What is Bitcoin?

March 6th, 2014

The Faculty of Information’s Yuri Takhteyev explains the mysterious currency

Jenny Hall

News of major Bitcoin exchanges closing after being hacked have left a lot of people scratching their heads over the mysterious “open-source” currency. We spoke to Yuri Takhteyev, a software researcher and status-only professor in the Faculty of Information, to help us make sense of Bitcoin’s confusing world of miners and math.

A lot of people—me included—have trouble understanding Bitcoin. Can you explain it?

People ask what it is. There is no “it,” really. People expect it to be an organization, but it’s not. It’s also not a piece of technology or a program. Bitcoin is a protocol. It’s a set of rules for keeping score, which creates a payment system. An analogy I use is hockey. Hockey is a set of rules. With Bitcoin, as with hockey, there may be organizations involved in managing it. They may even claim to represent it, like the NHL does for hockey. But they don’t really own it.

Bitcoin is a solution to a specific  problem. That problem was how to set up a way for people to make payments in a decentralized way electronically. It’s fairly easy to make electronic payments if you’re willing to have a central party keep track of who owns what. If I want to pay you electronically, I tell my bank to transfer money to your bank. But ultimately in order for that to work, we have to trust those banks. And in order to trust those banks, someone needs to monitor them—that’s the government. What this means is the government can watch—and ultimately block—any transfers we make electronically through the banking system. Bitcoin aims to set up something that has the convenience of electronic money transfers but where no one is in a position to interfere with payments. If I want to pay you, no one can stop me. That turns out to be a fairly difficult problem, and Bitcoin is one solution to that problem.

So Bitcoin is a protocol that solves a problem. But it is also a currency, right?

Let me give you an analogy. In Micronesia, there is an island known for its stone money. People used to carve giant stone wheels and use them as money. A bit like using seashells, except these wheels were really heavy—you couldn’t move them easily. So everyone just knows who owns which ones—the wheel near my house is actually yours, because my father gave it to your father in exchange for one thing or another. There’s a story that at some point one of those stones sank into the ocean. You couldn’t see it anymore. But the islanders kept using it as payment because everyone knew who the stone belonged to. If I was the owner of the stone that sank and I wanted to use it to pay you, I would just tell everyone that now this stone belongs to Jenny.

Bitcoin works kind of like that. Individual bitcoins don’t really exist—they’re like that stone at the bottom of the sea. But there is a public record of who owns them. If I am recognized as the owner, I can transfer it to someone else by publicly announcing it. Nothing actually gets transferred. If I transfer my bitcoin to you, I don’t actually send you anything. What I do is announce to the world that my bitcoin is now yours.

But Bitcoin claims to be anonymous. How does that work if you’re announcing transactions?

The coins are not associated with individual people—they’re  associated with accounts. What everyone knows is not that I own the coin, but that the coin belongs to an account identified by a long number. If I want to pay you with it, you give me your account number, and I announce the transfer to that account.

The question becomes how do we know it was really me doing the transfer if no one knows who I am? The answer is actually pretty straightforward, and the cryptography community has known how to do this since the 1970s. When you create accounts, you actually create pairs of numbers. The first number you announce publicly, and the second is a secret number—a long number that can be plugged into a mathematical formula to generate a confirmation code when you make a transaction. The math is such that others can verify the confirmation code without knowing the secret number.

But there is another piece of Bitcoin that is actually a lot more complicated, and that has to do with the time of transactions. For example, say I publish a message that says I’m transferring my bitcoin to you. Let’s say I charge you $500. Then after that, I publish another message saying I’m transferring that bitcoin to someone else—maybe even to another account I own. But I backdate this second message. When the community starts trying to figure out who owns that coin, we have a problem. You say it belongs to you, but it was transferred to someone else yesterday. This is a problem people have been struggling with for years. The biggest innovation in Bitcoin is that it figured out how to solve that.

How?

