2. Introduction
Encrypted currency is a crypto-protected digital or virtual currency,
which makes counterfeiting or double spending almost impossible.
Many cryptocurrencies are decentralized networks based on block-
chain technology, a distributed ledger applied by different computer
networks.
A defining characteristic of cryptocurrencies is that they are
generally not issued by any central authority, making them
theoretically immune to government intervention or
manipulation.
2
3. The most famous cryptocurrency, Bitcoin began with a white paper
written under the pseudonym "Satoshi Nakamoto" and published in
2008
It was sent via a cryptography email list and had the look of an
academic work
The original goal of Bitcoin's inventors was to create a cash-like
payment system that allowed for electronic transactions while
also retaining many of the benefits of actual cash
3
Bitcoin Creation
4. A physical object, such as a coin or a note, is used to represent Cash
When this thing is given to another person, its unit of value is
transmittedas well, without the requirement for a third party
Between the buyer and the seller, there is no credit relationship
As a result, the parties involvedcan maintain their anonymity
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Physical Cash vs. Digital cash
5. The major benefit of physical cash is that whoever has the physical
objectis automatically the owner of the unit of value.
This ensures that the property rights to the circulating units of value
are always evident, without the need for a central authority to keep
accounts
Furthermore, under a cash payment system, any agent can
participate; no one is excluded. It can be accessed without a password
Cash, on the other hand,has drawbacks. In order to trade, buyers and
sellers must be physically present at the same area, which makes it
impractical in many instances
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Physical Cash vs. Digital cash
6. For digital money (or cash) A perfect payment system would be
one that allowed for the electronic transfer of monetary value via
currency data files. These cash data files would have all of the benefits of
actual cash while also being able to travel freely via technological
networks
This type of data file could be delivered by email or social media.
Electronic data has the advantage of being able to be duplicated
indefinitely at a low cost
For money, this function is quite undesired
Cash data files cannot be utilized as a payment instrument if they may
becopied and the duplicates used as currency
The “double spending
problem” is the name given to this issue.
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Physical Cash vs. Digital cash
7. 7
Traditional electronic payment systems are based on a central
authority that checks the authenticity of the payments and keeps
track of the current state of ownership to combat the problem of
double spending
A central authority (typically a bank) maintains the accounts of
buyers andsellers in such systems. By submitting an order, the
buyer starts the payment process.
The central authority then verifies that the buyer has sufficient
monies and updates the accounts to reflect this
Physical Cash vs. Digital cash
8. The problem of duplicate spending is solved by centralised payment
systems, but they require confidence
Agents must have faith that the central authority will not abuse its
delegated authority and will keep the finances in order in any part of
the world—in other words, that the banker will not run away with
the money.
Additionally, centralized systems are subject to cyber-attacks,
technical breakdowns, and malevolent governments that can simply
intervene and seize funds
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Physical Cash vs. Digital cash
9.
10. The lack of a centrally controlled ledger is a critical aspect of the
Bitcoinsystem (and other cryptocurrencies). There is no central
authority withsole power over accounting.
Bitcoin is a digital currency that does not have a physical form. A
Bitcoinunit is divisible, and the smallest portion of a Bitcoin is 100
million Satoshis.” The Bitcoin Blockchain is a data file that
contains the recordsof all previous Bitcoin transactions,
including fresh Bitcoin unit generation
It is frequently referred to as the Bitcoin system's ledger. TheBitcoin
Blockchain is made up of a series of blocks, each of which builds on
the previous one and contains data about new Bitcoin transactions
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Blockchain
12. The average time between Bitcoin blocks is 10 minutes. The first block,
block #0, was created in 2009; and, at the time of this writing, block
#689481 was appended as the most recent block to the chain
Because everyone can download and read the Bitcoin Blockchain, it is a
publicrecord, a ledger that contains Bitcoin ownership information for
any point in time
The term "ledger" must be qualified in this context.
