Bitcoin, not blockchain, part one.
Have you ever heard from a seemingly clever friend that he’s not sure about Bitcoin, but believes in blockchain technology? It’s like saying that you believe in planes, but you’re not sure about wings, and there’s a good chance that someone who thinks that doesn’t know the subject. In fact, Bitcoin and blockchain depend on each other. But it can be incredibly difficult for a beginner to figure out how it all works. Frankly speaking, it can turn out to be impossible: given the complexity and number of projects, who has time to analyze it all? There is still a convenient way to do it, but you need to know where to start. Although there are thousands of cryptocurrencies and blockchain initiatives, the only thing that really matters is Bitcoin. First, you should ignore everything else as if it didn’t exist and try to understand why Bitcoin exists and how it works. This will be the best foundation that will then allow us to look at the rest.
It is also the most practical entry point. Before risking your hard-earned money, take time to understand Bitcoin and then apply that knowledge to analyze the whole area. There is no guarantee that you will come to the same conclusions, but most of the time it is easier for those who take the time to intuitively understand how and why Bitcoin works to recognize the inherent flaws in the field. And even if not, starting with Bitcoin is still the best chance to make a competent and independent assessment. Ultimately, Bitcoin is not just about making money or getting rich quickly. Its essence is to preserve the value you have already created, so you should not risk it without the necessary theoretical basis. Bitcoin has the longest history to appreciate and the most educational resources in the digital currency world, which is why Bitcoin is the best tool for learning.
Before embarking on this journey, it should be recognized that Bitcoin was created with the specific aim of solving the existing problem of modern money. Bitcoin’s creator intended to create a peer-to-peer digital cash system without the need for a trusted third party, and blockchain is a critical part of the solution. In practice, Bitcoin as a currency and its blockchain are interdependent. One does not exist without the other: Bitcoin needs blockchain to function, but there would not be a functioning blockchain without an internal currency that properly encourages the use of resources to protect it. This domestic currency must be a viable form of money because it provides security, and to do so it must have reliable monetary properties.
Without money, there is no security, and without security, the cost and permanence of blockchain will collapse. That’s why blockchain is only useful for monetary use, and money doesn’t grow on trees. Yes, everything is so simple. Blockchain is only good for one thing – eliminating the need for a trusted third party, which works only in the context of money. Blockchain cannot regulate anything that exists offline. Although blockchain is able to track ownership outside the network, it can only regulate ownership of the internal currency of its network.
Bitcoin monitors and regulates ownership. If blockchain is unable to do both, any records it maintains will be inherently unprotected and subject to change. In this sense, immutability is not an inherent feature of blockchain, but an emergent property. And if blockchain isn’t invariable, its currency will never be a viable form of money, because the transfer and final settlement will not be reliable. Without reliable calculations, the monetary system is not functional and will not attract liquidity.
Ultimately, monetary systems converge on one medium because their usefulness is in liquidity, not in consumption or production. And liquidity consolidates around the safest, most long-term savings medium. It would be irrational to store money in a less secure, less liquid money network if a safer and more liquid network is available. The general conclusion is that only one blockchain is viable and ultimately necessary. All other cryptocurrencies compete for the same use as Bitcoin – use as money. Not everyone is aware of this, but the cost continues to consolidate around Bitcoin because it is the safest blockchain and everyone competes for the same use. The assimilation of these concepts provides the foundation for understanding Bitcoin, which then allows us to consider and evaluate noise outside Bitcoin. With a basic knowledge of how Bitcoin actually works, it becomes clear why there is no blockchain without Bitcoin.
Blockchain doesn’t exist
Often, Bitcoin’s transaction registry is presented as a public blockchain living somewhere in the cloud, a kind of digital public space where all transactions are collected. However, there is no single source of truth. There is no oracle, no central public blockchain, where everyone contributes transactions independently. Instead, each member of the network constructs and maintains its own independent version of blockchain-based on a common set of rules. Nobody trusts anyone and everyone checks everything. Everyone can come to the same version of the truth without having to trust any third party. This is the essence of how Bitcoin solves the task of removing intermediaries from the digital cash system.
Each participant supporting the Bitcoin network node independently checks each transaction and each block. Each node has its own independent version of blockchain. Consensus is reached on the network because each node verifies each transaction (and each block) based on a basic set of rules (and wins the longest chain). If a node translates a transaction or block that does not meet the consensus rules, the other nodes will reject it as invalid. It is thanks to this function that Bitcoin is able to do without a central third party. The network converges on the same agreed blockchain state, and no one trusts any third party. However, currency plays a key role in coordinating Bitcoin’s consensual mechanism and streamlining the blocks, which ultimately represents the complete and actual history of Bitcoin’s transactions (or his blockchain).
