Bitcoin and Cryptographic Finance. Technology, Shortcomings and Alternative Cryptocurrencies E-Book

Lukas Leys

• Herausgeber: Studylab
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 252

Veröffentlichungsjahr: 2017

Beschreibung

Designed by an anonymous creator, Bitcoin is an intriguing and revolutionary modern technology and payment transaction infrastructure. But as with any new technology, there are many obstacles and threats on the path towards mainstream acceptance. What are the shortcomings of the Bitcoin protocol and Bitcoin as a currency? Moreover, which competitors may one day be able to surpass Bitcoin and make it obsolete? Could a suitable competitor replace Bitcoin, or will the open source virtual currency keep improving itself to make competition obsolete? Traditional classifications for currencies do not adequately apply to Bitcoin. It is a new type of financial technology that entered the global market in 2008 and has since been able to draw the attention of investors, business leaders, regulators and politicians. Whereas a Dollar, Yen, Yuan or Euro can be hold like a currency, they cannot be secured and transacted simply by itself. Individuals have to rely on third party intermediaries in order to transfer funds for them and in order to store them securely. Contrary to that, one cannot focus on Bitcoin as a currency without acknowledging that it is also a transaction system in itself and would not be able to function is one part of this duality is gone. In fact it is even more precise to look at Bitcoin as a decentralized transaction and financial services system, with a currency function being only one aspect of the technology. In this book: - Bitcoin; - Ripple; - cryptocurrency; - financial technology; - financial service; - virtual currency

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Table of Contents

Abstract

Acknowledgement

List of Abbreviations

List of Images

List of Tables

1. Executive Summary

2. Definition of Bitcoin

2.1 Technical Description of Bitcoin Transaction

2.2 Blocks

2.3 The Byzantine Generals Problem

2.4 Double Spending Solution

2.5 Decentralization

3. Technology of Bitcoin

3.1 Method of Operating

3.2 Network

3.3 The Block Chain

3.4 Wallets

3.5 Bitcoin Addresses

3.6 Public Key

3.7 Private Key

3.8 Mining

3.9 Difficulty

3.10 Anonymity

4. The Shortcomings of Bitcoin

4.1 Zero-Sum Game and Investor Problem

4.2 Price Volatility

4.3 51% Attack

4.4 Mining Incentive Scheme Flaws

4.5 Private Key Vulnerability

4.6 Irreversible Transactions

4.7 Information Asymmetry

4.8 Fraud and Hacking

4.9 Confirmation Times

4.10 Deflationary Bias

4.11 Bitcoin Wealth Distribution

4.12 Scalability

4.13 Energy Consumption

4.14 Illicit Transactions and Money Laundering

4.15 Conclusions

5. Analysis: Alternative Cryptocurrencies

5.1 Alternative Cryptocurrencies

5.2 Litecoin

5.3 Dogecoin

5.4 Darkcoin

5.5 Peercoin

5.6 Ethereum

5.7 Primecoin

5.8 Mastercoin

5.9 Network Effect of Bitcoin

6. Analysis: Ripple

7. Analysis: Bitcoin Side Chains

8. Conclusion

9. Bibliography

10. Appendix

A1: Bitcoin Vocabulary

Abstract

Designed by an anonymous creator, Bitcoin is an intriguing to modern technology and payment transaction infrastructure that has the potential to become a game changer within the sector of virtual payments. But as with any new technology, there are many obstacles and threats on the path towards mainstream acceptance. In this thesis we analyze key shortcomings of the Bitcoin protocol and Bitcoin as a currency. Moreover, we explore competitors that may one day be able surpass Bitcoin and even make it obsolete. The key question we as is if a suitable competitor can replace Bitcoin or can the open source virtual currency be improved itself in other to make competition obsolete.

Acknowledgement

My gratefulness goes first and foremost to the people who supported me during the research and writing phases of this diploma thesis. Getting a closer look at the technological innovation that Bitcoin represents and the potential benefits that it could offer was a very valuable experience that guided me through the process of creating this thesis.

