I am impressed with the novelty and cleverness behind the online phenomenon known as Bitcoin. For those who came in late, bitcoins could be described as digital commodities. People can trade them for actual currency and sometimes real goods. However, while it’s true that we’ve been using something called money for this purpose already, and so you may ask why we need it, Bitcoin has a couple of interesting properties:
- Trustless: If I engage in a Bitcoin transaction with you, I don’t need to trust you, your bank, your government, or anyone specifically. Once a transaction has completed, it can be verified to have happened as I expected, removing counter-party risk that exists in many markets (for example, a fraudster may pay me in counterfeit bills).
- Resilient: There is no central operator of the Bitcoin infrastructure, so everyone’s not worried about a particular company staying solvent, or a particular government staying in power or true to their promises in order for the system to keep working.
Up until Bitcoin, no-one had been able to come up with a system with these properties. Either counter-party risk was removed because there was an operator regulating the market (and the market wasn’t resilient in the face of that operator collapsing) or there were markets without central control that required a lot of trust when dealing with others. If the inventors of Bitcoin had not been hiding their identities, I wouldn’t be surprised if they would be in the running for a future Nobel Prize in Economics. Bitcoin is no less than a completely decentralised technology for financial contracts allowing for value to be transferred over any means – physical or virtual.
However, I’ve found that the way that Bitcoin operates to be a little surprising. It’s not like other systems that I’m used to. Since I haven’t seen these points noted down clearly in the one place, I thought others may be interested as well. (Unless you’re already very familiar with Bitcoin, in which case it’s likely to be old hat.)
1. Miners are both the source of new bitcoins and responsible for documenting all transactions
A miner is just the name for a computing node that works to discover the next block in the Bitcoin blockchain. Every ten minutes (on average), a new block containing all as-yet-undocumented transactions is generated. The first node to generate this block (which requires discovering the solution to a particular computing problem using trial-and-error approaches) also gets 25 bitcoins (BTC) for its trouble. The “winner” here is in part due to luck, and in part due to how much computing power the miner has dedicated to this. The blockchain is the ongoing record of each of these blocks, collectively forming something of a global ledger of all known transactions to date.
In theory, transactions can contain something akin to a tip, representing a fee to the (winning) miner, and these are in addition to the 25 BTC for each ten minutes work (with a single BTC worth something between US$40 and US$1140 over the last year, and currently around US$580). However, such transaction fees are relatively minor at the moment, with miners currently earning less than 20 BTC per day in total. The 25 BTC figure used to be 50 BTC in the early days, and reduces predictably over time with it halving again to 12.5 BTC by about the year 2017.
2. Transactions are not real-time and take around an hour before they are considered certain
Prospective transactions are broadcast around between all the various miners using a peer-to-peer network, who each check them for validity before including them in the current block that’s being worked on. Since a new block comes along every ten minutes (on average), there may be a wait of up to ten minutes for a new transaction to appear in the blockchain, and hence the receiver of BTC can read it and will know that they are going to get some coins.
Except miners may not include your transaction in the next block because there were already too many transactions in it, or perhaps the miner that “won” the block that time decided not to include any transactions at all, so you will need to wait for the next block. And even then it appears that there is a risk that a Bitcoin sender could “double spend” the BTC if two conflicting transactions were sent to different miners, so it’s considered prudent to wait until six blocks have been generated (including the first one with the relevant transaction) to get transaction certainty.
While this is fine for some types of transactions, such as a book order, it is not so fine for other types of transactions where goods are delivered immediately such as an app download or when at a Bitcoin ATM dispensing hard currency. Any solutions to this problem will sit outside of the standard Bitcoin infrastructure, e.g. merchant insurance, but in a world where transaction times are getting shorter and shorter, this may limit Bitcoin’s long term use in the general economy.
3. Bitcoins are not held in Bitcoin wallets
A Bitcoin wallet is technically just a public-private key pair (or multiple such pairs). This provides the means of generating a public address (from the public key, for others to send bitcoins to your wallet) and for generating new transactions (using the private key, when sending bitcoins to other people’s wallets). The bitcoins themselves are not held anywhere, but proof of ownership of them can be established from the records in the blockchain.
Given that everyone can see exactly how many bitcoins belong to every Bitcoin wallet, it’s considered good practice to use a different public address (and hence public-private key pair) for each transaction. A single transaction can take bitcoins from multiple wallets and send them out to multiple wallets, making this all a bit easier to manage.
4. Bitcoin transactions can be complex contracts
Since bitcoins themselves are not actually moved around and bitcoin balances are not kept within the Bitcoin infrastructure, each transaction sending some bitcoins refers to previous transactions where those bitcoins were “received”. At a minimum a single sending transaction needs to refer back to a single receiving transaction. As part of validating that this pair of transactions should be allowed, miners actually run a small script embedded within the sending transaction followed by another one embedded in the receiving transaction. The scripting language is pretty extensive.
Also, because Bitcoin transactions are just a series of bytes and can be sent directly to others, e.g. over email, instead of broadcasting them to the miners, complex contracts can be created. You can use Bitcoin to pay someone, but only if a third party also approves the transaction. Or you can use Bitcoin to pay a deposit / bond where the money comes back to you after an agreed period but the other party can’t spend it in the mean-time. Or you can use Bitcoin to contribute towards a transaction that will go ahead only if enough other people contribute towards it for it to reach a specified sum. Some are using Bitcoin to run a provably-fair lottery. Some are even looking to use Bitcoin to allow for electronic voting.
Bitcoin is still relatively new for a payment technology, and I would not pretend that using it is risk-free. Regulation of Bitcoin is still nascent and inconsistent between geographies, it operates in a legally grey area with perhaps half of all Bitcoin transactions being made with gambling services, and Bitcoin-based marketplaces seem to be regularly collapsing.
Even if Bitcoin itself is replaced by one of the other newer “cryptocurrencies” such as LiteCoin, Ripple or dogecoin, I suspect that its invention has opened the door for amazing new ways to transact online.