An introduction to Bitcoin makes it sound so user-friendly and a simpleton business, but elegant with modern encryption, but the actual system design is largely kept a secret like a Death Star. It doesn’t matter how a 100 km-wide space station roams around in space freely and shoot out a laser beam that will utterly destroy 12,500 km-wide planet; what mattered was that it destroys planets and can be stopped by a “one-man starship”. Considering how we even got a good prequel out of that story alone, the story behind Bitcoin also deserves some attention with its ever-increasing exchange rate.
The technologies behind Bitcoin are not entirely new. Satoshi Nakamoto created what he later defined as a blockchain, out of technologies and ideas that are already available. There are three concepts or cryptographic methods that are fundamental to Bitcoin and are hard to explain with common metaphors: hash, PKI, and proof-of work, in the increasing order of difficulty.
Hashing, which I believe most people would have heard at least once from security breaches, is simply an algorithm which generates entirely different results per input. Think of it as a program that writes an index page on a phone book. Every phone book with different sets of numbers will have different index pages. As to why an index-page-building algorithm is so important to information security, you cannot rebuild your way through a phone book from index pages. However, you can confirm your phonebook is not missing any pages or entry by comparing against the index.
A well-updated phone book will always have all of its contacts listed on the index page, and all phone books, unless they are completely identical –same publisher, same edition, same region, and etc.– each indexes will be unique to its own. A well kept hash key, therefore, can act as a public notary; you can confirm a document is original and that confirmation does not require a carbon copy. If its original contents has not changed, we can get the same hash key out of the same contents, much like we can create same index pages out of same phone book. Bitcoin is using hash to prove the previous transaction records are not forged. Because hash algorithm is publicly available, anyone can act as a notary as long as they have access to a transaction and a hash key, starting off the system decentralized.
PKI, or public key cryptography, is something that you would normally see on communications term, not on financial articles. It stands for Public Key Infrastructure, but you can scratch that off. What is significant with PKI is the fact that in modern cryptography, we now finally built a system that works with two keys where if one key locks only the matching pair can unlock it. These keys are also reversible; not one key is designated as a locker or an unlocker. While browsing internet, even on The Mad Tea Party, you would have seen how there is a padlock or a green-themed address bar with a certificate. That’s precisely the same technology; on internet, your lines are not secure at all, so we chose to encrypt the information that uses the line to each other send.
A pair of keys is constituted of a public key and a private key. They are literally what their name represents; public key, you are obliged to share, private key, don’t. They can make as many as they want, but the point is the matching pair. If a content is encrypted with a public key, only the owner of the matching private key can open it, and if a content is encrypted with a private key it can be opened by anyone with the public key. On Bitcoin, public key is your account number, your wallet address, and the matching private key is your password. For a transaction to occur, one must encrypt the information of said transaction with the owner’s private key, and then the rest of the world can re-examine the transaction with a public key. No one has to print out account number and verify the matching password, so it helps to keep the system decentralized.
Now what I’ve explained so far should be able to trick some people. But some smarter readers who are on top of the reading materials would be asking, then what do miners do? If everything has a detailed instruction with nicely laid out mathematical explanation footnote to it, why is mining so power-consuming? Bitcoin is essentially a P2P financial service, much like a trackerless BitTorrent. BitTorrent relies on the network of seeders and leechers, relying on the goodness of seeders to first spread the files. But this is not desirable for a currency system, one that wishes to be decentralized and remain high availability so that the ledger, the full history of exchanges, will not be tempered. That is where proof-of-work comes in. The actual size of the ledger and a workload of adding a transaction to the existing ledger is not huge, increasing the chance of nodes, the miners, going offline.
Let me provide an example. A ledger containing all the transactions from the previous day is marked ledger1. On the following day, any miners can add any transaction from the pool, mark it ledger2-a and share it. But this file will be shared so quick and be deprived of any active seeders and leechers, as acquiring and/or sharing the file itself is not important as long as the file already has your money with the right name on it. Simply put, proof-of-work provides literally “work” for miners, much like seeders keeping their computers on to distribute large files and incentives for users to keep the network alive, and this arbitrary work is completely irrelevant to the actual transaction.
Proof-of-work is where hash finally meets PKI. Bitcoin comes with a threshold, a “difficulty” setting for miners. In order for a block to be added, the hash has to meet the difficulty. To do so, miners are given 32-bits long room that will affect the overall value of a hash. This room, in Bitcoin terminology called “nonce”, has no bearing on the actual transaction. The only way to figure out the hash that meets the requirement is to try them all. It is mathematically proven, or at least so we assume, that we cannot backtrace from hash key to the original contents. Which leads to keeping any tampering at bay, giving them exact cost of tampering should they try to re-work with fake transactions; any changes made in a ledger requires additional work. However, that “work” still needs to be done for every legitimate transaction.
That being said, all the computing power around the world, all the Bitcoin farms are essentially wasting their electricity and valuable resources to calculate non-important variable that fits the rules of a game. And this game makes Bitcoin essentially tamper-proof, at the cost of your own Bitcoin as fees and energies used to pay for a cup of coffee. It must also be noted that the computational work put into mining has no correlation with the actual price of Bitcoin.
However, due to the design and the community pressure, Bitcoin returns less for more amount of computing, making Bitcoin mined later effectively more expensive than the ones previously; the farms will be rewarded less with Bitcoin for bigger competition making it literally more expensive to mine Bitcoin and Bitcoin becoming more precious medium than it previously was. This bubble can grow to a certain point, but either the generation will stop or it will pass the point of no-profit for miners, bursting the price effective immediately, similar to the Great Depression.
Any money that you would find around the world is based on fiat system as of Nixon’s administration. We have come at least 40 years since the markets learned what any representative currency, much like gold standard and possibly Bitcoin, no longer works; having limited number of something does not automatically qualify for being a good medium of currency. Users behind Bitcoin must learn putting “works” to mine Bitcoin does not justify the current boom in cryptocurrency, and to do otherwise is plain gambling.
updated Jan 9, 2017: edited for better readability.