Understanding Bitcoin and cryptocurrency
Blockchain is the technology behind Bitcoin, which is considered the origin of all cryptocurrencies. In this section, we will introduce the basics of Bitcoin and discuss the digital payment mechanism with Bitcoin.
Bitcoin basics
Bitcoin is a decentralized electronic cash system that makes peer-to-peer payment possible without going through an intermediary. The original Bitcoin software was developed by Satoshi Nakamoto, released under the MIT license in 2009, following the Bitcoin whitepaper, Bitcoin: A Peer-to-Peer Electronic Cash System. Bitcoin is the first successful implementation of a distributed cryptocurrency. Thirteen years after Bitcoin was born, as of May 23, 2022, it has about 19 million Bitcoins in circulation and it has reached about a 556 billion market cap (https://coinmarketcap.com/currencies/bitcoin/).
Like any fiat currencies or tangible assets, the price of Bitcoins can fluctuate over time and its valuation is determined by the open market. Several factors can influence the price, including supply and demand on the market, competing cryptocurrencies and altcoins, and governance and regulations. The following screenshot shows the Bitcoin market cap, daily transaction volume, and price movement since its inception up to May 23, 2022:
Figure 1.22 – Bitcoin market cap
In this section, we will present key concepts in Bitcoin, including the wallet, transaction and account balances, Bitcoin supply, and bootstrap. We will demonstrate how Bitcoin payments work with blockchain. We will also discuss major challenges in Bitcoin and the Bitcoin blockchain. Finally, we also briefly talk about various altcoins, different types of cryptocurrency on the market.
What is a wallet?
Bitcoin is a cryptocurrency, digital cash, or virtual money. Unlike a fiat currency, you can’t touch or feel it. You can’t stash Bitcoins under your bed. So, where do you store your Bitcoins? How do you prove ownership of the Bitcoins? Technically, Bitcoins aren’t stored anywhere. They don’t exist in any physical form. They are a set of software objects circulating around the Bitcoin network, where ownership of the Bitcoin is proved with a cryptographic key. Payment records detailing money being transferred in or out of people’s wallets are recorded as a chain of private keys showing ownership transfer in the blockchain. If you own the private keys, you own that Bitcoin. If you lose your keys, you lose everything you have on the Bitcoin network.
A Bitcoin wallet is an application where the cryptographic keys, that is, pairs of public and private keys, are stored. There are many forms of Bitcoin wallets in use, as shown in the following diagram, but broadly, they are categorized into the following four types: desktop, mobile, web, and hardware wallets. Hardware wallets are considered cold wallets, while the rest are considered hot wallets. We have an extensive discussion on crypto wallets in Chapter 14, Build Ethereum Wallets:
Figure 1.23 – Types of Bitcoin wallets
Your private key is used by you to digitally sign the transaction when you spend some Bitcoin. Anyone who knows your public key can verify your signature on the payment you make to them. The public key — or more accurately, a wallet address associated with your public key — is used by anyone else to pay Bitcoin to you. You can have as many pairs of public and private keys as you want in your wallet.
In Bitcoin, a private key is a 256-bit-long hash and a public key is 512 bits long. They can be converted into shorter lengths in a hexadecimal representation. A Bitcoin address is generated based on the public key, using multiple rounds of mixed use of the SHA-256 and RIPEMD-160 cryptographic hash functions. You can have as many addresses as you need, and each address can be used once for each Bitcoin transaction.
The following screenshot gives an example of a Bitcoin wallet generated from the website at https://www.bitaddress.org/bitaddress.org-v3.3.0-SHA256-dec17c07685e1870960903d8f58090475b25af946fe95a734f88408cef4aa194.html:
Figure 1.24 – Bitcoin wallet
The QR code on the left side is the Bitcoin address you can share with your trading partners. The secret one, the QR code on the right, is your private key with which you sign your transaction.
Transactions, UTXO, and account balances
Whenever you check your bank account, you always see a balance associated with your checking or savings accounts. Your bank keeps track of all of your transactions and updates your balances following each and every transaction. A Bitcoin wallet provides you with a balance too. However, the balance in Bitcoin is not that straightforward. Instead of keeping track of every transaction, Bitcoin keeps track of unspent coins, also called UTXO.
UTXO stands for unspent transaction output. In Bitcoin, a transaction is a collection of inputs and outputs transferring the ownership of bitcoins between payer and payee. Inputs instruct the network which coin or coins the payment will draw from. Those coins in the inputs have to be unspent, which means they have not been used to pay someone else. Outputs provide the spendable amounts of bitcoins that the payer agrees to pay to the payees. Once the transaction is made, the outputs become the unspent amounts to the payee; they remain unspent until the current payee pays someone else with the coin.
