How Bitcoin works? Technical properties of Bitcoin

The technical properties of the bitcoin network are seemingly very complex, as they are the product of many years of attempts to solve the main problem of the digital world: the absence of information rarity. Since the entire digital world is based on information, we can easily send it around the world at no cost, using communication protocols such as the Internet Protocol TCP/IP. The problem arises when we want to send a value expressed in units of money via the communication protocol. When sending information, the sender creates a copy of it, which is then forwarded to the recipient. At the same time, he keeps the original, which does not differ in content from the copy. Since digital information has no physical form, we can easily create countless identical copies of the data.

Sending money through communication channels creates an opportunity for abuse, where the sender creates a copy of the digital money to send to the recipient, while keeping the original for themselves. Since both parties have an identical copy of the money, the sender made the purchase at no cost, and the money supply increased by the amount he sent. This means, in theory, that digital money cannot exist in the absence of information scarcity, as its supply would expand indefinitely, leading to monetary hyperinflation and imminent economic collapse. The solution is therefore to ensure information sparsity. We managed to partially solve this problem several decades ago with the help of centralized clearing houses . This role was usually performed by banks and payment processors, who kept users’ money balances on their centralized databases and thus ensured the validity of transactions and the prevention of multiple spending of funds.

Because they held huge amounts of money, these entities were easy targets for hacker attacks, to which they very often succumbed. They were also an easy target for attacks by the authorities, which imposed mandatory identification of users, reporting of cash flows, prevention of money laundering and similar nebulae. This gave the government unlimited power in controlling the monetary policy and capital of its population, as it could alienate or freeze the assets of individuals with just a few clicks and decrees. Digital money also allowed the authorities a very simple method of increasing the money supply, as fiat money became possible to print at no cost because it represented only numbers on a screen.

Another solution to solving the absence of information rarity developed in the circles of cryptographers, who for decades fought against government encroachment on individual privacy and freedom, and were aware of the role that money played in this. After many failed attempts to create digital money, which mostly failed due to the centralization of certain parts of the system, the first potential solution appeared in 2008. An anonymous programmer who went by the pseudonym Satoshi Nakamoto published a white paper on a cryptographic forum that presented the architecture of a peer-to-peer monetary system with its own currency called bitcoin.

PEER TO PEER TECHNOLOGY

Bitcoin is based on peer-to-peer technology, which allows parties to transact directly without relying on a payment intermediary. This technology has been around for many years, and we use it to share files directly, without relying on centralized servers. In peer-to-peer technology, each “peer” or node is both a server and a client. Peer-to-peer technology allows network decentralization without the need for a central authentication server.

NODES

Since each peer in the Bitcoin network is both a server and a client, the name “node” has been established for easier understanding. A node is any computer that has bitcoin software installed and can receive or send transactions and verify their validity on the blockchain.

MINING

Issuing bitcoins partially mimics the traditional mining of gold ore from the Earth’s crust. The process is called mining, which in the eyes of many is a dirty and harmful concept. The truth is that mining new coins is simply a process where specialized computers use electricity to calculate a cryptographic equation. In this respect, they are no different from other computers and, despite the erroneous belief of many environmentalists, they do not pollute the environment, since the side effect of electricity consumption is only the emission of heat. The computer that first correctly calculates or guess the solution to the cryptographic puzzle, he is rewarded with new coins that enter circulation through him. The most appropriate analogy for the process of calculating and verifying a cryptographic equation is solving a Sudoku puzzle. The solution to the puzzle is very complicated, but its verification is extremely easy. Similar to Sudoku, when computing a cryptographic puzzle, miners spend a lot of energy to arrive at a suitable result. The nodes can then easily check the appropriateness of their solution, as it must correspond to the exact rules set by the system.

In addition to discovering new coins, miners also maintain the network. This is actually their main task, for which the system rewards them. Mining computers ensure that new transactions are entered into the blockchain, thereby updating balances. Their work is constantly monitored by nodes that check the compliance of the newly calculated blocks with the rules of the network. If a mining computer tries to enter inconsistent information into the chain, the nodes discard its change and commit to new ones. The whole process is very similar to playing a board game where all players agree to the rules. When someone comes along who wants to change the rules in his favor, the other players reject him, and he can only play his game with himself. If he wants others to join him, he has to convince them, which is an increasingly difficult task with a growing number of users.