Bitcoin fundamentals: blocks and mining
The block can be imagined as a data set linking the past to the present. In the technical sense, individual blocks record changes in the overall state of ownership of bitcoins within a specific time period. Taken together, the blocks record the entire Bitcoin transaction history as well as the ownership of all Bitcoins at any given time. In each subsequent block, only changes in state are recorded. How blocks are built, computed and inspected is critical to the network consensus process and also provides a fixed BTC offer (21 million). Miners compete to create and calculate the blocks that are then offered to accept the rest of the network. For simplicity, you can imagine mining as a continuous process of verifying the history and completion of Bitcoin transactions waiting in the queue. With each block, miners add new transactions to the blockchain and check the entire blockchain history. It is through this process that miners ensure network security. However, all nodes in the network then check the work done by the miners to ensure a network consensus. Technically, miners create blocks that represent a set of data that includes three critical elements (again, in a simplified form):
Reference to the previous block → blockchain history check.
Bitcoin transactions → completion of transactions from the queue (change of ownership status).
Coinbase + commission → compensation to miners for network security.
To calculate the blocks, miners perform a so-called PoW or “proof of work” function, wasting energy resources. For blocks to be valid, all input data must be valid and each block must meet the current complexity of the network. In order to satisfy the complexity of the network, each block is added a random value (called nonsense), after which the combined data set is passed through the Bitcoin Hash algorithm (SHA-256). The resulting output (or hash) must match the complexity of the network to be valid. You can imagine this as a simple search function, only from the point of view of probability theory, in order to find a valid proof for each proposed block, you need to search trillions of random values. Adding a random nose may seem superfluous. However, it is this function that forces miners to spend significant energy resources to calculate the block, which ultimately makes the network more secure, as it is extremely costly to attack.
Because of the addition of a random nonse to the proposed block, which otherwise represents a static data set, each resulting output (or hash) is unique. When checking each nose, the resulting output has an equally low probability of matching the network complexity (i.e., the probability of being a valid proof). Although this is often referred to as an extremely complex mathematical task, the real difficulty is that finding valid evidence requires a search for trillions of possible solutions. There are no shortcuts; energy needs to be expended. The actual proof is easily corroborated by other nodes, but it is impossible to calculate it without spending a lot of resources. As new computational resources are added to the network, the complexity of the network increases, requiring more values to be searched and more energy to be used to calculate each block. In essence, miners incur material costs in calculating the blocks, but all other nodes can then test their performance very easily and with little or no cost.
In general, the incentive structure allows the network to reach consensus. Miners have to bear a substantial cost of securing the network, but are rewarded only when the actual work is done; and the rest of the network can directly determine whether the work is valid, based on consensus rules and without incurring costs. There are several consensus rules, but if a transaction in a block is invalid, the whole block is invalid. In order for a transaction to be valid, it must originate from an earlier valid Bitcoin block and may not duplicate a previously expended transaction. To be valid, each block must be based on the most current version of the history and must include a valid coinbase transaction. A coinbase transaction rewards miners with new bitcoins for securing the network, but it is only valid if the work is valid.
Coinbase rewards are managed by a pre-defined offer schedule, and currently, 12.5 new bitcoins are issued with each valid block. In May 2020, the remuneration will be halved to 6.25 bitcoins and then every 210,000 blocks (or approximately every 4 years) will be further halved until it reaches zero. If the miners include invalid remuneration in the proposed block, the rest of the network will reject it, which is the basic mechanism for managing the limited total supply of 21 million bitcoins. However, software alone is not sufficient to guarantee a fixed offer or an accurate transaction register. Everything is based on economic incentives.
Consensus on a decentralized basis
Why is it so important? With one integrated feature, miners check history, validate transactions and receive secure payments without the need for trust. The invariability of Bitcoin’s fixed offer is built into its security function, and since the network independently verifies performance, it is possible to achieve consensus on a decentralized basis. If the miner is doing actual work, he can rely on being rewarded without having to trust anyone. Conversely, if the miner is doing an invalid job, the rest of the network applies the rules, effectively withholding payment until the actual job is done. And the offer of currency is one of the conditions of validity. If a miner wants to be rewarded, he must also provide a fixed currency offer that maintains the consistency of the network. The currency incentive system is so strong that everyone has to follow the rules that it promotes a decentralized consensus.
If the miner calculates and offers an invalid block, including either invalid transactions or invalid coinbase fees, the rest of the network will reject it. In addition, if the version of the miner’s history does not represent the longest chain with the greatest proof of performance, any proposed block will also be considered invalid. In fact, as soon as the miner has seen the new actual block proposed in the network, it should immediately begin to work on top of this block, otherwise, it runs the risk of falling behind and doing the invalid work, incurring irrecoverable costs. That is, having executed invalid work, the miner will bear real expenses, but will not receive for it any indemnification.
