At the heart of this matter
Bitcoin is decentralized, and its control is distributed around the world to the miners. Miners verify every transaction that is being made, and they add a record of it in the blockchain. Since its control is decentralized, which gives it more security and autonomy, it has a massive advantage over previous money systems. This same factor also slows down the whole bitcoin network because all the miners need to verify a transaction with frequently increasing network congestions, and since keeping in sync with all the miners worldwide takes a while. This slows down the bitcoin network. Since this slowdown is threatening the very existence of this cryptocurrency, many fundamental changes have been proposed for quite some while and debate is ongoing what system is best for this massive network.
The Money systems and their flaws
Bitcoin is a new money system that promises to revolutionize the way we trade. It emphasizes security and autonomous nature preventing it from being abused. To understand the concept of Bitcoin, we have explained the concept of money itself from the very beginning. This helps you understand the various aspects of money systems and their respective flaws so that you can understand the need for a new model. It also helps in briefing the topic about which many of us are instinctively aware but not intellectually. If this comes as too much of reading for you, then you can skip this section altogether and get started with Bitcoin right away. We promise you wouldn’t miss a thing.
Before the concept of money didn’t exist, people exchange services and goods for other services and goods in return. This is called the Barter System. Currently, this type of trading is very limited and is usually done through Online auctions and swap markets.
Barter System: It is an old method of exchange where people exchanged goods and services with each other without any involvement of money.
The advantage of Barter Money is that it has no involvement of money or intermediary medium, which allows the traders to exchange what they want instantly. But this also becomes the biggest disadvantage of it too. Many times the trading parties might offer something that isn’t needed by another party; thus, this becomes a blockage in a successful trade. To get around this, one of the traders has to go a long way to get something that the other trader wants.
Consider this by an example, a merchant has milk with him and wants some Iron Nails, the ironsmith can provide the nails but wants an apron instead of milk. The tailor can provide the apron, but neither iron nails or milk and instead wanted a table. Finally, the carpenter can make a table and wanted some milk. So, the merchant will exchange the milk with a table from the carpenter which he will give it to tailor to get an apron. Now the merchant can successfully trade the apron with an ironsmith to get the nails he originally wanted. As confusing as this already is, this is a very inefficient form of trade. This inefficiency of the Barter System paved the way for the Money System.
We’ll mention this beforehand; Money isn’t wealth.
It is a system that is used to facilitate the exchange of wealth. Money is a means of credibly conveying information about the value given but not yet received (or at least not yet received in the form which can directly satisfy a person’s wants or needs). Money needs to fulfill the following aspects to become an efficient model of trading:
1. Store of Value: Money doesn’t create value, but it serves as a proof of value that is being exchanged. It stores a value in it, consider it by the analogy of batteries. A battery does not generate any electricity, but they help to store it for later use. Not only they save and store electricity, but they also make it valuable when it is retrieved.
2. Unit of Account
- Countable: Money should be quantifiable.
- Divisible: A money should have a standard unit of measurement which can be further divided just to understand how much money we have. Without losing its original value.
- Fungible: Each unit must be perceived as equivalent to any other unit of it. For example; a banknote of a certain value should be equivalent to another banknote of the same value.
3. It must be a medium of exchange
- Divisible: So that it can be traded for the exact value of goods and services are being sold at.
- High Market Value: They should have a high market value in terms of volume and weight.
- Recognizable: Individuals on either side of exchange should realize and acknowledge the worth of that money.
- Transportable: It should be easier to carry so as it can facilitate trading.
- Resistant to Counterfeiting: So the fraudulent money is not created, which in turn devalues the system.
4. Standard of Deferred Payment: If the ironsmith is willing to give merchant iron nails, ‘trusting’ the merchant to pay him when the milk is ready, then in this way we can defer the payment. The money must be considered as the appropriate way to settle debt with the smith. The money then becomes what is known as ‘Tender,’ and if the government issues a tender for deferred payments, then it is known as ‘legal tender.’
Gold works exceptionally well with these functions. It is universally recognized as valuable, so it makes an excellent medium of exchange. Since every gram of gold is the same (assuming the same purity levels). It is fungible. If divided into two, the two half grams are worth the same as the full gram. It is a store of value; in fact, it retains its value incredibly well over time, and thus for these reasons, it presents itself as an excellent medium for deferred payment.
