increase in value and he’d be able to sell it to someone else (for dollars!) And that works, until it doesn’t.

    If you bought bitcoin back when it sold for 10c, $1 or $100, congratulations! You just made your life’s fortune, assuming you go ahead and cash it out into dollars before the inevitable collapse occurs. If you are buying in now, in the hopes of dumping them later onto a greater fool, be careful that the fool in question isn’t looking back at you in the mirror.

    • #7
    • January 14, 2018 at 10:06 am
    • 10 likes
  8. Member

    I’ll read this, but no matter, I won’t impose predictable loses that follow my speculative investments on all those hopeful souls.

    • #8
    • January 14, 2018 at 10:12 am
    • Like
  9. Thatcher

    Poindexter (View Comment):
    It sounds like there’s no such thing as a private financial transaction with Bitcoin. Even if the owner of a “wallet” isn’t named in the ledger, is that information not knowable by someone (or government)?

    There’s no names in the bitcoin ledger, only public keys that have signed off on the departure of bitcoin that have previously been listed as a recipient in a prior transaction, or the recipient of bitcoin from the mining reward. The “sign off” is performed with asymmetric encryption technology, which Michael didn’t get into. Public keys have private counterparts that must be kept secret or the bitcoin can be stolen.

    The exposed public keys can be indirectly connected to real people and/or organizations in a variety of ways. There are mitigations for most:

    • A person/org must provide a public key to receive bitcoin when they first buy into the system. Whichever currency conversion service took your money would have a record of who you are. This can be avoided by the use of pre-paid debit cards purchased with cash, or similar anonymizing transactions.
    • Bitcoin mining organizations not only receive a bitcoin reward for successfully finding the nonce, but also require submitted transactions to pay a sliver of the bitcoin involved. The receiving keys for these payments must be known in advance for everyone involved, so these organizations are known. Side note: the algorithm for the nonce rewards is designed to atrophy to zero, at which point the system will have to be sustained by the transaction fees.
    • A person/org may advertise the key as the payment point for a public good or service. Necessary if you want the general public to pay you in bitcoin. Transactions involving that key would therefore be known to belong to that person/org. However, a new public key could be constructed for every transaction, and only given to the buyer, in which case an outsider would have to have access to the buyers’ records. The seller would have to keep track of many private keys to later spend the bitcoin. The seller’s identity would remain known only to buyer and seller until then.
    • When a person/org cashes out of bitcoin back to conventional currency, the broker will have a record of what public keys were used and where the money went. Again, some shenanigans are possible to get the cash without yielding an identity.

    Bottom line: unless you are remarkably technically inclined, bitcoin transactions are effectively open to a determined investigator.

    • #9
    • January 14, 2018 at 10:59 am
    • 6 likes
  10. Member

    Re ‘mining’: It’s basically trying repeatedly to find the ‘nonce’ such that SHA-256(nonce + SHA-256(block-1)) < bunch-of-zeros + positive-value

    where + is bit-by-bit concatenation, SHA-256 is the secure hash function, and block-1 is the previous block in the chain.

    The reason this works is that SHA is a non-invertible function, that is, given a target output value, it’s mathematically impossible to predict the input value that will create that value. You just have to laboriously try input values until you get what you want. Having done so is called ‘proof of work’ in the bitcoin scheme and it’s how scarcity is enforced: any ‘miner’ who comes up with a correct nonce to solve the problem earns some bitcoin, and that’s the only way new coins are generated. The scheme also has the length of the ‘bunch-of-zeros’ field get longer over time, making the nonce problem ever tougher to solve.

    It’s also a reason that bitcoin itself is problematic as a currency. The pseudonymous Satoshi Nakamoto who invented the scheme designed it so that there is practical maximum number of bitcoins that can ever be mined. So the current value of bitcoin can swing radically depending on the balance of trade in and out of it. That’s leading to the bubble phenomenon, and its unsuitability for use in transactions that have any sort of ‘futures’ element in them, e.g., debt.

    Aside: Other than creating the hard problem that creates ‘proof of work’, the purpose of the SHA-256 function is to protect the integrity of the blockchain, since it’s nearly impossible to find another value of ‘block-1’ other than the true one which generates the same output value, and even if found it will probably be gibberish. So the published chain protects its own integrity.

    • #10
    • January 14, 2018 at 11:06 am
    • 1 like
  11. Inactive

    So what is going to prevent dozens of other similar currencies? Sure Bitcoin is limited vertically but the horizontals will do it in.

    Bubble city.

    • #11
    • January 14, 2018 at 11:25 am
    • 3 likes
  12. Thatcher

    DocJay (View Comment):
    So what is going to prevent dozens of other similar currencies? Sure Bitcoin is limited vertically but the horizontals will do it in.

    Bubble city.

    Nothing prevents people from inventing new ones. And they have. Wikipedia counts 1381 to date.

    I don’t own any.

