Bitcoin originated with the white paper that was published in 2008 under the pseudonym “Satoshi Nakamoto.” The creators’ original motivation behind Bitcoin was to develop a cash-like payment system that permitted electronic transactions but that also included many of the advantageous characteristics of physical cash. To understand the specific features of physical monetary units and the desire to develop digital cash, we will begin our analysis by considering a simple cash transaction.
Cash is represented by a physical object, usually a coin or a note. When this object is handed to another individual, its unit of value is also transferred, without the need for a third party to be involved. No credit relationship arises between the buyer and the seller. This is why it is possible for the parties involved to remain anonymous.
1.2 Digital Cash
An ideal payment system would be one in which monetary value could be transferred electronically via cash data files. Such cash data files retain the advantages of physical cash but would be able to circulate freely on electronic networks. A data file of this type could be sent via email or social media channels.
1.3 Electronic Payment Systems
Classical electronic payment systems are based on a central authority that verifies the legitimacy of the payments and keeps track of the current state of ownership. In such systems, a central authority (usually a bank) manages the accounts of buyers and sellers. The buyer initiates a payment by submitting an order. The central authority then ensures that the buyer has the necessary funds and adjusts the accounts accordingly.
1.4 Stone Money of Yap
The key feature of the Bitcoin system is the absence of a centrally managed ledger. There is no central authority with an exclusive right to keep accounts. In order to understand how this is possible, we will first discuss a historical payment system that has certain similarities with the Bitcoin system.
On Yap Island, large millstone-like stones were used as a medium of exchange. The stones were quarried almost 280 miles away on the island of Palau and brought to Yap by small boats. Every inhabitant could bring new stone money units into the system. The money creation costs, in the form of labour effort and equipment such as boats, protected the economy from inflation. Instead of having to laboriously move the stones, which are up to 13 feet in diameter, with every transaction from a buyer’s front yard to a seller’s front yard, the ownership rights were transferred virtually. A stone remained at its original location, and the unit of value could be detached from it and circulated irrespective of the stone’s whereabouts. It was sufficient that all the inhabitants knew who the owner of every stone was. The separation between the unit of value and the stone went so far that even the unit of value for stones that were lost at sea remained in circulation. The stone money of Yap can therefore be described as a quasivirtual currency, as each unit of value was only loosely linked to a physical object.
1.5 Bitcoin and the Bitcoin Blockchain
Bitcoin is a virtual monetary unit and therefore has no physical representation. A Bitcoin unit is divisible and can be divided into 100 million “Satoshis,” the smallest fraction of a Bitcoin. The Bitcoin Blockchain is a data file that carries the records of all past Bitcoin transactions, including the creation of new Bitcoin units. It is often referred to as the ledger of the Bitcoin system. The Bitcoin Blockchain consists of a sequence of blocks where each block builds on its predecessors and contains information about new Bitcoin transactions. The average time between Bitcoin blocks is 10 minutes. The first block, block #0, was created in 2009; and, at the time of this writing, block # 510868 was appended as the most recent block to the chain. Because everyone can download and read the Bitcoin Blockchain, it is a public record, a ledger that contains Bitcoin ownership information for any point in time.
The word “ledger” has to be qualified here. There is no single instance of the Bitcoin Blockchain. Instead, every participant is free to manage his or her own copy of the ledger. As it was with the stone money, there is no central authority with an exclusive right to keep accounts. Instead, there is a predefined set of rules and the opportunity for individuals to monitor that other participants adhere to the rules. The notion of “public record of ownership” also has to be qualified because the owners of Bitcoin units usually remain anonymous through the use of pseudonyms.
To use the Bitcoin system, an agent downloads a Bitcoin wallet. A Bitcoin wallet is software that allows the receiving, storing, and sending of (fractions of) Bitcoin units. The next step is to exchange fiat currencies, such as the U.S. dollar, for Bitcoin units. The most common way is to open an account at one of the many Bitcoin exchanges and to transfer fiat currency to it. The account holder can then use these funds to buy Bitcoin units or one of the many other cryptoassets on the exchange. Due to the widespread adoption of Bitcoin, the pricing on large exchanges is very competitive with relatively small bid-ask spreads. Most exchanges provide order books and many other financial tools that make the trading process transparent.
A Bitcoin transaction works in a way that is similar to a transaction in the Yap payment system. A buyer broadcasts to the network that a seller’s Bitcoin address is the new owner of a specific Bitcoin unit. This information is distributed on the network until all nodes are informed about the ownership transfer.
2 BITCOIN TRANSACTIONS
Berentsen and Schär (2017) argue that transaction processing demands that three requirements are satisfied: (1) transaction capability, (2) transaction legitimacy, and (3) transaction consensus.
2.1 Transaction Capability
What has to be resolved is how transactions can be initiated if there is no central authority.
In the Bitcoin system, a payment order can be communicated to any number of network nodes. The network nodes are linked together in a loose network and forward the message until all nodes have been informed about the transaction.
2.2 Transaction Legitimacy
Every participant can generate new payment orders and spread them across the network. This feature carries the risk of fraudulent messages. In the Bitcoin system, transaction legitimacy is guaranteed using asymmetric cryptography. The idea is based on using pairs of keys consisting of a private and a public key. A private key should not be shared. It corresponds to a random value from an incredibly large set of numbers. A public key, on the other hand, is derived from that number and can be shared freely. It serves as a pseudonym in the Bitcoin network.
For example, consider Edith, who wants to send a Bitcoin payment to Daniel over the Bitcoin network. She uses her private key to encrypt the message. The other network participants can only decrypt this message using Edith’s public key. If an attempt is successful, it ensures that the message was encrypted using the corresponding private key. Because no one else has access to Edith’s private key, this approach can be used to validate the transaction’s origin. When the transaction circulates in the network, any network participant can decrypt this message and is in the position to subsequently change the payment instructions. However, because the participant does not possess Edith’s private key, he or she cannot re-encrypt the manipulated message. The tampered transaction will therefore be identified and rejected by the rest of the network.
2.3 Transaction Consensus
Edith would be able to generate two transactions that both reference the same Bitcoin units. Both transactions could be propagated simultaneously over the network (transaction capability), and both would display a valid origin (transaction legitimacy). Because of differences in the propagation of these two messages in the Bitcoin network, some of the nodes would first receive a message for transaction A while others would first receive a message for transaction B (Figure 10). In order to avoid double spending, it is important that only one of the two transactions finds its way into the Bitcoin Blockchain. A mechanism that decides which of the two transactions gets included in the Blockchain is therefore necessary. The Bitcoin system solves this double spending problem in a clever way. The transaction that is first added to a valid block candidate, and therefore added to the Blockchain, is considered confirmed. The system ceases to process the other one.
The Bitcoin creators’ intention was to develop a decentralized cash-like electronic payment system. In this process, they faced the fundamental challenge of how to establish and transfer digital property rights of a monetary unit without a central authority. They solved this challenge by inventing the Bitcoin Blockchain. This novel technology allows us to store and transfer a monetary unit without the need for a central authority, similar to cash. Though, price volatility and scaling issues frequently raise concerns about the suitability of Bitcoin as a payment instrument.
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