Kavinga Yapa Abeywardena

Department of Computer Systems Engineering

Origins of Money
Virtualization of Money
Cryptographic Concepts used in Bitcoin
Bitcoin Transactions
Recording Bitcoin Transactions
Bitcoin Mining
Bitcoin Inflation
ORIGINS OF MONEY
Part 1
WHAT IS MONEY?
▪ Hunter-gatherer tribe. Group of hunters kill mammoth. Mammoth cut up and meat
taken home to feed tribe.

▪ Tribe “owes” each hunter for his part in killing mammoth.

▪ Debt settled by share of meat.

▪ Easy to remember who is owed what in small group.

Invention of agriculture:
• Domestication of plants and animals.
• Hunting declines - people settle -
cities founded.

Specialization of trades:
• Farmers,
• Carpenters
• Metal smiths…etc.
Too many people now for informal debts
easily to be remembered/enforced.

Barter systems develop:

• Exchange of eggs for apples.
• Grain for swords…etc. Aristotle (384-322BC) on the origin of money:
Every commodity has a primary (original) use and a
secondary use as an item of barter.
 Is worth 0.002
of…

Is worth 500
of…

Is Is worth 0.5 of…

Is Is
worth worth worth 2
0.4 of… 2.5 of… of…

Is worth 0.01
of…

Is worth 100
of…
No universal measure of worth
A pig is worth 100 apples, but without the entire “web” of exchange rates that tells you nothing about the
universal worth of pigs and apples.
Also all apples are not the same!
 Is Is
worth worth
0.5 of… 250
of…

“Standard” “Money”
Commodity
Is Is
worth worth
0.2 of… 125
of…
WHAT MAKES GOOD MONEY?
▪ Aristotle: the commodity must…

1. Be durable
▪ Must not fade, corrode etc.
2. Be portable
▪ Must have a high worth relative to its weight and size
3. Be divisible/fungible
▪ May be separated, re-combined, exchanged, replaced without affecting value.
4. Have intrinsic value
▪ The value of money must be independent of anything except the money itself.
▪ Usually linked to its scarcity.
 GOLD AS MONEY
▪ 1. Durable - YES
▪ Gold remains gold (though gold coins can be chipped – original reason why coins have “milled” edges).
▪ 2. Portable - YES
▪ Gold is valuable relative to its weight. Gold coins can be carried
▪ 3. Divisible/fungible - YES
▪ Different sized coins/ingots can be cast and recast.
▪ 4. Intrinsic value - PARTIALLY
▪ Value of gold depends on the amount of gold there is in circulation. (As more gold is mined, value of
existing gold falls.)

▪ Gold used to mint gold coins of standard weight/purity – payees know they are getting the amount of
gold they think they are.
 Is Is worth
worth 2 1000 of…
of…

Is Is
worth worth
0.8 of… 250
of…

The worth of everything is now expressible in terms of a common “yardstick”

▪ Sir Martyn Poliakoff talking about the gold in the Bank of England…
▪ https://www.youtube.com/watch?v=CTtf5s2HFkA

▪ Professor Lawrence White on the “Gold Standard”…

▪ https://www.youtube.com/watch?v=LdyHso5iSZI
VIRTUALIZATION OF
MONEY
Part 2
FIAT MONEY AND VIRTUAL MONEY
▪ Gold replaced by promissory tokens/banknotes issued by governments and banks.
▪ Under “gold standard” these could be exchanged for gold coin.

▪ “Fiat” system nowadays more common.

▪ debt acknowledged, but not actually backed up with gold.
▪ Value of notes/base-metal coins depends on authority of issuer, which must be trusted.
▪ Can be counterfeited! (Counterfeit coins are becoming a nuisance!)

▪ Now however…
▪ most money is “virtual” – it does not exist even as fiat tokens!
▪ Exists as a balance in a bank account – acknowledgment of debt.
▪ Most money is now merely information. (As it originally was!)
MONEY AS INFORMATION
▪ We no longer have physical tokens to record debt
▪ Their properties must be replicated virtually:
▪ Integrity
▪ Total amount of money must be conserved during every transaction. (Money may not be “double
spent”).
▪ Transaction must be irrevocable; payer may not (unilaterally) reverse transaction afterwards.
▪ Scarcity
▪ “New” money cannot be created by anyone without appropriate authority.

