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Bitcoin and Cryptocurrency

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(Stanford University - Jaclyn Chen)

 

Bitcoin and Cryptocurrency


Bitcoin is a digital asset and a payment system. It is an innovative payment network and a new kind of money. It is designed to enable users to send money over the Internet in a very simple and efficient way. Bitcoin made digital transactions possible without a trusted intermediary. The technology allowed this to happen at scale, globally, with cryptography doing what institutions like commercial banks, financial regulators, and central banks used to do: verify the legitimacy of transactions and safeguard the integrity of the underlying asset.

Like paper money and gold before it, bitcoin is a paperless, bank-less, state-less currency that allows people to exchange value, to pay directly for goods and services. It is a system which allows you to do anonymous currency transactions and no one will come to know about the payment or about all other info related to the payment, including who sent it, who received it, etc. Unlike its predecessors, bitcoin is digital and decentralized. The bitcoin generation algorithm defines, in advance, how currency will be created and at what rate. Any currency that is generated by a malicious user that does not follow the rules will be rejected by the network and thus is worthless. Since the system works without a central repository or single administrator, the U.S. Treasury categorizes bitcoin as a decentralized virtual currency. Bitcoin is often called the first cryptocurrency. 

The success of bitcoin has led to the development of many alternative cryptocurrencies (or altcoins). Most of these altcoins offer their own take on the bitcoin protocol, and are interesting in their own right. Currently, there are hundreds of alcoins out in the wild being traded every single day. But, most altcoins don’t last very long. In addition, just like the unfounded fear of many governments in the world that bitcoin and other virtual currencies are a conduit for money laundering, smuggling, terrorism and tax evasion, they believe that the only means of curbing these harmful elements is through acceptance and regulation.

Bitcoin Network and Bitcoin Clients


Bitcoin is not a fiat currency controlled by a nation-state. It uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network where each terminal or node is equal in terms of hierarchy. The bitcoin network is a peer-to-peer payment network that operates on a cryptographic protocol. Users send and receive bitcoins, the units of currency, by broadcasting digitally signed messages to the network using bitcoin cryptocurrency wallet software. Transactions are recorded into a distributed, replicated public database known as the blockchain, with consensus achieved by a proof-of-work system called "mining". 

Bitcoin is open-source; its design is public, nobody owns or controls bitcoin and everyone can take part. Bitcoin is run collectively by the users who uses the bitcoin client, and any changes to the bitcoin system have to be approved by the majority of users before they are implemented. Bitcoin clients are the base level of technology for conducting bitcoin transactions. 

Bitcoin is a peer-to-peer network. Any computer that connects to the bitcoin network is called a node. Each node runs a specialized piece of software called a bitcoin client. This client downloads the entire network (i.e history of all transaction blocks) at once on the node and takes care of all the communication with the bitcoin network. The client connects with the user’s ‘wallet’ and updates it with incoming and outgoing funds and uses the keys generated by the ‘wallet’ to sign the transactions. The protocol is designed in such a way that a bitcoin client cannot enforce its own rules and all other nodes running the bitcoin client ensure that every other node is following the rules (in short not trying to hack or corrupt the network). Bitcoin client has to continuously synchronize itself with the entire network. 

The different types of bitcoin client are: full clients, thin clients, web clients, and mobile clients.

Bitcoin Transactions


Bitcoin uses public-key cryptography, peer-to-peer networking, and proof-of-work to process and verify payments. Transactions take place between users directly, without an intermediary. Assets - digital assets like money to music and everything in between - are not stored in a central place, but they're distributed across a global ledger, using the highest level of cryptography. There is no trusted third party controlling the ledger. When transactions are conducted, they are posted globally, across millions and millions of computers. These transactions are verified by the network nodes and recorded in a public distributed ledger called the blockchain, which uses bitcoin as its unit of account. 

Bitcoin transactions are not reversible! Any transaction issued with bitcoin cannot be reversed, they can only be refunded by the person receiving the funds. Bitcoins are sent (or signed over) from one address to another with each user potentially having many, many addresses. Addresses are identifiers which you use to send bitcoins to another person. Transactions sent and received from bitcoin address. Every bitcoin address has a matching private key, which is saved in the wallet file of the person who owns the balance. Please keep your private keys safe, and make periodic backups to prevent the loss of bitcoins. Anyone with your private keys can spend your bitcoins. 

With PayPal you send funds to an email address, and similarly with bitcoin you send funds to a bitcoin address. You can send bitcoins to anyone once you know their bitcoin address. Each payment transaction is broadcast to the network and included in the blockchain so that the included bitcoins cannot be spent twice. This way, no one can copy the currency and use it for more than one time. It’s a simple but effective idea to stop double spending of the same bitcoin. After an hour or two, each transaction is locked in time by the massive amount of processing power that continues to extend the blockchain. Using these techniques, bitcoin provides a fast and extremely reliable payment network that anyone can use.

Bitcoin Wallet, Mining, and Miner


A bitcoin wallet, a piece of software used to store the private keys, is the first step to use bitcoin. Without a wallet, you can’t receive, store, or spend bitcoins. You can think of a wallet as your personal interface to the bitcoin network, similar to how your online bank account is an interface to the regular monetary system. Primary purposes of wallets are: (1)  generation and management of bitcoin addresses. The bitcoin address, like e-mail addresses, is public and broadcast to the entire network. The user just has to give the public address (which is a string of 27–34 alphanumeric characters starting with 1 or 3) for transfer of funds. (b) generation and management of the public and private keys associated with each address.

Bitcoin wallets contain private keys; secret codes that allow you to spend your bitcoins. In reality, it’s not bitcoins that need to be stored and secured, but the private keys that give you access to them. A bitcoin wallet is simply an app, website, or device that manages bitcoin private keys for you. However, there is no "one size fits all" bitcoin wallet. Wallets come on different platforms with different features.

