Chapter 1
Bitcoin and Blockchain
Money is an essential component of civilization. It acts as a medium of exchange for individuals, enabling them to buy and sell goods and services. When it functions properly, money also allows individuals to store value over time.
Over thousands of years, people have employed many different kinds of money—from beads to metal coins and from shells to coffee beans. Some forms of money are more effective than others. “To be a really good currency,” wrote economist and Financial Times columnist Martin Wolf, “it needs to be durable, portable, divisible, uniform, limited in supply, and acceptable.”
Today, most people use fiat money, or what we would recognize as coins and paper bills. Fiat money is made legal tender, or currency, by government regulation. This money actually has no intrinsic value on its own. People give and receive money for real goods and services because it is a socially accepted symbol of value. Citizens must also use it to pay their taxes.
However, it can be unnerving to realize that fiat money is based mostly on trust. Citizens have to believe that the government won’t simply make more when it needs to. When the government prints too much money, inflation rises. The value of the currency declines because it doesn’t buy as much as it used to. Hyperinflation occurs when the currency loses its value. When a society loses faith in its currency, the results can be catastrophic. Citizens can’t afford food, savings are destroyed, and law and order breaks down.
There is no way to track the origins and history of a paper bill, making it much easier to counterfeit than cryptocurrency coins, each of which can be fully tracked on the blockchain.
“The root problem with conventional currency is all the trust that’s required to make it work,” said researchers Stanton Heister and Kristi Yuthas. “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of trust.”
Some critics believe that governments, inevitably, will print money to solve short-term problems or meet immediate needs. These people are often skeptical of government in general, which they argue has too much power—to print money, collect it, and monitor it. Some people believe that the government won’t properly oversee the financial system, which is charged with holding savings, making loans, and investing. If the government fails in this role, citizens’ savings would be jeopardized.
All of these fears appeared to come true during the global financial crisis of 2007–2008. In January 2009, the global financial system was near collapse. In the United States, millions of home mortgages had been given to people who were unable to repay them. These mortgages had been repackaged into securities that had been sold to banks and other financial institutions around the world. When the home mortgages soured, financial firms began to implode.
Governments were forced to spend hundreds of billions of dollars to prop up financial institutions to avoid a catastrophic economic depression. The bailouts were controversial. Families lost their homes, and investors lost fortunes. But the CEOs who ran these companies seemed to largely escape punishment. The global financial crisis of 2007–2008 eroded trust across society—in government, institutions, and individuals.
In the very first Bitcoin transaction, Satoshi Nakamoto quoted the title of a story in the London Times from January 3, 2009: “Chancellor on Brink of Second Bailout for Banks.” With this reference, Nakamoto summed up the issues that led them to launch Bitcoin. They didn’t have to make a case. They only had to point to the global financial crisis of 2007–2008, which led many people to an extreme conclusion: governments can’t be trusted with money.
Bitcoin was Nakamoto’s answer to the challenges of fiat money. It could be easily stored, instantly transmitted, and verifiable through a simple process.
As technology journalist Brian Patrick Eha said, “Bitcoin looks like money’s dream of itself.”
Who Is Satoshi Nakamoto?
No one knows who Nakamoto truly is—or if they are even a real person.
Digital Currency: A Problem and a Solution
To create Bitcoin, Nakamoto had to overcome an enormous challenge: anything on the internet can be easily copied. Money has value, in part, because its supply is limited. If all the gold in the world was gathered together, it would make a cube less than 75 feet (23 m) on each side. If someone were able to cheaply create gold in a laboratory, though, it would quickly lose value.
There are many ways in which creators of a product deliberately limit supply. In the late 1990s, music was primarily available only on compact discs (CDs). If you wanted a song, you had to buy an individual copy, which you usually got only if you purchased the whole album. Once you owned the CD, you could not make copies. If you wanted to share the song with a friend, they had to borrow your CD (in which case you couldn’t listen to it). This was also true of most other forms of media—newspapers, books, and DVDs. It is no surprise that these industries enjoyed strong profits in the late 1990s.
The internet, however, destroyed this model. New websites allowed users to download entire movies and to share music files. One person could simply buy a song and make an enormous number of copies to share with friends at no additional cost. Once newspapers posted stories online in digital form, they could be easily copied and reproduced elsewhere.
Music sales dropped by more than half over the next fifteen years. Many newspapers were forced to merge or close. Writers and musicians struggled to generate new revenue from their work. Anything that could be digitized could be infinitely reproduced at no cost, effectively making it worthless. The internet, it turns out, was extremely good at transferring information and, in doing so, destroying value.
Given this reality, how could a digital currency exist? A ten-dollar bill in your pocket can’t be reproduced. If you lose it, it’s gone. If you use it to buy goods, the person receiving the money can trust that it’s real money. A digital currency is just a computer file. It could simply be reproduced by the holder and used repeatedly. Bitcoin, however, achieved something extraordinary in the digital world: it’s almost impossible to counterfeit the coins. Nakamoto accomplished this through blockchain.
The Basics of Blockchain
Blockchain is an online ledger, or a list of records. It identifies who owns something at any given time. One group of Chinese blockchain experts called it “the latest and most trustworthy form of bookkeeping.” Each record is time-stamped and combined with other records via cryptography to create a block. The blocks are independently checked and validated by a peer-to-peer network, which consists of independent computers all over the world. They combine the blocks into a chain (hence the “blockchain”), including the most recent transactions.
If you wanted to pass a file to a friend, the blockchain would establish that you are the current owner and then confirm the new owner. The peer-to-peer network would validate the transaction and update the blockchain. The file can’t be copied and distributed to anyone else. There is only one file. Thus, blockchain effectively solves the problem of digitization and makes a digital currency possible.
