At the heart of this matter
This same factor also slows down the whole bitcoin network because all the miners need to verify a transaction with frequently increasing network congestion, and 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 on 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 in the need for a new model. It also helps in briefing the topic that many of us instinctively know but not intellectually. If this is too much reading for you, you can skip this section and start with Bitcoin immediately. We promise you wouldn’t miss a thing.
Before the concept of money didn’t exist, people exchanged 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. The trading parties often offer something that another party doesn’t need; thus, this becomes a blockage in a successful trade. To get around this, one of the traders must go a long way to get something the other trader wants.
Consider this as 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 could provide the apron, but neither iron nails nor milk, and instead wanted a table. Finally, the carpenter can make a table and wants some milk. So, the merchant will exchange the milk with a table from the carpenter, which he will give to the 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 serves as proof of the value being exchanged. It stores a value in it by the analogy of batteries. A battery does not generate any electricity, but they help to store it for later use. Not only do 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: 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. 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: It can be traded for the exact value of goods and services sold.
- High Market Value: They should have a high market value in terms of volume and weight.
- Recognizable: Individuals on either side of the exchange should realize and acknowledge the worth of that money.
- Transportable: It should be easier to carry to facilitate trading.
- Resistant to Counterfeiting: The fraudulent money is not created, which devalues the system.
4. Standard of Deferred Payment: If the ironsmith is willing to give the merchant iron nails, ‘trusting’ the merchant to pay him when the milk is ready, we can defer the payment. The money must be considered the appropriate way to settle debt with the smith. The money then becomes what is known as a ‘Tender,’ and if the government issues a tender for deferred payments, it is known as ‘legal tender.’
Gold works exceptionally well with these functions. It is universally recognized as valuable, making it 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 prone to counterfeiting, 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 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, new money enters circulation with people mining and extracting gold. This controls 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 initially used to obtain it. Since money needs a 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 abuse, which can cause massive economic uncertainty. 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, encouraging businesses to step up their production. By pushing interest rates lower, the loans get cheaper, and more people and businesses go into debt. All of this sends fake signals into the economy because the newly created money represents the same economic wealth as before. As the artificially lowered interest rates make loans less risky, the economy slips into recession.
With the Gold standard, people mined new gold only if the money they’ll create by mining was worth more than the resources they put into it. This serves as 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 are significant setbacks 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 was it 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 our 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 Rs 1000 in your bank account and tried to buy two things for Rs 1000 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 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 remove 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 recording every transaction in one central file, all the users will record all the transactions simultaneously.
Therefore, any attempt to fool the community will be noticed, and the payment will be rejected. No single user, government, or 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 we call 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. 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 your friends take a sheet of paper and start recording 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 to confirm the game's validity. If there is any discrepancy, then it would easily be caught. Think of each page as a ‘block’ of transactions; eventually, your notebook will be filled with transactions on each page — a chain of those blocks. Thus, a Blockchain.
Formally, a Blockchain is more of a concept than any physical thing. It comprises a global network of computers communicating with each other. The computers in the network must verify any transaction that has to take place first. 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 the bank is centralized, prone to mistakes, and corruption, charges interests, and re-invests your money. Blockchain creates security while cutting out the middleman.
As explained above, every transaction must be announced in the network before it gets verified and 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 are declared. Now all the verifying users (miners) keeping copies of the blockchain will add the transaction to the current block.
Traders’ identities are kept safe as every transaction announcement is attached with a key. A bitcoin is secure because of keys, 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 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 a scam artist can fake.
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 ensure his signature checks out. That way, everyone keeping track of BTC trading knows 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 daily and 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 transaction block, miners are also tipped a very small amount for each transaction.
After every 210,000 blocks, the number of coins generated when adding a new block 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 2140. The bitcoin features this decreasing number model just like the rate at which things like gold are dug out of the earth. And the idea is to keep the supply of Bitcoins limited. Thus, raising their value over time.
What are the Block Size and the limitations of Blocks?
A bitcoin block comprises 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, 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 used by the miners works by grouping the recent transactions into blocks. Since many people are verifying the blockchain, network delays mean miners wouldn’t receive the transaction requests in the same order.
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 bitcoin implements is called SHA256, which the NSA of the United States originally developed.
This works as follows, several users make multiple transactions, and the details of each transaction are announced in the network along with their respective public keys. The mining software groups these new chunks of transactions into blocks and then distribute them 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 know 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 can clear on time. That is, the throughput of the bitcoin transaction is limited. It is called the Scaling Debate and is about getting 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 transaction 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 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 distributed for hashing. This could solve the current deadlock, but it has some problems. If some people kept using smaller blocks, they would reject the bigger block, creating two different blockchains. Additionally, if everyone used the bigger block, miners might not receive them in time for hashing.
Many mining systems can't download and hash the block (a very resource-intensive process). 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 on an ideal block size wasn’t found. The developers calculated that this block size limit would soon become obsolete, arguing in favor of increasing the block size shortly.
For the following years, Bitcoin witnessed many proposals advocating for an increase in block size to reduce fees, network congestion, and transaction throughput. This becomes crucially important when Bitcoins aim 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 initially proposed at 8MB, doubling itself every 730 days until January 2036. This proposal was well-received by 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 it promised.
This proposal introduces the use of new types of blocks called ‘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 transactions, 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 blocks.
It sends the entire block, including the signatures, to everyone accepting the larger box. Since 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 miners 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 blocks 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 a consensus regarding the solution which promises a reduction in network congestion.