Understanding Bitcoin: Cryptography, Engineering and Economics

Praise for Understanding Bitcoin "This book is a one stop source for much-needed information about cryptocurrencies. Finally a single resource for everyone who wants to understand Bitcoin, the technologies it is based on and it's whole surrounding ecosystem. No more googling around and going through wikis and forums." —Pavol "stick" Rusnak, Core developer of TREZOR "Bitcoin is a large domain encompassing many diverse areas of expertise. Franco's Understanding Bitcoin: Cryptography, Engineering and Economics is a welcome endeavour which provides a coherent picture of the framework. His book is a timely reference guide for a hot, quickly evolving, crucially relevant subject." —Prof. Ferdinando M. Ametrano, QuantLib, Hayek Money, Milan Bicocca University, Banca IMI IntesaSanpaolo "Anyone interested in electronic payments will treasure this book for its depth and breadth, as it covers a very wide range of topics ranging from cryptography to software engineering to monetary economics. Pedro has created a comprehensive and very accessible introduction to the world of cryptocurrencies, which is very fun to read." —Jan Pelzl, Author of Understanding Cryptography "Bitcoin is a challenging subject for most people to wrap their heads around. Understanding Bitcoin: Cryptography, Engineering and Economics offers a simple and understandable glimpse into the world of bitcoin that anyone can follow. The book not only explores Bitcoin's potential to transform commerce, but also it's potential to reshape the Internet itself. It's a must read for anyone looking to learn about Bitcoin." —Stephen Pair, BitPay co-founder and CEO

