Bitcoin Digital signatures
Monday, November 19, 2018
Bitcoin: Overview
Bitcoin: Overview
Voiceover: Bitcoin is a new virtual currency system that's been gathering a lot of attention recently, and I thought I would do a series of videos where I really dive into the innards of bitcoin and explain how it works in detail, and my plan for this first video in this series is to describe some of those mechanics at a high level.
And then what I'll do in subsequent videos is dive a bit deeper into all of the underlying aspects that I have touched upon within this first video. And my hope is that by the end of this video series, you'll know not only what a bitcoin is, but you'll also understand the mechanics of how transactions are initiated. You'll see how verification occurs for those transactions, and you'll also learn what it means for someone to really engage in a process known as "bitcoin mining", and that may be a term that you've heard if you've had any interest in bitcoin recently.
I do want to point out, also, that the bitcoin scheme is fairly involved. It requires some time to really cover all of the relevant details, and to me the best way to really wrap your head around a scheme like bitcoin is to really suspend belief for a bit and get exposed to all of these relevant details.
Now, undoubtedly, you'll have a lot of questions along the way, but my hope is that by the end of this video series, all of the relevant stones will have been overturned and your questions will have been appropriately answered, but it might take some time to get there, and in part, that's because I'll try to describe things in a way that's sensible and that might involve leaving some details out until I can explain enough pieces of the scheme and then add in those details in as I go along so that you're not inundated with too many minor points and nuances along the way, but you get a feel for the overall system as I go through things.
With that, let me go ahead and just dive right in. First of all, I do want to point out that bitcoin has been described, really, as a decentralized currency because there's no real central bank or entity that's involved in generating or transacting bitcoins, and, in fact, what happens in the content of a bitcoin is all the transactions really require what's known as a peer-to-peer network, a network of just individual hosts that essentially collectively agree on different aspects of how the protocol is implemented and used.
Bitcoin itself is also referred to sometimes as a cryptocurrency, and by a cryptocurrency, I mean that we use a lot of cryptographic techniques in order to facilitate or to really enable bitcoin transactions to take place, and I'll do separate videos on some of these techniques, but just take it at face value right now, that it's decentralized and is a type of cryptocurrency. I also want to point out that the term "bitcoin" itself can in fact be a bit confusing, and in many ways, bitcoin transactions don't really resemble traditional coin transactions so much as they represent really entries in some type of a global ledger, and by that, I mean let's say you have a transaction taking place, and let's say the transaction is taking place within, or among two parties, and we'll call them Alice and Bob, which are traditional names that are used in many cryptographic protocols to describe the parties involved, and imagine that Alice wants to transfer, or really wants to assign, a certain number of bitcoins that she possesses over to Bob, and you can think of this transaction, really, as an entry in a ledger of some sort, and I also want to point out before proceeding that even though I've used terms like Alice and Bob, what I really mean in the context of bitcoin is not the actual identities in the physical sense, but really that Alice and Bob are identities in the bitcoin system, and these identities are just, in actual implementation, are just collections of numbers that do not have to be tied with Alice and Bob's real-world identities. In that capacity, you can think of bitcoin at any, it really is effectively being, of being pseudonyms, rather than real names, and the idea is that bitcoin really becomes more of a pseudonymous protocol, where people are addressed by their pseudonyms, and that provides some level of privacy to users that want to transact using the bitcoin system.
