A beginner’s guide to bitcoin: the technical genius behind bitcoin and the blockchain – and how it all works
In the second in his series on bitcoin, Dominic Frisby looks at the blockchain – bitcoin’s unique underlying architecture – and what makes it and the cryptocurrency so revolutionary.
In September 1992 computer scientist Tim May, whose inventions had once made him a great deal of money at Intel, invited a group of eminent, free-thinking programmers to his house near Silicon Valley in California. They were there to discuss this exciting new development called “the internet”.
They were excited about the possibilities, but they were also concerned. Privacy was their issue. On the internet, banks, credit card companies, merchants, and – most worryingly for May and his friends – the government, would all have access to vast quantities of payment information. How would they use it? They were scared of Big Brother.
Their mistrust was born of experience. Their friend, the programmer Phil Zimmerman, was under criminal investigation for a simple piece of privacy software he had developed – PGP (pretty good privacy). US authorities claimed he had violated the Arms Export Control Act.
Their solution was to develop computer code, especially in the field of cryptography, that protected privacy. By the end of the meeting, an anarchist philosophy had been born, that of the “Cypherpunks”. They believed that cryptography could lead to social and political change.
They were a committed, disparate and in some cases, extremely able group of computer scientists and coders; their belief system was largely libertarian; and while they understood the potential of the internet, they also saw the possibilities it was opening up for state and corporate invasion of privacy.
Your spending habits say more about you than anything. So the ultimate dream of the movement was a system of anonymous cash, beyond the invasive capabilities of governments or banks. For years these brilliant coders tried to develop a system to digitally replicate the cash transaction. But they had a problem.
Bitcoin mining and the “double spending” problem
If I send you an email or a picture or a video – any type of digital code – you can copy and paste that code and send it to a hundred or a million different people. If you can copy and paste money, it instantly loses its scarcity and value, so it is useless. This problem was known among coders as the problem of “double spending”.
Nobody could find a way round it without using a middleman of some kind to verify and process transactions. But a cash transaction has to be direct from A to B. There can be no middleman. Try as they might, nobody could come up with a system that worked. By the early 2000s, most had given up even trying. Internet cash was an impossibility.
The genius of bitcoin that so caught the attention of coders was that it solved this problem. Satoshi Nakamoto's invention was a new system of record-keeping – an enormous automated database, which verifies transactions. A transaction is only complete once it is recorded on that database; once it is recorded, it is final. The database is public for all to see and it is maintained, not by any one individual or corporation, but by computers across the bitcoin network – it is “decentralised”, to use the buzzword.
If I want to, I can set up my computer to run the bitcoin software and maintain this database. In exchange for doing this, the network will sometimes reward me with bitcoins. This is the process known as “mining” – you're bound to have heard of it. This amazing database, which makes the digital cash transaction possible, is known as the “blockchain”.
Every ten minutes a new set of transactions is processed and verified – that is to say a new block is mined. Once the verification process is complete, a new block is added to the blockchain. Each block is permanent. Many have tried, but none have succeeded in hacking this immutable database. It is the most secure digital technology ever invented.
But not every computer receives the bitcoin reward every ten minutes. Only one does. A plethora of computers around the world are competing with each other to get the reward. The more powerful the computer, the more likely it is to successfully mine the block, and so the power of the computers mining bitcoin keeps growing. As a result bitcoin gets stronger and stronger. Even though only one computer receives the world, all the competing computers contribute by verifying and processing transactions and so make the network stronger.
Whereas once bitcoins were cheap and easy to mine, now the network has grown extraordinarily powerful, consuming vast amounts of electricity in the process (you can read more about that and its climate implications here).
It is like the concept of Adam Smith’s “invisible hand” – the idea that an individual acting in their own self-interest benefits society as a whole. Each individual miner is acting in their own self interest. They are putting their computer to work in the hope of receiving a bitcoin reward. But in doing so bitcoin benefits, because that miner’s computer power helps the network grow and strengthen.
So that is the principle of how bitcoins are created and how the network functions. Even if you don’t understand it straight away, you will come to, in time. The main takeaway is this: the network is incredibly robust. The blockchain cannot be tampered with. The inflation rate is set in code, so that everybody knows exactly how many bitcoins there are.
If you’d like to read more, Dominic has put together a downloadable Beginner’s Guide to Bitcoin for MoneyWeek subscribers, which includes a bonus section on other cryptocurrencies. If you’re not already a subscriber, sign up now to get the report plus your first six issues free.