An introduction to cryptography, blockchain and bitcoin
By: Mohamed Elshawaf
Tags: Cryptocurrency, Bitcoin, Cryptography, Bitcoin Mining, Blockchain

This article aims to introduce bitcoin and blockchain to beginners with no prior knowledge of the topic. Bitcoin is a cryptocurrency monetary system based on cryptography, thus, the name “cryptocurrency”, so a basic understanding of some cryptography functions is required. If you are comfortable with any of the topics discussed below, feel free to jump to another.

The need for cryptography

Since the early days of human civilization, there was a need to secure communications, so only the involved parties can send and receive messages securely. The process of securing communications went through many stages from using simple cipher languages to using complex maths functions.

Figure 1: German Lorenz cipher machine, used in World War II

to encrypt very-high-level general staff messages (from Wikipedia)

Cryptography

is a set of means used to secure the communications between the involved parties, such that third parties cannot read the messages or alter them. Cryptography uses mathematical functions to convert plaintext to an unreadable ciphertext. It may produce a reversible ciphertext, in a process called encryption, and the process that converts it back to the plaintext is called decryption, or it can produce an irreversible ciphertext (called hash or digest) in a process called hashing.

There are three types of cryptography:

1. Symmetric cryptography

uses a single key for both encryption and decryption, so both sender and recipient have the same key to encrypt and decrypt messages. It’s fast but not secure, as the key is shared and anyone can have it. Example of symmetric algorithms: Data Encryption Standard (DES).

The key: is a very long number, the bigger the key size is, the more the algorithm resists brute-force attacks.

Brute force attack: trying all available keys until a key is found, for a key with size 1024 bits, it means trying 21024 keys.

2. Asymmetric cryptography

uses two keys that are mathematically correlated, one is public and the other one is private, the public key can be extracted from the private key, but not vice versa, of course. The public key is used to encrypt the plaintext, while the private key is used to decrypt the ciphertext. The owner of the key keeps the private key, no one should know it, while the public key is shared with whoever wants to send encrypted messages to the key owner. Asymmetric cryptography is secure but is slow compared with symmetric cryptography.

3. Hashing

is a one-way standard function that produces an irreversible digest, it’s like the fingerprint in the sense that every input has its hash, two different inputs must not produce the same hash, and you cannot revert the original input from its hash. Some standard hash functions include; SHA256, SHA512, MD5. However, MD5 has been deprecated due to serious vulnerabilities (see: ref:6). One of the hash function vulnerabilities is the collision, which means; two different inputs produce the same hash, and this can happen due to the limited space of the hash algorithm against the unlimited input possibilities, but SHA256 is considered a strong hash algorithm, it produces a 256 bits long hash (or 64 hexadecimal characters), to see how big is this number, see this video: How secure is 256 bit security?

For example: the SHA256 of (abc) is

ba7816bf8f01cfea414140de5dae2223b00361a396177a9cb410ff61f20015ad

Changing any character, produces totally different hash, for example, the SHA256 of (Abc) is

06d90109c8cce34ec0c776950465421e176f08b831a938b3c6e76cb7bee8790b

You can play around with SHA256 using this utility: https://andersbrownworth.com/blockchain/hash

(it’s a demo utility for the great tutorial by Anders Brownworth, see ref:5)

Digital signature

Like paper signatures, digital signature is used as an authentication method. For example; A wants to send B a message, it doesn’t have to be encrypted, the message itself is not confidential, but there should be a method for B to make sure it’s really from A, and no one has altered the message. A sends the message along with his signature of that message, and B can then check if the message was tampered with.

In RSA, digital signature combines encryption and hashing.

There are two functions:

Sign: hashes the message and then encrypts the hash with the private key, the output is the digital signature.

Verify: decrypts the digital signature with the public key, the result is compared to the hash of the message sent along with the digital signature, if both are identical, then the message is intact, otherwise it should have changed since it was signed.

Figure 2: Digital signature in RSA

Notice: in digital signature using RSA, the public key encrypts the message after hashing while the private key decrypts the signature to get the hash back. This is the opposite of what happens when using the confidentiality service, where the public key encrypts the message and the private key decrypts the ciphertext. Bitcoin uses the ECDSA algorithm for digital signature, which works differently than RSA.

Cryptography services

Cryptography provides three main services:

Confidentiality

Non-repudiation

Integrity

Each one of those is achieved through special kinds of cryptographic functions.