Blockchain does not exist in a single instance. Instead, each
participant is in charge of his or her own ledger copy. There is no
central authority withexclusive accounting rights, as there was with
stone money. Instead, there is a set of pre-determined rules and the
ability for individuals to monitor that other participants follow the rules.
12
Blockchain
13. The concept of a "public record of ownership" must also be
qualified because Bitcoin unit owners are typically anonymous due to
the usage of pseudonyms.
To use the Bitcoin system, the agent needs to download a Bitcoin
wallet.
A Bitcoin wallet is software that allows you to receive, store, and send
Bitcoin units.
The next step is to convert fiat currencies (such as U.S. dollars) into
Bitcoin units.
The most common method is to open an account on one of the many
Bitcoin exchanges and transfer fiat currency to that account.
Account holders can use these funds to buy Bitcoin units or one of the
many other crypto assets on the exchange.
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Blockchain
14. Due to the widespread adoption of Bitcoin, prices on large exchanges
are very competitive, with relatively small bid-ask spreads.
Most exchanges provide order books and many other financial
instruments that make thetrading process transparent
The buyer broadcasts to the network that the seller's bitcoin address
is the new owner of a specific bitcoin unit. This information is
distributed over the network until all nodes are notified of the
transfer of ownership
For virtual currency to work, it is crucial to determine at each
moment how many monetary units exist and how many new units are
created.
There should also be a consensus mechanism to ensure that all
participants agree on the ownership of virtual currency units.
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Blockchain
15. In the Bitcoin system, the number of participants is high, and the
network participants can remain anonymous.
Hence, there is a consensus mechanism that allows the Bitcoin system
to reach an agreement. This consensus mechanism is the core
innovation of the Bitcoin system, and consensus can be reached on a
larger scale without any personalrelationship
To understand the consensus mechanism of the Bitcoin
system, we must first discuss the role of miners.
Miners collect pending bitcoin transactions, verify their legitimacy,
and combine them into so-called "candidate blocks." The goal is to
earn newlycreated Bitcoin units through this activity.
If the miner can persuade all other network participants to add his
candidate block to their copy of theBitcoin blockchain, he can achieve
this
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Mining
16. Anyone can become a miner by downloading the corresponding
softwareand the latest copy of the Bitcoin blockchain.
However, in practice, there are some large miners that produce most
of the new generally accepted blocks
The reason is that competition has become fierce and only large
mining farms with highly specialized hardware and cheap electricity
can benefit from mining
For a generally accepted candidate block, it must meet a specific set
of predefined criteria. For example, all included transactions must
be legal. Another important criterion is the so-called "fingerprint"
of the candidate block.
The miner obtains this fingerprint by using the dSHA256
hash function to calculate the hash value of the candidate
block
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Mining
17. For example, we will see the hash value of the text "Federal Reserve
Bankof St. Louis". The fingerprint of the text calculated using the
dSHA256 hash function is
72641707ba7c9be334f111ef5238f4a0b355481796fdddfdaac4c5f2320eea68
Now pay attention to the minor changes to "federal Reserve Bank of St.
Louis" in the original text. It will cause unpredictable fingerprint
changes,as can be seen from the corresponding new hash value :
423f5dd7246de6faf8b839c41bf46d303014cffa65724ab008431514e36c4dba
As shown in this example, the hash value of the data file cannot be
predicted
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Mining
18. This function is used in the mining process as follows. For a candidate
block to be accepted by all miners, its fingerprint must have an extremely
rare feature: the hash value must be below a certain threshold, that is,
it must show several zeros at the beginning of the fingerprint.
Miners are constantly trying to find candidate blocks whose hash value
meets the above criteria. To this end, a block includes a data field (called a
random number) containing arbitrary data. Miners modify these arbitrary
data to obtain new fingerprints These changes will not affect the included
transaction set.
In our example, each modification will generate a new hash value. Most of
the time, the hash value is higher than the threshold and the miner
discards the candidate block. However, if miners successfully create a
candidate block with a hash value lower thanthe current threshold, they
will transmit the candidate block to the network as soon as possible.