Now, in a transaction between Alice and Bob, what Alice will basically do is specify a few different numbers. She has to specify how many bitcoins she wants to allocate to Bob. Let's say Alice started off with 50 bitcoins of her own. She might decide that she wants to give, let's say, 30 of these bitcoins over to Bob, and let's say she wants to have some number of bitcoins returned back to her, so you have to specify, or Alice has to specify, rather, how much change she's going to get, so in this case, let's say her change is going to be 18 bitcoins for herself, and then the remaining 2 bitcoins are going to be a transaction fee, and we'll talk about what a transaction fee means a little later, and I think I'll also dive into it in future videos, but it's basically an incentive for other nodes in the bitcoin network to help Alice in essentially validating some of the details of this transaction for Bob. Now, Alice will take these transaction details and apply what's known as a digital signature to these transaction details, and a digital signature is basically the mathematical analog of a traditional signature. It really binds Alice's identity to the details of this transaction. And by Alice's identity, again, I mean her identity within the bitcoin system, and this binding is really done in a cryptographically strong way. Now, the details of this transaction once it takes place, are going to be broadcast out, so Alice is going to take these transaction details and effectively just broadcast them out to all the nodes in the peer-to-peer network that represent bitcoin nodes. Now, Bob, when he receives information about this transaction, he receives it over the peer-to-peer network.
He'll probably sandy check some part of the transaction. For example, he might check that the numbers work out correctly, that Alice, let's say, started off with 50 bitcoins and is not trying to transfer more than 50 bitcoins to him, and so on and so forth. He's going to have some mathematical assurance because of some of the cryptography involved that some of these claims are accurate, that Alice, let's say, has the bitcoins that she's claimed to possess, and that she's expressed an interest to assign those bitcoins to him, but what he won't know yet is whether Alice has really tried to transfer those same bitcoins to anyone else over the course of time or maybe just prior to that point.
the way that we handle that situation, and by the way, I should point out that this concept of Alice trying to, let's say, spend coins twice, in the context of digital cash and electronic currency systems, this concept is known as double spending, and it's something you have to worry about when you have virtual currencies because it's very easy for someone to just copy the numbers that represent this transaction and try to use them elsewhere. The way we basically handle and reduce the risk of double spending is through a specific set of nodes in this peer-to-peer network who are known as bitcoin miners. You might have heard this term bitcoin miners, and the bitcoin miners are basically specific individuals, specific nodes within this peer-to-peer network, and what they basically do is they take all of the transactions that they see, and remember, they're listening to all of these transactions, and not just Alice and Bob's, but other transactions that are taking place, and they'll take those transactions, and ultimately, they will take those transactions and will compile them into what's known as a transaction block. So it's basically a recording of all the previously unrecorded transactions.
If you think of a single transaction let's say, as a ledger item, you could think of a transaction block as representing, let's say, an entire page in a ledger book. These bitcoin miners will also include in this block, in addition to all these unrecorded transactions, they will also include in this block a special transaction that's meant just for themselves to basically reward themselves for the effort of doing this mining. Now, a transaction block will also contain an encoding of the previous transaction block, so there's going to be some level of continuity, and then Bitcoin miners will also include a specially-crafted sequence of numbers associated with these transactions, and this sequence of numbers is known as a proof of work, and it's called a proof of work because it's something that's really hard to generate, something that requires a lot of effort to do, and that kind of makes it hard for just anybody to get involved with bitcoin mining willy-nilly, but it requires that they really exhibit or exert some computational effort, basically in exchange for getting this extra reward of a payment, and also in exchange for getting this transaction fee that they're going to be promised by Alice to engage in this sort of work.
I'll talk about what proof-of-work protocols are in a separate video in more detail. Now, because each transaction block contains information about previous transactions, really what you end up having is not just a single block. You ultimately have what you can think of as a chain of transactions, and you can call this a transaction block chain. The idea is as soon as a bitcoin miner is able to construct a transaction block chain containing all these unrecorded transactions, and this proof of work, it'll broadcast the details of that chain out to all of the nodes, all of the peers on that peer-to-peer network for bitcoin. And then once the newly-broadcast chain gets kind of verified and meets the right properties, the nodes on the network are just going to go ahead and start using it, and they're going to start appending new transaction blocks to that chain.
They're going to take anything that hasn't yet been processed and start incorporating it into the transaction chain that was broadcast out by the node who came up with the proof of work correctly. Now, this transaction block chain, really what we're going to be doing in the context of bitcoin is the nodes are only going to consider the transaction block chain that reflects the greatest amount of work to generate its contents, and again, there's this proof of work that I mentioned that is used to kind of determine or identify what the, what work was involved in coming up with the transaction block chain. The one that's the longest is going to be considered sacrosanct within the bitcoin system.
