The virtual currency bitcoin has been getting a lot of hype and news recently, as the price per coin has gone from about \$14 at the beginning of the year to a high of over \$1200 last week with a subsequent drop to its current value, which is between \$700 and \$800 (see here). While nobody really knows the future of bitcoin, the success of which depends highly on regulations, the technical aspects of its implementation are quite interesting. For the basic overview, first check out this explanation from the website, which the rest of this post assumes at least cursory knowledge of. The original bitcoin paper that contains all of the technical details I will be explaining can be found here. The core concept is a virtual currency that does not require a centralized authority to manage, which naturally makes it much more flexible and reduces the overhead of processing transactions. In order for such a system to work, there must be some source of trust, which is accomplished through a combination of public-key cryptography and a proof-of-work system.
Bitcoin, at its core, is really just a sequence of transactions between wallets, each of which is signed by the sender. Each wallet has a public key and a private key, and senders sign transactions with their private key such that everyone else can validate the transactions using the public key, as is typical with public-key cryptography. The problem that arises is that there is no easy way to verify that the sender did not "double-spend" their bitcoins, i.e. signing two transactions which send the same bitcoins. As it turns out, the only way to prevent such a situation without a centralized authority is to have a public, linear history of all transactions (known as the block chain). Assuming such a history, every new transaction can be verified to not include double-spending, and we have a working system.
So the remaining problem is how a distributed, peer-to-peer system can generate a transaction history that everyone agrees on. The solution is a proof-of-work system that is based on cryptographic hashing. At any point in time, bitcoin miners are continuously brute-forcing through hash computations in order to produce the next block in the chain. A block consists of the previous block hash, a set of transactions, and a nonce; it is only valid if its hash has sufficient difficulty, where difficulty is the number of 0's the hash begins with. Miners continually increment the nonce until they produce a block whose hash difficulty is accepted by the system (i.e. everyone else). The difficulty is chosen such that blocks are produced around every 10 minutes, which is why bitcoin transactions typically take that long to verify. Once a block has been committed to the chain, all the miners will generally accept it and move on to the next block, where there are some details about blocks being produced simultaneously, etc. The transactions that are part of the chain form the history from which future transactions can be verified. An example of a recently-produced block can be seen here.
There are a couple of remaining points that should be addressed when talking about bitcoin. Firstly, what is the incentive for people to mine (and thus produce the transaction history necessary for the system to function)? Bitcoin mining is the only way to produce new bitcoins; each block has a special transaction that gives the producer of the block some bitcoins, currently 25, although this reward decreases over time since the total number of bitcoins in circulation is capped at 21 million. The other incentive is transaction fees that are collected as payment for keeping the system running. Another issue is that the transaction history seems like it will grow infinitely and become unmanageable. This can be alleviated using the fact that transactions which are used as inputs to other transactions can be garbage-collected using Merkle trees (details in the paper). Lastly, it is important to consider the possibility of attackers producing fake blocks that reverse old transactions. The key point is that reversing an old transaction involves recomputing all of the blocks from that transaction onward since each block is a function of the previous one's hash. As such, the attacker would have to produce transaction history as quickly as the rest of the network combined, which seems to be a strong enough guarantee for people to trust bitcoin.
Whether bitcoin is a fad or not, it has a neat theoretical foundation, and I'm impressed by all of the work people are putting into it (blockchain.info is super cool). There is certainly room for disruption in the currency and payments industry, and it's only a matter of time before money is a purely virtual concept. Bitcoin also shows us that cryptography is a powerful tool, and it's worth thinking about how we can rely on mathematics for trust instead of other people (as depressing as that might sound).