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Mining
19. All other network participants can easily verify that the fingerprint
meets the threshold standard by reporting fingerprints by themselves
The consensus among miners is that every miner who receives a
candidate block with a valid fingerprint will add it to his
copy of the Bitcoin blockchain.
From a game theory perspective, the strategy profile for all miners to
add valid blocks to their own copy of the Bitcoin blockchain is the
Nash equilibrium.
If a miner believes that all other miners have acted accordingly, then
the miner would better add valid candidate blocks to their own copy
of the Bitcoin blockchain.
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Mining
20. Deviation is not worthwhile, because there is no profit to work on a
version of the Bitcoin blockchain that is not universally accepted.
Any reward for finding a block in a version of the chain
that no one else would accept is worthless.
Therefore, although there is no right to enforce this rule, miners can
freely modify their copy of the blockchain according to their own
wishes, but they have a strong motivation to follow this rule.
This self-enforcing rule allows the network to reach consensus on the
ownership of all units of Bitcoin.
Mining is expensive because calculations use a lot of electricity and
relymore and more on highly specialized hardware
In addition, valid candidate blocks can only be found through error
proofing procedures
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Mining
21. Therefore, the consensus mechanism is called "Proof of Work". If
minersfind valid fingerprints of block candidates, it proves that
they perform a lot of expensive calculations on average
Adding false information (for example, illegal transactions) to
the candidate block invalidates the candidate block and
essentially wastes all calculations
Hence, finding a valid fingerprint to prove that the miner helped
maintain the Bitcoin system.
Every payment system needs to regulate how new monetary units are
produced (or destroyed)
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Mining
22. The Bitcoin network is calibrated in such a waythat, on average, a block
with a valid hash value is found every 10 minutes.
The winner of the mining contest will receive a predetermined number
of newly created Bitcoin units. The current figure is 12.5.
In the Bitcoin system, currency creation is planned, so the number of
Bitcoin units will converge to 21 million units
This limitation exists because the miner's reward is cut in half
every 210,000 blocks (roughly every four years). Consequently,
miners will get more and more rewardsthrough transaction fees.
But even today, just paying enough fees to motivate miners to include
transactions in their candidate blocks can guarantee fast transaction
processing
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Mining
24. Most Bitcoin users believe that the limited supply of Bitcoin will lead to
deflation. In other words, they believe that their value will always
increase.
In fact, we have witnessed an incredible price increase so far, from the
value of a Bitcoin unit of $ 0 in 2009 to the value of $ 34572 atthe time
of this writing
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Bitcoin Value
25. However, these beliefs must be challenged. Bitcoin units have no
intrinsicvalue. Therefore, the current price of a currency depends
entirely on the expectations of its future price.
Only when the buyer assumes that the unit will be sold at least at the
same price in the future, will he be willing to buy the unit of Bitcoin.
Therefore, Bitcoin's price reacts very flexibly tochanges expected by
market participants and is reflected in extreme price fluctuations.
From monetary theory, we know that money without intrinsic
value has many equilibrium prices. One of them is always zero.
If all market participants expect Bitcoin to be worthless in the future, no
one is willing to pay any price for it today. However, Bitcoin is not the
only currency that has no intrinsic value. National monopoly currencies,
such as the US dollar, the euro, and the Swiss franc, also have no
intrinsic value. They are legal tender created bygovernment decree.
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Bitcoin Value
26. The history of state monopoly coins is a history of large price
fluctuations and failures. This is why decentralized cryptocurrencies are
a welcome addition to the existing monetary system
In the Bitcoin system, the path of money supply is predetermined
by theBitcoin protocol written in 2008 and early 2009. Since then,
many changes have taken place in the Bitcoin protocol. Most of
these changes are not controversial and improve the way the
Bitcoin system works.
However, in principle, all aspects of the Bitcoin protocol can be modified,
including the money supply. Many critics of Bitcoin consider this to be a
major drawback.
In theory, this is correct. Any participant in the network can decide to
follow a new set of rules, such as doubling the number of newly created
"Bitcoin" units in its version of the ledger.