Furthermore, I want to thank Univ.-Prof. DDr. Jürgen Huber for his continuing support and his enthusiasm for the topic of my diploma thesis during the entire time of researching and writing it. Likewise, I want to thank Univ.-Prof. Dr. Matthias Bank, CFA for his support and input during the Diplomanden AG at the University of Innsbruck.

Next, I want to acknowledge the outstanding work that MMag. Matthias Korp has provided with his diploma thesis about Bitcoin in 2012, which represented the basis for my thesis.

Additional thanks and appreciation go to family and friends who kept me motivated and provided me with valuable input during this phase of my life.

List of Abbreviations

List of Images

Figure 1: Historical Bitcoin Price in USD

Figure 2: Differences between Electronic Money and Virtual Currency

Figure 3: Bitcoin Transaction

Figure 4: Schematic Bitcoin Block Chain

Figure 5: Illustrative Bitcoin Block

Figure 6: Merke Tree Root Hash

Figure 7: Byzantine Generals Problem

Figure 8: Double Spending Schematic

Figure 9: Centralization vs. Decentralization vs. Distributed Networks

Figure 10: Simple Bitcoin Transactions

Figure 11: Timestamp Server

Figure 12: Proof-of-Work

Figure 13: Merkle Tree Block Implementation

Figure 14: Longest Proof-of-Work Chain of Blocks

Figure 15: Bitcoin Transfer Inputs and Outputs

Figure 16: Network Message Propagation

Figure 17: Schematic Bitcoin Block

Figure 18: Schematic Bitcoin Block Chain

Figure 19: Public-Private Key Schematic

Figure 20: Elliptic-Curve Public Key to BTC Address Conversion

Figure 21: Bitcoin Address on Blockchain.com

Figure 22: Cost of Generating One Bitcoin vs. Resulting Reward

Figure 23: Constrained Input Small Output Illustration

Figure 24: Bitcoin Hash Rate vs. Difficulty

Figure 25: Bitcoin Hash Rate Fluctuation

Figure 26: Total Bitcoins in Circulation

Figure 28: Banking Privacy to Bitcoin Privacy Comparison

Figure 29: Gaussian Loss versus Return on Zero-Sum Investment

Figure 30: Bitcoin Price Volatility Comparison

Figure 31: Bitcoin Price Volatility Comparison

Figure 32: Trend of Bitcoin Volatility

Figure 33: Miner Network Distribution

Figure 34: Litecoin Hash Rate Distribution

Figure 35: GHash.io Mining Distribution Dominance

Figure 36: Pool Revenue of Selfish Miners

Figure 37: Threats to Mining and Decentralization

Figure 38: Taxonomy of Wallet Threats

Figure 39: Daily Volatility to Risk of Breach Relationship

Figure 40: Maturity of Business to Breach Relationship

Figure 41: Mt. Gox Hacker-Induced Flash Crash during 2011

Figure 42: Bitcoin Fork during Double-Spending Attack

Figure 43: Bitcoin Monetary Base and Growth

Figure 44: Inequality Distribution

Figure 45: Block Chain Size over Time

Figure 46: Average Block Size over Time

Figure 47: Network Propagation Delays and Block Sizes

Figure 48: Estimated Power Consumption of the Miner Network

Figure 49: Bitcoin Hash Rate vs. Difficulty

Figure 50: Historical Influence of Silk Road on Bitcoin

Figure 51: Silk Road Shutdown Impact on Bitcoin Price

Figure 52: Tagged Transactions: Stolen Mt.Gox Bitcoins

Figure 53: Bitcoin vs. Altcoin Market Capitalization

Figure 54: Litecoin Hash Rate vs. Difficulty

Figure 55: Online Tipping

Figure 56: Anonymizing of Darkcoin Transactions

Figure 58: Mastercoin Protocol Layers

Figure 59: Ripple Function Schematic

Figure 60: Multiple Currency Pairs vs. Vehicle Currency

Figure 61: Ripple Protocol to Email Protocol Comparison

Figure 62: Ripple Ledger

List of Tables

Table 1: Bitcoin Specific Benefits

Table 2: Bitcoin Units

Table 3: Block Term Description

Table 4: Input – Output Differences of SHA-256 Hashes

Table 5: Client Description

Table 6: Types of Wallets

Table 7: Proof-Of-Work Example

Table 8: Double Spending Probabilities

Table 9: Projected Bitcoin Money Supply

Table 10: Bitcoin Distribution by Address at Block 300,000

Table 11: Altcoin Comparison

Table 12: Proposed Applications of the Ripple Payment System

Table 13: Cryptocurrency Quadrant

I’m sure that in 20 years there will either be very large (bitcoin) transaction volume or no volume.

1. Executive Summary

This thesis aims to look at the virtual currency Bitcoin in order to investigate some of the potential of cryptocurrencies. Traditional classifications for currencies do not adequately apply to Bitcoin. Regulators and banks currently share this view on cryptocurrencies. Existing currencies have certain common characteristics that Bitcoin does not share. It is a new type of financial technology that entered the global market in 2008 and has since been able to draw the attention of investors, business leaders, regulators and politicians.

