Understanding Bitcoin: Cryptography, engineering and economics by Pedro Franco [Review]

At the core of this scholarly book is a dissection of bitcoin's biggest achievement. That is the transmission of value over the internet, an inherently insecure channel, without any reliance on a trusted third party. Even the harshest critics of bitcoin the currency (as opposed to Bitcoin the protocol) would agree the technology has legs, and then some.

Pedro Franco, the author of 'Understanding Bitcoin: Cryptography, engineering and economics' begins with a lapel-grabbing analogy: "Bitcoin could be used as an open platform for the exchange of value in much the same way that the internet is an open platform for the exchange of information."

He adds that it would have been impossible to predict the importance of social networking in 1994, for example, reminding us we are currently witnessing "the first round of applications in the cryptocurrencies ecosystem".

Franco's preface claims that a sceptical view of Bitcoin is perhaps the easiest to understand, which could be taken as a hint at the technical discussions that will follow. The sceptical view he is talking about is driven by a number of issues.

It was very important in the beginning, when bitcoin bootstrapped itself into relevance, to rely on its miners to spread the word, to market it. This they did, sending it viral. Added to this hype, is the fact that miners are paid in bitcoin for their work securing the public ledger of transactions.

This self-generating style of remuneration, combined with a wildly fluctuating exchange price, earned bitcoin a reputation among some as some kind of carefully wrought confidence trick. Perhaps mining for block rewards reminds people of scams like chain letters. Then there's Satoshi, bitcoin's nebulous mastermind, who also mined about a million bitcoins in the early days.

Doubts seemed to be confirmed by events like the collapse of the Mt.Gox exchange, or the closure of Silk Road - formative events which had a seismic impact on the exchange value of bitcoin. Franco doesn't name names, however. He simply states that Bitcoin should not be confused with a Ponzi scheme because it is decentralised and not controlled by any individual.

But in the fast-evolving and fiercely polarised world of bitcoin, it's become impossible make pronouncements on the technology's future from an entirely impartial standpoint. Facing off the sceptics is a devoutly anti-corporate hardcore of bitcoin enthusiasts, who would sooner join nodes and declare cyber-geddon on the world's banks than see them squeeze a cent out of cryptocurrencies.

Part One: Introduction and Economics

The book promises financial professionals a comprehensive guide to bitcoin and other cryptocurrencies. In this regard, Franco's position could be described as a liberal third way. He takes a measured pop at the economic policies of reserve banks, but this is balanced by a passing invitation to the lower orders of the financial services sector, such as those involved in electronic payments.

For example, Franco discusses ways of resolving disputes over transactions using funds held in escrow: this facility is built into credit cards, but is lacking from bitcoin. "Credit card processors are good candidates to provide these services, leveraging their expertise in dispute mediation," he says.

Bitcoin start-ups are attractive because they seem to be able to hurdle prohibitive barriers to highly regulated financial services industry, such as holding a large capital base.

But bitcoin currently inhabits a regulatory grey area. The issuance of private currencies is permitted under US law, provided they don't resemble the dollar. Since bitcoin is a decentralised system it cannot be classed as a money transmitter. However businesses that deal in it can, like payment processors and bitcoin exchanges. These fall under the definition of money transmitters in the US, which require a licence to operate from each state.

Recent updates from America's Financial Crimes Enforcement Network (FinCEN) declared that neither bitcoin investors nor miners should be considered money transmitters, but this ruling did not cover web wallet services.

At stake here are bitcoin's very low transaction fees. The average fee in the remittance market is reported to be in the range of 8% to 9%, as opposed to bitcoin transactions which cost between 0.01% and 0.05%.

Standard anti-money laundering (AML) and know your customer (KYC) regulations cover all money transmitters. These compliance costs are ultimately passed onto customers. In defence of looming regulations, cryptocurrency advocates argue that money laundering using bitcoin would be very risky because all transaction records are kept in a public ledger.

"A regulatory framework that took into account this transparency could help reduce the compliance costs of money transmitting services," argues Franco.

Franco talks about "trust" when comparing the operations of cryptocurrency holdings to the way assets are held by banks. He refers to practices such as fractional reserve banking, where the bank holds only a small percentage of the money deposited and lends the rest back into the financial system.

"Although nothing prevents an institution from practising fractional reserve banking with bitcoins, it is not clear that users would favour such an institution," he says.

Bitcoin exchanges that might have carried on fractional reserve banking are the sorts of companies that users should not trust. Regarding a cryptocurrency lender of last resort, an advantage would be "keeping the monetary authority honest".

