Bitcoin

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In this article by Imran Bashir, the author of the book Mastering Blockchain, will see about bitcoin and it’s importance in electronic cash system.

(For more resources related to this topic, see here.)

Bitcoin is the first application of blockchain technology. In this article readers will be introduced to the bitcoin technology in detail.

Bitcoin has started a revolution with the introduction of very first fully decentralized digital currency that has been proven to be extremely secure and stable. This has also sparked great interest in academic and industrial research and introduced many new research areas. Since its introduction in 2008 bitcoin has gained much popularity and currently is the most successful digital currency in the world with billions of dollars invested in it. It is built on decades of research in the field of cryptography, digital cash and distributed computing. In the following section brief history is presented in order to provide background required to understand the foundations behind the invention of bitcoin.


Digital currencies have always been an active area of research for many decades. Early proposals to create digital cash goes as far back as the early 1980s. In 1982 David Chaum proposed a scheme that used blind signatures to build untraceable digital currency. In this scheme a bank would issue digital money by signing a blinded and random serial number presented to it by the user. The user can then use the digital token signed by the bank as currency. The limitation in this scheme is that the bank has to keep track of all used serial numbers. This is a central system by design and requires to be trusted by the users. Later on in 1990 David Chaum proposed a refined version named ecash that not only used blinded signature but also some private identification data to craft a message that was then sent to the bank. This scheme allowed detection of double spending but did not prevent it. If the same token is used at two different location then the identity of the double spender would be revealed. ecash could only represent fixed amount of money. Adam Back’s hashcash introduced in 1997 was originally proposed to thwart the email spam. The idea behind hashcash is to solve a computational puzzle that is easy to verify but is comparatively difficult to compute. The idea is that for a single user and single email extra computational effort it not noticeable but someone sending large number of spam emails would be discouraged as the time and resources required to run the spam campaign will increase substantially.

B-money was proposed by Wei Dai in 1998 which introduced the idea of using proof of work to create money. Major weakness in the system was that some adversary with higher computational power could generate unsolicited money without giving the chance to the network to adjust to an appropriate difficulty level. The system was lacking details on the consensus mechanism between nodes and some security issues like Sybil attacks were also not addressed. At the same time Nick Szabo introduced the concept of bit gold which was also based on proof of work mechanism but had same problems as b-money had with one exception that network difficulty level was adjustable. Tomas Sander and Ammon TaShama introduced an ecash scheme in 1999 that for the first time used merkle trees to represent coins and zero knowledge proofs to prove possession of coins. In the scheme a central bank was required who kept record of all used serial numbers. This scheme allowed users to be fully anonymous albeit at some computational cost. RPOW (Reusable Proof of Work) was introduced by Hal Finney in 2004 that used hash cash scheme by Adam Back as a proof of computational resources spent to create the money. This was also a central system that kept a central database to keep track of all used PoW tokens. This was an online system that used remote attestation made possible by trusted computing platform (TPM hardware).

All the above mentioned schemes are intelligently designed but were weak from one aspect or another. Especially all these schemes rely on a central server which is required to be trusted by the users.

Bitcoin

In 2008 bitcoin paper Bitcoin: A Peer-to-Peer Electronic Cash System was written by Satoshi Nakamoto. First key idea introduced in the paper is that it is a purely peer to peer electronic cash that does need an intermediary bank to transfer payments between peers.

Bitcoin is built on decades of Cryptographic research like merkle trees, hash functions, public key cryptography and digital signatures. Moreover ideas like bit gold, b-money, hashcash and cryptographic time stamping have provided the foundations for bitcoin invention. All these technologies are cleverly combined in bitcoin to create world’s first decentralized currency. Key issue that has been addressed in bitcoin is an elegant solution to Byzantine Generals problem along with a practical solution of double spend problem. Value of bitcoin has increased significantly since 2011 as shown in the graph below:

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Bitcoin price and volume since 2012 (on logarithmic scale)

Regulation of bitcoin is a controversial subject and as much as it is a libertarian’s dream law enforcement agencies and governments are proposing various regulations to control it such as bitlicense issued by NewYorks state department of financial services. This is a license issued to businesses which perform activities related to virtual currencies.

