Introduction To Bitcoin and Cryptocurrencies (Nov. 2017)

Cambridge Centre for Alternative Finance
INTRODUCTION TO
BITCOIN AND
CRYPTOCURRENCIES
Michel Rauchs
Luxembourg Bitcoin Meetup
8 November 2017

1. Context and History
2. How Do Cryptocurrencies Work?
3. Value Propositions and Usage
4. Beyond Bitcoin
5. Conclusion
Agenda
Introduction to Bitcoin and Cryptocurrencies - Michel Rauchs

• Accounting and measurement system
o Tool to measure economic value and to facilitate exchange
o Has taken many different forms in history
o Two main forms/foundations:
What is Money?
Bearer instruments
Physical ’things’ (e.g., precious
metals, paper, shells, …)
Registered instruments
‘Abstract’ account balances (records)
in a ledger, hosted by a central
authority

There are three types of money in the current fiat monetary system:
How Does the Current Fiat Monetary System Work?
Cash
• Physical coins and bills
• < 3% of money in
circulation
Central bank reserves
• Digital equivalent to
physical cash
• Only accessible to
large banks that
have an account at
the central bank
Commercial bank money
• Created by commercial
banks when giving out
loans
• Essentially an IOU
• ± 97% of money in
circulation
Backed and issued by the
central bank
Private money issued by
banks; not backed by the
central bank
Bearer
instrument
Registered instruments based on ledgers
(only in electronic form)

• Each bank creates its own electronic money (‘BGL-euro’, ‘BCEE-euro’, ‘BIL-
euro’)
à just numbers in a ledger hosted in the bank’s private database
• Why would BGL accept ‘BCEE-euro’ (or vice versa)?
o Interbank market: open balances between banks are settled using
‘real’ money (central bank reserves)
o Netting is applied to increase efficiency and lower the amount of
reserves a bank needs to hold at any given time
The Interbank Market

Fiat Money Tends To Be a Bad Store Of Value In the Long Run
• Exposes savers to inflation risk and makes savings worth less over time
• In the long run, fiat money gets always devalued (‘debased’) because
there is close to 0 cost to print more money

Commercial Bank Money Deficits and Drawbacks
• Bank account requirement
• Account can get frozen for a variety of reasons (wealth seizure)
• Payments can get blocked/censored
• No privacy: all transactions are monitored
• PII (personally identifiable information) is distributed all over the Internet
and hosted on insecure servers
• Payments are slow and expensive (not always visible to consumers)

The Cypherpunk Movement
• A group of technologists calling themselves cypherpunks set out in the
early ’90s to achieve privacy and security on the Internet for all
• Main tool = cryptography
• The holy grail was to create a purely digital anonymous currency not
controlled and governed by the state, but by the laws of cryptography
Some early attempts:
o 1997: Hashcash (Adam Back)
o 1998: B-money (Wei Dai)
o 2002: RPOW (Hal Finney)
o 2005: Bit Gold (Nick Szabo)

Announcement of Bitcoin Out of The Blue In Late 2008
Email by Satoshi Nakamoto sent to the
cypherpunk mailing list
Linked whitepaper

Genesis Block Mined on 3 January 2009; the Rest Is History…
Source: CoinDesk (8 November 2017)

Is Bitcoin Simply an Obscure Get-Rich-Quick/Ponzi Scheme?
• Offers a new kind of sound, purely digital money that combines the
concepts of cash and ledger (unit and medium), resulting in the most
transparent monetary system that exists
• Provides a new way to prevent arbitrary copying of digital data (‘double-
spending’) without the need for a trusted third party
• Constitutes a fascinating social experiment: incentive-driven coordination
game with no clear governance model à according to theory, it shouldn’t
work!
• And much more…
NO!

Some Characteristics
• Decentralised:
o Enables censorship-resistance
as no-one is in control
o Global reach: not bound to a
particular jurisdiction
• Bearer asset: private key holder
owns the asset – unseizable
• Artificial scarcity: fixed coin supply
algorithm, enforced through PoW
• Permissionless: open to anyone, no
permission required
• Transparent:
o All transactions are public
and visible to anyone
o Codebase is open-source
and publicly inspectable
• Integrated payment network:
value transfer on the blockchain
• ‘Trust-minimised’: independently
verify validity and state of the
system without relying on a
trusted third party

HOW DO CRYPTOCURRENCIES
WORK?

