Bitcoin Foundations, Part 1

Bitcoin – Origins of an idea

As with any idea, the concept of Bitcoin started because of an observed loophole in the market. There seemed to be no system in existence that enabled one to make payments over a communicative channel without a trusted third party. For Bitcoin it was the observation that in the commerce on the Internet, reliance on financial institutions such as banks or even PayPal have become trusted third parties that process electronic payments, where completely non-reversible transactions are not possible, because they cannot avoid mediating disputes.[1]

The problem with mediation is that the cost of it increases transaction fees and limits the minimum practical transaction size, therefore cutting off the possibility of small casual transactions.

Because of the possibility of reversible transactions, the need for trust spreads, as does the need for banks. Merchants need to be cautious about their customers and customers are hassled for more information. A certain percentage of fraud cannot be avoided under trust-based Internet commerce.[2]

The costs and payment uncertainties under this system seem to be avoidable only through face-to-face transaction using physical currency.

This is where Bitcoin comes in.

Summary of how Bitcoin works

The basic idea behind it is that an electronic payment system based on cryptographic proof will enable any two willing parties to transact directly with each other, without the need of a trusted third party, such as banks or PayPal.

Protection from fraud will be secured by making transactions computationally impractical to reverse.

The only problem, double-spending[3], can be solved by using a peer-to-peer distributed timestamp server that generates computational proof of the chronological order of transactions.[4]

The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

Transactions

A transaction is a transfer of value between Bitcoin wallets that is then included in the block chain. Bitcoin wallets have a private key, or seed, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet. The signature also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and usually begin to be confirmed by the network in the following 10 minutes, through a process called mining.[5]

Transactions consist of the sender’s (Owner 1) Public Key that is inserted into the hash. At the end of the hash, the recipient (Owner 0) adds his own Signature.

An electronic coin is a chain of digital signatures. For a transfer of a coin from one person to another, the current owner has to:
a.     Digitally sign the hash of the previous transaction and the public key of the next owner AND
b.     Add these to the end of the coin.

A hash is a summary of all previous transactions related to a particular coin.

The way the double spending problem is solved is by letting the recipients find out if the previous owners of the coin has signed any earlier transactions, because for the purposes of Bitcoin, the earliest transaction is the one that counts – which makes transactions very difficult to reverse.  To accomplish this without a trusted third party, transactions must be publicly announced, and the system requires participants to agree on a single history of the order in which they were received.

Timestamp Server

A timestamp server works by taking a hash of a block of items to be timestamped. After that the hash is widely published (like information in a newspaper). The timestamp proves that the data must have existed at the time in order to be in the hash.

Each timestamp includes the previous timestamp in its hash and forms a chain with each additional timestamp reinforcing the ones before it. [6]

________________________________________________________
[1] Bitcoin: A Peer-To-Peer Electronic Cash System, Satoshi Nakamoto 2009 p.1

[2] ibid

[3] If a malicious user tries to spend their bitcoins to two different recipients at the same time, this is double spending. (via https://bitcoin.org/en/vocabulary stand 27.04.2014)

[4] ibid

[5] https://bitcoin.org/en/how-it-works stand 28.04.2014

[6] Bitcoin: A Peer-To-Peer Electronic Cash System, Satoshi Nakamoto 2009 p. 2