Bitcoin ATMs will probably fall under same level of regulatory compliance as money transmitters, and might require banking relationships, he states. The obvious future application of these would be using bitcoins to buy currency in foreign countries and therefore avoiding the charges/fees associated with travellers cheques.

Part Two: Bitcoin Technology

Franco states in his preface that certain of the technical sections of the book can be safely skipped by those who are not attempting to implement the Bitcoin protocol. In any case, he should be praised for his clear and concise explanation of cryptography, which is the subject of the first chapter in the book's technical analysis, despite his admission that "a single chapter does not do justice to the subject, and the treatment here is necessarily shallow and incomplete".

He starts by looking at public key encryption: using an algorithm to generate a mathematically linked public-private keypair. Public keys are exchanged and used to encrypt messages, which can only be decrypted by the person holding the private key. A bitcoin wallet is simply a collection of private keys used to sign transactions with the bitcoin ledger, which holds a record of the amount of funds available to each address.

Bitcoin wallets generally offer additional encryption of the private keys they hold, and the wallet itself can be distributed across several devices so that accessing the funds would require cooperation between the devices.

Storing private keys offline is also highly recommended. Despite the complexity of cryptographic security, the safest approach in many respects remains the "paper wallet" i.e. printing out bitcoin addresses and private keys on paper and hiding them somewhere safe. Franco makes the point that offline storage on disk or USB can corrupt over time so back them up. Losing the keys generally means you lose the bitcoins.

The blockchain technology is an amalgam of cryptography techniques. It borrowed proof-of-work function from Hashcash, which was introduced to curb spam on email, and combined it with linked time-stamping to arrive at a way of securing the distributed database. Franco analyses the useful pieces of technology that are combined to create the blockchain's innovation, and also traces each component back to its "cypherpunk" roots in the 1990s.

To prevent two transactions from spending the same funds, the protocol decides that the valid transaction is the one that is time-stamped on the blockchain first. The transaction is further secured as more blocks are piled on top of it. This elegantly adds additional layers of security, backed by the combined computing power of the network.

To alter a transaction, an attacker would have to re-mine a given block all the way back to the blockchain head, keeping pace with the rate of new blocks being added by the network. The only sure way to alter the blockchain therefore would be to control over half the total computing power of the network. Thus Bitcoin represents an ever expanding apotheosis of encrypted security.

Part Three: The Cryptocurrencies Landscape

Here Franco traces bitcoin's origins back to early experiments in public key cryptography and blind signatures, as set out in documents such as the "Cryto Anarchist Manifesto" (May 1992).

He charts a course through innovations such as David Chaum's ecash, an untraceable payment system first mooted in 1982; Adam Back's Hashcash, which ingeniously added computational time and costs to spammers; through to the first published papers by Satoshi Nakamoto in 2008. This was followed by the launch of the bitcoin peer-to-peer network on January 3, 2009.

There is survey of some alt-coins that have proposed interesting changes, either technical or to the economics of bitcoin.

Litecoin (2011) uses a different proof of work algorithm to bitcoin and its block generation time of 2.5 minutes is shorter. Peercoin (2012) uses a hybrid proof-of-work/proof-of-stake system that requires less computing power, making it arguably a green alternative to bitcoin. Auroracoin (Feb 2014), was 50% pre-mined, so that half its monetary supply could be distributed among the population of Iceland.

Alt-coins, which are forks in bitcoin's open source code, can now be created on dedicated websites with just a few mouse clicks, notes Franco.

A section on the future applications looks at smart contracts that could in some cases substitute the legal governance: "interactions that today are governed by law could be governed in the future by digital contracts and cryptoledgers".

The most commonly cited example of smart property is the car. In this case the car's ownership is represented by a digital asset in the blockchain. The telematics system of the car is connected to the internet and can read the blockchain. It sees that a change of ownership has occurred and updates the public key of its owner accordingly. The new owner can open the car and start the engine by signing a message with his or her private key. This can be sent to the car via a wallet application in a smartphone.

More complex transactions are explored: the car could grant an address access for a limited period, say for a rental, or the car could update payment by instalments.

Other emerging bitcoin applications include digital bonds or digital shares; the next generation of micropayments and crowd-funding; autonomous agents that can operate Decentralised Autonomous Corporations and so on.

We are living though a technological revolution. Who knows what applications will dominate a decade from now? Bitcoin founder Satoshi's predictions made in 2009 are already looking very modest: "I would be surprised if 10 years from now we're not using electronic currency in some way..."

Understanding Bitcoin is published by academic research heavyweights Wiley in 2015.