Since gold is very prone to counterfeiting, and transport and gold-mining demand too many resources and workforce. These drawbacks made it very obvious for the introduction of a new system of money.
Paper itself isn’t a store of value, nor it is the standard for deferred payment, the paper is acting as a proxy for a different kind of value. It represents the trust that the trade is made between the parties. Fiat money is the term for most of the currency that is being circulated in many nations right now. Our fiat money has value because the authoring government says so. It mandates its use as a standard of deferred payment. If a debt is owed, the person to whom the debt is owed must accept the circulated money as payment for a debt. That’s the concept of ‘legal tender.’
With the gold standard, how new money enters circulation is with people mining and extracting gold. This keeps control on how much money is being circulated, thus preventing inflation. With fiat currency, it is just ink and paper. The new money doesn’t represent any significant amount of resources being used to obtain it initially. Since money needs value, its value needs to seek equilibrium based on supply and demand, just like every other commodity.
The problem with fiat money is that the issuing authority fully controls the value of this money. This makes it very prone to be abused, which can cause massive uncertainty in the economy. Printing more money does not increase economic wealth; it lowers the value of everyone else’s money. It happens as follows:
When new money is circulated, it appears as additional sales and investments which encourages businesses to step up their production. By pushing interest rates lower, the loans get cheaper and then more people and businesses go into debt. All of this sends fake signals into the economy because the newly created money represents the same level of economic wealth as was there before. As the artificially lowered interest rates make loans less risky, the economy slips into recession.
With Gold standard, people mined new gold only if the money they’ll create by mining is worth more than the resources they put into it. This serves protection from money getting too valuable and causing deflation. If money starts getting less valuable and threatens to cause inflation, more people will trade their money for gold, taking it out of circulation and thus arresting inflation.
As the value rises again, they may trade their gold back for more money, keeping the system in balance.
With fiat money, only the government has the power to control the value of money and since they can control the printing of new money. It is hard to prevent the economy from being inflated or deflated. Drastic measures and shock therapy methods prove as a significant setback to the economy and the population in general. These disadvantages of fiat money are severe, and the scale of damage they can do is portrayed very well in The Great Depression of 1920 or the recent worldwide economic slowdown of 2008. These factors depict an urgent need for a new monetary system. Thus, cryptocurrency was created.
What is Bitcoin and why it was created?
Our current transaction system works on the principle of a middleman or intermediary parties like banks, card services, or online merchants. These intermediaries take a small cut from out transaction and rely on our ‘trust’ that they’ll do everything right and keep our money secured. We trust our card companies to keep our confidential details safe. Removing these middlemen creates a different set of problems.
Suppose, if you had Rs1000 in your bank account and tried to buy two things of Rs1000 each. The bank would honor the first purchase and deny the second one. If the bank didn’t do that, you’d be able to spend the same money multiple times. This is known as the Double Spending Problem and is terrible for our financial system. Also, you wouldn’t be able to prove if you have paid for something unless you take a receipt of it. The middleman takes care of it.
To overcome the difficulties of our traditional money system (as discussed in the previous section) and removing the middlemen. A blog published in 2008 by the Bitcoin creator aliased as Satoshi Nakamoto suggested a new way of the money system. He suggested that instead of a bank or credit card company taking a record of every transaction in one central file, all the users will record all the transactions at the same time. Therefore, any attempt to fool the community will be noticed, and the payment will be rejected. No single user, government, or a bank can force a fee on a payment or control its flow. As a result, we’ll have a cheaper, quicker, and easier way to spend money even across national borders. This is Bitcoin.
Bitcoin is a digital cryptocurrency that is based on the technology of cryptography. Bitcoin doesn’t have any central authority which regulates the flow of bitcoin or creates them as per demand. Bitcoin runs on a worldwide peer-to-peer network, and its distribution is given to those that we call as miners. Bitcoin isn’t a string of files that can be duplicated. A bitcoin transaction is an entry on a huge global entry ledger called a blockchain. The bitcoin’s blockchain is a distributed database that contains a continuously growing list of all Bitcoin transactions that have ever happened. As of July 2019, the size of the ledger is more than 200 GBs.
