Many people do not understand what cryptocurrencies are, but after reading this overview, we hope that you will understand one cryptocurrency, Bitcoin. Before we begin, we need to make a distinction between “Bitcoin” (upper-case B) and “bitcoin” (lower-case b). “Bitcoin” (upper-case B) is the software that runs the Bitcoin network. “bitcoin” (lower-case b) is the native token or “cryptocurrency” that is used to transact in the network. We have broken up this overview into five sections: (1) the participants in the Bitcoin network, (2) the underlying technology, (3) how users transact, (4) network security, and (5) regulatory environment.
BITCOIN NETWORK PARTICIPANTS
- Users: Users are the parties who transact with one another on the Bitcoin network. Users do not hold bitcoin physically; rather, they control the right to move specific amounts of bitcoin across the network. Users safeguard this control in “wallets”, which can be stored on a personal computer, a piece of paper, a specially designed piece of hardware, or through a third-party service provider, such as Exchanges.
- Exchanges: Most people purchase bitcoin from Exchanges. Exchanges can either sell bitcoin directly to Users, or create a marketplace where Users can transact amongst themselves. They can also store bitcoin for Users or help initiate transactions to other parties on the Bitcoin network. A parallel might be an online bank account where one can purchase financial products, in addition to wiring money.
- Miners: Mining is the process by which transactions are verified and confirmed on the Bitcoin network. Miners, which are specialized computers, race to solve a computationally intensive mathematical problem. Solving this math problem verifies and confirms that the proposed Bitcoin transactions are legitimate and that no one is sending bitcoin that they do not own. The first Miner to win the race is awarded with newly created bitcoin, as well as transaction fees from senders who want their transactions processed more quickly. Around the year 2140, new bitcoin will cease to be created and Miners will only be rewarded with transaction fees.
Bitcoin solved a problem in computer science originating in 1982, called “The Byzantine General’s Problem”. The question was how to establish trust and reach agreement among parties who do not necessarily know or trust one another. To solve this problem, Bitcoin employed a combination of cryptography and economic incentives. The cryptography ensures, among other things, that people only spend bitcoin that they own, and the economic incentives make it more profitable for Miners to act honestly rather than nefariously.
The blockchain is a continually growing database of all past transactions. Each “block” is a collection of transactions that are validated at the same time, and the “chain” is the chronological sequence of blocks containing all past transactions. A new block is created approximately every ten minutes by Miners, who are awarded with new bitcoin, currently 12.5 BTC, as well as any transaction fees.
Bitcoin uses several cryptographic functions, but for purposes of this overview, it is only important that you understand Private Keys, Public Keys, Addresses, and Wallets.
- Private Keys are strings of random numbers and letters, chosen at random by the Bitcoin software that can be used to spend the bitcoin associated with a specific Address. A parallel might be the PIN number of a checking account; and thus, Private Keys should not be shared.
- Public Keys are derived from their associated Private Key, but can be publicly shared. Addresses are derived from Public Keys.
- Addresses often represent Users’ public identities, like a bank account number. This is where you send or receive bitcoin and both the sender’s and receiver’s Address are included in the transaction data stored on the Bitcoin blockchain.
- Wallets are a collection of Users’ Private Keys and Public Keys that give Users the right to move the associated bitcoin. Wallets do not physically contain any bitcoin.
Transactions are like the double entry accounting system that dates back hundreds of years. Each transaction contains inputs, or debits against a sender’s account, and outputs, or credits to a receiver’s account. Balances are the sum of all debits associated with their private keys, minus all credits.
To initiate a transaction, you only need to know the Address of the person to whom you want to send bitcoin. You, or the Exchange on your behalf, will “sign” the transaction with your Private Key, thereby authorizing the transfer of bitcoin. Once the transaction is initiated, the Bitcoin software will look at all previous unspent outputs (debits) related to your Public Key to make sure you hold at least as much bitcoin as you want to send. Because a new block is only created every ten minutes, the transaction is not completed immediately, but is instead added to a list of unprocessed and unverified transactions called the Memory Pool or “Mempool”.
Miners participate in a competition to create new blocks that contain transactions from the Mempool. Because blocks have a fixed size, all pending transactions in the Mempool do not necessarily fit in one block, and Miners prioritize transactions with higher fees. Transaction fees are specified by the sender of bitcoin, so if timeliness is important, the sender may consider paying higher fees.
The competition is a race among the Miners to find the solution to a mathematical puzzle that confirms the validity of a Bitcoin transaction. This competition requires Miners to contribute significant amounts of computer processing power to the network, making the puzzle difficult to solve. Although difficult to solve, it is very easy to verify that the solution is legitimate. After solving the puzzle, the winning Miner notifies the other Miners in the network of its solution, and the other Miners then verify that the solution is indeed legitimate. Once verified, the new block is cryptographically linked to the chain of previous blocks. Miners then begin solving the puzzle for new transactions that have accumulated in the Mempool.
If you have heard about Bitcoin, you have also probably heard about hacks, thefts, and lost hard drives containing access to large amounts of bitcoin. The software running the Bitcoin network is extremely secure, built on decades of cryptographic research, and has an economic incentive structure making it is more profitable to protect the integrity of the blockchain than to attack it. However, Bitcoin is still in its infancy and should be considered an experimental technology. Although rare, other cryptocurrencies have had critical errors in their codebases.
Most cryptocurrency-related security incidents resulting in theft or loss of funds have been due to user-error or issues with third party service providers. Because Bitcoin is an open source, decentralized network, there is no central authority to reset passwords or recover lost funds if something goes wrong. The security of private keys, and therefore access to funds, is the sole responsibility of Users. Private keys can be stored locally on a computer, paper wallet, or hardware security module, such as a Ledger Nano S. They can also be entrusted to third parties, such as Exchanges and online wallet providers. When using any online service, we encourage best practices with regards to internet security, such as the use of strong, unique passwords and two factor authentication services, such as Google Authenticator. Exchanges and online wallet providers have been hacked in the past, which exposed Users to loss of funds, even when they followed best security practices. Therefore, we encourage the use of only vetted, reputable third party service providers to mitigate counterparty risk.
Bitcoin, at its heart, is a technology and the U.S. government generally does not regulate technologies themselves, but rather, how technologies are used. For example, PayPal is regulated as a money service business because it enables the sending of money over the Internet, but the Internet itself is not regulated as such. Not surprisingly, the U.S. Congress and many U.S. federal and state agencies, including the SEC and the CFTC, have begun examining the operations of digital asset issuers, their Users and the market for digital assets, and have claimed authority to govern various aspects of the digital assets ecosystem.
It is not always easy to determine which agency has governing authority. For example, a CFTC commissioner recently said that digital assets “may actually transform at some point from something that starts off as a security and transforms into a commodity.” The CFTC determined in 2015 that bitcoin is a commodity and that fraud and manipulation involving bitcoin is within the purview of the agency. However, financial products linked to the value of digital assets, including bitcoin, may be structured as securities and subject to U.S. securities laws. In addition to complying with federal laws, bitcoin-related companies must also comply with state regulations, some of which are tailored specifically to digital asset activity, such as the “BitLicense”, which was created by the New York State Department of Financial Institutions in 2015. Still, because Bitcoin is a global network, the laws and regulations from jurisdictions around the world are applicable and how countries approach digital assets range from clear regulatory guidance and approval to outright bans on digital asset ownership.
For a more in-depth look at the underlying technology behind Bitcoin and Ethereum, we have a Digital Assets Primer that is available to our clients here.
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