    • #12
    • January 14, 2018 at 11:29 am
    • 6 likes
  13. Member

    Kinda. Just saying…

    • #13
    • January 14, 2018 at 11:37 am
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  14. Member

    Still makes zero sense to me.

    • #14
    • January 14, 2018 at 11:42 am
    • 6 likes
  15. Member

    Banks have issued their own banks notes since banks were first created. Note (IOU) holders have been burned forever. Banks might attempt to do the same thing in the cyber sphere. But ultimately, the state will try to intercede. Banks will be caught in the web of their brick and mortar presence and be forced to comply.

    So Bitcoin is better run by electron pushers who can move from wave length to wave length.

    I like Bitcoin for my illegitimate activities. It is not off balance sheet, it is off the end of this flat earth – hidden beyond the edge. It is better the bearer bonds because they get holes from worms and the print runs when they get burried in the ground. If you are selling stolen cars to Nigeria or buying meth from Sinaloa, you can’t beat it as a settlement currency.

    I can’t wait for the drug cartels to take over Bitcoin. Then, it will really be fun. Ay carumba.

    By the way, Peter, I have been meaning to ask you what “clear” means. I read this and it seems a bit obtuse, in a precise sort of way. This is well written, but a big nonce to me. As I read the word ‘hash’ I kept thinking, “Hey, we could pay for our hash imports with this too.”

    • #15
    • January 14, 2018 at 11:48 am
    • 3 likes
  16. Member

    DocJay (View Comment):
    So what is going to prevent dozens of other similar currencies? Sure Bitcoin is limited vertically but the horizontals will do it in.

    Bubble city.

    There are hundreds of crypto coins. Many have a unique utility. Etherium for instance can be used for contracts (I have some in an IRA)

    there are rumors that Litecoin may be soon accepted on Amazon. It is similar to bitcoin but “lighter” and faster and cheaper to use.

    When Bitcoin hit $10k I took a screenshot. Years from now my grandkids will say one of two things:

    1. What the hell is a Bitcoin ?

    2. Why didn’t you sell your house and everything you own to buy more?

    • #16
    • January 14, 2018 at 11:51 am
    • 5 likes
  17. Contributor

    One thing I find interesting about the blockchain currencies is that, as seemingly ephemeral as they are, they share a characteristic with the truly hard currencies (or stores of value) such as precious metals: because their scarcity is an artifact of mathematics and not government fiat, their value is relatively immune to central manipulation.

    Speculation can occur with any currency, and any currency’s value can fluctuate wildly, as history will attest. But the intrinsic scarcity of a properly implemented blockchain currency is more similar to that of gold than dollars or yen.

    That’s ironic, in that gold and blockchain currencies are about as real and unreal, respectively, as a currency can get.

    • #17
    • January 14, 2018 at 11:59 am
    • 5 likes
  18. Coolidge

    I just don’t understand the “mining” still. When I want to buy something, and I possess a bit coin, how do I know that someone hasn’t mined it away from me?

    Where is the mine shaft for mining? Do you stake a claim to keep others out? What keeps you from creating a bitcoin out of nothing? If you can’t create it yourself, then who creates them?

    Not understanding the process, I won’t trust it.

    • #18
    • January 14, 2018 at 12:19 pm
    • 1 like
  19. Contributor

    Incidentally, regarding the statistical uniqueness of the SHA-256 hash — the likelihood of two different things “hashing” to the same 256 bit code: it’s just a tiny bit more likely than a room full of 300 strangers not containing two people with the same birth month and day.

    Maybe that last doesn’t sound too unlikely, but, expressed as a percentage, it’s approximately this:

    0.000000000000000000000000000000000000000000000000000000000000000000000000000094 %

    • #19
    • January 14, 2018 at 12:36 pm
    • 2 likes
  20. Member

    Locke On (View Comment):
    bitcoin scheme

    That makes sense to me.

    • #20
    • January 14, 2018 at 12:40 pm
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  21. Coolidge

    Henry Racette (View Comment):
    Incidentally, regarding the statistical uniqueness of the SHA-256 hash — the likelihood of two different things “hashing” to the same 256 bit code: it’s just a tiny bit more likely than a room full of 300 strangers not containing two people with the same birth month and day.

    Maybe that last doesn’t sound too unlikely, but, expressed as a percentage, it’s approximately this:

    0.000000000000000000000000000000000000000000000000000000000000000000000000000094 %

    Except that statistics are voodoo math and the results are entirely dependent on how well facts are established. That might be the percentage of randomly finding the nonce, or whatever it is called, but the Germans thought the same about Enigma.

    • #21
    • January 14, 2018 at 12:44 pm
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  22. Member

    Skyler (View Comment):
    I just don’t understand the “mining” still. When I want to buy something, and I possess a bit coin, how do I know that someone hasn’t mined it away from me?

    Where is the mine shaft for mining? Do you stake a claim to keep others out? What keeps you from creating a bitcoin out of nothing? If you can’t create it yourself, then who creates them?