Consider you and your friends are playing poker without chips or money. So to keep the game running all of your friends take out a sheet of paper and starts to record every bet, win, and loss that happens in the game separately. At the end of each round, all of the friends will compare their records with each other to confirm the validity of the game. If there would be any discrepancy, then it would be easily be caught. Think of each page as a ‘block’ of transactions; eventually, your notebook will be filled with transactions on each page — chain of those blocks. Thus, a Blockchain.
Formally, a Blockchain is more of a concept than any physical thing. It is made up of a global network of computers that are in communication with each other. Any transaction that has to take place first needs to be verified by the computers in the network. Since all the users are tracking the transactions, it becomes incredibly secure. Blockchain is just like a bank that validates transactions and secures funds. The only difference is that whereas the bank is centralized, prone to mistakes, corruption, charges interests, and re-invests your money. Blockchain creates security while cutting out the middleman.
As explained above, every transaction needs to be announced in the network before it gets verified and gets added at the end of a blockchain. In every announcement, the sender’s account number, the receiver’s account number and the amount of BTC to be transferred is declared. Now all the verifying users (miners) who are keeping copies of blockchain will add the transaction to the current block.
Trader’s identities are kept safe as every transaction announcement is attached with a key. A bitcoin is secure because of keys, which is a chunk of information that can be used to make mathematical guarantees about messages. Whenever a user creates an account in the BTC network, he/she is assigned a wallet, and that is linked to two unique keys: a private key, and a public key. Here the private key can take some data and sign it so that other users can verify those signatures. This proof of identity isn’t something that can be faked by a scam artist.
Suppose a message, “Raju sends 4 Bitcoins to Reshma” then Raju will sign the message using his private key. Then this ‘signed’ message can be sent to the bitcoin network, and everyone can use Raju’s public key to make sure his signature checks out. That way everyone keeping track of BTC trading know to add Raju’s transaction to their copy of the blockchain. In a nutshell, “If the public key works, then that’s the proof that the message was signed by the private key of the owner and it is the transaction that the user wanted to complete.”
A blockchain is updated over 100 times a day and is sent to every other system that processes bitcoin to verify it. People who do this verification are called Bitcoin miners. After every successful block verification, the miner is awarded a specific amount of bitcoin. Every single bitcoin that exists today was created to reward a bitcoin miner. Besides the big payout when miners add a new block of a transaction, miners are also tipped a very small amount of each transaction.
After every 210,000 blocks, the number of coins generated when a new block is added goes down by half. What started with 50 BTC as rewards decreased to 25 BTC, then 12.5 BTC, and then 6.25 BTC. According to the current projections, the last bitcoin probably around the 21 millionth coin will be mined by the year 2140. The bitcoin features this decreasing number model just like at the rate at which things like gold is dug out of the earth. And the idea is to keep the supply of Bitcoins limited. Thus, raising their value over time.
What is Block Size and limitations of Blocks?
A bitcoin block comprises of digitally signed transactions. The current size of the bitcoin box is limited to 1MB. We can put just a few transactions in it so that it’s just empty, but we cannot overfill it.
Earlier the Bitcoin’s block size was limited to 36MB, but it was reduced to 1MB in July 2010 to prevent transactional spam clogging and potential DDoS attacks. The mining software that is used by the miners works by grouping the recent transactions into blocks. Since lots of people are verifying the blockchain, network delays mean that miners wouldn’t receive the transaction requests in the same order. The bitcoin solves this problem by actually solving mathematical problems. To add a block to the blockchain, a miner has to solve a special kind of math puzzle created by a cryptographic hash function. The hash function that the bitcoin implements is called SHA256, which was originally developed by the NSA of the United States.
This works as follows, several users make multiple transactions, and the details of each transaction is announced in the network along with their respective public key. The mining software groups these new chunks of transactions into blocks, which are then distributed over the network to all the miners. If any miner finds some discrepancy in the block, they will reject that block. Now whoever solves the hash function of that block first gets to add the next block of transactions to the blockchain and is rewarded with a specific amount of bitcoin.
