Introduction
The Bitcoin whitepaper has commonly been quoted as a piece of ‘must-read’ literature when one delves into the world of cryptocurrency. However, the paper itself can be highly technical and requires a background in previous digital currencies.
In this post, you will get acquainted with the Bitcoin whitepaper in 15 minutes- learn sufficient to know how things work and have a foundation to build your understanding of other crypto projects.
At the end of the post, I will link to other (longer) sources to allow you to delve deeper into the topic if you so desire.
Ready? Let’s get the timer going.
Significance
The Bitcoin whitepaper is significant in the fintech world as it solves the double spending problem in a trustless environment.
The double spending problem is as follow: without a central authority, it is hard to verify if a person has spent a certain amount of money. Thus, it may be possible for the person to spend the same $3 more than once.
Let’s look at how we have solved this in the physical world, then turn to the digital world.
Physical world
Physical scarcity of cash dictates that it cannot be double spent. If you hand over a dollar to the retail store counter, you simply do not possess that dollar anymore.
Digital world
We have previously solved the problem by relying on intermediaries like banks. We trust that when we pay a dollar to the retail store counter, the bank will debit a dollar from our account and credit a dollar to the retail store account.
Without a central authority, it is hard to ascertain if the dollar has indeed been debited/credited respectively. And without this constraint leading to scarcity, digital currencies essentially become worthless.
Solution
The key innovation of Bitcoin is that instead of trying to create trust among participants, it sidesteps the issue altogether by assuming low trust. It uses cryptography to ensure that the double spending problem will not happen.
Quick aside: What is cryptography?
The official definition: "The practice and study of techniques for secure communication in the presence of adversarial behavior."
Trivially, think of how you (used to) send letters. You may use a combination of enclosing the letter, secret codes, and signatures to ensure that your message is received securely. You have already practised simple forms of cryptography!
A walkthrough of how Bitcoin works
Bitcoin is set up as a peer to peer network of computers (i.e. these computers can communicate directly with each other). All participants on this network keep a record of timestamped transactions- it is a way to keep track of ‘who has what at when’.
Steps (in layman’s terms)
There are 2 types of participants- average users and miners. Average users are mainly concerned with the amount of Bitcoin they have, while miners need to keep track of the state (who has what at when).
When an average user Alice wishes to transact, she will shout “I want to pay Bob $5”.
All the miners will take note of this desired transaction and write it down on their whiteboard (in technical terms it is known as a block, but it is easier to visualize it as a whiteboard).
Each miner will try to solve a tough computation problem for their own whiteboard. (This tough computation problem has a special name- hash puzzle. Read more below.)
Once a miner has found a solution to the tough computation problem, they will inform the network about this solution.
Other nodes in the system (more specifically, full nodes) will verify the solution and transactions in the proposed block. If all pass, then the proposed block will become the block that other participants in the network continue to extend.
At this point, Alice will have effectively paid Bob $5!
Hash puzzle
It may be hard to understand the significance of the ‘tough computation problem’ mentioned in Step 4 if we do not explain what a hash puzzle is.
The hash puzzle is as defined: given the previous block’s summary and transactions in the current block, the miner has to find an unique value such that putting the unique number, previous block’s summary and current block’s transactions into a function (you can think of it as a special recipe) gives a number smaller than a target value.
There are 2 key attributes:
This unique number has to be found randomly, i.e. there is no ‘shortcut’ to get this number.
The function (aka our special recipe) will change its output even if its inputs were only marginally changed.
To put it in layman’s terms, imagine that you have a chef whose goal is to cook an amazing meal. This chef already has some prepared ingredients (previous block’s summary) and raw ingredients (current block’s transactions). He is looking for that unique spice. In addition, the cooking process (function) is very sensitive; if you change any of the inputs, the taste of the meal will be changed noticeably.
Thus, the hash puzzle is significant for 2 reasons:
Every miner’s node has the same chance of finding that unique answer. This implies that to ‘take over’ the system, a miner needs lots and lots of nodes, something that’ll be very financially expensive.
Because the function is so sensitive, a rogue miner is unable to change any previous transaction without others noticing (because the output will change as well). This adds security to the system.
Distributed consensus
Longest chain principle
In the original Bitcoin whitepaper, Step 6 of this transaction process has a special significance- it is the longest chain principle. Given that theoretically there may be thousands, or even millions, of participants wanting to transact at each moment, it is hard to get a consensus of the order of transactions.
A trivial example- if your long-lost aunt is 200m away from you and wishes to transact, you may note her desire to transact to be after your best friend’s (who happens to be right beside you), even though they both expressed their desire to transact at the same time.
Thus, the longest chain principle in Bitcoin dictates that the longest chain in Bitcoin is the ‘truth’. This helps individual nodes reach consensus on the current state of the system.
Most cumulatively worked valid chain
However, in July 2010, Satoshi Nakomoto changed from the longest chain to the most cumulatively worked valid chain as the principle to reach consensus.
The most cumulatively worked valid chain is as defined:
The sum of the difficulty of the hash puzzles in that chain has to be the largest among all chains
All transactions in all blocks of that chain have to be valid
This was to ensure that true proof of work was preserved, as it is theoretically possible for a lone miner to build the longest chain without actually invoking as much computational resources.
Keeping the system honest
While we now have an overview of the steps involved in each transaction, it is still not clear why/how miners and participants are kept honest. We will investigate the incentive structures in place to maintain honesty from each perspective.
How do we keep the miners honest?
Miners get block rewards, which breaks down into 2 parts:
Miners are paid mining fees when their block (whiteboard in our earlier analogy) gets accepted.
Miners are also paid transaction fees for verifying transactions.
However, what stops miners from simply verifying invalid transactions? The answer lies in the economic incentive underlying Bitcoin- if miners start to validate invalid transactions, the average participant will begin to lose faith in the value of their Bitcoin. This will encourage the average participant to leave the Bitcoin system. The value of Bitcoin will then drop, and miners will have wasted their prior computation resources to mine Bitcoins that are now worth less.
How do we keep participants honest?
The average user who wishes to transact with Bitcoin are ‘forced’ to be honest. This is so as invalid transactions will not be accepted by miners (due to the reasons mentioned above). In addition, they bear transaction costs, and are thus disincentivized to participate in spam transactions.
51% attack
While the average miner and participant may be incentivized to be honest, it is theoretically possible for a hostile individual to gain a majority of the computational resources in the Bitcoin ecosystem (thus the name 51% attack). With such a majority, the hostile individual is then able to ‘edit’ the current consensus by going back to a specific block in the chain, link a new block to that old block, and build on the new block. (Recall that consensus in the Bitcoin system is reached via the longest chain principle. Thus, the hostile individual’s goal is to build a chain that is longer than the current one.)
While this may get prohibitively expensive and more improbable as the longer, honest chain continues to extend, there is a greater concern. Should the average participant/miner becomes aware that there is an individual with > 50% of the computational resources, then the very fear of a 51% attack may drive them away from the system. This will lead to the decline and possibly death of Bitcoin, since there is no faith in the value of the currency.
Dive deeper
But how does bitcoin actually work? by 3Blue1Brown
Bitcoin and Cryptocurrency Technologies: A Comprehensive Introduction (a very in-depth read, chapters 1-3 can help you lay a very solid technical foundation)
Conclusion
You now have a basic understanding of Bitcoin. Using this as our foundation, we will build on our understanding with newer blockchain projects such as Ethereum and Solana. Do subscribe to keep updated with new posts, and please comment if you have any questions/feedback!