Cryptocurrency Technology

MODULE – 3

Bitcoin Engineering
Bitcoin Engineering
Bitcoin Engineering refers to the technical aspects and practices involved in
building, maintaining, and improving applications, infrastructure, and systems that
utilize Bitcoin.
It includes the design and development of software and hardware solutions for
interacting with the Bitcoin blockchain, managing transactions, ensuring security,
and creating new functionalities that extend Bitcoin's use cases.
Key areas of Bitcoin Engineering include:
• Blockchain Development
• Smart Contracts and Layers
• Security Engineering
• Payment Systems
• Decentralized Finance (DeFi)
• Mining Infrastructure
Bitcoin Engineering – Key Areas
Blockchain Development
• Building and maintaining Bitcoin nodes that participate in the
network by validating transactions, adding them to the blockchain,
and securing the network via Proof of Work.
• Blockchain development in the context of Bitcoin engineering
involves designing, building, and maintaining the underlying
infrastructure of the Bitcoin network, which is based on a
distributed ledger known as a blockchain.
• This is one of the most critical areas of Bitcoin engineering, as it
ensures the reliability, security, and scalability of the Bitcoin
network.
Bitcoin Engineering – Key Areas
Smart Contracts and Layers
• Smart contracts are like digital agreements that automatically execute
themselves when certain conditions are met—no middleman needed. Originally,
Bitcoin was just for simple transactions (like sending money from one person to
another) and didn’t support these programmable agreements.
• However, people wanted to do more with Bitcoin, such as building decentralized
finance (DeFi) applications, managing digital identities, and creating self-
executing contracts.
• To make this possible, developers created new tools and layers on top of Bitcoin.
• Lightning Network : Think of the Lightning Network as a fast and cheap add-on
to Bitcoin. It lets people make instant payments without waiting for the Bitcoin
network to confirm every small transaction. For example, if you and a friend
wanted to split a bill, you could set up a temporary payment channel on the
Lightning Network to handle this.
Bitcoin Engineering – Key Areas
Security Engineering
• Security Engineering is one of the most critical aspects of Bitcoin
engineering. Given that Bitcoin is a decentralized financial system
with billions of dollars in value at stake, ensuring the security of
transactions, wallets, exchanges, and the network itself is of utmost
importance.
• Securing wallets, exchanges, and transactions by building robust
systems that prevent attacks such as double-spending, 51%
attacks, or theft through hacking.
• Bitcoin’s design prioritizes security, but engineers still face
numerous challenges to maintain and improve it as the technology
evolves.
Bitcoin Engineering – Key Areas
Payment Systems
• Building Bitcoin payment processors, wallets, and integrations that
enable easy use of Bitcoin in everyday transactions.
• The Payment System is a fundamental aspect of Bitcoin
engineering that focuses on enabling efficient, secure, and scalable
transactions. As a decentralized, peer-to-peer digital currency,
• Bitcoin was designed to function as a medium of exchange,
allowing users to send and receive payments without
intermediaries like banks.
• Payment system engineering in Bitcoin involves developing tools,
protocols, and technologies that facilitate seamless transactions,
optimize network performance, and ensure security.
Bitcoin Engineering – Key Areas
Decentralized Finance (DeFi)
• Decentralized Finance, or DeFi, refers to a new form of financial system built on
blockchain technology that aims to recreate and improve upon traditional
financial services like lending, borrowing, trading, and investing—without relying
on centralized intermediaries like banks.
• DeFi uses smart contracts, which are self-executing pieces of code on a
blockchain, to automate and enforce financial agreements and transactions
directly between users.
• DeFi platforms are transparent, as all transactions are recorded on a public
ledger. They’re also accessible globally—anyone with an internet connection and
a digital wallet can participate, offering financial services to individuals who may
be underserved by traditional banks.
Bitcoin Engineering – Key Areas
Mining Infrastructure
• The infrastructure behind Bitcoin mining supports the Proof-of-Work (PoW) mechanism,
where miners solve cryptographic puzzles to add new blocks to the blockchain. This
system helps secure the network, prevents double-spending, and ensures that
transactions are verified and added transparently.
• Application-Specific Integrated Circuits (ASICs) are specialized devices designed
exclusively for mining Bitcoin. ASICs are far more efficient than general-purpose
processors, like CPUs or GPUs, and are essential to achieving the computational power
needed to mine Bitcoin profitably.
• Mining farms are large facilities housing hundreds or thousands of ASIC miners working
together to solve PoW puzzles. These farms are typically located in regions with affordable
electricity and favorable climates, as mining is energy-intensive and generates significant
heat.
Bitcoin Block
• A Bitcoin block is a fundamental unit of data that is added to the
Bitcoin blockchain. It contains a list of Bitcoin transactions that
have been verified and validated by miners, as well as other critical
information used to secure and maintain the integrity of the
network. Bitcoin blocks are created through the process of mining,
where miners compete to solve a complex mathematical puzzle
(proof-of-work).
• Each block is cryptographically linked to the previous one, forming
a blockchain — a continuous, immutable ledger of all Bitcoin
transactions.
Bitcoin Block Components
• Block Header
• Transaction List
• Block Size
• Block Reward
• Merkle Tree and Merkle Root
• Block HashTimestamp
• Difficulty Target
• Nonce
Hot and Cold Storage
• In Bitcoin engineering, hot and cold storage refer to different
methods of storing Bitcoin and other cryptocurrencies, each with
distinct security and accessibility characteristics.
• These storage methods are crucial for managing private keys,
which are necessary to access and control Bitcoin holdings.
• The main difference between the two lies in their connection to the
internet and their respective security levels.
Hot Storage (Hot Wallets)
• Hot storage refers to wallets or devices that are connected to the
internet, allowing for quick and convenient access to Bitcoin. Hot
wallets are used primarily for frequent transactions or trading, but
they are more vulnerable to cyberattacks due to their online
nature.
• Characteristics of Hot Storage:
– Online Access: Hot wallets are always connected to the internet, making them ideal
for active use, such as sending, receiving, or trading Bitcoin.
– Convenience: They offer immediate access, making them perfect for daily
transactions or exchanges. Users can access their funds via computers, mobile
devices, or web platforms.
– Private Key Storage: In hot wallets, the private keys (which control access to the
Bitcoin) are stored on internet-connected devices. This makes them more susceptible
to hacking, phishing, or malware attacks.
Hot Storage (Hot Wallets)
• Examples:
– Mobile Wallets: Apps like Exodus or Mycelium allow users to store and manage Bitcoin from a
smartphone.
– Desktop Wallets: Software wallets like Electrum that run on a desktop computer.
– Web Wallets: Exchange wallets or wallets hosted by third-party platforms
like Coinbase or Binance.

