Bitcoin and Beyond: How Does Bitcoin Work?

March 30, 2014

So, how is bitcoin different? First, it is a virtual currency with zero intrinsic value and no legal backing. Second, it has no central bank to manage the money supply—it is, in fact, devoid of any central authority.

How does bitcoin work? Andolfatto provides a basic look at the nuts and bolts of bitcoin. Next, he addresses the security concerns in regard to bitcoins, explaining that bitcoins are subject to theft and loss just like cash. What solutions are available to solve this problem? Andolfatto says establishing a relationship with a trusted intermediary—such as Coinbase—is essential and unavoidable. Another very important part of this process is the "blockchain." The blockchain, Andolfatto explains, is a transaction log for every bitcoin purchase since bitcoin was established in 2009. It is a public, shared record of which virtual wallets own which bitcoins. For the system to work, Andolfatto notes, participants must trust the integrity of the blockchain.

Presentation (PDF)

Another important feature of the Bitcoin program is people known as miners. The idea of communal record-keeping via miners, draws on a very basic, ancient premise—such as the hunter/gather society. The most critical, and perhaps the most difficult-to-grasp concept behind the bitcoin protocol, Andolfatto says, is understanding how it prevents miners from exploiting the system. To make this successful, the program must incorporate a set of incentives that encourages the miners to "do the right thing." Unlike gold miners, he notes, bitcoin miners aren't rewarded for producing bitcoins; rather, they are rewarded for their record-keeping services. They just happen to get paid, in part, with newly created bitcoins—this is what economist call seigniorage revenue. They are also paid, in part, with service fees.


David Andolfatto: So how is bitcoin different? Well, it's a completely virtual currency. It has zero intrinsic value, so it's not like gold or salt or stuff like that. If you were stranded on an island and you had some bitcoins in your pocket, you're going to starve. Mind you, if you're stranded on an island with a block of gold, you're probably going to starve too.

It has no legal backing, so it's not legal tender. The second main property is remarkable, in my view. It's the complete absence of any central authority. There's no central bank to manage the money supply. There's no select intermediaries you go to to process payments. And the hope of this program is two-fold. One, it's the hope to basically slay the inflation dragon that occasionally afflicts countries with central banks. The goal is to achieve some semblance of long-run price stability. And two, to drive transactions costs down to basically zero, so like I said before, one day, sending money to anyone in the globe would be as simple and costless as sending an email.

That's the vision. Let me describe now a little bit about the nuts and bolts about how bitcoin works or at least how I understand it works. The first thing you do is you go to the Internet and you download this computer wallet and it's free. You get an associated application that manages the wallet. This wallet is an encrypted computer file where your bitcoins are stored. This wallet can live in almost any physical device. It could live in your computer. It could live on your USB drive. Some people have taken bitcoins and embedded them in real physical coins, and some people have gone so far as to embed the bitcoins in paper, ironically. Your identity is disguised, so in that sense, it's like having some sort of post office box. And something that's important, the content of every wallet is publicly observable. That sounds weird, but that's true. So even though your wallet, the identity of your wallet, is not known... think of your wallet as a post office box with a slot where people can put money in, but only you have the key so you can take money out, but it's kind of transparent. Everybody can see how much money is in it. And people can potentially own multiple wallets. There's nothing to prevent you from creating hundreds of wallets if you wanted to.

Security Concerns

You know, your bitcoins are subject to loss or theft just like cash, and this is a serious concern for rich wallets. By rich wallets, imagine carrying around, I don't know, $10,000 or $100,000 or for some people $1 million in bitcoins on their USB drive. You're walking around, there's no insurance. What if you lost your USB drive? What would you do? I mean, if the security key was in there with the USB drive, the person who found it could use your wallet and spend it. If the security key wasn't there, and you lose it or suppose you die and it's kind of laying around in your desk, your kids can't find the key, that money is gone. It will never be used.

What are some solutions that are used out there to kind of circumvent this problem? Ironically, the solution is to use some trusted intermediaries. A very popular service is this company called Coinbase. Probably most of us, if we wanted to use bitcoin as currency, we would likely go and open an account at Coinbase. What they do is they open an account for you and they manage your wallet for you. It's just like online banking. They'll keep a record of all your transactions, except that the expenditures will be denoted in bitcoins. They'll charge you a service fee, of course. It's not insured. I don't think the FDIC covers this, does it Julie? No? So, o.k.

Another service for really big wallets — these are the guys with $8 million or $10 million — this Elliptic Vault will place or store your USB drive in cold storage, just take it offline and stuff it in a vault. Evidently, Lloyd's of London is willing to insure these things. Again, you have to pay the storage costs, you have to pay the costs of the intermediation service and you have to trust the intermediary. I find that a little ironic, right? If you think about it, the whole endeavor was motivated by the desire to circumvent the need of trusted parties, like third-party intermediaries, and yet I think if this program ever gets off the floor, third parties are going to be involved. It's just something that seems to be unavoidable.