Whereas a Dollar, Yen, Yuan or Euro can be hold like a currency, they cannot be secured and transacted simply by itself. Individuals have to rely on third party intermediaries in order to transfer funds for them and in order to store them securely. Contrary to that, one cannot focus on Bitcoin as a currency without acknowledging that it is also a transaction system in itself and would not be able to function is one part of this duality is gone. In fact it is even more precise to look at Bitcoin as a decentralized transaction and financial services system, with a currency function being only one aspect of the technology. In this thesis, we evaluate not only the technological characteristics of decentralized, cryptographic currencies, but also the current applications that are in development and which can result into a number of decentralized financial services that are not subject to financial institutions.

Third party intermediaries, such as banks and payment providers and other non-bank entities all essentially rely on trust. They provide security, confidentiality, fraud protection, transaction infrastructure, payment disputes and reversals, access to financial products and services, international money transfers and the like. In order to be able to provide these services, they have to charge fees and interest from customers. In many cases, these customers must meet a set of criteria in order to have access to banking services. Moreover, they have to provide institutions with a significant amount of personal information, private information and confidential data about them and their financial characteristics. Thus customers have to enter a costly, trust-based relationship with institutions in order to engage into financial activities and benefit from financial services.

So what are the prospects of a technology that was invented and designed in order to provide most of these services at a low-cost, trust-less basis? Do financial intermediaries have reasons to ignore this technology and expect that cryptocurrencies will remain only present within niche markets for nerdy or technologically savvy people, or should they make use of the open-source code and incorporate some of its features into their systems? Or could cryptocurrencies themselves evolve into new type of financial market – “decentralized finance” or “cryptographic finance”.

This thesis attempts to provide some answers to these questions and give an outlook for what can potentially be expected by cryptocurrencies.

In chapters two and three we will provide a detailed overview of Bitcoin’s technology and the necessary infrastructure that it is based on. We discuss how cryptography is employed by the system as well as how it facilitates secure transactions. We explain the significance of the solution to the Byzantine Generals problem that the cryptocurrency represents and that of decentralized networks.

Chapter four goes into detail about current and persistent shortcomings that can be identified. We discuss issues concerning network delay, incentive schemes of the decentralized network, transaction confirmation delays, energy consumption and the like. Furthermore, we discuss whether these imperfections are likely to be permanent issues or can be mitigated by improving Bitcoin’s current technology.

In chapter five we discuss a number of alternative cryptocurrencies that emerged after Bitcoin was developed and discuss some of their features that address certain weaknesses of Bitcoin that we discussed in chapter four. We list alternative options to Bitcoin’s current technology and discuss how they could mitigate the shortcomings that are present within Bitcoin. Moreover, the question whether there is a Bitcoin 2.0 version foreseeable within the current alternative cryptocurrency market.

Chapter six details a special type of cryptocurrency that is already in use within a few banks. Ripple is a network, a distributed exchange and a cryptocurrency that is very akin to Bitcoin, but differs in some key aspects. It provides a different solution to the Byzantine Generals problem and is specifically targeted towards being used as a transaction system for banks and financial institutions.

