On October 31, 2008, an unknown developer using the pseudonym Satoshi Nakamoto published the revolutionary whitepaper ‘Bitcoin: a peer-to-peer electronic cash system’. The document marked the beginning of the cryptocurrency industry, which is now valued at $200 billion, as well as the innovative blockchain technology that has turned the financial world upside down.
Bitcoin whitepaper is hardly light reading. However, we will retell the nine-page Nakamoto document so that it can be explained to children and parents. There are twelve sections in the original, but here we will highlight four key topics. These are trusted third parties, the problem of double-spending, motivation for miners and privacy.
Satoshi Nakamoto explains that the World Wide Web entrusts the processing of electronic payments to trusted third parties like banks. However, this process leads to problems like transaction reversibility and high fees. Moreover, such a system inevitably involves fraud, and this burdens everyone with additional costs.
According to Satoshi, there is a better approach that allows the parties to interact with each other directly. This can be achieved through a peer-to-peer network with equal participants, where trust is replaced by verification. In this case, the transactions will be irreversible. To ensure network security, decentralized computers – in the cryptocurrency language of nodes or miners – will provide evidence of transactions in chronological order.
All transactions will be broadcast on the network, and each will adhere to a single transaction order. Such a single version of reality (or database) will give users the confidence that electronic records are accurate and valid.
Moreover, a proof-of-work system — or PoW — requires computer nodes to solve mathematical problems. Nakamoto says that it will be difficult for a hacker to succeed because computers will always look for the longest chain as a truly distributed registry. It is such features of the system and such a sequence of blocks that makes Bitcoin transactions irreversible.
Double Spending Issue
Before Bitcoin, the problem of double-spending did not allow organizations to create a digital currency. Double-spending means that the user will spend the same digital tokens more than once. If one token can be spent several times, this will harm the virtual economy because such currency will not be reliable.
Satoshi Nakamoto has come up with innovative solutions that partly revolutionize the digital economy.
First, all transactions must be publicly available. Secondly, all network participants must agree to the same sequence of transactions – a single and true version of the procedure for receiving transactions. For example, sending the same coin to two different sellers will not work, because different timestamps will make the second payment (attempt of double spending) invalid.
In other words, everyone is in agreement, which allows each node, the miner, to determine whether certain transactions are valid or not. Everyone also adheres to the same time sequence, so invalid payments will not be allowed and/or not detected by unique timestamps.
Nakamoto also talks about how a peer-to-peer network works. New transactions are broadcast to all computers on the network. Each computing node combines transactions into a block, forming a chain of blocks – a blockchain. A block is valid only if all transactions in it are valid and the coins have not been used up before.
Due to the lack of a central authority that determines the fate of bitcoins, the motivation for nodes (miners) is arranged in a peculiar way. Miners receive a reward in bitcoins for ensuring the functioning and security of the network. At the same time, motivation is a mechanism by which new bitcoins come into circulation. In other words, it is the miners who mine new coins.
Satoshi Nakamoto says the processes described above create added value due to the time and resources spent creating bitcoins, like gold mining.
Stable addition of a fixed amount of new coins is similar to how gold miners spend resources to add gold to circulation. In our case, time, computing power and electricity are wasted.
When a pre-set number of coins comes into circulation, the motivation will be able to completely switch to transaction commissions and inflation will finally stop.
Bitcoin is not free, and its creation is expensive. This makes it a useful store of value and a medium of exchange in a peer-to-peer network that does not require trust. Unlike the fiat currencies issued by governments and central banks, Bitcoin is not subject to inflation. After all, you can’t create it on your own – there will be exactly 21 million bitcoins.
Nakamoto claims that the network’s reward system encourages the nodes to remain honest and that it will be difficult for attackers to attack Bitcoin.
A potential hacker will inevitably discover that it is more profitable to play by the rules that will give him more new coins than all the others together – than undermine the system and, therefore, the reality of his own wealth.
Traditional banks achieve it by restricting access to information. In Bitcoin, confidentiality is achieved through the anonymity of public keys. Outsiders can see the amounts sent and received by addresses, but transactions are not tied to any personal data.
The network is robust in its unstructured simplicity. All nodes operate simultaneously with minimal coordination. They do not need to be identified, because messages are not sent to a specific place, but should only be delivered in an optimal way.