Taking the earlier example where Alice needs to pay Bob 10 BTCs, let’s assume, prior to this transaction, that Alice has two UTXOs in her wallet, one with 5 BTCs and another with 8 BTCs. Bob has one UTXO of 30 BTCs in his wallet from other transactions. Let’s also ignore the transaction fee for now. When Alice uses both UTXOs as the input to pay 10 BTCs to Bob, both will be the inputs of the transaction. One 10 BTC UTXO will be created as output to Bob, and one 3 BTC UTXO will be returned to Alice. After the transaction, Alice will have one 3 BTC UTXO in her account, and Bob will have two UTXOs in his account. They remain as UTXOs until they are used to pay for other transactions:
Figure 1.25 – How UTXOs work
When either Alice or Bob pays someone with the remaining UTXOs, the unspent output from the previous transaction becomes an input to the new transaction. Since all transactions are digitally signed, essentially a Bitcoin becomes a chain of digital signatures on the Bitcoin blockchain network.
In fact, the blockchain is a state machine that records all transactions on an immutable ledger. Each UTXO can be ultimately traced back to the original coins that were mined by miners, which in turn can be traced back to the first set of bitcoins on the first block. Piecing together all the transactions that have occurred on the Bitcoin blockchain, from the genesis block to all blocks on the blockchain, you would see Bitcoins changing hands as in the following directed acyclic graph:
Figure 1.26 – UTXO in a directed acyclic graph
To count the number of UTXO transactions or the total amount of unspent bitcoins, you have to count the number of leaf UTXOs, and the total amounts of bitcoins in the leaf UTXOs. To count how much bitcoin you have in your own wallet, all you need to do is add all unspent bitcoins in all leaf UTXOs where you are specified as the payee in the transaction outputs.
Genesis block and coin supply
In Bitcoin, there is no central authority to issue the cryptocurrency and control the money supply. Instead, Bitcoin is created by the Bitcoin blockchain network through the discovery of new blocks. As shown in the following screenshot, the first block is also called the genesis block, or block #0, which was mined on June 3, 2009, with an output of 50 BTC. The first 50 BTC is not spendable.
The following screenshot shows the genesis block in the Bitcoin blockchain:
Figure 1.27 – Genesis block
Bitcoin uses a Bitcoin generation algorithm to control how many coins will be minted and at what rate. It is a function of the Bitcoin block height and its block reward. It started with a block reward of 50 BTC. The block reward is cut in half for every 210,000 blocks, or approximately every four years. The rate of block creation is adjusted based on mining difficulty. The maximum capacity of Bitcoins in the system is 21 million, which can be reached when 6,929,999 blocks have been mined.
For more information, you should check out the Bitcoin wiki site: https://en.Bitcoin.it/wiki/Controlled_supply.
How does Bitcoin payment work?
Take the earlier example when Alice needs to pay Bob 10 BTC. Alice opens her Bitcoin wallet, scans or copies Bob’s transaction address, and creates a transaction with a 10 BTC payment to Bob. Once the transaction is digitally signed and submitted, it is sent to the Bitcoin blockchain network:
Figure 1.28 – How Bitcoin payment works
Once the transaction is broadcasted to the Bitcoin network, the bookkeeper node, usually a full node in a P2P network that receives the transactions, will validate it according to Bitcoin protocol rules. If the transaction is valid, the bookkeeper will add it to the transaction pool and relay the transaction to the peers in the network. In the Bitcoin network, every 10 minutes, a subset of network nodes, called mining nodes or miners, will collect all valid transactions from the transaction pool and create the candidate blocks. They also create a Coinbase transaction for themselves to be rewarded by collecting the transaction fees in the event they win the mining race and add the block to the chain. All nodes will verify the new block and add it to their own copies of the blockchain. Magically, Bob will be able to see the payment from Alice and 10 BTC in his wallet.
Bitcoin transaction and block structure
When creating a Bitcoin transaction, the wallet application has to follow the Bitcoin protocol rules and create the transaction data structure in line with the Bitcoin specification. Invalid transactions will be rejected by the network. For details of the Bitcoin transaction and block structure, please refer to https://en.Bitcoin.it/wiki/.
The following are key data structures in a Bitcoin transaction and block:
- Bitcoin block structure: The following table shows the data structure within a Bitcoin block:
Figure 1.29 – Bitcoin block structure
Figure 1.30 – Bitcoin header structure
In particular, hashPrevBlock references the 256-bit hash value of the previous block, and hashMerkleRoot is the hash Merkle root of all transactions in the block, including the Coinbase transactions. And the nonce is the magic number that miners need to find so that the SHA-256 hash value of the block header is smaller than or equal to the blockchain-defined specific target.