• Security Risks:
– Higher Risk of Cyberattacks: Since hot wallets are connected to the internet, they are
vulnerable to hacking attempts, phishing scams, and malware. Users should use strong
passwords, two-factor authentication (2FA), and encryption to mitigate risks.
– Potential Exchange Hacks: Funds stored in exchange wallets (which are a type of hot wallet)
are at risk if the exchange platform itself gets hacked.
Cold Storage (Cold Wallets)
• Cold storage refers to wallets that are offline and not connected to
the internet, making them highly secure but less convenient for
frequent transactions. Cold wallets are used to store large amounts
of Bitcoin for long periods, minimizing the risk of theft or hacking.
• Characteristics of Cold Storage:
– Offline Storage: Cold wallets are disconnected from the internet, which makes them
immune to online hacking attempts, phishing, or malware.
– Security: By keeping the private keys offline, cold storage provides the highest level
of security for long-term storage of Bitcoin. The keys are stored on physical devices or
paper, far away from potential online threats.
Cold Storage (Cold Wallets)
• Examples:
– Hardware Wallets: Devices like Ledger Nano S/X or Trezor that store private keys offline. Users
connect the hardware wallet to the internet only when they need to make a transaction.
– Paper Wallets: A piece of paper that has printed private and public keys or a QR code
representing the private key. This method is extremely secure if stored in a safe physical location.
– Air-Gapped Computers: Computers that are permanently offline and used only to sign Bitcoin
transactions without ever being connected to the internet.

