October 2022
From: Bitcoin: A Peer-to-Peer Electronic Cash System
By Satoshi Nakamoto, 10/31/2008
Introduction
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.
Fourteen years ago in just nine pages and a little over three thousand words, Satoshi launched a peaceful revolution whose impact we have barely begun to appreciate. Incredible to think that without a CEO, management team, marketing budget, sponsor or institutional support of any type, the vision articulated in those nine pages has been codified into free and open source software that now processes billions of dollars of value transfers every day! This short paper, now commonly referred to as the "Bitcoin Whitepaper" is worth reading in its entirety. The ramifications of Satoshi's work are bounded only by imagination and frequently grappled with in this and other bitcoin newsletters. This month, we reflect briefly on the problem that Satoshi set out to solve and its proposed solution.
As stated in the whitepaper introduction, Satoshi sought to create a method of value transfer in e-commerce transactions such that final settlement could occur without reliance on any third party intermediaries. The great promise of the internet is an interconnected human population. This connectivity is a critical first step in the direction of distributed coordination networks and economies that transcend borders and barriers, but it is only the first step. And if not for the freedom of any given network participants to exchange value for value, the full potential of an interconnected humanity might never be realized. Settlement mechanics within the existing paradigm of financial intermediaries become exceedingly complex as value moves across jurisdictions and between currencies. As Satoshi highlights, settlement of very small payments - especially useful in the realm of digital commerce - are more or less dead on arrival. Unless, that is, an automated mechanism for final settlement could be achieved without the need for a trusted intermediary between the sender and the recipient.
The solution to the problem of peer-to-peer final settlement requires "Byzantine fault tolerance". That is, consensus must be achieved between network participants as to which parties have valid claims to economic value at any point in time, notwithstanding the fact that any network participant might try to game the system by sending the same value to two different counter-parties at roughly the same time (to get twice the purchasing power at the expense of one of the merchants). Similar to the functioning of the existing financial system, Satoshi proposed a system of ordering transactions with timestamps. However, in the existing financial system the role of determining the sequence of value exchanges falls to the financial institutions that must be eliminated in a truly peer-to-peer economic network. You can't spend the same dollar twice because once you've spent it the first time, your bank updates its ledger to remove the dollar from your account. Herein lies Satoshi's breakthrough: network participants compete to order transactions in hopes of receiving an economic reward in what is commonly referred to as "proof of work mining."
You might have heard that bitcoin miners attempt to solve complicated math problems in order to earn bitcoin. A more accurate description is that bitcoin miners engage in a rather tedious process of trial and error until one of them finds a result that has a given statistical probability*. The inputs to the trial and error calculation include the outputs of all prior transactions as well as the current set of pending transactions. Eventually, all of this trial and error results in one miner arriving at an output - specifically, a cryptographic hash using the SHA-256 algorithm - with sufficiently low probability of occurrence. At that point, the transactions that were pending become part of the transaction history. Instead of transactions being ordered by trusted financial intermediaries, they are ordered by a network of computers competing to prove that they have done the work to find a proverbial needle in a haystack. With each new proof, the ledger is updated, the network achieves a new consensus as to which participants have claim to what economic value, and miners begin the process of trial and error anew.
Today the mining trial and error process uses, in aggregate, computer hardware worth tens of billions of dollars and enough electricity to power a small, first world nation. Satoshi wrapped the entire system in a pretty ribbon by creating the incentive for such resource deployment and linking it to the transparent, algorithmic, and therefore "fair" rate of money supply growth and distribution. The network achieves consensus through a system of transaction timestamping. The timestamps can be relied upon without trusting any particular third party because of the resources that miners must expend to calculate a valid transaction timestamp. Miners commit resources to the network because calculating a valid timestamp results in the reward of newly minted bitcoin.
Happy whitepaper day!
*The probability of finding an answer also fluctuates based on the amount of effort put forth by the whole network in what is known as the "difficulty adjustment." In this way, the time it takes for the network to arrive at an acceptable answer stays relatively constant even as resources are added to or removed from the network.