Growth of bitcoin is also due to so called Network Effect. Also called demand-side economies of scale, it is a concept which basically means that more users who use the network the more valuable it becomes. Over time exponential increase has been seen in bitcoin network growth. Even though the price of bitcoin is quite volatile it has increased significantly over a period of last few years. Currently (at the time of writing) bitcoin price is 815 GBP.

Bitcoin definition

Bitcoin can be defined in various ways, it’s a protocol, a digital currency and a platform. It is a combination of peer to peer network, protocols and software that facilitate the creation and usage of digital currency named bitcoin. Note that Bitcoin with capital B is used to refer to Bitcoin protocol whereas bitcoin with lower case b is used to refer to bitcoin, the currency. Nodes in this peer to peer to network talk to each other using the Bitcoin protocol.

Decentralization of currency was made possible for the first time with the invention of Bitcoin. Moreover double spending problem was solved in an elegant and ingenious way in bitcoin. Double spending problem arises when for example a user sends coins to two different users at the same time and they will be verified independently as valid transactions.

Keys and addresses

Elliptic curve cryptography is used to generate public and private key pairs in the Bitcoin network. The Bitcoin address is created by taking the corresponding public key of a private key and hashing it twice, first with SHA256 algorithm and then with RIPEMD160. The resultant 160-bit hash is then prefixed with a version number and finally encoded with Base58Check encoding scheme. The bitcoin addresses are 26 to 35 characters long and begin with digit 1 or 3. A typical bitcoin address looks like a string shown as follows:

1ANAguGG8bikEv2fYsTBnRUmx7QUcK58wt

This is also commonly encoded in a QR code for easy sharing. The QR code of the preceding shown address is as follows:

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QR code of a bitcoin address 1ANAguGG8bikEv2fYsTBnRUmx7QUcK58wt

There are currently two types of addresses, commonly used P2PKH and another P2SH type starting with 1 and 3 respectively. In early days bitcoin used direct Pay-to-Pubkey which is now superseded by P2PKH. However direct Pay-to-Pubkey is still used in bitcoin for coinbase addresses. Addresses should not be used for more than once otherwise privacy and security issues can arise. Avoiding address reuse circumvents anonymity issues to some extent, bitcoin has some other security issues also, such as transaction malleability which requires different approach to resolve.

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from bitaddress.org private key and bitcoin address in a paper wallet

Public keys in bitcoin

In Public key cryptography, public keys are generated from private keys. Bitcoin uses ECC based on SECP256K1 standard. A private key is randomly selected and is 256-bit in length. Public keys can be presented in uncompressed or compressed format. Public keys are basically x and y coordinates on an elliptic curve and in uncompressed format are presented with a prefix of 04 in hexadecimal format. X and Y co-ordinates are both 32-bit in length. In total the compressed public key is 33 bytes long as compared to 65 bytes in uncompressed format. Compressed version of public keys basically include only X part, since Y part can be derived from it. The reason why compressed version of public keys works is that bitcoin client initially used uncompressed keys, but starting from bitcoin core client 0.6 compressed keys are used as standard.

Keys are identified by various prefixes described as follows:

  • Uncompressed public keys used 0x04 as prefix.
  • Compressed public key starts with 0x03 if the y 32-bit part of the public key is odd.
  • Compressed public key starts with 0x02 if the y 32-bit part of the public key is even.

More mathematical description and reason why it works is described later. If the ECC graph is visualized it reveals that the y co-ordinate can be either below the x-axis or above the x-axis and as the curve is symmetric only the location in the prime field is required to be stored.

Private keys in bitcoin

Private keys are basically 256-bit numbers chosen in the range specified by SECP256K1 ECDSA recommendation. Any randomly chosen 256-bit number from 0x1 to 0xFFFF FFFF FFFF FFFF FFFF FFFF FFFF FFFE BAAE DCE6 AF48 A03B BFD2 5E8C D036 4140 is a valid private key.

Private keys are usually encoded using Wallet Import Format (WIF) in order to make them easier to copy and use. WIF can be converted to private key and vice versa. Steps are described later.