Future miners are supposed to only work off the chain that has the most work put into it. Now, what's remarkable here is that the whole process is decentralized. There is no bank or no centrally-trusted entity that was actually involved in the transaction. Hopefully this first video gave you a bit of description, a flavor, if you will, for the high-level mechanics of the bitcoin system. There are a lot of stones I have left unturned, and what I'll do in subsequent videos is start covering those details, and I'm sure you have a lot of questions, and hopefully the future videos will help answer some of those questions for you.
Bitcoin: What is it?
But what I wanted to do in this video is talking about what a bitcoin is in more general terms and what differentiating characteristics they have compared to other approaches. So for starters, bitcoin is just an electronic payment system. By electronic payment system, I mean it's just a vehicle, a conduit, by which two parties can transact over the internet. I call these parties Alice and Bob.
And let's say Alice for whatever reason wants to give money to Bob over the internet. And this may be because she owes Bob money, or maybe Bob is a merchant and Alice is buying something from Bob. Or maybe Bob is a not-for-profit, and Alice is making a donation to Bob. So there could be many reasons why Alice is trying to pay Bob over the internet in some capacity. Now, if Bob is willing to accept bitcoins, which are a form of electronic payments, then Alice can go ahead and send Bob some value in bitcoins.
And really, a bitcoin transaction between Alice and Bob amounts to a specially constructed sequence of numbers that Alice will basically send over to Bob. And this will be done entirely over the internet. These numbers will have certain mathematical properties. They make it hard for someone to really defraud the system or to conduct some type of nefarious action on the system. And the way that Alice is actually going to conduct this transaction in practice is either by installing a special piece of software, which we call a bitcoin client, or she can work with a third-party service that can handle these mechanics for her.
But in either case, either the client or the service is going to generate these numbers for Alice. And on the flip side, Bob will also typically either have a piece of software installed or he'll use a third-party service that will take these numbers and allow him to do something else with those numbers. For example, Bob can, in turn, buy something on his own with those numbers, or he can trade those numbers in for real money and so on and so forth. Now, one of the first questions you might have-- and I kind of alluded to this earlier-- is why would Bob even want to accept bitcoins in the first place? After all, a bitcoin is just a bunch of numbers. What intrinsic value would it conceivably have? And it turns out, quite surprisingly, that bitcoins actually have real-world value.
There are more and more merchants popping up each day who accept bitcoins for transactions. There are also bitcoin exchanges, places where you can go and exchange bitcoins for more mainstream currencies. And some of the exchanges include-- the major one is one called Mt. Gox. And at Mt. Gox you could exchange a bitcoin for a euro or yen or dollar and so on and so forth. Now the current price of a bitcoin, the current value of a bitcoin in US dollars as of this video, is approximately US$100.
per bitcoin. That number is fluctuating. This is a new currency, and there's going to be some fluctuation. But as people understand the currency better, the hope is that that fluctuation will decrease. But I think ultimately, the thing to keep in mind is that the value of a bitcoin is going to be derived from the faith that you have in the value of what you can procure with that bitcoin. It's just like you would for a dollar, a euro or yen.
The faith that you have in that currency's value is how you value that currency. Now another question you might have is why do people even bother with bitcoins in the first place.
Aren't there other more standard ways?
Why couldn't Alice and Bob use Paypal? Why couldn't they use a credit card number to transact?
Why couldn't Alice just sent Bob an electronic check? Why not use one of these other approaches that are better understood, that is more mainstream, that is more established?
Why on earth would you possibly want to mess with a good thing?
So it turns out that there are a few properties of bitcoins that are worth noting.
For starters, there's privacy. It turns out that within the bitcoin ecosystem, within the bitcoin network, people can transact without divulging who they are in the real world. From the perspective of bitcoin, Alice's identity is just going to be a sequence of numbers.