Components
Cryptocurrencies are based on a combination of concepts from multiple
different disciplines:
• Cryptography
o Public key cryptography and digital signatures
o Cryptographic hashing functions
o Merkle trees
• Computer networking and data transmission
o P2P networking
• Game theory
• Economic and monetary theory
• And more…

Let’s Try To Create a Digital Currency: Step 1
A ledger records who owns what
• Movement of money/value is thus essentially simply passing a message
• “I, Bob, say that I have 10 coins, and want to send 1 coin to Alice”.
Two key questions:
1. How do we create digital identities for network participants and users in
the absence of a central authority?
2. How can we verify that a message really came from the supposed sender?

Solution 1: Public Key Cryptography and Digital Signatures
• Private key
o Similar to a physical key to unlock
the door, or a password
o Secret; used to sign messages
(‘digital signature’ is tied to a
specific message)
• Public key
o Similar to an address or account
number
o Publicly known; can be used to
verify someone’s digital signature
• Anyone can generate a public-private key pair à decentralised identity
management without a central coordinator!

Step 1 of Creating a Digital Currency (Cont.)
Now we can create a very simple digital currency:
• All participants generate a cryptographic key pair: public key acts as
‘account’ identifier, private key acts as password to the ‘account’
• When Alice wants to make a payment to Bob, she simply signs a message
stating how much she wants to send, and submits it to the P2P network
o The P2P (peer-to-peer) network is a distributed network that passes
messages directly between peers (participants running nodes)
o Anyone in the P2P network can verify that indeed Alice has signed
the message herself
o Limited protection from forgery

Step 2: One Major Problem Arises
There are no serial numbers for a coin!
• If Alice sends Bob 10 times the same message, does that mean she sends
him 10 different coins, or 10 times the same coin?
Solutions:
a. Central authority: introduce a central authority (e.g., bank) that acts as a
trusted source of serial numbers for the coin
à That’s what we want to avoid!
b. Shared public ledger: make the entire ledger (record of transactions)
public and let everyone collectively be the ‘bank’!
o This public ledger shared by all participants is the famous blockchain
o It has a very specific data structure:
§ Blocks contain multiple transactions (including the coinbase)
§ Blocks are cryptographically tied/linked to each other

Hashes: Digital Fingerprints
• Cryptographic hashing function:
o Input: any kind of data, irrespective of size and length
o Output: fixed-size string of ‘random’ characters
Examples
“Bitcoin”:
b4056df6691f8dc72e56302ddad345d65fead3ead92
99609a826e2344eb63aa4
“BitCoin”:
a47c917b3de15bac209127accd4f2502b2566fcaa8b
2525ae89f69072210910a
“Bitcion”:
ca32d9e752b78e0fa71e9d8d7ddf834a360e91d617f
d080a1f545ecb7d906764
Visualisation:
https://anders.com/blockchain/hash.html
• A hash is a digital fingerprint of some data:
enables to quickly identify and verify data
Illustration taken from Narayanan et al. (2016) Bitcoin and
Cryptocurrency Technologies: A Comprehensive Introduction

Solution 2: Hashes Enable the Creation of a Tamper-Evident Log
• Including the hash of
the previous ’block’ of
data creates a linked
list of hash pointers
(blockchain)
• Changing even a single
character in one of the
earlier data blocks
changes all subsequent
data blocks as the
hashes won’t match
à enables to detect data
tampering
Illustration taken from Narayanan et al. (2016) Bitcoin and
Cryptocurrency Technologies: A Comprehensive Introduction

Step 3a: the Key Design Challenge Of Digital Currency
How to prevent double-spending a transaction (i.e., spending the same coin
to different people simultaneously)?
Solutions:
a. Trusted third party: acts as central authority over the ledger and
determines which of the conflicting transactions will get accepted
à That’s what we want to avoid!
b. Random election:
1. Nodes collect broadcasted transactions in a new block.
2. In each round, a randomly selected node gets to add his block to the
ledger. All other nodes will then verify the block and accept it if it’s
valid (unspent coins, valid signatures).
3. Nodes show the acceptance of the block by including its hash in the
next block they create.
Illustration taken from Narayanan
et al. (2016) Bitcoin and
Cryptocurrency Technologies: A
Comprehensive Introduction

Step 3b: Why Not Simply Make It a Majority Vote?
Sybil attacks: in computer networks, it is very easy to set up multiple identities
controlled by the same individual
o The more identities (public keys) created, the higher the likelihood of
getting elected
Solution:
Proof-of-work (PoW): organising a ‘lottery’ between participants – the winner
gets the right to add his block to the blockchain (provided it is valid)
o However, winning the lottery (i.e., producing a new block) needs to be
expensive and hard to do, but easy and quick to verify
o The more lottery tickets an individual has, the higher the likelihood of
winning
o Getting more lottery tickets also means spending more, as each lottery
ticket has a cost