The basis of the mining process is a system for achieving consensus, which is called Proof of Work. This ensures that new blocks can only be discovered by honest computers that consume a sufficient amount of electricity converted into hashing power to calculate the cryptographic equation. Electricity consumption alone is not enough, as this would allow the authorities to easily interfere with the grid, since they own most of the power plants and thus free electricity with which they could censor and attack the grid. Mining computers contain special processors whose sole role is to compute the SHA-256 cryptographic algorithm. Because of the specialization, these computers are much more efficient at computing new hashes than the average computer with a general-purpose processor. The total hashing power of the bitcoin network currently exceeds the total computing power of all other computers in the world by several orders of magnitude. This means that we do not have sufficient infrastructure available for the authorities to interfere with the operation of the network, as it is protected by decentralized mining computers scattered around the world, while hiding behind VPN technology.

DIFFICULTY ADJUSTMENT ALGORITHM

We have already explained how the mining of new coins works. We also mentioned that the mining process of the new coins is temporary and is completed after 32 halvings to mine the entire supply of bitcoins. We will explain the coin release schedule in more detail in the next part.

A common question people have when understanding the mining process is how to ensure that new blocks are mined every 10 minutes without causing too much variance due to fluctuating mining power. If the mining power spikes, it means that the blocks will be mined faster, and vice versa. The creator of the bitcoin network solved this problem with this difficulty adjustment algorithm . This monitors the average mining power over a period of 2016 blocks (about 14 days) and adjusts the difficulty of the cryptographic equation if necessary so that the average block addition time corresponds to 10 minutes. The difficulty adjustment mechanism is similar to the servo mechanism in vehicles, which helps drivers with precise steering. A similar calibration mechanism is used by other devices and machines such as watches, airplanes, compasses, etc.

The effectiveness of the difficulty adjustment algorithm is evident from the fact that the average block addition time throughout the history of the Bitcoin blockchain is very close to 10 minutes.

COIN ISSUANCE SCHEDULE

Bitcoin’s coin release schedule is derived from a logarithmic function where the mining process is divided into 32 periods. In the first period, from the start of the block chain, 50 coins were issued with the new block. This period lasted for the first 210,000 blocks or about 4 years. In the next period, the reward for a successfully calculated block was halved to 25 coins. After 420,000 blocks, the reward was halved again to 12.5 coins, and in 2023 it is 6.25 coins. Sometime in the first half of 2024, with 840,000. block, the reward will be halved to 3,125 coins, bringing inflation of new coins below 1%/year.

After the end of the 32nd coin release period, sometime in the first half of the 22nd century, the entire supply of bitcoins will be released, and this will complete the mining process. After this period, the only reward for adding blocks will be the transaction fees paid by users to send coins to other users. Many worry that these costs will be so high that no one will want to send coins across the blockchain, leading to the centralization of the network at higher levels where central payment intermediaries will handle settlements.

ELLIPTIC CURVE CRYPTOGRAPHY

Bitcoin’s security is based on mathematical rules. Cryptography is a special field of computer science that deals with the protection of information and secure ways of communication with the help of mathematical concepts. Through the many attempts of cryptographers to encrypt data and create digital money, many cryptographic algorithms have been developed, such as Merkle trees, public and private key cryptography, hashing algorithms, consensus mechanisms, and the like.

The bitcoin network works using a combination of these mechanisms, and its security is mainly provided by the mathematical reality of elliptic curve cryptography, which allows the public key that represents our digital safe not to reveal the private key that represents our access to the digital safe. The public key is a mailbox that people can send bitcoins to, and it can only be unlocked by knowing the private key. Elliptic curve cryptography thus allows us to sign or approve our transactions with the help of a private key and thus send them from our account to another without revealing our key to the public.

In the next chapter, we will go over the (too) often mentioned term “blockchain” and review its characteristics.