    Not understanding the process, I won’t trust it.

    Each bitcoin is a unique sequence of digits. The miners are crunching numbers trying to find new combinations that are valid. They can’t duplicate previously released bitcoins. There are a limited number of valid combinations putting a hard cap on the number of bitcoin. So unlike our fiat currency it’s not infinitely expandable.

    I got some Bitcoin several years ago while working in Saudi as a way to buy things on the internet when it was sometimes difficult to use my credit card. No intention to invest. So I bought 4 at about 250$. Never used them. Last year I sold 1 at 5000$ and locked in my profit . Last year Bitcoin “forked” and I was given 4 Bitcoin Cash. Each now worth about 2500$ now. I did invest about 2500 of my profit a month ago in Litecoin at just under a 100$. Each now worth 250$

    So my initial purchase of 1000 is now worth about 57k. At this point it’s all gravy.

    • #22
    • January 14, 2018 at 1:04 pm
    • 4 likes
  23. Member

    Peter Robinson: 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.

    Though it isn’t working out that way in practice, I’ve heard that bitcoin transaction fees are now over $10. They tend to be a flat fee regardless of the size of the transaction, so that may be a reasonable fee if you’re transferring $1000, but no one’s going to buy something from Amazon for $10 if the transaction fee doubles the price.

    • #23
    • January 14, 2018 at 1:13 pm
    • 1 like
  24. Member

    Phil Turmel (View Comment):
    Public keys have private counterparts that must be kept secret or the bitcoin can be stolen.

    Also worth noting: if you lose your private key, the bitcoins in the “wallet” associated with that key are gone forever. No one in the world can retrieve them for you. There’s no bank you can call and ask them to reset your password, you’re just out of luck.

    • #24
    • January 14, 2018 at 1:21 pm
    • 1 like
  25. Member

    Joseph Stanko (View Comment):

    Phil Turmel (View Comment):
    Public keys have private counterparts that must be kept secret or the bitcoin can be stolen.

    Also worth noting: if you lose your private key, the bitcoins in the “wallet” associated with that key are gone forever. No one in the world can retrieve them for you. There’s no bank you can call and ask them to reset your password, you’re just out of luck.

    LOL. Ask the guy who threw away a hard drive with an estimated 150 million worth of bit coin on it. He’s going to excavate a dump to try and retrieve it…

    • #25
    • January 14, 2018 at 1:26 pm
    • 5 likes
  26. Member

    Kozak (View Comment):
    Each bitcoin is a unique sequence of digits.

    I don’t think that’s actually how it works. There’s no such thing as “a bitcoin,” not even in cyberspace. All that exists is the blockchain ledger with a list of transactions in it like:

    • ABC123 transfers 3.57 BTC to EFG456
    • EFG456 transfers 0.073 BTC to XYZ789
    • HIJ007 transfers 0.003 BTC to XYZ789

    At this point XYZ789 owns 0.076 bitcoins, because that’s the total of the amounts that have ever been transferred into that wallet. EFG456 owns 3.497 bitcoins, because 3.57-0.073=3.497.

    • #26
    • January 14, 2018 at 1:33 pm
    • 1 like
  27. Member

    Skyler (View Comment):
    Where is the mine shaft for mining?

    It’s on the planet Cybertron.

    • #27
    • January 14, 2018 at 2:32 pm
    • Like
  28. Member

    Kozak (View Comment):

    Joseph Stanko (View Comment):

    Phil Turmel (View Comment):
    Public keys have private counterparts that must be kept secret or the bitcoin can be stolen.

    Also worth noting: if you lose your private key, the bitcoins in the “wallet” associated with that key are gone forever. No one in the world can retrieve them for you. There’s no bank you can call and ask them to reset your password, you’re just out of luck.

    LOL. Ask the guy who threw away a hard drive with an estimated 150 million worth of bit coin on it. He’s going to excavate a dump to try and retrieve it…

    I think about that guy all the time – and told the story to my husband this week after I lost our only Volvo key. $600 for two replacement keys …

    • #28
    • January 14, 2018 at 2:41 pm
    • Like
  29. Member

    Joseph Stanko (View Comment):

    Skyler (View Comment):
    Where is the mine shaft for mining?

    It’s on the planet Cybertron nVidia.

    FIFY.

    • #29
    • January 14, 2018 at 2:43 pm
    • 2 likes
  30. Podcaster

    Poindexter (View Comment):

    Peter Robinson: 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.

    It sounds like there’s no such thing as a private financial transaction with Bitcoin. Even if the owner of a “wallet” isn’t named in the ledger, is that information not knowable by someone (or government)?

    I think that the answer to that is yes. I think that it will just be difficult from a practical point of view to keep your real identity secret if you are doing a lot of transactions. You need to convert to other currencies (often) to buy stuff that is not for sale in bitcoin and then there is the IRS…

    • #30
    • January 14, 2018 at 3:01 pm
    • Like
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