Also Mini Private Key Format is used sometimes to encode the key in under 30 characters to allow storage where physical space is limited, for example, etching on physical coins or damage resistant QR codes. Bitcoin core client also allows encryption of the wallet which contains the private keys.

Bitcoin currency units

Bitcoin currency units are described as follows. Smallest bitcoin denomination is Satoshi.

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Base58Check encoding

This encoding is used to limit the confusion between various characters such as 0OIl as they can look same in different fonts. The encoding basically takes the binary byte arrays and converts them into human readable string. This string is composed by utilizing a set of 58 alphanumeric symbols. More explanation and logic can be found in base58.h source file in bitcoin source code.

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Explanation from bitcoin source code

Bitcoin addresses are encoded using Base58check encoding.

Vanity addresses

As the bitcoin addresses are based on base 58 encoding, it is possible to generate addresses that contain human readable messages. An example is shown as follows:

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Public address encoded in QR

Vanity addresses are generated by using a purely brute force method. An example is shown as follows:

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Vanity address generated from https://bitcoinvanitygen.com/

Transactions

Transactions are at the core of bitcoin ecosystem. Transactions can be as simple as just sending some bitcoins to a bitcoin address or it can be quite complex depending on the requirements. Each transaction is composed of at least one input and output. Inputs can be thought of as coins being spent that have been created in a previous transaction and outputs as coins being created. If a transaction is minting new coins then there is no input and therefore no signature is needed. If a transaction is to send coins to some other user (a bitcoin address), then it needs to be signed by the sender with their private key and also a reference is required to the previous transaction to show the origin of the coins. Coins are in fact unspent transactions outputs represented in Satoshis.

Transactions are not encrypted and are publicly visible in the blockchain. Blocks are made up of transactions and these can be viewed by using any online blockchain explorer.

Transaction life cycle

  1. A user/sender sends a transaction using wallet software or some other interface.
  2. Wallet software signs the transaction using the sender’s private key.
  3. Transaction is broadcasted to the Bitcoin network using a flooding algorithm.
  4. Mining nodes include this transaction in the next block to be mined.
  5. Mining starts and once a miner who solves the Proof of Work problem broadcasts the newly mined block to the network. Proof of Work is explained in detail later.
  6. The nodes verify the block and propagate the block further and confirmation start to generate.
  7. Finally the confirmations start to appear in the receiver’s wallet and after approximately 6 confirmations the transaction is considered finalized and confirmed. However 6 is just a recommended number , the transaction can be considered final even after first confirmation. The key idea behind waiting for six confirmations is that the probability of double spending virtually eliminates after 6 confirmations.

Transaction structure

A transaction at a high level contains metadata, inputs and outputs. Transactions are combined together to create a block. The transaction structure is shown in the following table:

Field

Size

Description

Version Number

4 bytes

Used to specify rules to be used by the miners and nodes for transaction processing.

Input counter

1 to 9 bytes

Number of inputs included in the transaction.

list of inputs

variable

Each input is composed of several fields including Previous Transaction hash, Previous Txout-index, Txin-script length, Txin-script and optional sequence number. The first transaction in a block is also called coinbase transaction. Specifies on or more transaction inputs.

Out-counter

1 to 9 bytes

positive integer representing the number of outputs.

list of outputs

variable

Outputs included in the transaction.

lock_time

4 bytes

It defines the earliest time when a transaction becomes valid. It is either a Unix timestamp or block number.

  • MetaData: This part of the transaction contains some values like size of transaction, number of inputs and outputs, hash of the transaction and a lock_time field. Every transaction has a prefix specifying the version number.
  • Inputs: Generally each input spends a previous output. Each output is considered a UTXO, Unspent transaction output until an input consumes it.
  • Outputs: Outputs have only two fields and it contains instructions for sending bitcoins. First field contains the amount of Satoshis where as second field is a locking script which contains the conditions that needs to be met in order for the output to be spent. More information about transaction spending by using locking and unlocking scripts and producing outputs is discussed later.
  • Verification: Verification is performed by using Bitcoin’s scripting language

Summary

In this article, we learned the importance of bitcoin in digital currency and how bitcoins are encoded using various private keys and encoding techniques.

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Further resources on this subject:


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