We need to verify the transaction quite often so that people can have a good idea of how much money they have. So a block is sent at every 10-minute interval for hashing. Since there is a limit to block size, there are limitations to how many transactions that can clear on time. That is, the throughput of the bitcoin transaction is limited. It is called the Scaling Debate and is really about how to get more transactions through the system.
The network delay, block size and need for frequent block updating affect the speed at which miners verify the transactions. It reduces the transactions processing speed of the BTC network. If the transactions get processed slowly, the transaction fees will rise dramatically, and people will soon start to switch to alternative currency options, thereby reducing the supply and demand of bitcoin. This, in turn, would render Bitcoin redundant as a means of exchange. Thus, this is a very severe concern, and many proposals are introduced to overcome these drawbacks in the following section.
Proposed Methods and where are they now?
The first proposed solutions recommend increasing the block size that is distributed for hashing. This could solve the current deadlock, but there are some problems with it. If some people kept using smaller block, they would reject the bigger block and this, in turn, would create two different blockchains. Additionally, if everyone used the bigger block, miners might not receive them in time for hashing. Downloading the block along with hashing it (a very resource-intensive process) isn’t possible for many mining systems. The main advantage of making the block bigger is that it’s a relatively simple change. There aren’t any new style checks to worry about, and everything can function as before.
Even after reducing the block size in 2010, a consensus of an ideal block size wasn’t found, and the developers calculated that this block size limit will soon become obsolete, arguing in favor to increase the block size shortly.
For the following years, Bitcoin witnessed many proposals advocating for an increase in block size to reduce fees, and network congestion and to increase the transaction throughput. This becomes crucially important when Bitcoins aims to compete with mainstream payment technologies.
Gavin Anderson introduced the idea of BIP (Bitcoin improvement proposal) on June 22, 2015. It advocated, “Replacing the fixed 1MB maximum block size with a maximum size that grows over time at a predictable rate.” The block size was proposed to be initially at 8MB which would double itself every 730 days until January 2036. This proposal was well-received by the large segments of the public. Its code was even introduced within the Bitcoin XT network, but surprisingly it didn’t live up to the hype which it promised.
This proposal introduces the use of new types of blocks which we call ‘SegWit’ (Segregated Witness). With this solution, we could still make larger boxes available but only to those that want them. This new block system removes the signature part of a transaction for those receiving smaller boxes. In BTC transaction, the signature takes about 50% of the space. Segwit cuts that transaction data in half and sends everything but the signature to everyone who is accepting old, smaller block. It sends the entire block including the signatures to everyone that’s accepting the larger box. Since now the transaction data are now half the size of a smaller block, we can double the number of transactions in the same small block, increasing the throughput. Anyone receiving the larger blocks can hash them as before, and anyone receiving the smaller block can hash them without worrying about the signatures in time. Since we are accommodating those miners who are using smaller blocks, SegWit is backward compatible. The main drawback to SegWit is that everyone will have to get used to the new style of blocks before we witness some gains. It is also more complicated than just making everyone use a larger block. Additionally, everyone receiving the new blocks, but using smaller block wouldn’t get to hash the signature since they won’t receive them.
Hitting the ethos of Bitcoin
On June 23, 2015, Brahm Cohen published an article titled “Bitcoin’s Ironic Crisis.” He favored the transaction feels to be determined by market forces:
“The proposed ‘solution’ to the ‘problem’ of hitting the transaction rate limit is to raise the limit from 1 megabyte to 20 megabytes. This sort of change flies directly in the face of the ethos of Bitcoin.”
“In the long term the mining rewards for Bitcoin will go away completely (there’s a strict schedule for this) and all that’s left will be transaction fees. Attempting to ‘solve’ the problem of transaction fees would, in the long run, undermine the security of Bitcoin even if it were done perfectly.”
He asserted that transaction fees would serve as evidence of Bitcoin to be ‘providing real value’ which in turn would offer to miners in exchange for securing the network.
The current block size of the BTC network is still 1MB, and the BTC community is unable to find consensus regarding the solution which promises a reduction in network congestion.