Bitcoin’s blockchain is replicated on networked computers around the globe and is accessible to anyone with a computer and an Internet connection. A class of participants on this network, called miners, is responsible for detecting transaction requests from users, aggregating them, validating them, and adding them to the blockchain as new blocks. Bitcoins are created as a reward for payment processing work in which users offer their computing power to verify and record payments into a public ledger. This activity is called mining, and miners are rewarded with transaction fees and newly created bitcoins. With a single bitcoin's price continues to rise, this is a very strong incentive. The main role of miners is to ensure the irreversibility of new transactions, making them final and tamperproof. However, when miners devote computational power, they also use a tremendous amount of electricity.

Bitcoins are kept in a digital wallet which you can keep in your computer, or on a website online, which will manage and secure your wallet for you. You can have as many wallets and bitcoin addresses (where you receive money from others) as you like. When a transaction is conducted, it's posted globally. And they compete: the first miner to find out the truth and to validate the block, is rewarded in digital currency, in the case of the bitcoin blockchain, with bitcoin. And then, that block is linked to the previous block and the previous block to create a chain of blocks. And every one is time-stamped. So if I wanted to go and hack a block and, say, pay you and you with the same money, I'd have to hack that block, plus all the preceding blocks, the entire history of commerce on that blockchain, not just on one computer but across millions of computers, simultaneously, all using the highest levels of encryption, in the light of the most powerful computing resource in the world that's watching me. Tough to do. This would scare away hackers because hacking bitcoin to get everyone’s coins would cost a tremendous amount of computing power, electricity, and money. Further, if the bitcoin community became aware of the hack, it would likely cause the price of bitcoin to drop steeply. This makes such an attack economically self-defeating.  This is infinitely more secure than the computer systems that we have today.

Besides being obtained by mining, bitcoins can be exchanged for other currencies, products, and services. When sending bitcoins, users can pay an optional transaction fee to the miners. In many places, bitcoin is less volatile than the local currency so some use it to store value while others use it to consume at hundreds of thousands of vendors across the globe and online.

Bitcoin's Proof of Work (PoW)


But in bitcoin, there is no central authority to enforce the rules. Miners are operating anonymously all over the world driven by a diversity of cultures and bound by different legal systems and regulatory obligations. Therefore, there is no way of holding them accountable. The bitcoin code alone must suffice. To ensure proper behavior, bitcoin uses a scheme called Proof of Work (PoW). A PoW is a piece of data which is difficult (costly, time-consuming) to produce but easy for others to verify and which satisfies certain requirements. Producing a PoW can be a random process with low probability so that a lot of trial and error is required on average before a valid PoW is generated. 

One application of this idea is using Hashcash as a method to preventing email spam, requiring a PoW on the email's contents (including the To address), on every email. Legitimate emails will be able to do the work to generate the proof easily (not much work is required for a single email), but mass spam emailers will have difficulty generating the required proofs (which would require huge computational resources).

Hashcash PoWs are used in Bitcoin for block generation. In order for a block to be accepted by network participants, miners must complete a PoW which covers all of the data in the block. The difficulty of this work is adjusted so as to limit the rate at which new blocks can be generated by the network to one every 10 minutes. Due to the very low probability of successful generation, this makes it unpredictable which worker computer in the network will be able to generate the next block.

For a block to be valid it must hash to a value less than the current target; this means that each block indicates that work has been done generating it. Each block contains the hash of the preceding block, thus each block has a chain of blocks that together contain a large amount of work. Changing a block (which can only be done by making a new block containing the same predecessor) requires regenerating all successors and redoing the work they contain. This protects the block chain from tampering. 

The most widely used proof-of-work scheme is based on SHA-256 (SHA stands for Secure Hash Algorithm) and was introduced as a part of Bitcoin. Some other hashing algorithms that are used for PoW include Scrypt, Blake-256, CryptoNight, HEFTY1, Quark, SHA-3, scrypt-jane, scrypt-n, and combinations thereof.

Therefore, it is crucial that all miners on the bitcoin network have the same copy of the blockchain, and that all changes and transactions are irreversible. 

Bitcoin's Golden Future?


Bitcoin, Ethereum and other blockchain assets are a new way for investors to gain exposure to a high-growth industry. Bitcoin and blockchain technology is a disruptive force in financial services and will likely be the foundation of the next-generation Internet also called Web 3.0. The current market price for a bitcoin is always changing due to the supply and demand for it. It goes up and down. Bitcoins are traded at bitcoin exchanges. A historical bitcoin price chart can be found at: https://blockchain.info/charts/market-price. How can we buy some bitcoin? If you are an individual investor and want to buy bitcoin the easiest way is through a digital asset exchange like Coinbase. Coinbase is one of the largest U.S.-based bitcoin companies that facilitates not only buying bitcoin, but also the storage of bitcoin. Open an account with Coinbase, and once you link your bank account you can buy and sell bitcoin. In addition, Coinbase also offers a "vault" that can be used to store your bitcoin. Since bitcoin is a new financial system that can operate without traditional banks, you control your finances. However, this financial freedom means that you are responsible for the safekeeping of bitcoin.

What does the future hold for bitcoin? As outlined previously, it has many advantages and for this reason it will remain relevant as a currency. We see the biggest risk to bitcoin being its substitution and/or parallel use by other cryptocurrencies. One of bitcoin's primary uses is being a store of value and for this reason other cryptocurrencies can always step in and enjoy similar status if aggregate demand requires it. Is bitcoin simply a 21st century version of gold, only without the storage issues? Or is it just a short-lived popular fad that may soon evolve into something quite different? Only time will tell. The only certainty is that its price will remain very volatile in the future.

 

 

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