A Monetary System and Money Like No Other
The separation of money from the state is no longer just a theory.
Bitcoin is both a new type of monetary system and a form of money within that system. This system is so innovative that it can be considered a technological breakthrough worthy to be dubbed a revolution. The launch of this system has initiated a process that will eventually affect all market participants. A hard currency has emerged that is outside the control of states. The separation of money from the state is no longer just a theory.
Money and Digital Money
Let's start with what money is. Many definitions have been created, but it can be generally accepted that money is a technology that enables payment, saving, and measuring value. Throughout history, various technologies have been used for this purpose, some better than others, including shells, stones, animal skins, glass beads, metals, including precious metals such as silver and gold, paper, and finally, digital recording. We will focus on money in the form of digital recording, which dominates today's world.
Digital money is essentially a chronological list of transactions recorded in a computer. Think of a spreadsheet in which each payment is recorded. This spreadsheet contains user accounts, and each subsequent market transaction reduces or increases the balance of these accounts. If I pay 10 zlotys in a store, the entry "minus 10 PLN“ will appear in my account and the entry "plus 10 PLN“ will appear in the store's account. If we add up all the transactions recorded in my or the store's account, we will know their balance.
In the world of fiduciary money that we use every day, banks keep such ledgers. They record information about inflows and outflows on the accounts of individual customers.
Trust issue
If digital money is recorded in someone's ledger, it is in our interest to ensure that this ledger cannot be falsified. The goal is to ensure that every transaction is recorded in the order that corresponds to the actual chronology of events. So that no one can spend funds they do not possess or falsify the balance on their or someone else's account. One of the most important tasks of banks is to ensure the correctness of transaction records.
For us, however, this involves the need to trust banks. We must trust that the ledger entries will accurately reflect market events. We must also trust that the bank will pay us the funds when we demand it or make a payment that we commission them to do so. This trust is strengthened by creating special rules for the functioning of banks, which are more stringent than the rules for other entrepreneurs, as well as by creating a specialized institution that supervises their functioning (in Poland, it is Komisja Nadzoru Finansowego — the Financial Supervision Commission).
Relying on such trust was dictated by necessity. Simply put, paying with digital money was not possible without an intermediary who would ensure that the payment was accurately recorded in the accounts of transaction participants: to reduce the payer's account by the appropriate amount and to increase the payee's account by that amount. There was really no way to get around it. There was no technology that would allow for digital money payments or any remote payments without an intermediary, and therefore without the need to trust someone.
This changed with the invention of Bitcoin.
The Bitcoin transaction ledger
Bitcoin is a digital currency, so it is also simply a digitally recorded ledger of transactions. Every instance of transferring bitcoins from one account to another is recorded in this ledger.
Anyone can open such an account without asking for permission or providing any personal information. All you need to do is flip a coin 256 times and record the result of each flip. I'm not joking. If we write down tails as 0 and heads as 1, and record the result of each flip, we will get a functioning bitcoin address. However, creating an address in this way seems rather tedious, so software comes to our aid. Nowadays, anyone can install one of the many available programs called "wallets" that can generate such an address for us without the need to flip a coin.
So, who keeps the Bitcoin transaction ledger? The answer is: anyone who wants to. In practice, these are the computers of tens of thousands of users of this system. You, dear reader, can also store this ledger. All you need is a computer with enough disk space (today, a disk with a capacity of just 1TB is enough) and a publicly available and free computer program called Bitcoin Core.
Who guards the Bitcoin transaction ledger?
Since a copy of the ledger is stored on many computers at the same time, how do we know that the records in the ledger are secure? Who guards it? How do we know that someone has not tampered with its contents?
The accuracy of transactions in the Bitcoin ledger is ensured through the innovative use of cryptography, blockchain, and proof-of-work (PoW) technology. They work in an automated manner without the need to trust anyone.