Confidentiality: This service is used when message confidentiality is required, for example sending a message to a WhatsApp contact uses this service to ensure the message is encrypted with the recipient’s public key and at his end, the message is decrypted using his private key.

Non-repudiation: is a security service by which evidence is maintained so that the sender and the recipient of data cannot deny having participated in the communication. Individually, they are referred to as the “non-repudiation of origin” and “non-repudiation of receipt.”. In simple terms, you receive a message from someone in a special “format”, and you are sure it’s from him, think of “signatures”. Digital signature offers non-repudiation

Integrity: making sure the message is sent as it is, and no one alters the message without knowing. Hashing offers integrity.

Now that you have a basic knowledge of cryptography, let’s understand how bitcoin works on top of it.

What is money?

Money is a store of value; it’s not a value by itself. You pay 100 L.E. for pizza, you are actually exchanging a piece of gold worth 100 L.E. for this pizza. The gold here is also known as a medium of exchange.

So what makes something, like gold, a medium of exchange or “money”?

Properties of money (from Wikipedia):

Fungibility: its individual units must be capable of mutual substitution (i.e., interchangeability).

Durability: able to withstand repeated use.

Divisibility: divisible to small units.

Portability: easily carried and transported.

Cognizability: its value must be easily identified.

Scarcity: its supply in circulation must be limited.

Once there’s a medium with these properties, it can be used to store value, thus, called money.

What is Bitcoin?

First of all, some might get overwhelmed by the popular bitcoin images and think it’s real especially when it’s depicted as real coins. This is not Bitcoin:

Figure 3: Bitcoin

It’s just a design from artists’ imagination, by the end of this article you will realize that there’s no rigid representation of Bitcoin, even at the low level.

What’s confusing most for beginners about bitcoin and other digital currencies, is how we can use intangible assets like bitcoin, as money, and if we could use them, why did we think about a new monetary system, what is wrong with the current monetary system? And many other questions that I will try to answer in this article.

Bitcoin uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network. Bitcoin is open-source; its design is public, nobody owns or controls Bitcoin and everyone can take part.

Peer-to-peer means it’s a collaborative system, or more-often-called, a decentralized monetary system, in contrast to a single authority or central bank controlling the whole thing, the transactions are validated through a group of computers, anyone can participate, they are called nodes, they have the same copy of the blockchain (the public database that holds all transactions ever occurred since the launch of the bitcoin in 2009).

Think of its design as the torrent vs Google Drive.

A decentralized digital currency that is run over the internet is not a new idea, the economic Nobel prize laureate Milton Friedman, gave this visionary statement in 1999

The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A.

And different e-cash systems have been introduced before Bitcoin but never adopted widely, until this day in 2008, Satoshi Nakamoto announced his work on Bitcoin:

Figure 4: Satoshi Nakamoto email letter

Nobody knows who Satoshi is, as his identity remains mysterious, but his work on bitcoin and blockchain is considered revolutionary that is changing the world that we know.

Bitcoin is money?

Most of the newcomers to the cryptocurrency topic, including me a few months ago, don’t understand how some tokens can be treated like money that we know, here’s an analogy that may approach the topic to the money we know (it helped my little brother):

Imagine, in a perfect world, all our financial transactions are made through our bank accounts, and everyone has a bank account, literally everyone, even kids, buy candies from a local shop by their credit card, and public transportation (I’m thinking of Egypt) has means to pay through your credit card. In this perfect world (we already are heading to) no need for cash, your company transfers your salary every month to your account, and your company customers pay to your company by transferring to its bank account. The cash becomes useless, and your account balance becomes just a record in the bank system database, no more than that, which gets incremented if your company pays your salary or you when you sell your old laptop online or to your friend, and get decremented when you go to the shopping mall.

At this stage, fiat money disappears and our wealth becomes just a set of records in the bank’s databases. This is exactly how blockchain (the cryptocurrencies database/ledger) works, except for some technical details (important details) that make it competent to the current monetary system. And the bitcoin in this example is your balance records.

The blockchain is the backbone of all cryptocurrencies (Bitcoin, Etheruim, etc), and it has applications other than digital currencies, which makes it really revolutionary.

See this video if you want to know the impact of blockchain:

How the blockchain is changing money and business | Don Tapscott

Money properties in the bitcoin

Let’s see if money properties can be applied to bitcoin:

✅Fungibility: Any bitcoin is interchangeable with another.