Chapter seven gives an outlook on a proposal made by key people within the cryptography scene that is currently in development. Bitcoin side chains are alternative block chains that give Bitcoin additional features. These could incorporate features of alternative cryptocurrencies without altering the Bitcoin protocol itself. We discuss the influence that side chains could have on the cryptographic currency market.

2. Definition of Bitcoin

Bitcoin is a peer-to-peer version of electronic currency that allows direct payments between two parties without a financial intermediary. It is based on a decentralized network that facilitates and verifies transactions. It allows users to verify valid transactions and generate bitcoins by solving complex mathematical puzzles, which are based on a proof-of-work (PoW) concept.{1} It has become characteristic to refer to the network protocol as “Bitcoin” with a capital “B” and to the unit of currency as “bitcoin” in its lowercase form.

Bitcoin is both a special type of virtual currency and a peer-to-peer transaction system. It is based on a network of nodes that all share data and hardware resources in order to form a chain of transactions that are stored on the so-called block chain.

Goldman Sachs Global Investment Research (GS GIR) defined Bitcoin as “Bitcoin is a decentralized, peer-to-peer network that allows for the proof and transfer of ownership without the need for a trusted third party. The unit of the network is bitcoin (with a little “b”), or BTC, which many consider a currency or internet cash.“{2}

The concept was initially proposed by an anonymous individual or group that operates under the alias ‘Satoshi Nakamoto’ and who published the concept in form of a white paper called “Bitcoin: A Peer-to-Peer Electronic Cash System” in October 2008. Nakamoto (2008) described Bitcoin as a purely peer-to-peer version of electronic cash which allows sending transactions from one person to another without relying on a third party payment transmitter. The first bitcoins were created on January 3rd 2009 by solving the so-called genesis block, which was accomplished by Satoshi Nakamoto.{3} The genesis block is the first block in the block chain – a non-alterable, majority consensus based public ledger that records and publishes the entire transaction history of Bitcoin.

What makes Bitcoin a significant innovation are two main reasons. First, it is the first successful attempt to establishing a cryptocurrency which has managed to gather a significant following behind it. Secondly, Bitcoin offers important technological innovations to the field of financial transactions that were previously inexistent. It solves the so-called Byzantine Generals problem in a way that enables the creation of a payment transaction system that does not rely on trust and therefore does not require a number of services that traditional financial intermediaries provide, as the software itself is designed to provide these functions. It is a decentralized, global means of payment that does not require financial intermediaries in order to conduct them.

Bitcoin transactions are significantly less expensive than currently existing payment transaction services. Wingfield (2013) compared Bitcoin transactions with credit card, PayPal or other transaction methods, which charge about 2-3% transaction fees. These forms of transactions rely on financial intermediaries and provide services to customers, such as security, facilitation, verification. Many of these services are, however, necessary to provide the current electronic payment infrastructure. Financial intermediaries are also present within the Bitcoin ecosystem. Examples such as Coinbase or Bitpay provide wallets services to securely store bitcoins or facilitate instant fiat conversion of received bitcoin transactions in order to hedge against price volatility. With these intermediaries present, transaction fees are still considerably lower than those of almost all current transaction services providers, which would broadly require 0.5-2.5% or fixed transaction fees to cover expenses and generate profit.{4}

Bitcoin must be seen as both a type of virtual currency and a decentralized transaction system. A clear differentiation from either use is not a simple task. GoldmanSachs (2014) argued that Bitcoin’s future lies within the payment transaction infrastructure, but it will not be used as a currency or store of value. Central banks of several countries have already stated that Bitcoin cannot be defined as a currency but rather resembles a commodity.{5}