Mining Bitcoin
In the context of Bitcoin
• Lottery = finding a nonce (random number) that produces a hash below a
specific target value (a hash value that starts with a lot of zeros)
• Lottery participant = miner (could also be called a ‘hasher’)
• Lottery ticket = hash --> the more hashes a miner produces per second,
the more likely it is he finds the ‘correct’ hash that is below the target
value (i.e., solving the proof-of-work)
• Winning prize of lottery: right to add a new block with transactions chosen
by the miner (prior to playing the lottery) to the blockchain
• Cost of lottery tickets: what does it cost to produce hashes?
o Mining equipment: specialised hardware
o Energy: a lot of electricity

Why Would Miners Want To Spend Costly Resources?
Bitcoin (and other cryptocurrencies) is all about clever incentive design
• Align incentives of self-interested/profit-driven participants in a way that
they work together to support the system (profitable to play by the rules)
We kill two birds with one stone:
• Reward the miner who successfully finds a new valid block with newly
created/minted bitcoin
• This way, we also solve the issue of initial distribution: how to decide how
new bitcoins will be distributed in a decentralised system?
Let’s recap all this using a neat visualisation tool:
https://anders.com/blockchain/block.html

Bitcoin Mining Has Significantly Evolved Over Time
Currently at roughly 11 Exahashes/s:
= 11*10^(18) hashes per second
= 11,000,000,000,000,000,000 h/s
Illustration taken from Narayanan et al. (2016) Bitcoin and Cryptocurrency Technologies: A Comprehensive Introduction
Source: Blockchain.info

A Quick Note On Difficulty
On average, a new block is found every 10 minutes
• However, block times can significantly vary as they depend on two factors:
o Total hashing power available
o Current difficulty of the mining algorithm (‘lottery’)
• Every 2016 blocks, the difficulty gets adjusted (retargeted)
o If more hashing power has entered (i.e., blocks are found less than
10 minutes on average), difficulty increases
o If some hashing power has left (i.e., block times are more than 10
minutes on average), difficulty decreases
Source: Blockchain.info

Isn’t Mining Just A Complete Waste?
Mining is purposefully a resource-intensive process
• Need to make it provably expensive
and hard to find new blocks (and
thereby creating new coins)
• This is what creates and enforces
digital scarcity in the absence of a
central authority
• This also secures the entire
transaction history: changing a
previous block would require redoing
the PoW for all subsequent blocks

How Do We Resolve Temporary Inconsistencies?
It is possible that two honest miners find a block at roughly the same time
• What block will get added to the blockchain?
• There will be a temporary chain split:
o ‘Longest’ chain (i.e., chain with the most cumulative work) wins
o Other chain gets orphaned (i.e., abandoned)

Bitcoin Has Four Key Value Propositions
bitcoin with lower-case ‘b’ (the unit)
• Digital asset:
o Scarce digital commodity: unseizable long-term store of
value (digital gold)
• Currency:
o Digital cash: global payment method native to the Internet
Bitcoin with capital ’B’ (the system)
• Payment network:
o Fast and relatively cheap global value transfer mechanism
• Public notary:
o Global data registry to verify existence and integrity of
data

Utility 1: Digital Asset
• Wealth preservation
(e.g., escape inflation)
• Wealth transferability
(e.g., refugees)
• Financial sovereignty
(independence)
• New asset class
(investment)

Utility 2: Currency
• First purely digital currency native to
the Internet (not a digital
representation of existing currencies)
• Stateless and global:
accepted all over the world
• Useful for online
purchases (both
licit and illicit)

Utility 3: Payment Network
• Neutral because
censorship-resistant
(e.g., WikiLeaks
blockade)
• Relatively cheap and fast cross-
border payments (e.g., B2B,
remittances)
• Ideal for large-value payments
• No downtime: operating 24/7

Utility 4: Public Notary (Timestamping)
• The most secure distributed computing system in the world
o Once recorded, data can only be ’changed’ at a very high cost that is
increasing exponentially over time (probabilistic immutability)
o Proof-of-existence and proof-of-integrity
o Can also be used to build overlay networks on top

An Entire Ecosystem and Industry Has Emerged Around Bitcoin
Illustrations taken from Rauchs (2016) Cryptocurrencies Meeting Ecosystems: The Case of Bitcoin