Bitcoin governance. pic.twitter.com/mrzBPg6LjL— Michael Goldstein (@bitstein) August 26, 2017
Thanks to this mechanism, miners are as motivated as possible to always do honest, real work within the framework of a blockchain consensus: either you get a reward or nothing. Also for this reason, the higher the cost of doing the job, the safer the network becomes. The more energy it takes to record or overwrite Bitcoin’s transaction history, the less likely a miner will sabotage the network. The motivation to collaborate is the higher the cost of the work that would otherwise be considered invalid by the rest of the network. As the security of the Bitcoin network increases, it becomes more valuable. With the increasing cost of bitcoin and the cost of calculating blocks, the motivation to do the actual work increases (more income, but also more costs), and the punishment for invalid work becomes more significant (more costs and no income). Why won’t miners collude? First, they cannot. Secondly, they tried. But third, the fundamental reason is that as the network grows, it becomes more fragmented and the economic compensation that miners receive in aggregate increases. From the point of view of the game theory, the growth of competition and alternative costs complicates collusion, and check of work carried out by miners by all knots of a network serves as a constant system of checks and balances. Miners are simply paid for the service, and the more miners they are, the more motivated they are to cooperate because as competition increases, the likelihood of punishment for invalid work increases. Remember also the random meaning of nonsense. It seemed redundant, but it is at the heart of a function that requires the use of energy resources. It is these tangible costs (hide in play) combined with the cost of currency that motivate the actual work and allow the network to reach consensus.
Since all nodes of the network independently check blocks and miners are punished as much as possible for invalid work, the network is able to reach consensus on the exact state of blockchain without relying on any single source of knowledge or truth. Such decentralized coordination would not have been possible without bitcoin as a currency. The Bitcoin network should reward miners for the security of their domestic currency, whether it is mainly in the form of new Bitcoins today or solely in the form of transaction fees in the future. If the compensation paid to miners is not considered a reliable form of money, there is no incentive to invest in the job.
The role of money in blockchain
If an asset’s primary (and even more so the only) utility is the exchange for other goods and services, and if it is not related to the return flow of a productive asset (such as shares or bonds), it must compete as a form of money and will only retain value if it has reliable monetary properties. Bitcoin is a bearer asset that has no utility other than the exchange for other goods and services. It is also unrelated to the flow of return on productive assets. Therefore, Bitcoin is valued only as a form of money and retains value only because of its reliable monetary properties. By definition, this applies to any blockchain. All that any blockchain can offer in exchange for security is a cash asset built into the network without any mandatory offline payment requirements, which is why blockchain can only be useful in connection with a monetary application.
Without an internal currency, blockchain security depends on trust, which eliminates the need for blockchain as such. In practice, Bitcoin’s security function (mining), which protects the reality of blockchain without the need for trust, requires significant capital investment in addition to high marginal costs (energy consumption). In order to recoup these investments and ensure future returns, payments in the form of bitcoins must more than compensate for the total costs, otherwise no one will invest. In essence, what miners receive for protection (bitcoins) should be a reliable form of money to stimulate investment in security.
It is also fundamentally important for a motivational framework that ensures consensus within the network. Miners have a built-in motivation not to sabotage the network, as this will directly undermine the value of the currency in which they receive compensation. If Bitcoin were not valued as money, there would be no miners, and without miners, there would be no blockchain worth protecting. Eventually, miners get paid to protect the validity of blockchain. If the network is unable to reach a reasonable consensus and if property rights are subject to change, no one can rely on Bitcoin as a value-sharing mechanism. The value of the currency ultimately protects blockchain, and the immutability of the network is the basis of the value of the currency. It is an inherently interdependent relationship.
Unchangeability is an emergent property
Unchangeability is an emergent property of Bitcoin, not a characteristic of blockchain. A global decentralized monetary network without central management cannot function without an unchangeable register (i.e., if the history of blockchain is unprotected and subject to change). If a unit value calculation (bitcoin) cannot be reliably considered final, no one will exchange the real value for it. As an example, we can consider a scenario where one side bought a car from the other for a bitcoin. Let’s assume that there is a transfer of ownership of the car and the buyer takes possession of it physically. If Bitcoin’s title register can be easily rewritten or changed (i.e., the history of blockchain can be changed), the party that gave away the bitcoins in exchange for the car can end up with both the bitcoins and the car, while the other party remains with nothing. That’s why the invariability and finality of the calculations are critical for Bitcoin’s functioning.