▪ These features enforced by a trusted financial institution/ authority, which all

participants trust.
YOUTUBE VIDEO…
▪ “Money as Debt” – documentary by Paul Grignon…
▪ https://www.youtube.com/watch?v=jqvKjsIxT_8
CENTRALIZED AUTHORITY
▪ “Payment” involves an authorized instruction to bank to transfer funds
from one account to another.
▪ Credit/Debit Cards
▪ Cheques/Wire Transfer

▪ Contrast to paying with coins, banknotes etc.

▪ These are issued by a central authority, but transferred on a “peer-to-peer” basis.
DECENTRALIZED CURRENCY
▪ Peer-to-Peer system – no centralized authority.
▪ Mimics buying/selling with gold coins (also peer-to-peer).
▪ We need an electronic equivalent to gold coins.

▪ Early attempts: “Hashcash”, “B-money”.

▪ Bitcoin introduced in 2009 by “Satoshi Nakamoto”
▪ This is not his real name.
▪ Sounds Japanese, but he is believed to be English or Norwegian.

▪ To understand how this works, we must first be sure to understand a few

cryptographic concepts.
CRYPTOGRAPHIC
FOUNDATIONS OF BITCOIN
Part 3
▪ To understand how this works, we must understand three basic cryptographic
concepts:
▪ Hash Functions
▪ Digital Signatures
▪ Proof-of-Work (PoW)
• A deterministic function H, mapping bit string of arbitrary length to fixed length string.
• Output bits are seemingly random.
• Algorithm needs to be:
• Fast - many hashes may be generated in a very short time.
• “Collision resistant”: chance of 2 inputs producing identical output very very small.
• “Pre-image resistant”: infeasible to find input given output.

▪ Hash demo: http://www.xorbin.com/tools/sha256-hash-calculator

MESSAGE HASH HASH

(Arbitrary FUNCTION (256 bits)
Length) (SHA 256)
8aff6b316dfd9bb9
Nice day, today! b3ced8cecfc9ce9
1163584cd6cd611
702959c79dac229
5d0
 Public Key Cryptography: keys are created in pairs:

KU Key Generator KR
(“public” Algorithm (“private”
key) key)
• Messages encrypted using KU can only be decrypted using KR.
• Messages encrypted using KR can only be decrypted using KU.
• Neither key can (feasibly) be inferred from the other.
Easy

Some
KU randomly KR
(“public” generated (“private”
key) information key)
(One-way or “trap
v. door” function)
Difficult
 Bob Insecure Alice
Channel
KUA KUB
KRB KRA

Key Key
Generator Generator

KUB KUA

KUA
KUB

“Harry the Hacker” can only ever hope to intercept the public keys. The private
keys are never transmitted.
 Bob Insecure Alice
(Sender) Channel (Receiver)
Plaintext “Plaintext
Message Message”

Hash Digital Bob’s Public

Function Signature Key
Hash
Function
Message Encryption Decryption
Digest Function Function

Digital “Message
“Signature =? “Message
“Signing” Bob’s Private
Verification” Digest 1” Digest 2”
Key
COMPARE TO VALIDATE!

“Harry the Hacker” cannot sent messages to Alice pretending to be Bob, because
he does not have Bob’s private key.
 “Challenge” “Response” Generate
String String
response
string
Around 2x
Hash Add iterations
Function challenge No
string
Perform Correct
hash Output
Required output: ?
function
000…..00XXXXX…..XX Yes
“x” consecutive 0’s Verify
Forces the challenged party to “do work” – if x=40, he/she must perform about 2^40=1,000,000,000,000
hashing operations.