How a Blockchain Transaction Works
“A blockchain is like the digital version of a scarf knitted by your grandmother,” wrote New Yorker reporter Nathan Heller. “She uses one ball of yarn, and the result is continuous. Each stitch depends on the one just before it. It’s impossible to remove part of the fabric, or to substitute a swatch, without leaving some trace: a few telling knots, or a change in the knit. In a blockchain system, too, every line is contingent on what came before it. Any breach of the weave leaves a trace, and trying to cover your tracks leaves a trace too.”
The Bitcoin Blockchain
Bitcoin is the most well-known and successful application of blockchain. Studying Bitcoin leads to a better understanding of how blockchain works in the real world.
Bitcoin accounts are called addresses. They are random strings of letters and numbers. Nothing else is associated with them—no names, no social security numbers, and no business or residential addresses that would identify the owner. Each Bitcoin address has a secret code, or a private key, that allows someone to access it. The owner of the secret code holds the Bitcoin. If the secret code is stolen, forgotten, or otherwise lost, the Bitcoin cannot be used.
The holder transfers the Bitcoin to another person by using their private key. The transaction actually becomes part of the Bitcoin code and is transparent, meaning anyone with access to a computer or smartphone can see which addresses have owned the Bitcoin and which address owns it currently.
Nakamoto created incentives for third parties to verify Bitcoin transactions. The verification involves solving a complicated math problem—or proof of work—that requires significant computing power and energy. The third parties, called miners, are compensated for their work by being paid a fraction of the transaction in Bitcoin. They also receive a block reward, or a certain quantity of newly generated Bitcoin. The miners race to validate the transactions, and the reward goes to the miner who completes the proof of work the fastest and most thoroughly.
Each transaction is recorded through an algorithm that takes its details—time, amounts, and sender and recipient addresses—and converts the transaction into a string of letters and numbers called a hash. Anyone running the information through the algorithm will come back with the same hash. Each hash can be combined with another, resulting in a new hash that embodies both. Thus, when a miner adds a block to the blockchain, it is linked to a chain of hashes that go back all the way to the first, or “Genesis,” block launched by Nakamoto on January 3, 2009.
Many miners use cooling devices and fans to keep their computers from overheating. In addition to using a lot of power and racking up the energy bill, mining requires powerful processors that ordinary personal computers don’t come with.
Any alteration to the chain, no matter how insignificant, results in a completely different hash. Consequently, the record of a transaction cannot be changed because many independent parties have already confirmed the information. After a miner verifies the transaction, other computers on the peer-to-peer network, called nodes, will validate the miner’s work with the original blockchain. If a node detects an irregularity, they will not attach a new block to it. Rather, they will go back to an earlier part of the chain that can be trusted and attach it there. The rejected block becomes an “orphan.” Orphans also result from situations where two miners solve the proof-of-work problem at the same time—the network has to choose one of the two blocks, and the rejected one becomes an orphan. Because of this process, any blockchain user can trust the ledger’s information because the peer-to-peer network has already confirmed it.
Nakamoto designed Bitcoin so it would take about ten minutes to mine each block. Sometimes, though, it can take just a few minutes or as long as an hour. If many Bitcoins are being mined and require more computing power, Nakamoto’s algorithms automatically adjust, making them easier to mine. However, if fewer blocks are being mined, the difficulty is increased. The goal is to maintain a mining time of ten minutes per block.
The value of a Bitcoin depends on the trust it generates among everyone who uses it—in investors, in users, and in society at large. As a result, Bitcoin miners have an incentive to be honest and to validate the transactions. If anyone commits fraud with the system and destroys trust, all Bitcoins become worthless.
“And so, a central authority is replaced by a network of volunteers pursuing their own self-interest,” wrote blockchain expert Omid Malekan.
Through Bitcoin, Nakamoto demonstrated the viability of blockchain. Over the years that followed, computer scientists, investors, regulators, governments, experts, economists, and ordinary citizens grappled with this new system and its implications.
“There is great confusion and debate about what a blockchain even is,” wrote tech journalist Gideon Lewis-Kraus, “but the standard definition describes a shared, decentralized, cryptographically secure, immutable digital ledger. In the broadest terms, a blockchain allows a group of strangers to agree on a state of affairs, and to proceed together on the basis of the covenant.”
This diagram illustrates three types of organization: centralized, distributed, and decentralized. A decentralized structure distributes decision-making power and authority across a large group of people. In a centralized system, most of the authority belongs to a single, central entity, such as a government or a corporation. Finally, distributed systems consist of nodes that coordinate their computing to reach a consensus; they can be either centralized or decentralized.
This language makes blockchain sound bland, but blockchain’s supporters believe it reveals how revolutionary blockchain could be. To them, “a group of strangers” who “agree on a state of affairs, and proceed together on the basis of the covenant” sounds like the beginning of a civilization.
Marc Andreessen, a venture capitalist who launched the first popular internet browser in the early 1990s and was a cofounder of Netscape, wrote in the New York Times that Bitcoin was the next big thing:
A mysterious new technology emerges, seemingly out of nowhere, but actually the result of two decades of intense research and development by nearly anonymous researchers.
Political idealists project visions of liberation and revolution onto it; establishment elites heap contempt and scorn on it.
On the other hand, technologists—nerds—are transfixed by it. They see within it enormous potential and spend nights and weekends tinkering with it.
What technology am I talking about? Personal computers in 1975, the internet in 1993, and—I believe—Bitcoin in 2014.