(Image Source: https://flic.kr/p/e9LG7B)
(This post is based in part on a paper earlier published by Rostrum Law Review)
This post first explains the Bitcoin Network itself and some of its vulnerabilities, and then the cyptography used by Bitcoins that gives it the title of Cryptocurrency.
The Bitcoin Network
Nakamoto Bitcoins system relies on a method of peer-to-peer networking, and uses proof-of-work to record a public history of transactions, called a Blockchain. Thus, the very same network of nodes that keeps Bitcoins working also at the same time maintains a public record of Bitcoin transactions, informing anyone who wishes to check that Bitcoins have been moved from person A to person B. This record counters double-spending, but protects the identity of the users, since the actual identities of A and B are only know to the parties of the transaction, if even that. This addresses the core issue of double spending that crippled earlier cryptocurrencies, requiring a central database to keep track of the spending. It therefore cuts out the middleman required by fiat currencies and older cryptocurrencies, allowing for an entirely decentralised currency system.
And at the same time, this system also allows individual users to leave and connect with the larger Bitcoin network as they wish, since they work with little or no coordination, and no identification is required – messages are not routed to any specific node, but to the network as a whole, and work on a best effort basis.Any nodes rejoining the network accept the proof-of-work chain as proof of what happened while they were disconnected, and start working again from the latest point.
The decentralised nature of the Bitcoin network is the most attractive feature of the cryptocurrency, but it is also its biggest weakeness. According to Nakamoto, as long as the total computing power of the ‘honest’ nodes dedicated to keeping the Bitcoin network up and running is more than the computing power of a group of attackers, the network will remain unharmed. But though the control of the network is spread through all the computers connected to it, if any one computer or, more likely, a group of computers was to gain control over more than fifty percent of the network, they would control the entire blockchain, and could fudge up the records as they wished, allowing them to double spend. Thus, even though almost all the attempts that have as of yet been made to hack the coding of Bitcoins themselves have been met with failure, the one attempt that worried Bitcoin proponents and users the most was when mining pool Ghash.io briefly gained control of 51% of the network. At the same time, even though the Bitcoin network is quite strong, other avenues of attack such as Bitcoin exchanges and wallets (softwares used by users to store Bitcoins), are also vulnerable, and have been hacked before.
As a result of the regulation of fiat currencies and centralised virtual currencies, all transactions involving them are monitored, and data on them is recorded by the central authority. Thus, no transaction involving these currencies can be entirely anonymous. Bitcoins, as mentioned earlier, do not involve an intermediary. The transactions are entirely peer-to-peer, in the sense that only the parties to the transaction are aware of each others’ identities. The public record of Bitcoin transactions does not note their identity – it only notes the details of the transaction, and the psudeonyms, the usernames, taking part in the transaction.
And this is where the ‘crypto’ part of the term ‘cryptocurrency’ comes in. Every Bitcoin transaction is encrypted with two sets of keys – the public key, and the private key. As their names imply, the public keys are available to everyone, thus adding the transaction to the public list of transactions, but the private keys are, ideally, known only to the owners of the wallet. Before a Bitcoin transaction can be confirmed, the user of the wallet must enter his or her private key. The private key of a Bitcoin address is stored in the wallet itself, designed so that the Bitcoin address can be calculated from the private key, but not the other way around. Hence, even among the parties to the transaction, no personal information is shared.
This part of the Bitcoin transaction is one of the most widely misinterpreted – Bitcoin transactions are not usually anonymous. They are actually pseudonymous, with the Bitcoin wallet address of the Bitcoin user function the same way as an email address. The public ledger of Bitcoin transactions also maintains a record of every user’s encrypted identity. Bitcoins are ‘anonymous’ in the sense that the actual identity might not directly be known, and that the governments do not have access to a collection of data about the users of Bitcoin as they would have with users of fiat currencies. Bitcoins do not offer absolute anonymity, only an increased level of privacy as compared to fiat currencies and centralised virtual currencies. It actually takes considerable intentional effort to make a Bitcoin transaction entirely anonymous.
Thus, the main factors that characterise Bitcoins are their decentralisation, the peer-to-peer nature of the transactions that excludes third parties, the public ledger of transactions and users, and their pseudonymous nature, and all of these factors culminate in taking away from the governments the power to regulate currencies. Bitcoins have become a functional and viable alternative to the existing system of currencies, essentially without costing their users anything, and at the same removing them from government regulation. The essence of Bitcoins, then, is not in anonymity per se, but in the lack of central regulation of the currency. It can even be said that the Bitcoin was actually designed to be regulated – not by a central agency, but by the public at large.
Bitcoin: Questions, Answers, and Analysis of Legal Issues, by the Congressional Research Service.
Virtual Currency: Bits and Bob, by J.P., The Economist.
Bitcoin May Not Be So Anonymous, After All, by Joshua Brustein, Businessweek.