Don’t forget that Bitcoin knows nothing about the outside world. Bitcoin only knows how to issue and check the currency. Bitcoin (like any other blockchain) is unable to regulate anything that exists offline; it is a fully enclosed system. Bitcoin’s network can only confirm one side of two-way value exchange. If Bitcoin transfers could not be reliably considered final, it would not be possible to functionally exchange anything of value for Bitcoins. That’s why the immutability of Bitcoin’s blockchain is inextricably linked to the value of Bitcoin as a currency. The finality of calculations in bitcoins is possible only due to the reliable invariability of the register. And the register can only be reliably changed due to the value of the currency. The more valuable the bitcoin becomes, the higher the security; and the higher the security, the more reliable the register is.
Ultimately, immutability is an emergent property, but it also depends on other emergent properties of the network. As Bitcoin becomes more decentralized, it becomes increasingly difficult to change the consensus rules and cancel or prevent actual transactions (also called Censorship Resilience). With Bitcoin’s increased Censorship Resilience, the network’s credibility is growing, contributing to acceptance by further decentralizing the network, including its mining function. Essentially, Bitcoin is becoming more decentralized and resistant to censorship as it grows, reinforcing the permanence of blockchain. It is becoming increasingly difficult to change the history of blockchain because each participant represents a smaller and smaller part of the network. No matter how concentrated the network property and mining are at any given point in time, they decentralize as value grows, thus increasing Bitcoin’s invariability.
Bitcoin, not blockchain
Such a multi-dimensional incentive structure is complex but critical to understanding how Bitcoin works and why Bitcoin as a currency and its blockchain depend on each other. Both are instruments that rely on each other. Without one another, it is virtually meaningless. And such symbiotic relationships work only when applied in monetary terms. Bitcoin is valuable as a form of money only because it has no other utility. This applies to any asset built into blockchain. Bitcoin provides value only through current or future exchanges. And the network can only perform one final function: to verify that each particular Bitcoin is indeed a Bitcoin and to confirm ownership. The Bitcoin network is a closed and completely independent system. Its only communication with the outside world is through security and transaction validation. Blockchain maintains a property rights register and the currency is used to pay for the security of the register. It is thanks to the functionality of the currency that the network is able to provide the necessary level of security to guarantee the permanence of blockchain, which allows network members to more easily and consistently reach consensus without the need to trust any third party. The overall result is a decentralized and unreliable fixed-offer monetary network that is available worldwide and does not require authorization.
All other fiat currencies, commodity money, and cryptocurrencies compete for the same use as Bitcoin, whether understood or not, and monetary systems converge on one medium because of their usefulness in liquidity rather than consumption or production. It would be irrational to store the value in a smaller, less liquid and less secure network if a larger, more liquid and safer network is available. Bitcoin is valuable not because of any particular quality, but because it has reached the ultimate digital rarity. This is the basis of why Bitcoin is as secure as a monetary network, and this property depends on many other emerging properties.
Blockchain, on the other hand, is simply a Bitcoin-related invention that eliminates trusted third parties. It serves no other purpose. It is only valuable as a part of a larger puzzle and is useless if it does not function in combination with currency. The rarity of Bitcoin and its immutability of blockchain ultimately depend on the value of the currency itself. The confidence of the aggregate function contributes to the growth of acceptance and liquidity, which increases the value of the Bitcoin network as a whole. When people choose Bitcoin, they also abandon the worst money networks. Essentially, this is why Bitcoin’s emergent properties are almost impossible to reproduce, and its monetary qualities increase over time (and as it grows in scale), also directly at the expense of the worst money networks.
“I don’t think we’ll ever have good money again if we don’t get it out of the hands of governments. That is, we cannot force them out of the hands of governments, but we can introduce something in some district way that they will not be able to stop. – F.A. Hayek
Ultimately, blockchain is only useful in monetary terms, because its security depends on the domestic currency. Bitcoin represents the safest blockchain. Because all other blockchains compete for the same fundamental monetary application and because Bitcoin’s network effect only continues to enhance its security and liquidity, no other digital currency can compete with it. Liquidity gives rise to even greater liquidity and, as a consequence, monetary systems converge on one medium. Bitcoin’s security and liquidity made all other cryptocurrencies obsolete even before they were born. Find a cryptocurrency approaching Bitcoin in terms of security, liquidity or reliability of its monetary qualities – and I will find you a unicorn.
Bitcoin’s real competition is made up of old money networks, particularly the dollar, euro, yen, and gold. Consider Bitcoin’s homework compared to these old money assets. Bitcoin does not exist in a vacuum; it provides an alternative to other forms of money. An estimate is based on the relative strength of its monetary properties, and when you have a comparison of Bitcoin and old systems, it will provide a solid foundation for the evaluation of any other blockchain-related projects.
Keep in mind that this is only the first part of a large series of articles on a very interesting topic. Keep an eye on the news on our site so as not to miss the continuation.