- Transaction structure in Bitcoin: The following screenshot shows the general data structure of a Bitcoin transaction:
Figure 1.31 – Bitcoin transaction structure
A transaction can have many inputs and outputs, as specified in the field of list of inputs and list of outputs fields. The input structure is shown as follows:
Figure 1.32 – Transaction inputs in a Bitcoin transaction
The following table shows the structure for the output:
Figure 1.33 – Transaction outputs in a Bitcoin transaction
Now, you understand transaction and block data structure. In the next subsection, let us see how transactions are processed in a blockchain network.
Transaction validation and block verification
Bitcoin protocol rules define a set of validation rules, including syntactic rules and valid values. Bookkeepers, or miner nodes, need to validate transactions according to those rules before the transaction is added to the pool. It also checks the following (https://en.Bitcoin.it/wiki/Protocol_rules):
- Transaction duplication: This is to see whether we have matching transactions in the transaction pool or in a block in the main branch
- Double spend: This is to check whether the input is used to pay concurrently in any other transactions in the pool or in the main branch
- Orphan transaction: For each input, this checks whether we can find the reference output transaction in the main branch and the transaction pool
- Coinbase maturity: This is to make sure coins from the Coinbase transaction are mature enough to be spent
- Overdraft: This checks the inputs and outputs to make sure there is enough to make the payment and be able to make a reasonable transaction fee
Once a miner completes a new block with the mining, the new block will be broadcasted to the Bitcoin network for verification. Each full node, including mining nodes, will verify the new block and all transactions within the block. The same set of transaction validation rules will be applied. For block verification, all nodes check whether the block has the right cryptographic hash and the nonce makes the hash smaller than the target. The miner will add the block to the longest chain. As we discussed earlier, temporary forking may happen; a Bitcoin block tends to self-heal and only the blocks in the longest chain will stay.
Limitations in Bitcoin
Thanks to Bitcoin, blockchain technology has attracted worldwide attention. Like any new technology, it has its limitations. Notable limitations include the following:
- Scalability and throughput: Scalability is a major concern in the Bitcoin network, and more broadly in any PoW-based blockchain. By design, every transaction has to be verified by all nodes, and it takes about an average of 10 minutes to create a new block with the block size limited to 1 MB. Block size and frequency limitations further constrain the network’s throughput.
- Transaction processing cost: Mining in the Bitcoin network is costly and energy intensive. The miners who add new blocks to the blockchain are rewarded with bitcoins. As the bitcoin supply gets closer to the maximum capacity of 21 M bitcoins, mining becomes less profitable. Miners will rely more and more on transaction fees to offset the mining cost and make a profit. It will drastically increase the transaction cost in Bitcoin. Please refer to https://Bitcoinfees.info for real-time transaction fees in the Bitcoin network.
- Security and privacy: Bitcoin has the 51% attack issue. At least in theory, network could be compromised if the majority of CPU hashing power is controlled by dishonest miners. It may not be economically feasible to launch such an attack on the main Bitcoin network. But recently, at least five cryptocurrencies with much smaller networks have been hit with attacks of this type. By design, all transactions are permanently stored in the Bitcoin network and can be traced to the involved parties. They are made public. This greatly improves transparency, however, unfortunately, also raises privacy concerns.
- Usability: Bitcoin uses a stack-based scripting system for transaction processing. It supports very rudimental operations and lacks the functionalities of modern programming languages. It is Turing-incomplete and inhibits the ability to build more sophisticated real-world business and payment applications.
- Finality: Transaction finality refers to the moment that blockchain transactions are considered complete and can no longer be reverted. In a PoW-based blockchain system such as Bitcoin, the blockchain goes with the longest chain, therefore there is no immediate finality. The deeper in the chain a given block becomes, the more likely it is that the transactions in the block will be finalized. In Bitcoin, transaction finality is probabilistic. It is believed that it takes 6 blocks to be considered as safe and final, which means about 60 minutes.