Let me describe something that's very important. It sounds crazy but is very important. It's called the blockchain. What is the blockchain? The blockchain is a public ledger containing the historical record of all bitcoin transactions from the beginning of time, which is 2009. It's this huge transaction history. It doesn't record the items that are purchased or sold. It doesn't include the identities of the transactors, but what it is, it's like this huge public database living out there, and you can see the movement of every bitcoin ever created and how it moves from wallet to wallet from the beginning of time. That's called the blockchain, and it's absolutely critical, the role that it plays in the system. It lives in a global network of computers around the world and anybody who has a bitcoin account will have access to this public ledger on their personal device. It's a communally shared record of which wallets own which bitcoins.

For the system to work, participants must trust the integrity of the blockchain. It's absolutely critical. The power to alter or fabricate the history of transactions is the power to steal.

[interruption from audience] From the perspective of just the retail user like you or me, if we were to actually use bitcoin, it would be very much just like doing online banking. What's different is that there's no single agent at the other end or a bank to process the payment. So how does the payment get processed? Well, that's where these miners come in, these so-called miners. The recordkeeping, that is to say how the wallets are debited and credited is performed by ‘volunteers' —I'll put that in quotes and describe it a little more in a bit — these volunteers are drawn from the community. They're called miners. The miners must reach a consensus. Pending transactions are cleared and added to the blockchain only after, well not quite, but some sort of majority vote approves them. It's like a communal thumbs-up. You send out your request. You broadcast your request. ‘I wish to send a bitcoin from this wallet, and I want to send it to that wallet.' That request is broadcast to the community. The miners kind of mull it over, and they either go thumbs-up or thumbs-down. If it's thumbs-up, they take that, they execute the payment, they add it to the blockchain, and that's how it works. That's how the blockchain evolves over time.

I thought it was interesting, actually, this bitcoin idea. This communal recordkeeping sounds like this amazing innovation, but in fact, it made me think about something that's actually very ancient. It's a very ancient sort of idea, this idea of communal recordkeeping of a public databank of virtual credits. From my reading of very primitive economies, think of old hunter-gatherer societies. A hunting party would go out, and they'd go to try to bag a stag or something and some members of the party are more skilled than others. Some members are willing to work harder than others. They go out and somebody bags the stag and what happens? Everybody knows who made the kill. This becomes part of the communal databank in everybody's mind. It's like this communal file sharing program. The successful hunter comes back to the village and he draws on that credit. The villagers know who's bringing home the bacon, so to speak. Maybe he gets the prime cut. Maybe he gets an extra service, his house cleaned, gets stuff done. In a sense, he's using his virtual credit to purchase goods and services from his community members. So this idea is in fact very ancient, I think. In that sense, this virtual currency idea is drawing on something very fundamental and very primitive, only it's extending it to the entire world. It's making it a global phenomenon, instead of in the past, these local communities.

The most critical and difficult to understand part of the bitcoin protocol, in my view at least, is how it prevents the miners from exploiting the system. If the miners could be trusted to do the recordkeeping, it's a no brainer. But of course, the whole protocol is built on the premise that you can't trust anyone. These miners are just regular folk. They have no history. They have no reputations. They're just anonymous users. Built within the program has to be a set of incentives that makes the miners do the right thing. Exactly how that works, maybe somebody can explain it to me, but I think you need three PhDs: one in computing science, one in cryptology and possibly even one in game theory to understand how potentially people would game the system, I mean to really have a deep understanding of how that works.

Now that we're on miners, I want to take a little sidestep here and describe this mining thing here a little more. The word ‘mining' here is a little bit unfortunate. I don't know where it came from, but it's a misleading analogy. We think of the fellow up there (showing a bitcoin cartoon). He's got his mining cap on. ‘You're mining for bitcoins.' Well, not really. Think about real gold miners. What are they producing? Gold miners are rewarded for producing gold. You would think, therefore, that bitcoin miners must be rewarded for producing bitcoins. No, that's not true. Bitcoin miners are not rewarded for producing bitcoins. They are rewarded for their recordkeeping services. They just happen to get paid in part with newly minted bitcoins, but they could be paid any way. For example, gold miners often get paid in U.S. dollars. Gold miners don't necessarily get paid in gold. So bitcoin miners get paid for the services — the auditing, the bookkeeping or recordkeeping services or whatever you want to call it — they get paid partly in newly created bitcoins, what economists call seigniorage revenue, but they also get paid in service fees. If I'm a transactor, for example, I could offer the miners a little bit of a fee to process the payment a little more quickly. So the whole system could in principle function completely on these fees. The upshot is that the bitcoin can function with even a constant money supply. You know these graphs you see with the bitcoin growing and then being capped at 21 million? That's just a red herring. You don't even worry about that for how the protocol functions.

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