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Bitcoin Protocol vs. Government
27. However, such a modification is worthless, because it is almost impossible
to convince all other network participants to comply with this new set of
rules.
If the protocol change is not unanimously supported, there will be a
so-called fork, that is, a network split, resulting in two coexisting
blockchains and essentiallycreating a new type of encrypted asset.
In this case, there will be Bitcoin (the original version) and Bitcoin42 (a
possible name for an alternative implementation, capped at 42 million
Bitcoin42 units).The market will set the price of the original and newly
created Bitcoin42assets based on the expectations and support of the
community
Therefore, although it is theoretically possible to increase the supply of
Bitcoin, in practice, the possibility of such a change is very small, because
a large part of the Bitcoin community will strongly oppose this attempt.
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Bitcoin Protocol vs. Government
28. In addition, the same criticism can be made against any statutory
currency system operated by the current government. For example,
sinceWorld War II, many central banks have become independent to
protect them from political interference that has some undesirable
consequences
This independence is granted by the respective parliament or related
agencies and can be cancelled if the politician decides. Political
interference in the fiat currency system can be explained as a change in
the "fiat currency agreement" Undesirable changes in the legal tender
agreement are very common, leading to the complete destruction of the
value of the relevant legal tender on many occasions
It can be said that,to some extent, the Bitcoin protocol is stronger
than many existing fiat currency protocols. Only time will give the
answer.
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Bitcoin Protocol vs. Government
29. Bitcoin transaction processing demands that three requirements are
satisfied:
1. Transaction capability
2. Transaction legitimacy
3. Transaction consensus
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Transactions Requirments
30. What must be resolved is how to initiate transactions without a central
authority.
In the classic banking system, customers talk to their advisors or
submit their payment instructions through the bank's online banking
service.
The infrastructure provided by commercial banks and other central
service providers ensures that transactions will be communicatedfor
execution. Without central authority, it is impossible to communicate
payment instructions in this traditional sense.
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Transaction Capability
31. In the Bitcoin system, payment instructions can be sent to any number of
nodes on the network.
Network nodes are linked to each other in a loose network and forward
messages until all nodes are notified of the transaction.
Decentralizing the system has many advantages. In particular, it
makes the system extremely robust.
There is no central point of failure that can be attacked, and no
system-related node that can cause the system to crash.
Therefore, even when some nodes in the network are inaccessible, the
system can function normally, and new connections and communication
channels can always be established
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Transaction Capability
33. Each participant can generate new payment orders and distribute
themto the entire network.
There is a risk of fraudulent messages with this feature. In this
regard, two important questions have arisen :
1. How does the node know that the initiator of the transaction is
the legal owner and therefore has the right to transfer Bitcoin
units ?
2. And How to ensure that transaction messages are not
tampered with before moving from one node to the next ?
In the Bitcoin system, asymmetric cryptography is used to
guarantee thelegality of transactions.
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Transaction Legality
34. The idea is based on using a key pair consisting of a Secret key (sk)
and a public key (pk).
The Secret key must not be shared. It corresponds to a random value
from a very large set of numbers.
On the other hand, the public key is derived from this number and can
be freely shared. It servesas a pseudonym on the Bitcoin network
The private key is used to encrypt a message, and the message can only
be decrypted with its corresponding public key. This type of encryption
isalso called a "signature." The signature clarifies that this method is not
used to hide any information in the encrypted message. Anyone can
simply use their public key to decrypt the message, but the signature
can prove that the message was previously encrypted with its
corresponding secret key; it is like a handwritten signature, but more
secure .
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Transaction Legality
35. For example, consider Esraa, who wants to send a Bitcoin payment to
Dalia through the Bitcoin network. She uses her secret key to encrypt the
message. Other network participants can only use Esraa's public key to
decrypt this message. If the attempt is successful, it will ensure that the
message is encrypted with the corresponding private key. Since no one
else has access to Esraa's secret key, this method can be used to verify
theorigin of the transaction
When the transaction circulates on the network, any participant on the
network can decrypt this message and later change the payment
instruction. However, since the participant does not have Esraa's secret
key, they cannot re-encrypt the tampered message.
