A bitcoin-primer


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A bitcoin-primer

  1. 1. A Bitcoin Primerby CoinLab.comAuthors: Chris Koss, Mike KossJanuary 1, 2012What if you could store and transfer money services closed without warning, disappearingsafely, securely, cheaply and quickly anywhere with their customers money.in the world yourself, without relying on anyoneelse? As users learned better and safer practices for handling their Bitcoin, price volatility decreased,Bitcoin is a new technology that has the and the price of a Bitcoin has climbed to overpotential of supplanting many of our $5. Many new services popped up includingcontemporary banking and money transfer margin trading and short selling, digitalservices (at least in the online economy). downloads, banking and escrow services, a World-of-Warcraft-style MMORPG where youWhat is Bitcoin? can gamble on everything with Bitcoin, web hosting, domain name registration, web design,The term Bitcoin refers to both the digital unit and currency exchanges.of stored value and the peer-to-peer network ofcomputers transmitting and validating How does Bitcoin work?transactions of these units. The project waspublicly launched in January 2009, by a A Bitcoin address is like a bank account, intomysterious inventor using the pseudonym which a user can receive, store, and send"Satoshi Nakamoto," whose identity is still a Bitcoins. Instead of being physically secured inmystery. For the first couple of years, it was a vault, Bitcoins are secured with public-keymostly just a novelty for computer geeks, cryptography. Each address consists of a publichackers, and idealistic anarchists. key, which is published, and a private key, which you must keep secret. Anyone can sendIn April 2011, Forbes Magazines Andy Bitcoins to any public key, but only the personGreenberg wrote an article describing the with the private key can spend them. Whilequalities of Bitcoin: it cannot be forged or addresses are public, nobody knows whichdouble-spent, controlled or inflated by any addresses belong to which people; Bitcoingovernment, it is not impeded by international addresses are pseudonymous.boundaries, has a geek-friendly economy of$30,000 per day, and some digital drug-dealers The Bitcoin protocol uses the strongesthave started accepting it. algorithms used by the NSA for encrypting Secret level documents. Anyone can generateThe price of a Bitcoin surged from less than a as many addresses as they want for free. Theredollar to over $30 as a new demographic are approximately as many possible Bitcoinbecame interested: speculators. Geeks who addresses as there are atoms in the Earth, sohad casually collected Bitcoin as a curiosity in generating duplicate addresses (and thus2009 found themselves sitting on tens, or even having access to someone elses funds) ishundreds, of thousands of dollars. Over the practically impossible. Most Bitcoin usersnext several months, Bitcoin prices were maintain a number of addresses, stored in aextremely volatile, dropping suddenly after each digital wallet.of a half dozen high profile incidents.Exchanges were hacked, Bitcoins were lost When someone wants to send money tofrom carelessness, viruses popped up which another user, they use software which creates astole any Bitcoin it could find, and some transaction containing the receivers addressA Bitcoin Primer -1- Jan-01-2012
  2. 2. and an amount, and cryptographically signs it January 2013), there will never be more thatwith their private key. This is published on a 21M total Bitcoins created. And since Bitcoinspeer-to-peer network which validates it against are almost infinitely divisible (up to 8 decimalthe senders public key, checks that the sending places), there is no fear that we wont haveaddresss balance is sufficient, and propagates enough Bitcoins to deal with an ever expandingit to all the other nodes on the network. economic base of Bitcoin-denominated transactions.A transaction does not become certified until itis included in a Block in the Bitcoin Block Chain. What are the benefits of Bitcoin?Today, there are thousands of computers Financial Self-Determinism and Controlmining on the Bitcoin network. Each computercollects transactions broadcast by other nodes The Bitcoin system is unique because it is theand tries to guess a number which solves an first digital store of value which can be safelyunpredictable cryptographic problem. A and securely saved and transacted bypowerful home computer can try 100s of individuals, without having to rely on a trustedmillions of numbers every second. The more third party. Once acquired and properlycomputers that mine, the more difficult finding a secured, Bitcoins cant be taken from theirsolution becomes; the difficulty is self-adjusting owner, by a thief, a bank, or a government.so that, on average, a new block is found every Neither can any entity freeze any account, nor10 minutes. The lucky computer that is the first prevent the owner from performing (essentiallyto find each block earns 50 Bitcoins for its free) transactions on the Bitcoin network.owner. Irrevocable TransactionsAs each Block is found, it is added to anever-growing Block Chain (now standing at Chargebacks are a big problem for manyover 150,000 Blocks). Any transaction listed in merchants. Virtually all current paymentthe Block Chain is deemed to be valid, and systems (credit card, inter-bank