Bitcoin for Nonmathematicians:. Slava Gomzin

earliest coinage originated in Asia Minor about 2,500 years ago from an alloy known as electrum or “elektron” to the Greeks. It is composed of silver and gold, along with other trace metals, occurs naturally in nugget form, and is found in riverbeds. It worked well for its purpose prior to the development of technology needed to separate elements. Merchants allowed trusted customers to carry a tab (the first use of credit) and pay with electrum coins when the bill was sufficiently high. The nuggets varied in size and weight and were treated as bullion. The first designs on coins were simple striation lines, which mimicked the lines formed on the nuggets from the water flow in rivers. It was Aristotle that championed the importance of having an image on the obverse, which really transitioned bullion into true coinage.

      In early colonial America, daily commerce was conducted using coins produced by the official mints of other established nations, along with a hodgepodge of tokens and medals issued by private individuals and mints from inside and outside of America. The first coins issued by the authority of the United States were the Fugio pieces in 1787, and they are some of my personal favorite coins. The design had 13 interlocking circles and a small circle in the middle with the words “United States” around it and the words “We Are One” in the center. On the other side there was a sundial with a meridian Sun above it, the word “Fugio” (the intended meaning is time flies) on the left, and the year 1787 to the right of the sundial. Under the sundial are the words “Mind Your Business,” a saying credited to Benjamin Franklin. To me, this coin encompasses a lot of pride, solidarity, and hope for the young United States of America.

      An important characteristic of a sovereign nation is the right to issue its own coins, and America began exercising that right in 1792 by issuing pattern coins, followed by copper coins in 1793, silver coins in 1794, and gold coins in 1795. Before the denominations we have circulating today, there have been some more unusual ones, starting with the half cent in 1793, two-cent pieces (1864–1873) in which the motto “In God We Trust” first appeared, along with three-cent pieces (1851–1889). There have also been half dimes (1794–1873) and twenty-cent pieces (1875–1878). Gold coins have been minted in denominations of $1, $2.50, $3, $4, $5, $10, and $20. Gold $50 and platinum $100 coins are issued today by the US Mint, but these are considered bullion. There have been various reasons for the different denominations, but bitcoin transactions can occur in fractions of a bitcoin, making them very versatile.

      As our society moves to a cashless environment, I wonder how that will impact future coin collectors. Bitcoins will never become a collectable, since they lack the characteristics of physical coins. Blockchains are free to anyone and have no varying condition state from circulating. At some future point in time, there won’t be a need for physical coinage and the billions of coins the US Mint currently produces each year will become obsolete. Will there still be an interest in collecting something that future generations would have never used for their intended purpose in their daily lives? Only time will tell.

      The future of bitcoins is also unknown. Early investors had a wild ride with large gains followed by large declines as they sought to find bitcoins’ true value in relation to other currencies. They had started to obtain a reputation as taboo due to their use in criminal activities based on the notion that they can be held anonymously. But as Slava explains, bitcoins are not entirely anonymous and can be traced and tracked back to a unique IP address.

      One thing is certain: bitcoins are becoming mainstream, and with their lower cost as a payment system, many merchants not only accept bitcoins as tender, some actually prefer them as a cost-saving method for processing electronic payments.

      As you read this book, you will learn both the history and possible future of bitcoins. With Slava’s in-depth analysis of the security aspect of bitcoin financial transactions, perhaps you will learn to prefer this cryptocurrency system as well.

      Introduction

      There are no conditions of life to which a man cannot get accustomed, especially if he sees them accepted by everyone about him.

      —Leo Tolstoy

      Several years ago I was fascinated by an experiment I did. I was trying to live cashless, paying only with plastic cards, either debit or credit. My attempt was pretty successful until I went on a business trip abroad. My first (but not last!) failure was in a restaurant, when I received a check without a placeholder for a tip amount. There were no problems paying with a credit card, but there was no way to add a tip to the bill. So I had to ask my friend (who was not participating in my experiment) to pay a cash tip. The payment system, even though it was “aware” of electronic payments, was not fully integrated into the world of plastic money. Such a situation is still common in many places, especially outside North America and Europe.

      I would face similar challenges today if suddenly I decided to do the same experiment with bitcoin, but this time the limitations would be different. Instead of geographical borders that divide the world into cash and cashless zones, there is an invisible Rubicon between the offline and online worlds. In this new version of my experiment, I could live a sustainable life without cash (or plastic) if I didn’t leave my house. I could shop online and even order food from local restaurants. Whenever I needed to make a transfer of traditional money, for example, to pay the commodity bills (still virtual but counted in dollars rather bitcoins), I could exchange my bitcoins online and convert them to dollar transfer. I could even earn a living by mining the cryptocurrencies at home. However, this pattern breaks very quickly when you go offline and enter traditional brick-and-mortar stores. Few retailers today accept bitcoin or any other cryptocurrency, despite the obvious benefits: convenience, security, lower transaction fees, and attracting new generation of customers.

      One of the most important goals of this book is to help people who are not closely familiar with math and cryptography to understand crypto payments. In order to do it smoothly and wisely, we need to understand several things, the first being the place cryptocurrency has in the modern payment ecosystem.

      Don’t let the fact that this book is technical scare you if you are not a programmer. This book can still be read by anyone who wants to get paid or pay with cryptocurrency, and the first several chapters will prove it by answering very basic questions, such as what are the players in the existing electronic payments game, and whether it is possible to integrate bitcoin into it painlessly without breaking the major rules.

      While I realize that the readers of this book might be in a sense obsessed with crypto payments, we should stay calm and remember that there were (and in fact still are!) other types of currencies and methods of payment. Although bitcoin enthusiasts often use the term “revolution,” from many perspectives, especially from the merchants’ point of view, creation of cryptocurrency is just an evolution of a payment system that was made possible by modern science and technology, namely cryptography and the Internet.

      If you ask how to characterize bitcoin in a single word, many would answer “cryptography.” Although I agree with this answer, it is too generic, so my answer would be more specific (but contain more words): “public-key encryption and hash function.” Here is why.

      If we analyze existing payment systems—predecessors of bitcoin—there are two main problems in their design: security and centralization. Security flaws in the design of payment cards resulted in the creation of PCI data security standards, which forced merchants, service providers, banks, and payment brands to invest billions of dollars into security controls, which eventually failed to protect them from data breaches. On the other hand, as you will see in part I of this book, centralized management of the first virtual currencies was the main reason for fiasco.

      Bitcoin design provides solutions to both the security and centralization problems: digital signature and proof of work. A digital signature is based on public-key cryptography, while a cryptographic hash function is the essential part of both a digital signature and a proof-of-work implementation.

      Before the invention of digital signatures, it was impossible to broadcast the message throughout a public channel such as the Internet and verify through multiple recipients that this message was unchanged since its creation by the original sender. Along with public-key encryption, the cryptographic hash function made creation of a digital signature possible, which protects