✅Durability: Bitcoins are there as long as the blockchain is maintained, currently it’s being maintained by thousands of nodes (more on that later). It’s even more durable than the fiat money that is subject to physical failures like tearing or damage.

✅Divisibility: in most cases, if you want to buy bitcoins, you will mostly buy a small fraction of it, the smallest unit of bitcoin is Satoshi (SAT), one bitcoin worth 108 SAT

✅Portability: it’s digital, it’s even more portable than fiat money.

✅Cognizability: the blockchain is public and anyone can download it (https://bitcoin.org/en/download).

✅Scarcity: there is a limited supply of bitcoin, the bitcoin protocol states that only 21 million BTC are available to be mined, 18 million bitcoin (BTC) have already been mined, only 3 million BTC remains to be mined in the upcoming 100 years (though, this is subject to change).

The decentralization nature of Bitcoin

So why the thinking of a different and controversial monetary system instead of the current known system?

Figure 5: Bitcoin decentralization vs fiat money centralization

The main strong point of the cryptocurrencies is that it’s decentralized, that means that there is no centralized authority or bank that controls the transactions and keeps track of them. Instead, it’s peer-to-peer and public that anyone can contribute to its network. The revolution and the growth of this network remind me of the emergence of the internet in the 90s. Also while the centralized system relies on trust (we put our money in banks because we trust them), the decentralized digital currency relies on cryptography.

But after all, how do all this work together; blockchain, nodes, miners, and cryptography, to make money?

That’s what I will try to answer in the next sections.

The Blockchain

As the name says, the blockchain is a chain of blocks, it’s a type of database (ledger) that keeps track of every transaction since the genesis block (first block added by Satoshi in 2009). Every block contains several transactions (can be 1000 transactions, more or less). Every block references the previous block by its hash.

Figure 6: The main components of a block

The life cycle of a transaction

Say, A wants to send B 1 BTC, A first specifies B’s address (his public key), then signs the transaction with his private key (A’s private key) as approval of the ownership of the bitcoins, and broadcasts this transaction waiting for the confirmation.

The nodes verify that A owns 1 BTC, if it’s true, they move the transaction to the mempool (memory pool) where miners can pick up transactions for mining, until then it’s in an unconfirmed state. Mining is the technique used to prove the work done by the miner and gets awarded for.

The Proof of Work

Miners get awarded with bitcoins for the work they do: adding blocks to the blockchain, but bitcoins are very valuable that there should be a nearly valuable effort miners have to do to get them, this effort is done by the CPUs, that try to solve very complex mathematical problems, that require a special kind of computers, and sadly consume a massive amount of power to add the block to the blockchain, thus winning the precious bitcoins (see for example this video of one of the bitcoin miners: Inside The Cryptocurrency Revolution).

The amount of the bitcoins awarded are defined in the bitcoin code and has restricted rules, such that every 210,000 blocks (about 4 years) get halved, it started with 50 BTCs when the bitcoin was launched, and as of February 2021, the award is 6.25 BTCs. The importance of the mining process is that it’s the main and only source of bitcoins, every bitcoin out there originated from a mining award.

The very complex problem

The problem or puzzle that miners need to solve is simple to understand but very complex to solve.

It requires producing a block hash with a specific number of leading zeros. You know that any input has a different hash, but how do miners change the input (the block)? They are not allowed to alter the block data, they don’t own it. Here comes the block field: the nonce (see Figure 6), it’s a number that should be changed so that the hash of the block changes, miners keep changing it until the hash meets the target difficulty, that’s why all blocks’ hashes start with zeros.

Tip: you can have a look at the real blockchain blocks, through some of the blockchain explorers (see ref:26)

Hacking the blockchain

The structure of the blockchain makes it impossible to hack, the Bitcoin network has thousands of nodes that guard the blockchain against bad actors, they all have the same copy of the blockchain, so if someone tried to modify a block on his copy, he also needs to do this for 51% of the nodes.

For example, if B tried to change the transaction “A sends B 1 BTC” to “A sends B 2 BTC”, then the hash of the containing block will also change and the nonce should be re-evaluated to meet the target difficulty, and if this happened (it will consume a lot of power) the next block hash will change because the previous hash has changed, thus re-evaluating the nonce is required, and so on until the most recent block. If the hacker managed to do this, he will also have to update at least 51% of the nodes (about 5,000 blockchain copies). This work is so insanely costly in terms of power consumption that it may not worth it at all, besides it’s not technically practicable.

