HOW WELL DO YOU KNOW ABOUT BITCOIN
INTERESTING, The Bitcoin creators’ intention was to develop a decentralized cash-like electronic payment
system. In this process, they faced the fundamental challenge of how to establish and transfer digital property rights of a monetary unit without a central authority. They solved this challenge
by inventing the Bitcoin Blockchain. This novel technology allows us to store and transfer a
monetary unit without the need for a central authority, similar to cash.
Price volatility and scaling issues frequently raise concerns about the suitability of Bitcoin
as a payment instrument. As an asset, however, Bitcoin and alternative blockchain-based
tokens should not be neglected. The innovation makes it possible to represent digital property
without the need for a central authority. This can lead to the creation of a new asset class that
can mature into a valuable portfolio diversification instrument. Moreover, blockchain technology provides an infrastructure that enables numerous applications. Promising applications
include using colored coins, smart contracts, and the possibility of using fingerprints to secure
the integrity of data files in a blockchain, which may bring change to the world of finance
and to many other sectors.
##Bitcoin and the Bitcoin Blockchain
Bitcoin is a virtual monetary unit and therefore has no physical representation. A Bitcoin
unit is divisible and can be divided into 100 million “Satoshis,” the smallest fraction of a Bitcoin.
The Bitcoin Blockchain is a data file that carries the records of all past Bitcoin transactions,
including the creation of new Bitcoin units. It is often referred to as the ledger of the Bitcoin system. The Bitcoin Blockchain consists of a sequence of blocks where each block builds on its predecessors and contains information about new Bitcoin transactions. The average time
between Bitcoin blocks is 10 minutes. The first block, block #0, was created in 2009; and, at
the time of this writing, block #494600 was appended as the most recent block to the chain.
Because everyone can download and read the Bitcoin Blockchain, it is a public record, a ledger
that contains Bitcoin ownership information for any point in time.
The word “ledger” has to be qualified here. There is no single instance of the Bitcoin
Blockchain. Instead, every participant is free to manage his or her own copy of the ledger.
As it was with the stone money, there is no central authority with an exclusive right to keep
accounts. Instead, there is a predefined set of rules and the opportunity for individuals to
monitor that other participants adhere to the rules. The notion of “public record of ownership” also has to be qualified because the owners of Bitcoin units usually remain anonymous through the use of pseudonyms.
To use the Bitcoin system, an agent downloads a Bitcoin wallet. A Bitcoin wallet is software that allows the receiving, storing, and sending of (fractions of) Bitcoin units.3 The next
step is to exchange fiat currencies, such as the U.S. dollar, for Bitcoin units. The most common
way is to open an account at one of the many Bitcoin exchanges and to transfer fiat currency
to it. The account holder can then use these funds to buy Bitcoin units or one of the many
other cryptoassets on the exchange. Due to the widespread adoption of Bitcoin, the pricing
on large exchanges is very competitive with relatively small bid-ask spreads. Most exchanges
provide order books and many other financial tools that make the trading process transparent.
A Bitcoin transaction works in a way that is similar to a transaction in the Yap payment
system. A buyer broadcasts to the network that a seller’s Bitcoin address is the new owner of
a specific Bitcoin unit. This information is distributed on the network until all nodes are
informed about the ownership transfer
For a virtual currency to function, it is crucial to establish at every point in time how
many monetary units exist, as well as how many new units have been created. There must
also be a consensus mechanism that ensures that all participants agree about the ownership
rights to the virtual currency units. In small communities, as with the Yap islanders, everyone knows everyone else. The participants care about their reputation, and conflicts can be disputed directly. In contrast, within the Bitcoin system the number of participants is substantially larger, and network participants can remain anonymous. Consequently, reputation effects cannot be expected to have a significant positive impact, and coordination becomes very difficult. Instead, there is a consensus mechanism that allows the Bitcoin system to reach an agreement. This consensus mechanism is the core innovation of the Bitcoin system and allows consensus to be reached on a larger scale and in the absence of any personal relations
## Bitcoin Mining
To understand the consensus mechanism of the Bitcoin system, we first have to discuss
the role of a miner. A miner collects pending Bitcoin transactions, verifies their legitimacy,
and assembles them into what is known as a “block candidate.” The goal is to earn newly created Bitcoin units through this activity. The miner can succeed in doing this if he or she can
convince all other network participants to add his or her block candidate to their copies of
the Bitcoin Blockchain.
Bitcoin mining is permissionless. Anyone can become a miner by downloading the respective software and the most recent copy of the Bitcoin Blockchain. In practice, however, there are a few large miners that produce most of the new generally accepted blocks. The reason is
that competition has become fierce and only large mining farms with highly specialized hardware and access to cheap electricity can still make a profit from mining.
For a block candidate to be generally accepted, it must fulfill a specific set of predefined
criteria. For instance, all included transactions must be legitimate. Another important criterion is the so-called “fingerprint” of the block candidate. A miner obtains this fingerprint by computing the block candidate’s hash value using the hash function dSHA256.
For example, we will look at the hash value for the text, “Federal Reserve Bank of Saint
Louis.”
The fingerprint of this text, which was calculated using the hash function dSHA256, is
72641707ba7c9be334f111ef5238f4a0b355481796fdddfdaac4c5f2320eea68.
Now notice the small change in the original text to “federal Reserve Bank of Saint Louis.” It
will cause an unpredictable change of the fingerprint, which can be seen from the corresponding new hash value:
423f5dd7246de6faf8b839c41bf46d303014cffa65724ab008431514e36c4dba.
As suggested by this example, a data file’s hash value cannot be prognosticated.
This characteristic is employed in the mining process as follows. For a block candidate to
be accepted by all miners, its fingerprint must possess an extremely rare feature: The hash
value must be below a certain threshold value—that is, it must display several zeroes at the
beginning of the fingerprint. An example of a fingerprint of a block that was added to the
Bitcoin Blockchain in 2010 is given in the following example:
Block #69785
0000000000
Need to be zero
14243 293b78a2833b45d78e97625 f 6484ddd1accbe0067c2b8 f 98b57995
Miners are continuously trying to find block candidates that have a hash value satisfying the
above mentioned criterion. For this purpose, a block includes a data field (called the nonce)
that contains arbitrary data. Miners modify this arbitrary data in order to gain a new fingerprint. These modifications do not affect the set of included transactions. Just as with our
example, every modification results in a new hash value. Most of the time, the hash value lies
above the threshold value, and the miner discards the block candidate. If, however, a miner succeeds in creating a block candidate with a hash value below the current threshold value, he or she broadcasts the block candidate as quickly as possible to the network. All the other network participants can then easily verify that the fingerprint satisfies the threshold criterion by computing it themselves.