Money As A Single Record Of All Transactions
Normally people think of money as something that they carry around and send to each other when they want to make a payment. But with digital currency it’s more useful to think of it as a single record of all transactions. So if I want to pay Bob $100, instead of handing over some cash, I would update the record with something like:
<Allen’s account #> -$100 <Bob’s account #> +$100
And if I wanted to know how much money I had I would just refer to the record and add up all my debits and credits.
So rather than thinking of money as something that you possess and give to someone else, you can think of it as reading and writing on a single record of all transactions. As a programmer you might think of this record as a single table in a database where everyone has read/write access, or maybe a google docs spreadsheet.
A Decentralized Distributed Network
But because bitcoin is decentralized, we can’t rely on any one party being the definitive host of this record. Consequently, everyone has (or at least can have) a complete copy of all bitcoin transactions. In a lot of ways it’s similar to git in that you can clone data, as well as push and pull updates, from the network.
But the big question is, how do we know that the record of transactions is true? What prevents people from making fake transactions and stealing other people’s money?
Logically Consistent Transactions
One problem that we can solve immediately is transactions that don’t make logical sense. For example a credit without a debit. Or debiting more money than you have. This is because when a new transaction is submitted to the network, each receiver will validate the transaction. If found to be invalid, they will reject it from being propagated to the rest of the network.
Digital Signatures
Another problem is, how do we know that the person sending the money is the person that owns the money? Can’t I just submit a transaction that says Bob gives me all his bitcoin since this would be a logically valid transaction? This problem can be solved by using public-key encryption.
Public-key encryption is a system where you can generate two keys, one private and one released to the public. These keys can be used to encrypt data, and then only the other key can be used to decrypt that data. This has 2 consequences.
- Anyone can encrypt data using the public key and be assured that only you can decrpyt it. (assuming only you have access to the private key). 2. You can encrypt data with the private key and anyone can use the public key to verify that the data really came from you, because your public key would only work on data that was encrypted with your private key.
#2 is what’s called a digital signature, and all bitcoin transactions are digitally signed to confirm that the sender of the money is really who they say they are.
Double-Spend Problem
The last problem is a more subtle one, which has to do with the fact that we can’t tell exactly when a transaction was submitted just by looking at it. This opens up the possibility of double spending, which works like this. Let’s say you only have one bitcoin but you try to pay two people one bitcoin each. But you send the transactions to geologically opposite ends of the network, say one guy in China and another in the US. Because it takes some time to propagate the transaction across the network both sides will think the transaction is valid until they realize that there is a conflict. Of course both sides will want their transaction to be the valid one, so there needs to be a way to resolve this conflict.
Mining And Consensus
This is where the whole mining thing comes into play. But first, you should know that transactions are added to the record in batches called “blocks”. These blocks are added on one after the other, so what I’ve been calling the “record of all transactions” is generally called the “blockchain”. Now before anyone can add a block to the blockchain, that person has to essentially brute-force guess a large number which should take on average 10 minutes. If they can successfully add a block to the blockchain they get a reward based on fees extracted from that block as well as newly generated bitcoins. But what is the point of this seemingly mindless computation? It’s not to verify the transaction which can be done by anyone near-instantly. Actually it’s a way of resolving double spend conflicts.
Since a block of transactions is put together by one user, they should all be logically consistent with each other. So really the problem is when the guy in China submits one block and the guy in the US submits another block with each block containing one of the double-spend transactions. So here you can see that it’s possible to submit more than one block that competes to become the official next block. (This would be true even without the double-spend problem, just as a result of network latency, but without the double-spend problem it wouldn’t matter which block wins.) So that means there’s now a fork in the blockchain, and people can add new blocks on to either branch. But the rule is that only the longest branch counts as the official branch.
This rule has some very interesting consequences. Because your block will be invalid if it turns out to be on the shorter branch (thus invalidating your reward) there is a very strong incentive not build on top of “losing” branches. You might have wondered, if one guy wins the right to add a block to the blockchain, what’s to stop him from adding an invalid block? What would happen is that miners would reject the invalid block by starting a new branch. Miners would be highly incentivised to abandon the invalid block because most likely rewards for blocks on that branch will become invalidated (assuming a majority of miners will choose to build on the valid branch).
51% Attack
In this way expending cpu power to mine is similar to voting, where your voting power is proportional to your cpu power. The correctness of the blockchain is the result of a majority of participating cpu power voting on what is correct by deciding to add their blocks to a specific branch. And if you’re wondering if one person had 51% of all participating cpu power could they have control over which branch ends up the longest branch, the answer if yes! This is known as the 51% attack. But as the number of people mining bitcoin grows it becomes harder and harder to coordinate 51% of all cpu power.