Chapter 1

Cryptocurrency Explained

IN THIS CHAPTER

Discovering digital currency

Working with blockchain

Hashing blocks

Understanding public-key encryption

Signing messages with the private key

You may be eager to get your mining operation started, but before you can create cryptocurrency, we want to make sure you understand what cryptocurrency actually is.

The cryptocurrency thing is so new — or at least, most of the interest in cryptocurrency has occurred recently, even though cryptocurrencies of various forms have been around since the 1980s — that most people involved have a rather shaky understanding of what cryptocurrency is and how it works. The average cryptocurrency owner, for example, may not know what they own.

In this chapter, we review the history of cryptocurrency and how the different components function together. You’ll have a better foundation to understand how to mine cryptocurrencies if you understand what it is.

A Short History of Digital Dollars

Cryptocurrency is just one type of digital currency … a special type. At the end of the day cryptocurrency may be thought of as a form of digital currency.

So, what’s digital currency, then? Well, digital currency is a very broad term that covers a variety of different things. But in a general sense, it’s money that exists in a digital form rather than tangible form (think coins and banknotes). You can transfer digital currency over an electronic network of some kind, whether the Internet or a private banking network.

In fact, even credit card transactions may be thought of as digital currency transactions. After all, when you use your credit or debit card at a store (online or off), the money is being transferred electronically; the network doesn’t package up dollar bills or pound notes and mail them to the merchant.

First, take the Internet

The cryptocurrency story really all begins with the Internet. Digital currencies existed before the Internet was in broad use, but for a digital currency to be useful, you need, well, some kind of digital transportation method for that currency. If almost nobody is using a digital communications network — and until 1994 very few people did — then what’s the use of a digital currency?

But after 1994, millions of people were using a global, digital communications network — the Internet — and a problem arose: How can you spend money online? Okay, today the answer is pretty simple: You use your credit cards, debit cards, or PayPal account. But back in the mid-90s, it was more complicated.

Add credit card confusion

Back in the mid-90s, some of you may recall (and many of you were too young back then to remember this, I realize), people were wary of using credit cards on the Internet. When I had my own publishing company and was selling books through my website in 1997, I (Peter — Tyler’s too young to remember 1997) would often receive printouts of my website product pages in the mail, along with a check to pay for the book being purchased. I was taking credit cards online, but many people simply didn’t want to use them; they didn’t trust the Interwebs to keep their plastic safe.

In addition, setting up a payment gateway for credit cards was difficult and expensive for the merchant. These days, it’s a pretty simple process to add credit card processing to a website — it’s built into virtually all ecommerce software, and with services like Stripe and Square lowering the barriers of entry, getting a merchant account is no longer the huge hassle and expense it used to be.

Of course, we’re talking commercial transactions here, but what about personal transactions? How can someone send a friend the money they owe, or how can a parent send beer money to their child away at college? (I’m talking PPP … pre-PayPal and web-based transfers between bank accounts.) If we were going to live in a digital world, surely we needed digital money.

One important characteristic of cash is that cash transactions are essentially anonymous — there’s no paper trail or electronic record of the transaction taking place. Plenty of people thought an equivalent form of anonymous or pseudonymous digital currency would be a vast improvement over traditional settlement methods.

So, many people thought there had to be a better way. We needed a digital currency for a digital world. These days, perhaps that viewpoint seems naïve; looking back it was obvious that the credit companies weren’t going to see trillions of dollars of transactions shifting online and just wave goodbye! They wanted a piece of the action, unwilling to give up their monopoly, and so today, the primary transaction methods in the United States and most of Europe are bank cards of various kinds.

Add a dash of David Chaum

In the mid-1990s, people were streaming online and for various reasons many didn’t want to, or couldn’t, use credit cards (see preceding section). Checks were even more difficult (unless you wanted to mail it), and cash was out of the question. (Though — and here’s a joke for the older geeks among you — I do recall a friend telling me to UUENCODE the $10 I owed him and email it to him. Again, this is Peter talking; I’m betting Tyler is too young to know what UUENCODE is.)

But back in 1983, a guy called David Chaum had written a paper called “Blind Signatures for Untraceable Transactions.” Chaum was a cryptographer (someone who works with cryptography) and professor of computer science. His paper described a way to use cryptography to create a digital-cash system that could enable anonymous transactions, just like cash. (Modern cryptography is the science of securing online communications; we’ll come back to this later.) In fact, Chaum is often referred to as the Father of Digital Currency as well as the Father of Online Anonymity.

Result? DigiCash, E-Gold, Millicent, CyberCash, and More

Bring together the Internet, complicated online transactions, a fear of using credit cards online, a desire for cash-like anonymous online transactions, and David Chaum’s work in the ’80s (see preceding section), and what do you end up with?

You get DigiCash, for a start, David Chaum’s 1990 digital-cash system. Unfortunately, Mr. Chaum seems to be early for the party too often, and DigiCash was out of business by 1998. There was also E-Gold, a digital cash system supposedly backed by gold, DEC’s Millicent (yes, yes, most of you are too young to remember DEC, too… . I’m starting to feel old writing this “historical” section), First Virtual, CyberCash, b-money, Hashcash, eCash, Bit Gold, Cybercoin, and many more. There was also Beenz, with $100 million in investment capital; Flooz, endorsed by Whoopi Goldberg (no, really!); Liberty Reserve (shut down after being accused of money laundering); and China’s QQ Coins.

With the exception of QQ Coins, still in use on Tencent’s QQ Messaging service, all these digital currencies are gone. Notably, many of these early digital currencies were in one way or another centralized with a trusted third-party intermediary.

Digital currency was not over, though. It got off to a rough start, with much trial and error, but plenty of people still thought that the world needed cash-like (in other words, anonymous) online transactions. A new era was about to begin: The cryptocurrency era.

The earlier digital currencies also depended on cryptography, it’s true, but they were never known as cryptocurrencies. It wasn’t until cryptocurrency was combined with a blockchain in 2008 that the term cryptocurrency started to gain usage, and the term really didn’t begin to appear widely until around 2012. (Blockchain? It’s a special form of database, but we’ll describe in more detail later in this chapter.)

The Bitcoin white paper

In 2008 Satoshi Nakamoto published and posted in a cryptography forum known as the “Cypherpunk Mailing List” a document titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” saying, “I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party,” he said.

The following list of attributes, Nakamoto stated, were key to Bitcoin:

• Double-spending is prevented with a peer-to-peer network.
• No mint or other trusted parties.
• Participants can be anonymous.
• New coins are made from Hashcash style proof of work.
• The proof of work for new coin generation also powers the network to prevent double spending.

The document is a fairly dry read, but it’s worth spending a few minutes checking it out. You can easily find it by navigating to https://bitcoin.org/bitcoin.pdf. The abstract for the Bitcoin white paper begins with the following statement: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution,” Nakamoto wrote. He explains that his method has solved the “double-spending” problem, an issue plaguing earlier digital currencies: the challenge was to make sure that a digital currency couldn’t be spent...