About the Author xi Acknowledgments xiii Foreword xv Prologue xvii Preface xix PART ONE: INTRODUCTION AND ECONOMICS 1 CHAPTER 1 Foundations 3 1.1 Decentralized 4 1.2 Open Source 6 1.3 Public Asset Ledger 8 1.4 It’s Not Only the Currency, It’s the Technology 9 CHAPTER 2 Technology (Introduction) 11 2.1 Centralized Database 11 2.2 Addresses, Transactions 13 2.3 Distributed Database, the Blockchain 15 2.4 Wallets 17 2.5 The Different Meanings of Bitcoin 18 CHAPTER 3 Economics 21 3.1 Medium of Exchange 22 3.1.1 Pros 25 3.1.2 Cons 26 3.2 Store of Value 27 3.2.1 Bitcoin as Investment 29 3.2.2 Pros 30 3.2.3 Cons 31 3.3 Unit of Account 32 3.4 Deflation 32 3.5 Volatility 33 3.6 Effect on the Financial Industry and Monetary Policy 35 3.7 Regulation 37 CHAPTER 4 Business Applications 39 4.1 Money Transfer 39 4.2 Exchanges 40 4.3 Payment Processors 43 4.4 Web Wallets 43 4.5 Multisignature Escrow Services 45 4.6 Mining 46 4.7 ATMs 48 PART TWO: BITCOIN TECHNOLOGY 49 CHAPTER 5 Public Key Cryptography 51 5.1 Public Key Encryption 53 5.2 Digital Signatures 56 5.3 RSA 59 5.4 Elliptic Curve Cryptography 62 5.4.1 Elliptic Curve Summary 63 5.4.2 Elliptic Curve Theory 64 5.5 Other Cryptographic Primitives 71 5.5.1 Blind Signatures 71 5.5.2 Shamir Secret Sharing 72 5.6 Bitcoin Addresses 73 CHAPTER 6 Transactions 77 6.1 Transaction Scripts 80 6.2 Pay–to–address and Pay–to–public–key Transactions 82 6.3 Multisignature (m–of–n) Transactions 84 6.4 Other Transaction Types 85 6.5 Transaction Signature 86 6.6 Pay–to–script–hash (P2SH) 89 6.7 Standard Transactions 92 CHAPTER 7 The Blockchain 95 7.1 Hash Functions 95 7.2 Time–stamp 99 7.3 Proof–of–work 101 7.4 The Blockchain 105 7.5 Double–spend and Other Attacks 113 7.5.1 Race Attack 115 7.5.2 Finney Attack 116 7.5.3 Transaction Spamming 116 7.6 Merkle Trees 117 7.6.1 Transaction Malleability 119 7.7 Scalability 120 CHAPTER 8 Wallets 123 8.1 Symmetric–key Cryptography 125 8.2 Offline Wallets 126 8.2.1 External Storage Media 127 8.2.2 Paper Wallets 127 8.2.3 Offline Devices 129 8.2.4 Hardware Wallets 130 8.3 Web Wallets 131 8.4 Brain Wallets 132 8.5 Deterministic Wallets 132 8.5.1 Message Authentication Code (MAC) 134 8.5.2 Hierarchical Deterministic Wallets 135 8.6 Multisignature Wallets 136 8.7 Vanity addresses 137 8.8 Simplified Payment Verification (SPV) 139 8.9 The “Payment Protocol” (BIP 70) 141 CHAPTER 9 Mining 143 9.1 Mining Technology 146 9.2 Pooled Mining 149 9.3 Transaction Fees 154 9.4 Selfish Mining 156 PART THREE: THE CRYPTOCURRENCIES LANDSCAPE 159 CHAPTER 10 The Origins Of Bitcoin 161 10.1 David Chaum’s Ecash 162 10.2 Adam Back’s Hashcash 163 10.3 Nick Szabo’s bit gold and Wei Dai’s b–money 164 10.4 Sander and Ta–Shma’s Auditable, Anonymous Electronic Cash 165 10.5 Hal Finney’s RPOW 167 10.6 Satoshi Nakamoto 168 CHAPTER 11 Alt(ernative) Coins 171 11.1 Litecoin 172 11.2 PeerCoin 173 11.3 Namecoin 174 11.4 Auroracoin 175 11.5 Primecoin 175 11.6 Dogecoin 176 11.7 Freicoin 177 11.8 Other Alt–coins 177 11.9 The Case For/Against Alt–coins 178 CHAPTER 12 Contracts (the Internet of Money or Cryptocurrencies 2.0) 183 12.1 Digital Assets 183 12.2 Smart Property 185 12.3 Micropayments 186 12.4 Autonomous Agents 187 12.5 Other Applications 189 12.5.1 Crowd–funding 189 12.5.2 External State Contract 190 12.5.3 Contract for Differences 190 12.5.4 Distributed Exchange 191 12.5.5 Deposits 191 12.5.6 Saving Addresses 192 12.6 Inserting Data into the Blockchain 192 12.7 Meta–coins 194 12.7.1 Colored Coins 196 12.7.2 Counterparty 197 12.7.3 Ethereum 199 12.7.4 Mastercoin 202 12.7.5 Nxt 203 12.7.6 Ripple 204 CHAPTER 13 The Privacy Battle 209 13.1 Network Analysis 209 13.2 Laundry Services 212 13.3 Greenlisting 213 13.4 Privacy–enhancing Technologies 214 13.4.1 CoinJoin 214 13.4.2 CoinSwap 215 13.4.3 Stealth Addresses 217 13.4.4 Merge Avoidance 219 13.4.5 Committed Transactions 220 13.5 Fully Anonymous Decentralized Currencies 221 13.5.1 Zero–knowledge Proofs 221 13.5.2 Zero–knowledge Proof of Graph 3–colorability 221 13.5.3 Zero–knowledge Proof for the Discrete Logarithm 223 13.5.4 Non–interactive Zero–knowledge Proofs 224 13.5.5 Accumulators 225 13.5.6 Zerocoin 226 13.5.7 Zerocash 228 CHAPTER 14 Odds and Ends 231 14.1 Other Transaction Protocols 231 14.1.1 Micropayment Channels 231 14.1.2 Atomic Cross–chain Trading 232 14.2 Alternatives to Proof–of–work 233 14.2.1 Proof–of–stake 234 14.2.2 Proof–of–burn 236 14.3 Merged Mining 237 14.4 Side–chains 238 14.5 Open Transactions 240 14.6 Quantum Computing 242 14.7 Recent Advances in Cryptography 244 14.7.1 Homomorphic Encryption 244 14.7.2 Obfuscation 245 Bibliography 247 Index 259

PEDRO FRANCO holds an MSc in Electrical Engineering from ICAI, a BSc in Economics and an MBA from INSEAD. He has been a consultant with McKinsey and Boston Consulting Group, as well as a researcher with IIT, prior to gaining more than 10 years of experience in financial markets, holding Quant and Trading positions in Credit, Counterparty Risk, Inflation and Interest Rates. He has created various mathematical libraries for financial derivatives, and managed teams of software developers. He can be contacted at pfrancobtc@gmail.com.