But Issues Remain…
• Limited throughput and increase in fees
o Limited number of transactions per day:
full blocks lead to rising transaction fees
• Privacy and fungibility
o Public and open ledger: addresses can
be linked/tied to identities (users)
o Impact on fungibility:
tainted/watermarked coins
• Forks, governance, and conflicting views on
Bitcoin’s nature
o Create uncertainty and collateral
damage (e.g., lost funds, delays)
o Civil war in the community

A Quick Note on Forks
A blockchain can permanently fork into two (or more) separate chains
o This happens if the consensus rules are changed
o What is valid on one chain is not valid on the other chain
o Both branches cannot be reconciled anymore

Storing and Securing Cryptocurrency Is Hard!
• Hacks, thefts and losses
o Social engineering attacks,
malware, spyware, …
o Loss of private key(s)
• Re-intermediation and centralisation
o A lot more convenient and easy for
users (especially newcomers) to
store their funds at a custodial
wallet or exchange
o Recreates intermediaries with the
same power (seize & block)
o You don’t control the private key
– not your bitcoin(s)!

A Lot of Other Cryptocurrencies Have Emerged Over Time
• Some, however, implement new, distinct features
• Most do not present any noticeable improvement over Bitcoin – merely copycats
that change a few parameters
Illustration taken from Hileman & Rauchs (2017)
Global Cryptocurrency Benchmarking Study

They Focus on a Variety of Things
Privacy
Computations (‘smart contracts’)
Storage

There Are Thousands of Cryptocurrencies and Tokens
• More than 1,200 coins and tokens are currently being traded
• Combined market capitalisation of nearly $200 billion
Source: CoinMarketCap

It’s Easy To Create Your Own Coin or Token…

… But It’s Difficult To Maintain!
• Price variations of 118 cryptocurrencies with more than $250,000 market
capitalisation plotted over their ‘life cycle’: the vast majority tend towards 0
Willy Woo (2016) Data visualisation: 118 coins plotted
over time this is why HODL altcoin indexes don't work

What’s The Fuzz With Tokens and ICOs?
• ICO (Initial Coin Offering): alternative fundraising mechanism where a project
or start-up raises funds by issuing and selling a token to the general public
o Number of ICOs has exploded in 2017: >$2.3 billion raised
o Facilitated through the use of standards (e.g., ERC20) and the relative
ease of deployment on an existing blockchain (mostly on Ethereum)
Autonomous Next (2017)
Token Mania

Investing In Cryptocurrencies and ICOs Is Very Risky!
• Lots of scams (especially targeting newcomers)
• Illiquid and irrational markets (depending on coin/token)
• Very high price volatility (FOMO, pumps & dumps, uncertainty)
• Tips:
o DON’T INVEST!
o NEVER INVEST MORE THAN YOU CAN AFFORD TO LOSE1!
o MAKE YOUR DUE DILIGENCE (4 TS: TEAM, TECHNOLOGY, TOKEN UTILITY,
TIMELINE)
1 Price à 0; wallet hacked; or keys lost

What About ‘Blockchain’?
• ‘Blockchain’ = blockchain (data structure + P2P network) without a coin/token
o Also called permissioned/closed/private blockchains
o Depend on strict access controls: only vetted actors are allowed to
participate in the network
o Security model: based on ‘off-chain’ legal contracts between known
participants
o Favoured by financial institutions, large corporations, and public sector
institutions --> ‘boring’ enterprise tech (evolutionary)

There Needs To Be a Good Reason For a Decentralised System
bitcoin
A scarce, unseizable, digital bearer asset that can be held and transferred
without having to rely on a central authority or trusted third party
Bitcoin
Secure distributed value transfer and record system that is censorship-
resistant and very difficult to change and tamper with
These properties derived from decentralisation come at a high cost:
• Inefficient: data replicated among 100,000+ computers
• Slow: system is very slow in comparison with centralised alternatives
• Expensive: reaching consensus (e.g., energy consumption for PoW)
• Uncertain: Only probabilistic guarantees as opposed to definite/final

Further Reading
• Two Benchmarking Studies
from the Cambridge Centre
for Alternative Finance:
https://www.jbs.cam.ac.uk/faculty-
research/centres/alternative-
finance/publications/
• Mastering Bitcoin:
https://github.com/bitcoinbook/bitc
oinbook
• Bitcoin and Cryptocurrency
Technologies:
http://bitcoinbook.cs.princeton.edu

Thank You
Michel Rauchs
m.rauchs@jbs.cam.ac.uk
www.jbs.cam.ac.uk/ccaf
@mrauchs

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