• Security Advantages:
– Protected from Online Threats: Since cold storage is offline, it is not vulnerable to
cyberattacks. Hackers cannot steal private keys without physical access to the cold wallet.
– Reduced Risk of Phishing and Malware: By not being connected to the internet, the risks of
phishing or malware that could compromise the wallet are virtually eliminated.
Key Differences Between Hot and Cold Storage:

Aspect Hot Storage Cold Storage

Internet Connectivity Always connected to the internet Completely offline (no internet
connection)
Security Vulnerable to online attacks Highly secure against online
(hacking, phishing, malware) threats
Convenience Easily accessible for frequent use Less convenient, primarily used for
or trading long-term storage
Private Key Storage Stored on internet-connected Stored on offline devices or
devices physical media
Use Cases Daily transactions, trading, Long-term holding, large sums,
spending institutional custody
Hybrid Approaches:
• Some users combine both hot and cold storage to
balance security and convenience. For example,
they may keep a small amount of Bitcoin in a hot
wallet for daily transactions while storing the bulk
of their funds in a cold wallet for security. This
hybrid strategy allows them to manage their
Bitcoin more flexibly while minimizing risk.
Splitting and Sharing Keys
• Splitting and sharing keys in Bitcoin engineering are techniques used
to enhance the security and management of private keys, which control
access to Bitcoin funds.
• These methods ensure that no single entity or device holds complete
control over a private key, thus reducing the risk of theft, loss, or
unauthorized access.
• These approaches are particularly important for securing large amounts of
Bitcoin and enabling multi-party governance of funds.
• There are several key techniques related to splitting and sharing private
keys, the most common of which are multi-signature (multisig)
wallets and Shamir’s Secret Sharing (SSS). These methods enhance
security by distributing control over a private key across multiple parties
or devices.
Splitting and Sharing Keys
• Multi-Signature (Multisig) Wallets: A multi-signature wallet is a Bitcoin wallet
that requires multiple private keys to authorize a transaction.
• In a standard Bitcoin wallet, a single private key is used to sign and authorize
transactions, but in a multisig setup, a predefined number of private keys are
needed to complete a transaction.
• Use Cases:
– Increased Security: Multisig wallets are used to reduce the risk of a single point of
failure. If one key is lost or compromised, the funds can still be accessed using the
other keys.
– Shared Control: Multisig wallets are ideal for organizations or businesses where
multiple parties need to authorize transactions. This prevents any one party from
having full control over the funds.
– Escrow Services: Multisig is commonly used in Bitcoin escrow transactions, where a
trusted third party can hold one of the keys and act as an arbitrator in case of
disputes.
– Protection Against Theft: Even if an attacker compromises one device, they would
still need access to other keys to steal the funds.
Splitting and Sharing Keys
• Shamir’s Secret Sharing (SSS): Cryptographic algorithm developed by Adi
Shamir that allows a secret key to be split into multiple parts, called "shares."
These shares are distributed to different parties, and a subset of those shares
(known as a threshold) is required to reconstruct the original secret. This
technique is used for secure key splitting and recovery in Bitcoin wallets.
• Use Cases:
– Backup and Recovery: Shamir’s Secret Sharing is commonly used for creating secure backups
of private keys. If a user loses access to one or more shares, they can still recover the private key
as long as they have the threshold number of shares.
– Distributed Custody: Institutions or organizations can use SSS to distribute control over a
Bitcoin wallet among multiple parties, ensuring that no single person can access the funds without
the cooperation of others.
– Cold Storage: Shamir’s Secret Sharing is often used for cold storage solutions, where shares of
the private key are stored in geographically dispersed locations for maximum security.
Splitting and Sharing Keys
• Threshold Signatures (TSS): It is another cryptographic
technique that enables multiple parties to collaboratively generate
and sign a transaction without reconstructing the entire private
key. TSS combines aspects of both multisig and Shamir’s Secret
Sharing to enhance security in a distributed environment.
Key Differences between Multisig, Shamir’s Secret
Sharing, and TSS:

Aspect Multisig Shamir’s Secret Sharing Threshold Signatures

Private Key Multiple private keys are Private key is split into Private key is split, but
used shares never reconstructed
Transaction Multiple signatures are Shares must be combined Multiple parties sign
Authorization required to reconstruct the private collaboratively without
key reconstruction
Use Case Shared control and Secure key backup and Distributed signing
transaction authorization distribution without reconstructing
the private key
Visibility on Blockchain Multisig transactions are Appears as a normal Looks like a standard
visible as multisig transaction single-signature
transaction
Security Level High (depends on number High (depends on Very high (private key is
of required signatures) threshold) never fully reconstructed)
Proof of Reserves (PoR) and Proof of Liabilities (PoL)
• Proof of Reserves (PoR) and Proof of Liabilities (PoL) are two
important concepts related to the transparency and solvency of
cryptocurrency exchanges, custodial services, and other financial
institutions operating with Bitcoin or other cryptocurrencies.
• These mechanisms help verify that an entity holding user funds
actually possesses the amount they claim to hold and can meet
their liabilities when required.
• These concepts are becoming increasingly critical for ensuring trust
and accountability in the crypto ecosystem.
Proof of Reserves (PoR)
• Proof of Reserves is a process that allows an entity (such
as a cryptocurrency exchange or custodial wallet service)
to prove that it holds enough assets (Bitcoin or other
cryptocurrencies) to cover all customer deposits.
• This is crucial for ensuring that the exchange or service
isn't engaging in fractional reserve practices, where it
holds less than it owes to customers.
Proof of Reserves (PoR) – Key Concepts
• Transparency: PoR is a way for exchanges or custodians to
provide transparency about their holdings. It demonstrates that the
company possesses the necessary assets to back up its liabilities.
• Cryptographic Proof: PoR usually involves the use of
cryptographic techniques, such as Merkle Trees, to verify the
ownership of assets without revealing sensitive information like
individual user balances or private keys.
• Auditable Process: In PoR, a third-party auditor or the public can
verify that the custodian has enough assets in their reserves to
cover customer deposits. This process can be done in a verifiable,
cryptographically secure manner.
Proof of Liabilities (PoL)
• Proof of Liabilities refers to the process of
demonstrating that an entity (such as an
exchange or custodial service) has sufficient
assets to cover its liabilities — the obligations it
owes to customers.
• PoL ensures that an organization is solvent,
meaning it can meet its debts and obligations.
Proof of Liabilities (PoL) – Key Concepts
• Debt Transparency: PoL requires the entity to provide a
transparent view of its liabilities, which include the amount owed to
users, creditors, and other stakeholders.
• Verifying Solvency: The goal of PoL is to show that the company
has enough assets (through PoR) to meet these liabilities. In other
words, PoL helps to ensure that the company is not over-leveraged
or insolvent.
• Cryptographic Proof: Like PoR, PoL can also use cryptographic
methods, such as Merkle Trees, to display liabilities in a
transparent, verifiable manner without disclosing personal user
data.
Introduction

Blockchain and cryptosystems are decentralized and secure technologies that promise privacy
and protection from third-party interference. However, as these systems gain popularity in finance,
data protection, and decentralized applications, ensuring user privacy has become increasingly
critical. Three major concepts—Anonymity, Pseudo-anonymity, and Unlinkability—play central
roles in safeguarding user privacy within these systems.

Blockchain privacy is essential not just for user trust but also for blockchain’s broader adoption,
especially in regulatory-sensitive environments.
Introduction

Why Privacy Matters

In blockchain systems, privacy helps:
● Protect financial information and prevent user profiling.
● Enable individuals to manage assets without exposure to tracking or hacking.
● Empower individuals in unregulated or high-risk environments to communicate or transact without
fear.
Anonymity in Blockchain and Cryptosystems

Definition of Anonymity
Anonymity in blockchain refers to full identity protection, where a user’s transactions and activities cannot
be directly linked to their real-world identity. Complete anonymity aims to prevent anyone from determining
who performed a transaction.

Examples in Blockchain
Some blockchain systems prioritize anonymity:
● Monero: Uses ring signatures and stealth addresses to prevent tracing transactions to any single
user.
● Zcash: Employs zero-knowledge proofs (zk-SNARKs) to allow “shielded” transactions that hide
sender, receiver, and transaction amount.
Anonymity in Blockchain and Cryptosystems

Mechanisms for Anonymity

● Zero-Knowledge Proofs (ZKPs): Allow transactions to be verified without revealing private
information.
● Ring Signatures: Blend a user’s transaction with others, creating “rings” that obscure the source.
● Stealth Addresses: One-time addresses generated per transaction to hide the recipient.

Benefits and Challenges

● Benefits: Complete privacy for users, protecting them from surveillance, profiling, and unauthorized
data collection.
● Challenges: Legal challenges around regulatory compliance, as well as the potential for misuse in
illegal activities.
Chaum’s Blind Signatures