Contrary to what is often believed, bitcoins are not simply ordinary computer files that are stored on a hard drive and can thus be treated like any other data. Bitcoins exist in a shared, globally networked database, which is stored simultaneously on a great many of servers across the world. All of these network nodes maintain identical copies of the same database. Bitcoins therefore exist in many locations simultaneously and can by itself be moved between locations or exchanged between peers. Ownership of bitcoins is represented by possessing the knowledge about a cryptographic key that allows access to bitcoin funds and enables transactions of bitcoins between Bitcoin addresses. Cryptographic keys are strings of alphanumeric characters that allow users to edit the shared database, e.g. when sending BTC from one address to another. Nakamoto (2008) described how Bitcoin relies on a peer-to-peer decentralized network that enables verifying transactions with a proof-of-work (PoW) method. PoW is used as a verifier to ensure that a enough computational effort has been performed in order to enable secure payments. {6} Traditional transaction processes require a trusted intermediary that verifies transactions and prevents funds from being counterfeited or subject to malicious attacks.

A simple peer-to-peer financial payment network would still be vulnerable to malicious attacks and theft. In fact, it would be very easy to do so within decentralized networks. The key innovation about Bitcoin that it provides security to the network and also provides similar benefits that financial intermediaries offer to financial networks. Transactions are verified based on a proof-ofwork (PoW) concept that distributes financial funds and prevents manipulation of the financial network. PoW imposes costs and resource requirements that prevent malicious attacks due to making them very resource-intensive and therefore unprofitable.

Bitcoins are not centrally issued but are created by a process referred to as “mining”, which is the process of solving complex mathematical computations (solving blocks) in order to receive bitcoins (block rewards) and at the same time verifying valid transactions. Bitcoin is based on a SHA-256 algorithm and designed to create new blocks every 10 minutes for which miners are competing against each other in order to solve a block and broadcast it to the remaining network first.

Citing the director of the Financial Crimes Enforcement Network Jennifer Calvery in a hearing in front of the United States Senate, as well as Gup (2014), Rogojanu & Badea (2014) and Barber et al. (2012) – among others – list the following advantages that Bitcoin offers:

Table1: Bitcoin Specific Benefits

Bitcoin and many other virtual currencies are, however, also subject to features that are less desirable and could cause them to fall under intense scrutiny by regulators, politics and law enforcement. Virtual currencies can also be misused to facilitate tax avoidance, money laundering, illegal goods purchases, fraud, and terrorism finance.{7} As such, it is logical to assume that Bitcoin and other virtual currencies will face regulatory uncertainty and political risk, and specific cryptocurrency-specific regulation will be in place at some time in the future.

Gup (2014) also noted that Bitcoin could be used as a secure store of value. This, however, is currently very questionable, as virtual currencies are still unregulated, highly speculative assets that are subject to limited liquidity, intense volatility and considerable operational risk (theft, business failure, hacking, etc.). Levin (2014) found an average daily price volatility of around 5%, which he compares to one of the most volatile currency pairs – ZAR:JPY (South African Rand : Japanese Yen) – which has a daily volatility close to 1%. In Bitcoin’s relatively short history there have been a number of intense price fluctuations.{8} Figure 1 provides an overview of the historical bitcoin price in USD, beginning at the time bitcoins were actively traded against the US Dollar on dedicated bitcoin exchanges.

Figure1: Historical Bitcoin Price in USD

Source: Blockchain (2014), blockchain.info, 12.10.2014

Nobel Prize laureate Milton Friedman is said to have predicted the development of ‘internet money’ in 1998, by stating: “So that I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A.”{9} Friedman, however, went on to also note the negative implications of such an invention, noting that illegal activities, such as illegal transactions and tax evasion will also be easier to conduct.{10}

Bergstra & de Leeuw (2013) proposed to classify Bitcoin as a hybrid form of money that falls under the definition of technically informational money (TIM). Money can be distinguished into informational and non-informational depending on e.g. its capacities to store, access and exchange informational value. They acknowledged that Bitcoin could also be a hybrid class of informational money that exhibits aspects of both technically informational money (TIM) and exclusively informational money (EXIM).

When attempting to analyze Bitcoin, it is fundamentally important to understand that the underlying technology. Digital currencies have been proposed and developed long before the invention of Bitcoin. Tanaka (1996) described the different aspects of digital cash just two years after the first online shops were opened and internet banking was still in its infancy.