transfer,eliminates the possibility that Bitcoins can be PayPal, etc.) allow the consumer to refute adoubly-spent. Since the only way to re-write transaction, and have their funds returned tohistory in the Block Chain is to use more them. Merchants have to follow an expensivecomputing power than is available in the rest of dispute process to receive their money andthe Bitcoin network, it is generally deemed too sometimes pay fees of $10-$50 percostly for any single party to cheat (the raw chargeback. Merchants can be chargedcomputing power of the Bitcoin network is 10 additional penalties up to $25,000 if they havetimes that of the worlds largest supercomputing an unusually high rate of chargebacks.center). Online merchants have chosen to live with aThe Block Chain allows every Bitcoin client to certain amount of fraudulent chargebacks whileexamine the complete historical transaction expending company resources on variousrecord to determine the current account anti-fraud detection measures. In an effort tobalance of every public address in the system. minimize chargebacks, merchants typically ask their customers to reveal personal informationSince newly created Bitcoins are constantly about themselves beyond what is necessary toissued to miners, one would think that the deliver their product or service, leading to a losscurrency is inherently inflationary (with an ever of personal privacy for the consumer.expanding money supply). While that is true inthe short-term, the rate of issuing coins is Bitcoin transactions reverse the role of trust byscheduled to be cut in half every four years. So, being inherently irrevocable. Once certified inwhile 2.6M Bitcoins are created each year (until the Block Chain, a transaction cannot beA Bitcoin Primer -2- Jan-01-2012
  3. 3. (practically) reversed. It is incumbent on the public outcry, many still havent had theirconsumer to trust each merchant they are situations remedied.ordering from. Since there are many ways toestablish the credibility of a merchant (e.g., Alex King is an open source software developeronline ratings and word-of-mouth reputation), who stopped accepting donations when somethe Bitcoin trust system is a good match for of them started costing him money. In 2009,Internet commerce (verifying the after an anonymous user donated $1 ($0.67trustworthiness of merchants is much easier after PayPals fees), they charged back theirthan verifying the trustworthiness of all donation. PayPal then passed a $10consumers). chargeback fee onto King, without any prior warning. He says, "I was never able to issue aBecause Bitcoin payments cannot be reversed refund to avoid this charge - the refund link was(without the consent of the merchant), unavailable as the payment was listed as inmerchants can offer their products to a wider dispute."audience and require less personal informationfrom their customers. PayPal exposes sellers to the risks of frozen accounts and chargeback fees. The benefit ofNo Need for Middlemen PayPal, giving customers the ability to get their money back if they dont receive what they paidThe policies of payment processors are for, does not apply in the donation scenario.sometimes not well aligned with those receiving Bitcoin transactions are irreversible and can bemoney; e.g., people who take donations. accepted without a middle man. As a result, Bitcoin donations can be accepted withoutIn December 2011, Regretsy, a humorous worrying about these risks.snarky craft blog, raised donations to buyChristmas presents for children in families Low Cost Transactionsundergoing financial hardship. After raisingthousands of dollars, Regretsys PayPal In addition to the unanticipated risks of usingaccount was frozen. payment processors (e.g., frozen accounts and chargebacks), the known per-transaction costsWhen Regretsys writer, Helen Killer, contacted of these services can significantly cut into thePayPal support, she was told that her account profits of some businesses. PayPal, Googlewas frozen because PayPals "Donate" button Checkout and Amazon Checkouts rates allcan only be used by non-profit organizations. start at 2.9% + $0.30 per transaction,PayPal later admitted this is false: any company decreasing to 1.9% for merchants with overcan use a "Donate" button. But PayPal support $30,000 of transactions per month. Otherwisetold her "its not a worthy cause, its charity," viable businesses with low profit margins orand that she would need to make a new requiring many small transactions may not bewebsite if she wanted to keep raising money, profitable due to these fees.and that gifts couldnt be shipped to a differentaddress from the customer who paid for them Bitcoin transaction fees are voluntary and(which was odd during the holiday gift-giving payments can be accepted directly byseason). merchants. Assuming a gross profit margin of 20%, eliminating processing fees wouldBy publicizing her frustrating experience on her increase a merchants profit by 10%, as theseblog, she eventually got an apology from expenses would come directly off the bottomPayPal, and they unfroze her account. But line.there are many similar stories from otherPayPal users who have had accounts closed orfunds frozen. Without an audience to create aA Bitcoin Primer -3- Jan-01-2012