Imposes a “cost” on the challenged party, deterring him/her from over-using/ abusing services (if
proof-of-work needed before access given).
 “Response”
string

Add “Correct” output:

challenge 000…..00XXXXX…..XX
string
Perform Correct No
hash Output
function ?
Yes
Verified Not
Verified

Only one hashing operation is needed to check that this work has
been done.
▪ Khan Academy – explanation of PoW
▪ https://www.youtube.com/watch?v=9V1bipPkCTU
▪ This video doesn’t really add much to what I’ve said, but you may want an alternative description.
BITCOIN TRANSACTIONS
Part 4
▪ Bitcoin (BTC) is a unit of currency (has an exchange rate with Rs., $, yen etc.
▪ Typically 1 bitcoin = $35,830 (Subject to huge fluctuations)
▪ There are lots of different denominations of units – e.g. thousandths and millions of
bitcoins.
▪ Bitcoin is the peer-to-peer protocol for the exchange of bitcoins between parties
(players).
▪ Also facilitates the “mining” of Bitcoins.
▪ Participants compete to record “blocks” of transactions.
▪ Winners rewarded with newly “minted” Bitcoins.
▪ Like mining gold – introduces a mechanism for devaluation
▪ A virtual “coin” that can be exchanged.
▪ Exists as a chain of digital signatures representing all the transactions in the coin’s
history.
▪ Validated checked by verifying of these signatures.
▪ Contains a “bitcoin address” = public key of the coin’s owner.
▪ Owner has the corresponding private key.
▪ Only owner can sign an instruction to transfer that Bitcoin to a new owner.
Last-but-1 Last Next
Transacti Transacti Transacti
on Tk-1 on Tk on Tk+1
KUk-1 || KUk || KUk+1

Hk-1 Hash Sign Hk Hash Sign Hk+1

Key Key

Authorization to Authorization to
KRk-1 spend KRk spend KRk+1
KUk-1 KUk Kuk+1
Previous Current Next
Owner Owner Owner
Ok-1 Ok Ok+1

“Now belongs to…” “Now belongs to…”

Last-but-1 Last Next
Transacti Transacti Transacti
|| Hash || Hash
on Tk-1 on Tk on Tk+1
KUk-1 Equal!!! KUk Equal!!! KUk+1

Hk-1 Verify Hk Verify Hk+1

Key Key

“Was “Was
KRk-1 authorized KRk authorized KRk+1
to spend” to spend”
KUk-1 KUk Kuk+1
Previou Current Next
s Owner Owner
Owner Ok Ok+1
Ok-1
“Once belonged “Once belonged
to…” to…”
 Last “Next” “Next”
Transaction Transaction Transaction
KU || KU1 || KU2

H Hash Sign H1 Hash Sign H2

Key Key

Authorization 1
KR KR1 KR2
Authorization 2
KU KU1 KU2
New New
“Owner” 1 “Owner” 2
 “Next” Hash || Last || Hash “Next”
Transaction Transaction Transaction
KU1 Equal! KU Equal! KU2
!! !!

H1 Verify H Verify H2
Key Key
“Was “Was
KR1 authorized KR authorized
to spend” KR2
to spend”
KU1 KU KU2
New New
“Owner” “Owner”
1 2

Both “owners” can also verify all earlier transactions in that bitcoin’s history, and each believe
they are its genuine owner. There is no mechanism to detect the previous owner’s fraud.
THE “BLOCK CHAIN”
AND BITCOIN MINING
Part 4
▪ Record of all Bitcoin transactions.

▪ Must be kept up-to-date and agreed upon by all players.

▪ Receiver of a Bitcoin must be able to verify from the ledger:

▪ That the payer genuinely owned the bitcoin with which he/she paid.
▪ The payer did not use that same bitcoin to pay someone else.

▪ This “ledger” may be:

▪ Held/maintained by a centralized authority.
▪ Older solution. (Bank)
▪ Maintained collectively by the entire community.
▪ Newer solution implemented in Bitcoin algorithm.
▪ The Bitcoin “ledger” is called the “Block Chain”.
▪ Maintained/updated by “Bitcoin Miners”.
Alice wants to pay a Bitcoin to Bob… Alice
Alice pays 1
Alice bitcoin
pays 1
pays 1 to Bob
bitcoin
bitcoin
to Bob
Alice to Bob
pays 1 Alice Alice
bitcoin I pay 1 pays 1 pays 1
to Bob bitcoin to bitcoin bitcoin
Bob I pay 1 to Bob to Bob
bitcoin to
Bob

I pay 1
bitcoin to
I pay 1 Bob
Alice bitcoin to Alice
Alice Alice
pays 1 Bob pays 1 pays 1 Bob
bitcoin bitcoin
bitcoin Alice
to Bob to Bob
to Bob pays 1
bitcoin
to Bob
Alice
pays 1
Mine
bitcoin Mine r
Some message recipients are Bitcoin
to Bob “Miners”…
r
The “Miners” add Alice’s transaction to “blocks” which they are compiling…