By design, if you lose your private keys, you lose access to your bitcoins. In the same way, if your private keys are compromised by hackers, they can take possession of your bitcoins and make any transactions they wish. To address this issue and some accompanying security concerns, Bitcoin introduced multiple signatures (multisig) in 2014 to allow multiple keys to be used to authorize one single Bitcoin transaction. Bitcoin Core has been using Elliptic Curve Digital Signature Algorithm or ECDSA as its cryptographic algorithm for digital signatures from day one, when it was distributed by Satoshi in 2009. As shown in the following diagram, three payors, Alice, Kyle, and Sam, each need to sign the transaction with their own keys. All three digital signatures need to be added to the transaction when they pay Bob some bitcoins together:
Figure 1.34 – Multisig in Bitcoin transactions
The latest update to Bitcoin Core in 2021 was the Taproot upgrade, designed to further address privacy concerns and improve scalability and throughput. The Taproot upgrade leverages Schnorr signatures as a replacement for the ECDSA schema when signing transactions, and introduces a Merklized Abstract Syntax Tree (MAST) schema to aggregate multiple signatures into one Schnorr signature for multisig transactions, as shown in the following screenshot:
Figure 1.35 – Schnorr signature in Bitcoin transactions
Schnorr signatures are much more efficient in signing and verification than the ECDSA schema, and require less data to be transmitted within the P2P network and stored on the blockchain, which in turn makes the Bitcoin blockchain more efficient, secure, and scalable. With the Taproot upgrade, you no longer need to expose all your public keys when making multi-signature Bitcoin transactions.
Note
For more information, you should check out the Bitcoin wiki site: https://en.bitcoin.it/wiki/Taproot_activation_proposals.
Altcoins
Altcoins are cryptocurrencies other than Bitcoin. Some earlier altcoins, such as Litecoin, are variations of Bitcoin with changes and improvements implemented to address some of the particular limitations we discussed in the previous section. Some, including Ethereum, BNB Chain, Cardano, and Solana, are intended as new blockchain platforms for building decentralized applications. According to http://coinmarketcap.com, the following are the top ten altcoins based on the market cap, as of May 23, 2022:
Figure 1.36 – Top 10 altcoins
Compared with the top 10 altcoins published in 2019 in the first edition of this book, Bitcoin and Ethereum continue to stay as the top two crypto coins. XRP and Cardano also remain in the top 10, but the other 6 were nowhere to be seen back in 2019, although their market caps now range from $10 billion to $73 billion. Bitcoin variants such as Litecoin or Bitcoin Cash declined to #18 and #24, respectively.
The following is a list of leading altcoins:
- Ethereum: This is one of the best-known smart contract platforms that enables Decentralized Applications (DApps). It was invented by Vitalik Buterin in 2013. Ether is the native currency of the Ethereum platform and uses the symbol ETH. It comes with the Ethereum Virtual Machine (EVM) to enable smart contract execution on the Ethereum blockchain. We will dive into the details of Ethereum throughout the rest of this book.
- XRP: XRP is a native cryptocurrency that powers the XRP ledger, enabling value transfers in the Ripple network. Unlike Bitcoin or Ethereum, all XRP tokens were pre-minted at the beginning. The XRP Ledger (XRPL) is a decentralized public blockchain that maintains the order and sequence of all XRP transactions. It doesn’t use PoW or PoS. Instead, in the XRP consensus protocol, designated servers reach an agreement on outstanding transactions every 3-5 seconds. All transactions are made public, with strong cryptography to guarantee the integrity of the system.
- BNB Chain: Similar to Ethereum, BNB Chain is another smart contract-enabled blockchain platform intended to create a Decentralized Finance (DeFi) ecosystem. It is EVM compatible, which means you can deploy Ethereum smart contracts on the Binance chain and vice versa. Instead of using PoW as in Bitcoin or PoS consensus as in Ethereum 2.0, it operates using a Proof-of-Authority (PoA) consensus mechanism. The native token of BNB Chain is the BNB coin. We will discuss in detail how BNB Chain and other EVM-compatible blockchains work in Chapter 4, EVM-Compatible Blockchain Networks.
- Solana: Solana is another native blockchain platform created for supporting smart contracts and DApps. It uses the SOL symbol. Different than other blockchain platforms, Solana uses a combination of the PoS consensus mechanism and a Proof-of-History (PoH) algorithm to ensure network security and the accurate recording of transaction sequences on the blockchain. We will briefly introduce the Solana blockchain in Chapter 5, Deep Research and Latest Developments in Ethereum.
- Litecoin: This is almost identical to Bitcoin except that the time for adding a new block was reduced from 10 minutes to 2 minutes.
- Bitcoin Cash: This is a hard fork of the Bitcoin chain that was created because of a group of Bitcoin Core developers that wanted to use a different way of addressing the scalability issue.
Blockchain technology will continue to evolve. As blockchain finds more usages in industry, more advanced blockchain networks and newer altcoins will continue to rise to the top. In the next section, we will showcase some of the influential blockchain use cases across all industries.