See ref:5, it’s a very good visualization of the process.

A sends B x BTC?

I’m using this analogy to simplify the transaction details, but it is more complex than that. Bitcoins are expressed in terms of inputs and outputs:

Figure 7: Transactions references

In the above image (from ref:25): A has total inputs (balance) of 100 BTC, they are called Unspent Transaction Outputs (UTXOs), but once they are referenced in another transaction (transaction C) they become spent and cannot be referenced anymore in another transaction. You will notice that any transaction input is another transaction’s output. Also, there’s no notion of balance, but instead “unspent transaction outputs”, what bitcoin wallets do is calculating the total UTXOs to show your balance.

The change

If A needs to send 3 bitcoins to B and he has 2 UTXOs with 2 BTCs each, that’s a total of 4 BTC, what he will do is sending the 4 BTC to two addresses, the first is B’s address with 3 BTC, and the second is his own address with 1 BTC to get the change, as it’s only permitted to reference a whole UTXO. If you didn’t specify the address that receives the change, it will be considered transaction fees.

The coinbase

The block must contain at least one transaction, it’s called the coinbase transaction, it’s a special type of transaction that contains the reward and fees sent to the miner’s address.

See figure 6, the coinbase transaction of block 5 sends 7 BTC to M1 (the address of the miner of that block), this 7 BTC is the total of the mining award + the fees, if the award is 6.25 BTC then the fees are 0.75 BTC.

The Fees

You (the one who sends bitcoins) must pay fees so that a miner picks your transaction, and packages it into a block. These fees differ but the more you pay, the more miners will prioritize your transaction, and the faster the transaction gets confirmed. When all bitcoins (21 million) get mined, the miners will only earn fees.

Summary

I started with some of the important concepts of cryptography, bitcoin relies on cryptography to secure transactions.

We use hashing to ensure the integrity of the data.

Bitcoin is a decentralized cryptocurrency, there’s no entity controlling it like banks, it’s kept secure with cryptography and run by people, also named nodes.

Bitcoins users have an asymmetric key-pair: the public key which acts as their address where others can use to send them BTCs, and the private key which acts as their password, they use to sign transactions to others.

Then we saw how bitcoin and money are related and saw that all money properties can be applied to bitcoin.

The blockchain is the ledger that all transactions ever happened live and will be there forever.

The blockchain is nearly impossible to hack, thanks to the collaborative work of the network nodes and cryptography.

Users send bitcoins by referencing previous inputs sent to them, called Unspent Transaction Outputs (UTXOs).

After the transaction being signed it moves to the network where nodes validate it, if verified, the transaction is moved to the memory pool (mempool).

Miners pick transactions from the mempool, pack them into a block then start the mining process, if they find the nonce, they get awarded with freshly mined Bitcoins and the fees.

The higher the fees, the faster the transaction gets picked by miners thus faster to be confirmed.

The coinbase is a special kind of transaction, it contains the miners' award and fees, it’s the first transaction in the block.

References:

The following references work as complementary to this article to fully understand how bitcoin works, I carefully collected them after watching and reading a lot of resources.

Videos:

(1): Bitcoin Fees and Unconfirmed Transactions — Complete Beginner’s Guide

(2): Bitcoin Transaction Details — Part 1

(3): Bitcoin Transactions — from “Send” to “Receive”

(4): What is Proof of Stake? — Earn Passive Income with Staking

(5): Blockchain 101 — A Visual Demo

(6): Hashing Algorithms and Security — Computerphile

(7): How secure is 256 bit security?

(8): Bitcoin Q&A: What is the Role of Nodes?

Medium:

(11): How are transactions validated?. The Bitcoin network’s ingenuity is… | by Blair Marshall

(12): How does a bitcoin transaction actually work? | by Blair Marshall

(13): What The Heck is UTXO. Peeking into the Bitcoin Transaction… | by Rajarshi Maitra | BitHyve

Others:

(21): Money

(22): investopedia.com What Happens to Bitcoin After All 21 Million Are Mined?

(23): How bitcoin transactions work | How Does Bitcoin Work? | Get Started with

(24): What is the coinbase?

(25): Bitcoin wiki Transaction

(26): Blockchain Explorer — Search the Blockchain | BTC | ETH | BCH

(27): The bitcoin transaction life cycle (image)