First, spending funds from a given account is only possible if funds have previously appeared on it. Attempts to spend funds without coverage in the account will be automatically rejected by the software. Each account is assigned two keys: a private and a public key. The private key must be kept strictly confidential. It enables us to make payments from our account. The public key is not confidential - we give it to the counterparty so that they can send payment to our account.
Secondly, our ledger is stored in the blockchain. The blockchain is a set of data that has been divided into many related parts. It can be imagined as a chain consisting of blocks. Subsequent transactions are recorded in successive blocks. The blocks are linked to each other in such a way that the encrypted fragment of each block is placed in the next block. This creates a mathematical relationship between the blocks and gives the effect that any attempt to manipulate historical blocks is impossible to hide because it results in inconsistencies with all blocks following the manipulated block. We call this type of resistance ‘tamper-evident’ as it enables immediate detection of forgeries in the database.
Thirdly, and most importantly for the system's security, the use of PoW technology, also known as Bitcoin mining, is crucial. Those who engage in mining are called miners. Simply put, making changes to the transaction list requires computational power and therefore involves a necessary expenditure of energy. PoW involves hundreds of thousands of computers that participate in a kind of lottery. These are specialised computers that perform only one function: they attempt to find the rewarded random number by guessing as quickly as possible. The system is built in such a way that regardless of the number of guessers, the rewarded number is found (mined) on average every 10 minutes. Thus, every 10 minutes a new block with transactions is added to the blockchain, and the lucky winner receives a monetary reward.
One might ask, well, how does this protect the network? In essence, all attempts to make changes to the ledger without incurring a cost are impossible, and any attempt to falsify the ledger by someone who has done the work will be rejected by the network, resulting in an immediate loss for the counterfeiter in the form of wasted energy. This incentive mechanism is the foundation of Bitcoin's security.
But can one imagine malicious behavior from someone who is insensitive to costs and possesses immense computational power? Yes, such a scenario is called a 51% attack. Someone who has accumulated the majority of computational power in the network can attempt to falsify an entry in the ledger. However, we are talking today about an amount of energy and computational power that is practically impossible to accumulate by any single player, even by a state or a group of states. Even if it were theoretically possible, the benefit that the attacker could derive would be at most the ability to double-spend funds. It is difficult to imagine that this benefit could be greater than the cost of the 51% attack itself. Even in such a case, however, the other participants would not be defenceless. Thanks to the transparency of the system, any attempt to gain dominance by one participant in the network would be immediately detected, which could lead to a kind of "arms race." In an extreme case, it would even be possible to create a special fork of the blockchain and disconnect from the part of the network dominated by the counterfeiter.
Tamper-proof
The use of energy and PoW technology has elevated Bitcoin's level of security to a previously unattainable level for computer systems. The first completely tamper-proof ledger in history has been created, which is also a breakthrough in the practical field of accounting. The system is not only 'tamper evident,' meaning it makes fraud impossible to hide, but also 'tamper-proof'—thanks to PoW and miners—as it makes fraud impossible to carry out.
The fact that no one has successfully attacked Bitcoin yet is evidence of its security. This applies even to the initial period when the computing power used to protect the network was relatively small. The network has been operating continuously for over 14 years based on unchanged principles. This does not mean a lack of innovation; it means that innovations are built in such a way as not to change the fundamental principles of the network. Bitcoin's stability is a guarantee of quality and resilience for its users. Over time, the security of the system increases as the number of blockchain copies, computing power, and energy used to protect it increase.
Questions, questions, questions
I assume that at this point additional questions pop up in readers’ minds. If the ledger is distributed across thousands of completely independent computers, what will happen if some of them make conflicting entries with the others? Where do new bitcoins come from? If there will only be 21 million of them, can they ever run out? Can Bitcoin be used to buy coffee? Does Bitcoin's constantly changing market price disqualify it as money? Can the system handle financial transactions for the entire planet?
We will try to answer these and other questions in subsequent articles in the series.
(Originally published in Polish, iMagazine issue 4/2023, English version prepared with the assistance of ChatGPT-4 by openai.com)