The BSV Academy’s free introduction to Bitcoin Theory course covers the design of Bitcoin as a system as prescribed by Satoshi Nakamoto. This course is open to anyone who is interested in Bitcoin and is the beginner course in this series. Some technical experience would be helpful to complete the course, however, it is open to anyone regardless of experience.
The course goes through the Bitcoin white paper section by section elaborating on the concepts contained within each. This section focuses on the concept of incentives and how they play a key role in the continued functioning of the blockchain.
To make it as effortless as possible for you to have access to this educational material, we are publishing the entire course here on our blog. Stay tuned for a section-by-section release, and remember that you are still welcome to enrol in the BSV Academy to gain a certificate of completion to add to your resume.
Bitcoin’s incentive system
By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for Bitcoin nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.
The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.
The incentive may help encourage nodes to stay honest. If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments, or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favour him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.
Learn about incentive-driven behaviours in Bitcoin.
The Coinbase transaction
By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block.
- Satoshi Nakamoto, Bitcoin white paper
The first transaction in any block is called a ‘Coinbase transaction’. This transaction has by definition a single input which contains an arbitrary string of text up to 100 bytes long which nodes use to mark the number of the block in the chain and in some cases to identify themselves.
The transaction can have multiple outputs, the value of which when combined must be equal to or less than the block reward, which includes a distribution of coins and the fees collected from all of the transactions that have been added to that block.
If the node fails to include coins that are part of the new coin distribution or were given as transaction fees to the value of the coinbase transaction’s outputs, those coins are lost and cannot be recovered.
Learn more about the Bitcoin Coinbase.
Bitcoin coin distribution
This adds an incentive for nodes to support the network and provides a way to initially distribute coins into circulation, since there is no central authority to issue.
- Satoshi Nakamoto, Bitcoin white paper
The distribution of new coins to the operators of block winning nodes acts as a subsidy to bootstrap the build-out of network infrastructure, giving the network time to accumulate users and providing a simple way to distribute the coinage used on the network to the miners who are providing the service of building blocks for network users.
Because there is no central authority, the distribution is moderated through Nakamoto Consensus, with nodes validating other nodes’ self awarding of coins in the coinbase transactions they construct as part of their blocks. Because of this, nodes are incentivised to behave honestly and to perform a highly accurate accounting of their subsidy payment and the fees contained in the block.
All satoshi tokens used in transactions on the Bitcoin network are distributed through this subsidy, and all coins in circulation can be traced via the transaction DAG (Directed Acyclic Graph) back to a coinbase transaction.
Nakamoto Consensus refers to the set of rules, in combination with the Proof of Work consensus model in the network, that govern the consensus mechanism and certifies its trustless nature. Nakamoto Consensus can be broken down into four main parts.
- Proof-of-work
- Block selection
- Scarcity
- Incentive structure
The combination of components allows Bitcoin to become the distributed network for value transfer that it is. It operates with trustless consensus and will remain secure as long as the majority of power contributed to the mining process is in the hands of honest miners.
Bitcoin mining analogy
The steady addition of a constant amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.
- Satoshi Nakamoto, Bitcoin white paper
As nodes extend the chain of proof-of-work and are awarded coins distributed from the initial issuance the quantity of coins in reserve is depleted. The analogy is akin to a group of miners digging out a stope to find gold to add to a circulating economy.
In the case of Bitcoin, nodes perform the work of ‘mining’ by compiling transactions into block templates then digging through hash combinations looking for a particular combination that solves the block difficulty puzzle. This exercise is costly in terms of computing power and requires both energy and infrastructure so it is similar to real world mining. Hash providers are incentivised to find efficiencies such as lower cost energy and more efficient machinery.
A good analogy is that in 1850, it was efficient to mine for gold with a shovel and a pan, thanks to the exceptionally high concentrations of gold in the available ore, however by 1900 sluice guns and larger machinery was needed to remain competitive as most of the easy to find gold had already been pulled from the land.
In today’s mining industry, large players spend hundreds of millions of dollars purchasing and operating plants and machinery as the amount of available gold reduces over time. This doesn’t mean one can’t find gold with a pan and shovel, however the rewards for doing so are much less than they were back at the beginning of the gold rush.
Learn about the difference between a Bitcoin node and a miner.
Bitcoin transaction fees
The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction.
- Satoshi Nakamoto, Bitcoin white paper
Nodes can also augment their income with transaction fees paid by users each time they make a transaction. These fees are paid by users creating transactions in which the combined value of the inputs is more than the value of the outputs. These tiny differences in value are aggregated by the nodes as they construct their block templates and paid out to the node operator in the coinbase transaction.
The more transactions that a node can fit into a block, the more earning potential it has through transaction fees. In this way, scaling the network can be seen as a way for node operators to improve their potential income.
The end of inflation in Bitcoin
Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.
- Satoshi Nakamoto, Bitcoin white paper
Over time, the amount of coins distributed to node operators through the block subsidy reduces. The first blocks found each awarded the winning blocks 50 bitcoins, however every 210,000 blocks, or approximately every four years, the amount is cut in half, eventually reaching 1 Satoshi per block and then going to zero in around 2140 or after 32 ‘halvening’ events. From this moment there will be no further inflation in the number of Satoshis that enter the network.
The reduction in the rate at which new bitcoins enter the economy is an important aspect of the system of incentives that encourage network scaling as it incentivises competing enterprises to build a network that can accommodate larger numbers of transactions with a view to using the fees paid as a means to replace the subsidy income.
This also creates an incentive for node operators to build usage through targeted funding and the creation of novel use cases as an investment in a highly used application can deliver a big long-term return in the form of additional transaction fees through the network.
Encouraging honesty in the Bitcoin network
The incentive may help encourage nodes to stay honest.
- Satoshi Nakamoto, Bitcoin white paper
Nodes make their income through the coins they award themselves in the coinbase transactions of valid blocks. The network has a rule that prevents coinbase rewards from being spent until 100 blocks have been built on top of the block in which they were awarded, meaning that without the support of the majority of competing nodes building on top of the block that contains it, a coinbase reward might never become a permanent part of the ledger, rendering the coins it contains unspendable.
For a node to create a block with dishonest activity such as a double spent transaction output or extra coinbase rewards, the rest of the network would have to collectively support their dishonest behaviour, investing proof-of-work and building upon the dishonest actions taken.
Node operators are diverse and have headquarters in many different nation states. They are largely enterprise level organisations who pay taxes and are beholden to the laws applicable in the country where they reside.
Actively spending money on work to build upon a block containing knowingly fraudulent activity is highly risky for an individual node, and if perpetrated by a collective majority of network actors would represent an existential threat to the network and their livelihoods thus creating a powerful incentive for all nodes to protect the integrity of the system. Importantly though it would be highly visible that this was happening to the entire world.
The attacker's dilemma
If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favour him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.
- Satoshi Nakamoto, Bitcoin white paper
To conduct a double-spend attack on the Bitcoin network, the attacking node must accumulate enough hash power to overrule more than half of the other nodes on the network, and must then pay to maintain that hash power for an indefinite period of time, while it tries to convince the remaining nodes on the network to support its illegal actions.
Maintaining the attack as a single malicious actor is tremendously expensive due to the cost of performing proof-of-work, yet the attacker must break the law in plain sight using the Bitcoin ledger in full view of the public and law enforcement.
It is easy to see that it is far less risky and much more lucrative for a node controlling such a large quantity of hash power to participate as an honest actor securing the network to legitimately win honest rewards as income.
Learn more about how Bitcoin solves the double-spending dilemma of the digital economy.