Tanaka (1996) argued that the key benefits of digital cash would be

1. Cost Reduction: transferring funds through the internet is significantly less expensive when compared to the traditional banking system, as online payments do not, or only to a very limited extend, require physical presences, human resources and electronic transaction systems. Moreover, digital cash payments can be done through already existing internet infrastructure, such as personal computers and already active online presences.

2. Cross-country money transfers: In the absence of national borders in the Internet, money can be transferred across countries without international money transfer infrastructure. Digital cash eliminates transfer fees as well as currency exchange fees. Moreover, in certain aspects of cross-country money transfers, digital cash would eliminate currency exchange risks.

3. Accessibility: Digital cash systems could be accessed and used by anyone who is connected to the internet, whereas conventional banking and non-bank financial service providers limit accessibility of their services. Limits as to who can use credit card payments or from which region in the world the payment can originate are not present with digital currency payments.

Due to these reasons digital cash certainly offers the potential for more efficient and broader financial services that are not present within the walled-garden architecture of the global financial market.

Tanaka (1996), however, also points out obvious drawbacks for digital cash. Internet currencies, due to its anonymity and the potential for untraceable money transfers could facilitate tax evasion and money laundering. Moreover, due to the absence of a central bank or institution backing the value of digital cash the exchange rate of digital currencies would be inherently unstable and there is a potential for financial crises as operations on the internet are subject to the thread of power outages, theft and malicious software.

The European Central Bank (ECB) provided a clear distinction between electronic money systems and virtual currency systems. They emphasize that virtual currency schemes do fulfill some of the criteria but remain a distinct category. Electronic money schemes have a link to traditional money and as such are connected to regulated currencies with a legal foundation. The unit of account are fiat currencies, and as such fall within the frameworks of electronic mine institutions and prudential supervisory requirements. As of yet, virtual currencies are privately generated and can be distinguished by whether they can be exchanged for virtual as well as real goods and services.

Figure 2: Differences between Electronic Money and Virtual Currency

Source: European Central Bank (2012), p. 16

They fundamental difference between both categories is that electronic money schemes refer to units of account that are regulated and issued by sovereign entities, such as the ECB or the Federal Reserve System (Fed). They are digital equivalents of Euro, Dollars, or Yuan. As such, they are legal tender within their jurisdictions that have to be redeemed at par value. Contrary to that, virtual currencies are private inventions that are unregulated and do not qualify as legal tender.

Early research in the field of digital cash payment systems repeatedly pointed out the potential for money laundering and tax evasion. This was due to the assumption that digital currencies would be untraceable and anonym. Despite being citizen for similar reasons, Bitcoin is in fact neither untraceable nor is its use as a payment system truly anonymous. The peer-to-peer based proof-ofwork concept of Bitcoin allows it to trace and publicly show every single payment that has been conducted in the network over the entire history of Bitcoin. All valid transactions are broadcasted publicly across the entire networked Bitcoin system and the data about these transactions will be stored and preserved inalterable within the public block chain ledger.

The monetary supply is defined by the protocol which imposes a fixed cap of about 21 million bitcoins. The precise reason why 21.000.000 was chosen to be the maximum amount of Bitcoin in existence is subject to discussion.{11}

The term “Bitcoin” is somewhat misleading for most individuals. Bergstra & de Leeuw (2013) argued that “Bitcash” would be a more adequate term. The term “coin” is commonly associated with a non-divisible unit of value consisting of valuable metals. Contrary to that, Bitcoin is designed to be highly divisible, with its base units commonly referred to as “satoshi” (0.00000001 BTC, or 10−8), in reference to the alias of Bitcoin’s inventor. Over time many major Bitcoin proponents began popularizing the term “bits” instead of “satoshis” for its base value in order to facilitate ease of use.{12}

Table 2: Bitcoin Units

Source: Bitcoin Wiki. Units, 09.07.2014

Thus the total amount of Bitcoin base units is 2,100,000,000,000,000 (21 quadrillion) bits.

