Nowadays, the tech world is innovating new ways in which transactions are made. Two hot words, in particular, have made quite a splash: Bitcoin and Blockchain. But what do they actually mean and how do they work?
To find out more about this complex topic, I interviewed Alessandro Olivo, a co-founder of BEN Italy (Blockchain Education Network). I met him at the University of Padua during a crowded lecture, where he explained with Emiliano Palermo, the second co-founder and vice-president of BEN Italy, the high potential of Bitcoin and Blockchain.
SOME BASICS FIRST
The idea behind everything
In our new digital world, where everything is relative and the lack of control on information is high, there is a need to develop a new concept of trust. In particular, we are talking about the so called Internet of Transactions, which is a way to think of transactions on a digital basis founded upon four main principles: decentralization, transparency, security and immutability.
In other words, there is a need of total accountability to guarantee everyone has transparent access to information and eradicate corruption, as well as other forms of deception.
The difference between Bitcoin and bitcoin
In 2009, an anonymous inventor, known with the alias of Satoshi Nakamoto, invented a digital currency called bitcoin (shortened as BTC or XBT). Conventionally, bitcoin with a lowercase "b", represents the currency itself. Bitcoin is a currency created to give consistency on new digital transactions based on the previously mentioned four pillars.
To make transactions possible with bitcoins, there is a necessary system called Bitcoin, with a capital "B". It is the whole technology and network of hardware and software behind these digital transactional processes.
Bitcoin differentiates itself from traditional currencies, due to the fact that there is no central institution or complex financial process to determine its value, which is defined, instead, only by leverage supply and demand. This system uses a database distributed (shared) among network’s hubs that keep track of transactions and exploit cryptography to manage functional aspects, such as generating new money and attributing properties to bitcoins. In simple words, the hub is none other than a computer.
Now it’s time to explain Blockchain.
What Blockchain is
Blockchain is one of the most mainstream words in the fintech world, but what does it really mean? As the name suggests, it is a database structured in blocks of information connected among themselves (hence the word “chain”). In addition, it also allows management of transactions shared among the various network’s hubs.
Before diving into this concept, it is necessary to understand how transactions work.
HOW TRANSACTIONS WORK
Cryptocurrency
The Bitcoin network allows one to own and transfer anonymously digital currencies with the use of digital wallets, which has one's necessary data saved to spend personal bitcoins. Digital wallets can also be held by third parties that provide a service similar to traditional banks.
Bitcoin is based on currency transactions among public accounts by using a public key cryptography (asymmetric cryptography). Every transaction is public and memorized in a distributed database (Blockchain) used to validate and verify each transaction to avoid the possibility of double spending the same bitcoin.
A peer-to-peer system
The network structure is peer-to-peer and the lack of a central authority makes it impossible for any one person to stop a transaction, seize bitcoins or depreciate its value (by creating new money) without the relative access keys.
Fundamentals of asymmetric cryptographyEvery user who participates in the Bitcoin network can have an unset number of cryptographical pairs of keys associated to his/her digital wallet.
User’s public keys, also known as “bitcoin addresses”, represent the sending and/or receiving points for each payment. This cryptography system, based on a pair of keys (one public and one private), is called “asymmetric cryptography”.
This system needs a public key, which must be shared, and a private key, which must stay personal and known to the owner. These keys can be interchanged to code or encode a message, so it’s clear that for each private key there should be associated one specific public key.
The strength of this system is represented by the difficulty of finding the private key linked to the public one.
How Bitcoin network verifies transactions
Asymmetric cryptography is founded on cryptographical algorithms based on complex mathematical problems. Finding a solution to these problems, a “hash” must be obtained: a 32 hexadecimal digits long code which uniquely identifies a key.
Inasmuch, the ownership of bitcoins implies that users can spend only the bitcoins associated to a specific address, thus, there is a need to authenticate every transaction. So, users attach their private keys to each transaction as a fingerprint to authorize the payment only for the real money owner.
The Bitcoin network verifies a specific fingerprint by using the related public key. In this way, it is possible to associate a public key to a person and a digital certificate is created. If a transaction is validated 6 times, it is considered confirmed.
The Bitcoin network can verify a transaction by:
Calculating the message’s hash;
Encoding the message’s hash;
Comparing the message’s fingerprint.
Recapping bitcoins transaction process
Bitcoins contain the public key of their owner (the owner’s bitcoin address). When user A transfers money to user B, he/she renounces to his/her money ownership by adding user B’s public key and his/her fingerprint to the money. As written before, in this example the fingerprint is made by using user A’s private key.
Afterwords, user A sends a message that represents the transaction to the peer-to-peer network. The rest of the hubs validate the fingerprints and hashes before accepting it.