• In cryptography a blind signature, as introduced by David Chaum, is a form of digital signature in which
the content of a message is disguised (blinded) before it is signed.
• The resulting blind signature can be publicly verified against the original, unblinded message in the
manner of a regular digital signature.
• Blind signatures are typically employed in privacy-related protocols where the signer and message
author are different parties.
• Examples include cryptographic election systems and digital cash schemes.
• Blind signatures can also be used to provide unlinkability, which prevents the signer from linking
the blinded message it signs to a later un-blinded version that it may be called upon to verify.
• In this case, the signer's response is first "un-blinded" prior to verification in such a way that the
signature remains valid for the un-blinded message.
• This can be useful in schemes where anonymity is required.
• Blind signature schemes can be implemented using a number of common public key signing schemes,
for instance RSA and DSA.
• To perform such a signature, the message is first "blinded", typically by combining it in some way with
a random "blinding factor". The blinded message is passed to a signer, who then signs it using a
standard signing algorithm.
• The resulting message, along with the blinding factor, can be later verified against the signer's public
key.
• In some blind signature schemes, such as RSA, it is even possible to remove the blinding factor from
the signature before it is verified. In these schemes, the final output (message/signature) of the blind
signature scheme is identical to that of the normal signing protocol.
Single Mix and Mix Chains

• “single mix" and "mix chains" refer to methods used for increasing privacy and anonymity by obfuscating
the relationship between the sender and the receiver of a transaction. Both techniques are typically
employed in privacy-preserving cryptocurrencies or applications that want to mask transaction details.

Single Mix
• A single mix refers to a privacy-enhancing technique where multiple parties' transactions are mixed
together in a single, large transaction.
• The goal is to obscure which input belongs to which output, making it difficult to trace the origin of funds.
This is akin to a "coinjoin" concept in some cryptocurrency protocols like Bitcoin.
• Here's how it works:
• Users send their cryptocurrencies to a mixing service that pools their coins with those of other users.
• The coins are then mixed together, and new output addresses are created, which are distributed back to
participants.
• The result is that the original source of the coins is obfuscated, providing more privacy.
Mix Chains
• A mix chain (or mix network) is an enhanced form of mixing that involves multiple rounds or stages of
mixing before the final transaction is sent to the recipient.
• The idea is that coins pass through a series of cryptographic mixing services (the "chain"), with each
round further obscuring the relationship between sender and receiver.
• In a mix chain: A series of intermediaries, known as mix nodes, each perform some form of mixing on the
coins.
• Each stage in the chain adds an additional layer of anonymity. Coins are routed through multiple hops or
stages in a way that makes it nearly impossible for anyone to determine how funds moved through the
system.
• Example: Mix chains often resemble Tor or I2P, where each participant relays data through multiple layers
to avoid easy tracing. In the case of the cryptocurrency Monero, transactions use multiple mixing
techniques to ensure high levels of privacy, and one of these includes ring signatures and stealth
addresses (though these aren't strictly mix chains in a traditional sense).
Decentralized Mixing

• Decentralized mixing in the context of cryptography and cryptocurrency refers to privacy-enhancing

techniques that combine user transactions in a way that obfuscates the links between inputs and
outputs, without relying on a centralized service or authority.
• Instead of using a trusted third-party service to mix coins (as with centralized mixing services),
decentralized mixing uses blockchain-based mechanisms or distributed protocols, which can include
user-driven cooperation, cryptographic techniques, and smart contracts.

Key Features of Decentralized Mixing:

• No Trusted Third Parties
• Anonymity and Privacy
• Collusion Resistance
• Peer-to-Peer or Smart Contract-Driven
Zero Knowledge Proofs

• Zero-Knowledge Proof (ZKP) cryptocurrencies utilize zero-knowledge proof cryptography to enable

private and secure transactions on a blockchain.
• With ZKPs, one party (the prover) can prove to another party (the verifier) that a statement is true
without revealing any additional information beyond the validity of the statement itself.
• This technology ensures the privacy of transaction data like sender, receiver, and transaction amount,
while still maintaining the integrity of the blockchain.

Key Features of Zero-Knowledge Proof Cryptocurrencies:

• Privacy and Anonymity
• Decentralization
• Scalability
• Security
Advantages:
• Privacy ZKP ensures sensitive details like addresses and amounts remain confidential.
• Security All transactions remain cryptographically validated, eliminating risks of tampering.
• Efficiency Certain ZKPs, such as zk-Rollups, can improve throughput and reduce transaction costs.
• Regulatory Compliance Some ZKP systems allow optional auditability, striking a balance between
privacy and regulatory needs.

Challenges
• Complexity Developing and maintaining ZKP-based systems requires significant technical
expertise.
• Performance Overhead Proof generation and verification, especially in zk-SNARKs and zk-STARKs,
can be computationally expensive.
• Trusted Setup zk-SNARKs may require a trusted setup, introducing potential vulnerabilities during
initial key generation.
• Adoption Barriers ZKP integration can face resistance due to its complexity, especially in legacy
systems.