  4. 4. A World-Wide System What is a Bitcoin worth? The underlying value is a function of the demand of the currency byUnlike current payment processing systems, consumers, and their ability to use it toBitcoins are inherently world-wide and exchange it for other goods and services. Justmulti-national. There are no artificial barriers for as fiat currencies no longer are tied to the valuemaking payments across national boundaries; of an underlying commodity, like gold, Bitcoinsin fact, its impossible to verify a transactions are only valuable in as much as people wantcountry of origin. A merchant accepting Bitcoins them and use them.immediately has access to a world-wide market,without any risk of non-payment from those Numerous public exchanges exist for people tooutside his own countrys legal enforcement buy and sell Bitcoin in exchange for dollars orsystem. other currencies. This helps establish an underlying comparative value and allowsAn Inflation Hedge for Long-term merchants to cash out of their Bitcoin holdingsSavings on a regular (e.g., daily) basis, minimizing their exposure to any currency volatility of Bitcoins.Because the lifetime creation limit is 21M While Bitcoins have fluctuated in value betweenBitcoins, it may be that they will be a good way $1 and $30 in 2011 alone, there areto store long-term value as a hedge against mechanisms for merchants to quote prices ininflation. This may be especially true for citizens dollar-equivalents (or other currency), and toof countries that are experiencing run-away exchange the Bitcoins they receive for otherinflation. If they can transfer their earnings to currencies immediately upon receipt.Bitcoins, they can be isolated from the rapidinflation of their native currency, and only An additional concern with the price volatility ofconvert back when needed to purchase goods Bitcoin is that the total value of all Bitcoinsor services using their native currency. mined so far is just over $30 million. This relatively small market cap, in conjunction withWhile this strategy is premature due to Bitcoins a lack of regulatory oversight, exposes Bitcoinvery volatile valuation today, it may become prices to market manipulation.common as Bitcoin becomes more widelyadopted and develops a history of value There is already significant speculation in onlinestability. forums about who may be manipulating prices and to what end. When Bitcoin speculators talkWhat are the Inherent Risks of about surprising market movements, theyBitcoins? discuss "The Manipulator," a shadowy individual or group who is manipulating theIrrevocable Transactions price of Bitcoin with their great wealth. Whether they have actually recognized a wealthy marketMerchants do not have to trust their customers manipulator or are anthropomorphizing theto verify payments, but customers have to now Invisible Hand of the market remains unclear.trust merchants to deliver the goods or servicesthey have paid for. There are methods to Anti-Inflationaryalleviate this problem; for example, use ofthird-party trusted escrow services which Noted economist Paul Krugman wrote an articlerequire merchants to post a performance bond in the New York Times criticizing Bitcoinsand enter into binding arbitration of disputes. anti-inflationary provision (due to the 21M Bitcoin creation limit). His argument is thatUnderlying Value and Volatility in Prices Bitcoins will cause people to hoard the currency rather than spend it. But we feel his argument ignores the near infinite divisibility of theA Bitcoin Primer -4- Jan-01-2012
  5. 5. currency. If Bitcoin values go up, people will still A computational attack would be very difficult todesire to spend some of their gains from the carry out today. The total computational powercurrency by using a fraction of what they own. of the Bitcoin network is the equivalent of overWhile fiat currencies are artificially inflated by 100 PetaFLOPs (the number of computations itexpanding government debts, Bitcoin will can perform per second). By comparison, this isremain relatively stable in value over time. about 10 times the speed of the worlds greatest supercomputer, Japans K computer,As a creditor, I would be happy to loan Bitcoins at 10.51 PetaFLOPs. The expense of creating aas I can be assured that they wont be artificially large supercomputer outweighs any potentialinflated before they are returned to me (with gains that could come from the ability to doubleinterest). spend a portion of Bitcoins.Contrary to his argument, we also have Because of the risk of double spending, it hasexamples where deflationary prices in some become common practice in the Bitcoinmarkets (consumer electronics and computers) community to wait for six confirmations (sixwould seem to predict consumers refraining ten-minute blocks to be added to the blockfrom purchases (why spend $2,000 on a chain after your transaction) before treating acomputer today when I can wait 2 years and get payment as received. While a scammer mightthe same computer for $500). Rather, we see a get lucky and reverse one or two blocks with anhealthy market providing ever-increasing value alternate chain and a great amount ofto consumers. computation, each additional block is exponentially more unlikely.Computational Attack Regulatory UncertaintyThe Bitcoin network recognizes the longestBlock Chain as the current valid ledger of all The legal classification of Bitcoin is still unclear:transactions. Block chains can only be it could be considered a commodity, a currency,extended