BITCOIN MINING
Who validates transactions
Before going forward, it’s fundamental to understand what “the network verifies bitcoins transactions” means. Who is behind this validation process?
In reality, the answer is very simple and there are not thousands of Chinese tech gurus with calculators solving cryptographical algorithms.
As already touched upon, the Bitcoin network is formed by hardware and software which solve the necessary mathematical problems.
At the beginning, there were clients which managed the calculations by exploiting CPU (Central Processing Unit) power. But then, due to increased costs and competitors, this technique was abandoned. Now, there are special software that use GPU (Graphics Processing Unit) and FPGA (Field-Programmable Gate Array) power. The more efficient and modern ones use a dedicated hardware based on ASIC (Application Specific Integrated Circuit) processors, specifically made for this purpose.
But why all the competition?
Because all the network hubs compete to be the first to find a solution to a single cryptographical problem. So, the more players there are, the higher the competition is. But higher competition also means higher mining costs.
How to generate bitcoins
These clients which contribute in securing the network and solving problems with their calculation power, receive a proportional number of bitcoins according to their computing power compared to the computing power of the whole network.
This process is called “mining”, like the old gold mining.
Mining bitcoins is very expensive nowadays due to the rise of electricity costs and computing power needed to verify each transaction. That’s why many miners have joined guilds, called “mining pools”, where all participants put together their assets and split the bitcoin rewards among themselves according to each personal contribution.
Transactions also have costs paid by the creators involved. So, miners will receive a public reward generated by the Bitcoin network, and also a commission fee given by the creators of a specific transaction. This fee is variable, because it is at the creators’ discretion; the higher the fee is, the faster the calculations will be. Obviously, clients will rush to verify transactions with the highest commission fees.
Bitcoin is a closed monetary system
Bitcoin has been projected to generate a specific total number of bitcoins which is 21M in about 130 years. It means that the public reward given for every completed transaction will decrease according to a geometric progression and will halve aprroximately every 4 years.
There will come a day when the rewards in bitcoins will cease and calculations for the transactions will be paid only by private commission fees.
WHY YOU SHOULD INVEST IN BITCOIN
Advice from Alessandro Olivo
Bitcoin and Blockchain scenarios are still uncertain and these new technologies still have much to be developed. Alessandro Olivo suggests the best investment someone could make is spending time and resources to gain a better understanding of what Bitcoin and Blockchain are all about.
They clearly represent the fintech solution that has been changing the world. For this reason, people should prepare themselves with education and information to face this imminent future.
Economical investment
In these times, the value of bitcoins and other cryptocurrencies are very volatile. Experts agree that if someone wants to invest money in cryptocurrencies, he/she should prepare themselves with the risk that comes with monetary investment. In layman's terms, if you choose to invest, hope for the best, but prepare for the worst.
Other celebrities, like Mark Cuban, suggest to invest in bitcoins only 10% of your monthly salary. But with a clear warning: «Consider those money lost».
DEEPENING BLOCKCHAIN: HOW IT WORKS
Bitcoin network’s hubs
As written above, Blockchain is a database structured in a network of hubs which contain blocks of confirmed transactions linked together by a timestamp. Every block also includes the hash of the previous block, so they are chained together.
Every hub contains and manages more than one transaction and its “duty” is to check and approve all transactions in a way to allow their traceability.
How Blockchain works
The following exchange needs to occur between user A and user B:
User A and B create all related information to the specific transaction by using the cryptographical keys;
The transaction is sent to the network to be validated;
A new block is created, containing all the information of the transaction;
The new block is added to the chain which forms Blockchain and it becomes accessible to every participant. At the same time, it is also present in all participants’ database, because of the distributive property of Blockchain;
This block becomes the permanent, immutable and unmodifiable reference of user A’s and B’s specific transaction;
Once the block is validated and confirmed by the network, the transaction is closed;
This block is then inserted to another bigger block which contains other authorized transactions that occurred in the same time lapse;
Once a miner completes this last block and adds it to Blockchain, he/she receives a payoff that corresponds to the addition of all transaction fees associated to that block.
Bruteforce and proof-of-work
All the network’s hubs compete to be first to find a solution to a certain cryptographical problem. The only way to solve it is by bruteforce, therefore through a large number of trials. Once a hub finds a valid solution, it is announced to the rest of the network and the hub receives its bitcoin reward. Hubs that receive this new block verify and add it to Blockchain. Afterwards, all the hubs continue to mine again, adding upon the block they just received.
We can say that this valid solution is also called proof-of-work and it is a necessary condition for a block to be accepted by the rest of the network.
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