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Mark Warburton (Global) - Bitcoin: a Virtual Currency for the Future? part I

In the last decade, many attempts at creating virtual currency have come and gone. It is only now, with the introduction of Bitcoin, that virtual currency appears on the verge of making a real impact. Bitcoin is an ambitious project - started by a programmer named Satoshi Nakamoto in 2009. Initial popularity stems from it being built around public key encryption (PKE), i.e. it's a peer-to-peer open network, free from a central authority (human or computerized). Bitcoin's emergence is creating quite a stir amongst government officials in the U.S; with senators Chuck Schumer and Joe Manchin last month calling for the shutdown of Silk Road: an anonymous virtual market that uses Bitcoins to sell hard drugs and other contraband. Of course, the senators are most likely sweating on Bitcoin's evasive relationship with the U.S Federal Reserve.

Such concerns have generated publicity regarding the project over the last few months. In addition to Bitcoin's authority dodging, it is attractive because it avoids ‘double-spending'. Double-spending has been a common flaw in previous digital cash systems, where it was possible to spend a single digital money token twice. Unlike physical money, the act of spending a digital coin does not remove its data from the ownership of the original holder, so some other means is needed to prevent double-spending. The question that needs answering, then, is how does Bitcoin work?

How does it all work then?

Bitcoin is ingenious in its structure. Any person participating in the Bitcoin network has a wallet containing a number of cryptographic key pairs. The user's public key pairs are transformed into Bitcoin addresses, which act as the receiving nodes for all payments. The incentive in being a node is that by contributing to the network verification of Bitcoin exchange transactions, you earn Bitcoins. As a node, you are constantly receiving new transactions from the network as people are spending Bitcoins. Essentially people hold the cryptographic keys to their own money. When someone spends Bitcoins, they sign the transaction with a private key (preventing double spending). The network can then check the transaction was authentic by verifying the public keys of the buyer and seller.

New transactions are collected into ‘blocks'. As a reward for participating in the network, the node can add one additional transaction to the block, assigning 50 newly created coins to your own personal Bitcoin address. When a node finalizes a block, its authenticity will be received by all other nodes. Each node checks whether the individual node's input (proof-of-work) is valid for the block. The block is safe from manipulation because it relies on the original node's PKE configuration. When a block is verified by all nodes in the network, it is added to the top of the chain of previously created valid blocks and so on. The crucial aspect of the system is that each node maintains a chain of blocks that register all the transactions that have ever taken place on the Bitcoin network.

Bitcoin mining


Participating in transactions isn't the only way to earn Bitcoins. One of its key incentives is that anyone can begin to ‘mine' Bitcoin blocks by using his or her computer's computational power, along with open source Bitcoin software, to solve a difficult cryptographic proof-of-work puzzle. If successful in solving a block, it will lead to the standard 50 Bitcoin reward*. Hardware-customized computers specifically dedicated to generating Bitcoins known as ‘mining rigs' are being put together as the Bitcoins can only be created at a diminishing rate. This limitation is designed to prevent inflation. So, regardless of the influx of miners, inflation is avoided: the finite number of Bitcoins in existence prevents the conjuring of fiat money. The supply limit is fixed at 21 million (at least until 2040). As more people look to get mining, the complexity of the solution to crack blocks rises to adjust the fixed rate of Bitcoin dispersal. This means a CPU is no longer sufficient to solve a block in a realistic time period - leading to the use of more powerful GPUs.

*the number of coins from block mining/creating will be halved every 4 years. This incentivizes node participation and transactional fees, instead of the creation of more Bitcoins.

In the concluding part of this post (published here), I will look at Bitcoin as a currency and where its future might lie.

By Mark Warburton, editorial assistant, IDG Connect

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