And that sequence of numbers is effectively going to function like a pseudonym for Alice.
And that sequence of numbers has nothing to do with your real-world identity. Nobody needs to know this is Alice transacting. All they need to worry about is their pseudonym within the system. And this is kind of but not quite like what you would get if you bought something using cash. In that capacity, when you buy something using cash, then you don't have to provide any details or proof regarding who you are in the real world. And that's different from, let's say, using a credit card, where you have to provide your name and your billing address and so on.
Or let's say providing an electronic check, where you need to tie that electronic check, typically your bank account details. Now, I do want to also mention here that sometimes when you have a cash list or a transaction that uses cash, there is now the possibility that people might try to use these transactions for malicious purposes to buy illicit goods and services. That definitely is a risk that occurs when you provide anonymity and privacy.
But there are certainly legitimate reasons why somebody might want to conduct a transaction privately and not have the whole world know what they're transacting. Another property of bitcoin is that it's open. Literally, anyone can get involved. Literally, anyone who was an internet connection can make a bitcoin transaction. And all you need to do to get started is, as I alluded to earlier, is download this special bitcoin client. And the bitcoin client, or for that matter, you can use a service like Mt. Gox which will effectively do the same work as a client for you.
But the short of it is that anyone who has a bitcoin client or who has an account with an exchange like Mt. Gox can engage in bitcoin transactions. That transaction, the details of it, the mechanics of it will be transparent to the user. All the user has to worry about-- all Alice needs to worry about-- is how much money she has and whether she can give that money to Bob. The actual software underneath will take care of all the underlying mechanics of making that transaction work. Now, this is different.
When you think about a traditional currency like a dollar, if I want to transact something online, typically I need a bank account, I need a credit card, and so on and so forth. Then we often take it for granted that there are people out there who may not have access to a credit card, who may not have a bank account. For example, in the United States alone it turns out-- and I just looked this up-- the number of households without a bank account, I read it, is somewhere north of about 8%. It's pretty high.
There are a lot of people out there who wouldn't be able to conduct a traditional internet transaction, but who can conduct a transaction using bitcoin. And by the way, there are people using bitcoin all over the world. And literally it doesn't matter where you are in the world, as long as you have an internet connection, you can start transacting bitcoins. Now, another property of bitcoin that's worth mentioning is that it's decentralized. There's no bank or centralized entity that can really control what's happening in the bitcoin ecosystem. It's all done in this kind of ad hoc fashion.
And what that means is that when you do a transact-- or when Alice transacts with Bob over the internet, that transaction doesn't have to go through a third party. There's no bank that gets in the way of that transaction. And that can have certain benefits as well. For example, that means that no one entity can directly control the money supply of bitcoins. That also means that no one entity can see your assets. Or for that matter, no one entity can reverse a transaction, which is definitely desirable for certain merchants.
Some merchants might not be able to conduct business online because of fraud concerns. And if you have a system where the transactions cannot be charged back easily, then from the merchant's perspective, they may be able to inhibit fraud and thereby that might enable their business entirely online. Now I want to point out that this last property of decentralization definitely causes concern among some people or not in bitcoin after all. When you think about it, a central authority like a bank does perform an important function in the context of a traditional currency.
For example, banks might validate currencies. They might validate transactions against fraud. Now, in bitcoin, this validation is basically done in a decentralized way by the other parties, the other nodes, in the bitcoin network. Now, the goal of the remaining videos in this series is to walk through the underlying mechanics of bitcoin transactions and really how they're validated, even though the system is decentralized. And there are some pretty amazing techniques that are used to make all this work. So I suspect that at this point, you may have a ton of questions about bitcoin, and that's entirely to be expected. Bitcoin is a very complex protocol. It has many moving parts. And I think it's critical when you're trying to understand something as complex and wrap your head around something as sophisticated as bitcoin, it's important to get exposed to all the parts first so that you can ultimately get a flavor for how they fit together.
And hopefully, the other videos in this series will help you to understand these different parts and along the way address many of the questions that you might have.