with computation-intensive a financial product, or legally equivalent tocryptographic hashing. Anyone wanting to World of Warcraft gold. It remains to be seenmaliciously re-write the history of the Block what licenses and financial regulations BitcoinChain must have available greater businesses will be required to obtain. Thecomputational power than the entire remainder largest currency exchange market, MtGox,of the Bitcoin network. reportedly has experienced some difficulties wiring money because of money launderingCreating this "alternate history" does not allow investigations.transactions to be created without a private key,but it has the ability to erase transactions in the Bitcoin is inherently hard to regulate as there ispast. Theoretically, a scammer could buy a no central authority. Because transactions areproduct with Bitcoin, and once they receive it, semi-anonymous and accounts cannot berelease an alternate block chain, of greater frozen, it could become a medium of choice forlength than the current one, that does not money laundering, tax evasion, and illicit trade.contain the scammers transaction. Because Using the TOR anonymizing network, anythis new block chain is longer, and thus internet user with some technical savvy candemonstrates greater past computation, the access a service called the Silk Road, anetwork will accept it as the current, most-up-to marketplace for illegal drugs denominated indate block chain. This allows the scammer to Bitcoin.spend Bitcoin to receive a good, then reversehis transaction to keep both the good and the In the above respects, Bitcoin has very similarBitcoin (i.e., double-spending). characteristics to governmental paper currency, like US dollar bills (i.e., cash). They can both beA Bitcoin Primer -5- Jan-01-2012
  6. 6. transacted nearly anonymously without an 2. Online donations. Payments can optionallyeasily auditable paper trail. However, Bitcoins be publicly visible to demonstrate socialtechnological complexity may cause regulators proof of support for a charitable cause.to view it as a threat to the rule of law. The 3. Super Vault. A Bitcoin wallet can beregulatory classification and legality of direct created from a passphrase or stored on oneparty-to-party business transactions are still or more USB-keys. Bitcoins can beuncertain. deposited to the generated public addresses even when the wallet is offline. So there isRisk of Loss no risk of loss through online hacking; money can flow in, but is impossible to flowUsers of Bitcoin today have to ensure that they out without retrieving the offline wallet fromsecure their digital wallets from both loss and storage (or the memory of the wallettheft. This can be challenging, requiring use of creator).secure encryption, password management, and 4. Remittances. Inexpensive money transferinformation backup methods. There have been system across national boundaries. Agentssome high-profile cases where people made could accept cash in a developed country,mistakes and lost hundreds of dollars worth of and transfer Bitcoins to an agent in theBitcoin. With no central authority to appeal to, home country of a foreign worker, to bethese funds are truly unrecoverable. picked up by the family of the worker.It is important for Bitcoin adopters to employbest practices and use methods commensuratewith the potential for loss of their Bitcoinholdings.Is Bitcoin "The One"?The Bitcoin system is very young, barely 3years old. While it has an engaged communityof early adopters, many of whom have done adeep technical analysis of the security of theBitcoin protocol, there may be inherent flaws inthe design leading people to abandon thecurrency in favor of some other design (or tolose faith in the concept of a distributedanonymous currency altogether).Some competing digital currencies have beenproposed, but with much more limited adoptionthan Bitcoin has seen. It seems likely to us, thatBitcoin, or something very much like it, will be aviable option for many types of transactions andexchanges in the online world.Applications Well-suited to Bitcoin1. Online sales of digital goods. Customers can receive delivery immediately and the merchant gets a guaranteed irrevocable payment.A Bitcoin Primer -6- Jan-01-2012
  7. 7. References and Links1. Bitcoin: A Peer-to-Peer Electronic Cash System - by Satoshi Nakamoto (original paper)2. Bitcoin on Wikipedia3. We Use Coins - An Excellent introductory video.4. Bitcoin Forum - Online discussions of Bitcoin by early adopters and enthusiasts.5. Bitcoin Wiki - Technical information on the Bitcoin protocol, software, and services.6. Bitcoin.org - Primary download site for the "official" Bitcoin client (source code)7. BlockChain and Block Explorer - Online browsers of Bitcoin published transactions8. MtGox - The largest Bitcoin exchange (Dollars exchanged with Bitcoin) - live price and order book chart at MtGoxLive.9. Bitcoinica - The 2nd most popular Bitcoin trading site, offers margin and short-selling not offered on MyGox.10. TradeHill - Another popular (international) Bitcoin exchange.11. StrongCoin - An easy-to-use online digital wallet.12. InstaWallet - On-demand online wallet with no account needed - creates a private URL per address.13. DeepBit - One of the largest mining pools for Bitcoin with a combined compute power of 3,000 Giga-hashes per second (3 x 10^12 hashes/sec)A Bitcoin Primer -7- Jan-01-2012