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Berentsen and Schär
Having presented a broad overview of
the Bitcoin system, we will explain a few
technical elements of the system in greater
detail. Blockchain uses proven technologies
and links these in an innovative way. This
combination has made the decentralized
management of a ledger possible for the
first time.
Berentsen and Schär (2017) argue that
transaction processing demands that three
requirements are satisfied: (1) transaction
capability, (2) transaction legitimacy, and
(3) transaction consensus. These three
requirements will now be considered. In
particular, we will explain how these con-
ditions can be satisfied in the absence of a
central authority.
Figure 7
Interdisciplinarity
Cryptography
Economics
Computer
Science
2.1 Transaction Capability
What has to be resolved is how transactions can be initiated if there is no central authority.
In a classical banking system, a client talks to his or her advisor or submits his or her payment
instructions via the bank’s online banking service. The infrastructure provided by the com-
mercial bank and other central service providers ensures that the transaction will be commu-
nicated for execution. In the absence of a central authority, communicating a payment order
in this traditional sense is not possible.
In the Bitcoin system, a payment order can be communicated to any number of network
nodes. The network nodes are linked together in a loose network and forward the message
until all nodes have been informed about the transaction (Figure 8).
The decentralization of the system has many advantages. In particular, it makes the system
extremely robust. There is neither a central point of failure that can be attacked nor any system-
relevant nodes that could cause the system to collapse. Therefore, the system functions even
when some network nodes are unreachable, and it can always establish new connections and
communication channels.
2.2 Transaction Legitimacy
Every participant can generate new payment orders and spread them across the network.
This feature carries the risk of fraudulent messages. In this respect, there are two important
questions that arise:
1. How do the nodes know that the initiator of the transaction is the rightful owner and
that he or she is thereby entitled to transfer the Bitcoin units?
2. How can one ensure that the transaction message will not be tampered with before it
is passed from one node to the next?
10
First Quarter 2018
Federal Reserve Bank of St. Louis REVIEW