Public Ledger (“Block

I pay 1 Chain”)
bitcoin to
Bob
Bill paid Fred 4 bitcoins

Block
Ann paid Sue 2
bitcoins Jim paid Jane 2 bitcoins
Ted paid Emily 1 …
bitcoin
Alice paid Bob 1 Blah blah….
bitcoin …
I pay 1 Ann paid Sue 2 bitcoins
Alice bitcoin to
Bob Ted paid Emily 1 bitcoin
Alice paid Bob 1 bitcoin

Miners “compete” to add

Block

Ann paid Sue2

bitcoins
their new block of records
Ted paid Emily 1 to the ledger!
bitcoin
Alice paid Bob 1
bitcoin
 Winner adds his block (including Alice’s transaction) to the
Public Ledger
Public Ledger (“Block
“Winning” Chain”)
Miner Gets prize of
newly minted Bill paid Fred 4 bitcoins
bitcoins!!!
Block
Ann paid Sue 2 Jim paid Jane 2 bitcoins
bitcoins …
Ted paid Emily 1
bitcoin Blah blah….
Alice paid Bob 1 …
bitcoin
Ann paid Sue 2 bitcoins
The is the only way in which
Ted paid Emily 1 bitcoin
new bitcoins are ever
Alice paid Bob 1 bitcoin
produced.
Block from winning miner is
Analogous to digging gold! time-stamped and added to
But… ledger
• Where is this “block chain” stored? (Remember, there is no central
authority to hold it.)
• Who decides which miner “wins”?
Copy of the Block Chain is stored “Genesis”
by all “Players” (participants in the Block
Bitcoin network). Can take ages to
download! 324GB Hash
(Hash)
Each block contains a hash of its
predecessor – anyone can verify no Block #2
preceding block was modified!
Hash
(Hash)
Block #3

Hash
(Hash)
Block #4
 || Random
Nonce
Valid Result:
Hash 000…000XX…
XX Any other
“x” straight values
zeros

One new block added to the block chain approximately every

10 minutes.
Add any new
transactions to
… block No
Fred paid Jim 2 Add block to chain.
bitcoins Choose random Hash
George paid Tim 1
Obtain reward.
nonce and add to valid?
Yes
bitcoin Start new block.
block
Ann paid Sue 2
bitcoins
Apply hash
Ted paid Emily 1
bitcoin function to the
Alice paid Bob 1 result
New
bitcoin
….
Transactions
BITCOIN INFLATION
Part 5
▪ If Bitcoin mining goes on forever…
▪ …the supply of bitcoins will steadily increase, and…
▪ …the real value of each existing bitcoin will fall!
▪ INFLATION!!
▪ This is the usual result of the supply of money increasing faster than the quantity of goods
available to be bought.

▪ Solution…
▪ Implement a “law of diminishing returns”
▪ Number of reward bitcoins programmed to half every time 210,000 bitcoins are mined.
 ▪ Eventually almost no new Bitcoins will be
produced.
▪ As if nearly all the gold in the world were
mined
TRANSACTION ▪ Rewards for mining more do not cover costs.

FEES ▪ Former “miners” will need a new incentive to

continue their work
▪ From then onwards, incentives will be
provided in the form of “transaction fees”
payable by users.
▪ US Philosopher Stefan Molyneux on Bitcoin…
▪ https://www.youtube.com/watch?v=w4HGVJjqDVk
▪ Note: I find Molyneaux’s ideas interesting, but I disagree with most of them: please don’t think that
by recommending this video I’m advocating Molyneux’s (or anyone else’s) brand of anarcho-
capitalism. I’m not!
▪ Origins of Money
▪ Debt, barter, gold

▪ Virtualization of Money
▪ Fiat currency, bank accounts

▪ Cryptographic Concepts used in Bitcoin

▪ Public key ciphers, hash functions and proof-of-
work
▪ Bitcoin Transactions
▪ Problem of “double spending”

▪ Recording Bitcoin Transactions

▪ The “Block Chain”

▪ Bitcoin Mining
▪ Bitcoin Inflation
THANK YOU
Kavinga Yapa Abeywardena
Dept. CSE