In this thesis, we focus on Bitcoin primarily as a transaction system and discuss the details of its underlying technology that enables high-speed, low-cost, secure payments across the globe. Aspects concerning the question whether Bitcoin can be defined as a currency or an alternative monetary system are not within the focus of this thesis, and as such are discussed only incidental, wherever such discussion is deemed necessary.

2.1 Technical Description of Bitcoin Transaction

While a Bitcoin transaction is very simple to conduct and the process of transacting bitcoins is rather straightforward, the technological process underlying to it is complex and full understanding requires some relevant knowledge in the field of cryptography. More details about public keys, private keys, processing, mining and the block chain is provided in subsequent chapters of this thesis.

In order to transfer bitcoins from sender ­­0to receiver ­­1, the sender must know the public key of the receiver. Transactions are sent to and received from Bitcoin addresses. Addresses are derived from public keys and vary in length but tend to be around 31 characters long. An address is a hash containing 160 bits and a checksum that provides error-detection. Transacting the cryptographic currency requires a hash value, which is the value that the SHA-256 algorithm produces in order to map larger data sets to smaller, fixed-length data sets. Notably, this process requires that that the code of the bitcoins includes and stores information about which public addresses where involved in the transaction. ­­0 digitally signs the hash with his secret private key in order to transmit the transaction. Thereby he broadcasts the transaction to the decentralized peer-to-peer

Bitcoin network, where all other nodes receive and rebroadcast the transaction.{13}

Figure 3: Bitcoin Transaction

Source: European Central Bank (2012), p. 23

After a valid transaction is sent to the Bitcoin network it is included into the currently calculated block within the block chain. The block chain is a decentralized, consensus-driven public ledger that includes every valid transaction and archives them. {14} It timestamps and records valid transactions and shares this data with all nodes within the network. Stored information includes public addresses of sender and receiver, transaction key, transaction size, fees, timestamp and network propagation (number and location of nodes that received the broadcast about the transaction). It does not include identities of the payee and receiver, the IP addresses of their devices, or purpose of the transaction.

A transaction remains unverified until a valid block is found, verified by the network and linked to the longest chain of blocks within the Bitcoin block chain. If the transaction is included in the data set of the most recent block, and not fraudulent activity was detected, it will be verified by the network and confirmed. As new blocks are generated every 10 minutes, the first confirmation of the transaction should be obtained within these 10 minutes or less, depending on the progression of the current block period. For each subsequent block that is added to the block chain another confirmation is obtained. The number of confirmations can be seen as a measure of confidence that the transaction is valid.

Figure 4: Schematic Bitcoin Block Chain

Source: Green (2013) blog.cryptographyengineering.com, 05.05.2014

Confirmations act as a verification that bitcoins have actually been successfully transferred and e.g. no double-speding of bitcoins has occurred. This represents one of the key functions of the public block chain and the proof-of-work mining process.

Meiklejohn et al. (2013) explained that in each transaction the previous owner signs with his private key a hash of the received transaction and the public key of the new owner, thus forming a chain. This chain is used to verify the validity of a Bitcoin transaction and also allows to track the history of the received bitcoins.

Nakamoto (2008) argued that in order to achieve a decentralized payment network that does not require a trusted intermediary, transactions must be publicly announced and all participants in the network must agree on a single history of transactions. Without consensus of the network, it could be possible to send the same bitcoins from one address to more than one receiver, thus doublespending them. As only one of those can be validated by the block chain, the other one would be classified as double-spent and rejected by the network.

Transactions of bitcoins are not reversible. As all transactions with bitcoins require to be signed with a cryptographic private key, there is no technical method built-in the protocol to reverse transaction from the sender’s perspective once they are completed and added to the public block chain ledger.

Bitcoin transactions are verified and broadcasted by Bitcoin miners, who provide the necessary network that enables transactions between peers. In order for miners to identify valid transactions and propagate them, transactions are included into a ‘block’.

2.2 Blocks

A block is a set of data that contains all transaction data that was created since validation of the previous block.{15}