What Bitcoin Is and How It Works
First described by Satoshi Nakamoto in a whitepaper released in late 2008, Bitcoin is a “P2P electronic cash system” that enables two people on the Internet to transact with each other without having to go through a traditional payment processor such as a bank or credit card network. Bitcoin was invented by combining several previously existing technologies, including digital signatures, peer-to-peer networking, and cryptographic proof of work, into a single application.
In Bitcoin, digital signatures are used to transfer the bitcoin digital currency from one account to another, peer-to-peer networking is used to broadcast transactions to the network for verification, and proof of work is used to determine which transactions get confirmed by the network. This process of determining which transactions are confirmed has come to be known as “Nakamoto consensus,” and it enables computers on the Bitcoin network to come to agreement on the current record of all transactions that have been accepted by the Bitcoin network. This Nakamoto consensus process produced a key innovation that did not exist before Bitcoin: a decentralized solution to the double-spending problem.
The Nakamoto consensus process confirms new transactions on the network by batching them into “blocks” which are produced and verified by the network approximately every ten minutes. Anyone can participate in the Nakamoto consensus process and make blocks by adding their computational power to the network. This decentralized network of block makers competes to collect a block reward consisting of new bitcoins and any transaction fees by racing to solve a complex math puzzle. The number of new bitcoins that are produced with every block is programmed to get smaller over time until the block reward disappears completely. At that point, block makers will be competing to earn only the transaction fees from all of the transactions that are included in the blocks they produce.
Each block is mathematically linked to all previous blocks, forming a “chain” that stretches back to the very first block produced by the network. This chain of blocks is referred to as “the blockchain,” and the network is designed to always refer to the longest blockchain when disputing the legitimacy of a transaction. As more blocks are built on top of a transaction that has been confirmed by the network, it becomes less likely that the transaction will be removed from the record, reducing the risk of a double-spend attack. An attacker trying to double-spend the network would have to be able to solve Bitcoin’s complex math puzzles faster than the rest of the network, which would require more than half of all the computing resources securing the network at the time of the attack. It is essential to the security of Bitcoin that no one party gains such a concentration of power in the network.
The pursuit of a decentralized solution to the double-spending problem was the primary motivator that led Satoshi Nakamoto to invent Bitcoin. In the Bitcoin whitepaper, Nakamoto wrote:
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution… What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
Trusted third parties, Nakamoto pointed out, introduce “inherent weaknesses of the trust based model” into payment systems, including “the possibility of reversal” by the trusted third party or an attacker who is able to compromise the trusted third party. It was this understanding that led Nakamoto to come up with the Nakamoto consensus process to solve the double-spending problem using a decentralized network of computers instead of a trusted third party.
Nakamoto designed Bitcoin so that the more computational power there is securing the Bitcoin network, and the more widely that computational power is distributed, the more difficult it would be for an attacker to launch a double-spending attack. With the number of people using the network growing larger every day, the requirement that the distribution of computational power remains decentralized has led to debates about how the Bitcoin software should evolve to accommodate higher transaction volumes. Both change and inaction could disrupt the equilibrium that allows the Bitcoin network to function today and deliver on its key innovation by providing a decentralized solution to the double-spending problem. Increase transaction capacity too much, and fewer computers will have the resources required to participate in the network, concentrating power in the computers that remain. Increase transaction capacity too little, and people may lose interest in Bitcoin as the cost of using it goes up, causing the system to collapse under the weight of its own success.
This is the challenge for Bitcoin developers: to engineer a way to scale bitcoin transaction volume while preserving Bitcoin’s key innovation, for to lose Bitcoin’s key innovation would be to lose Bitcoin itself. This will be no easy feat, and it may require taking risks that would be considered unacceptable or even impossible in other systems, but it is necessary for Bitcoin to scale if it is to continue to grow and become the world’s standard for “peer-to-peer electronic cash.”
When Bitcoin’s key innovation is used as the guiding principle for deciding which scalability proposal to implement, the decision chart looks like this:
|Proposal 1||Proposal 2||Proposal 3||…etc|
|Doesn’t preserve Bitcoin’s key innovation|
It is up to the community of Bitcoin developers, miners, and users to experiment with each proposal and fill in the blanks. The proposal that increases transaction capacity the most while preserving Bitcoin’s key innovation is the one that should be adopted.