Bitcoin transactions are available in a public log generated in a distributed process by people called miners. People think of mining as the point of Bitcoin, but miners are like notaries. They notarize transactions and get rewarded for it. Transactions are recorded in sets are called Bitcoin blocks. A new block is generated roughly every 10 minutes. Each block generates a mathematical problem that can only be solved by massive trial and error. The person who solves it gets a prize for solving it and publishes the next block of transactions.

So you end up with a chain of transactions that is really difficult to forge. In order to forge it, you would need to go back and resolve the solutions to all of those problems, which would take really, really massive computing power. In practice, this ends up setting up a scheme where no one person is in control.

Who are these miners?

Anyone can try to solve these puzzles. You need only a simple computer program, and miners compete against each other. The catch is that the game is really competitive. There are a lot of people trying to solve these puzzles, so your chances of being the first are very slim. Also, people who are serious about mining tend to invest a lot of money into computer hardware, so their mining software can run really fast and maximize their chance of winning.

What do they win?

Whoever solves the problem generated by a block of transactions wins 25 bitcoins, which is currently worth about $17,000. These rewards are newly-created bitcoins, so every 10 minutes the total supply of bitcoins grows by 25. They also get optional transaction fees—people who make payments sometimes add a “tip” for the miner who will record their transaction. Those tips are small, but they can add up.

Bitcoin has been all over the news lately because one of the major exchanges, Mt. Gox, got hacked, and hackings of others followed. What does this mean for the future of Bitocin?

It’s important to distinguish between flaws in the scheme itself and flaws in how people work with it. If someone hacks into my bank and siphons off all my money, we don’t say this is a flaw with the Canadian dollar or with government-issued currency in general. We say the bank had bad software. Software that works with bitcoins also can have bugs. It’s possible that at some point someone will discover an actual flaw in the Bitcoin protocol, but in this case this was a flaw in how those exchanges verified transactions.

That said, the future of Bitcoin may well end up being affected by the recent problems these exchanges have had. It may end up turning people away from Bitcoin in the same way people at some point decided they didn’t want anything to do with Argentinian pesos. But it’s important to remember that when they turned away from Argentinian pesos, they weren’t turning away from the concept of government-issued money. It’s possible that a few years from now Bitcoin will be forgotten, but something else will take its place.

Again, what we’re really talking about is “cryptocurrencies”—distributed payment systems based on cryptography. Bitcoin is a particular implementation of that idea. But there other implementations. Some are a bit different from Bitcoin. For example, some cryptocurrencies take it to the next level and provide even more anonymity than Bitcoin. Some of the other cryptocurrencies are really just like bitcoin but not bitcoin, like the Canadian dollar is just like the American dollar but it is not the American dollar.

So, it’s hard to know what is going to happen to Bitcoin specifically. But cryptocurrencies are probably here to stay. It might be like forecasting the future of AOL in the early 1990s. AOL turned out to be the wrong internet company to bet on, but other internet companies made it big.

It seems that the anonymity Bitcoin allows can have positive or negative implications.

Bitcoin does potentially offer both benefits and risks. On the positive side, in principle it provides a much more secure approach to electronic payment than what we tend to use today. It also opens the whole financial industry to new players, which allows for innovation. For example, there are companies now starting to use Bitcoin for remittance payments to developing countries. And they can do this at a fraction of a fees that are usually charged for such transfers, which can really be exorbitant. And they can do that because Bitcoin allows them to bypass a lot of intermediaries.

On the downside, if you are thinking of engaging in crime, and you want to not be tracked, Bitcoin is a godsend. So, no surprise that it really first took off with Silk Road, which is an online marketplace for drugs.

Who invented Bitcoin?

No one knows. It was proposed in a paper published anonymously in 2008, and later a piece of software was released to implement the idea. People have made guesses about who the author might be, but no one really knows. Whoever it is, though, that person is not really in control of Bitcoin. But they are likely sitting on a stash of bitcoins worth a billion dollars or more.

 

 

 

 

"Give me your bitcoins" graffiti.

The cryptocurrency known as Bitcoin offers the possibility of anonymous, decentralized payments. Photo by Mark Bridge via Flickr.