Therefore, the manipulated transaction will be recognized and rejected
by the rest ofthe network
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Transaction Legality
37. o We have now discussed how transaction information is communicated
and how to verify its legitimacy and source.
o We also explain how to reachconsensus on the ownership of Bitcoin
units on the Bitcoin network by using a proof-of-work consensus
protocol
o However, Esraa will be able to generate two transactions that refer to
the same Bitcoin unit. Both transactions can be simultaneously
distributed on the network (transaction capacity) and both will show a
valid source (transaction legitimacy).
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Consensus of Transactions
38. o Due to the different propagation methods of these two messages on the
Bitcoin network, some nodes will receive the message from transaction A
first, while other nodes will receive the message from transaction B first.
To avoid double spending, it is important that only one of the two
transactions can enter the Bitcoin blockchain. Therefore, a mechanism is
needed to decide which of the twotransactions to include in the blockchain
o The Bitcoin system cleverly solves this double spending problem.
o A transaction that is added to the valid candidate block first and thus
addedto the blockchain is considered confirmed.
o The system stops processing another, that is, miners will stop adding
conflicting transactions to their candidate blocks. Also, it is impossible for
miners to add conflicting transactions to the same candidate block. Such
blocks will be illegal and therefore will be rejected by all other participants
on the network
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Consensus of Transactions
39. Much like any other key innovation, blockchain technology
introducessome risks.
Forks
As previously discussed Bitcoin protocol can be altered if the
network participants, or at least a sufficient number of them, agree on
the suggested modification. It can happen (and in fact has happened)
that ablockchain splits because various groups cannot agree about a
modification.
A split that persists is referred to as a “fork.” The two best
known examples of persistent splits are the Bitcoin Cash fork and
Ethereum`s ideological dissent, which resulted in the split to
Ethereum and Ethereum Classic
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Risks
41. Energy Wastage
Proof of work mining is expensive, as it uses a great deal of
energy. Thereare those that criticize Bitcoin and assert that a
centralized accounting system is more efficient because consensus can
be attained without the allocation of massive amounts of computational
power.
Bitcoin Price Volatility
The price of Bitcoin is highly volatile. This leads us to the question
ofwhether the rigid predetermined supply of Bitcoin is a desirable
monetary policy in the sense that it leads to a stable currency. The
answer is no because the price of Bitcoin also depends on
aggregate demand. If a constant supply of money meets a
fluctuating aggregatedemand, the result is fluctuating prices
41
42. Bitcoin Price Volatility
In government run fiat currency systems, the central bank aims to
adjust the money supply in response to changes in aggregate demand
for moneyin order to stabilize the price level. In particular, the Federal
Reserve System has been explicitly founded “to provide an elastic
currency” to mitigate the price fluctuations that arise from changes in
the aggregate demand for the U.S. dollar.
Since such a mechanism is absent in the current Bitcoin protocol,
it is very likely that the Bitcoin unit will displaymuch higher
short-term price fluctuations than many governments run fiat
currency units.
42
44. Conclusion
The intention of the creators of Bitcoin is to develop a decentralized
electronic payment system similar to cash. In this process, they are
faced with the fundamental challenge of how to establish and
transfer digital property rights of a currency unit without central
authority.
They solved this challenge by inventing the Bitcoin blockchain. This
new technology allows us to store and transfer monetary units
without the need for a central authority, similar to cash .
Price fluctuations and scale issues often raise concerns about the
applicability of Bitcoin as a payment tool. However, as an asset,
Bitcoin and alternative blockchain-based tokens should not be
ignored. This innovation enables digital property to be embodied
without the need for central authority.
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45. References
1. Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash System.”
2008;https://bitcoin.org/bitcoin.pdf.
2. Berentsen and Schär, "A Short Introduction to the world of Cryptocurrencies"
3. Eli Dourado and Jerry Brito, "The New Palgrave Dictionary of Economics“
4. BBC
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