Introduction to cryptocurrencies (Part 1/4)
This series of posts is aimed at providing an introduction to blockchain and cryptocurrencies for those new to the space. It will aim to cover:
- What is blockchain?
- What are cryptocurrencies, and more specifically what are Bitcoin and Ethereum?
- How can I invest in the space?
- External resources
The below post will look at what blockchain technology is and the applications it can provide.
Part 1: What is blockchain?
You've seen it in the news. It's apparently the future of banking and multiple other industries. Adherents claim it will have an impact as great as the internet. But what exactly is it? And what problem is it actually solving?
Put simply, blockchain is:
- A globally distributed and decentralised ledger that enables the movement, storage and management of any kind of asset (from money to intellectual property to votes)
- Built on a peer to peer network that enables participants to confirm transactions safely without the need for a central certifying authority
A ledger? This is all this revolutionary technology is? However this seemingly small development solves a problem that mankind has struggled with for centuries, one which is of increasing importance in a globalised world where you often interact with people that neither you nor anyone in your community knows; how can I securely transfer an asset to someone I don’t know in such a way that it is an undeniable fact that I gave or received Asset X without the need for a third party to witness it?
Blockchain makes this possible through a public ledger that displays the trade for all to see. This ledger is available to, and confirmed by, all market participants. It removes the need for an intermediary body (e.g. a bank or court of law) to regulate and maintain a record of the transfer. This eliminates unnecessary time and costs and engenders a decentralised and more democratically achieved ‘database’. Rather than having to rely on the honesty, accuracy and safekeeping of a centralised body (be it government or private institution), the ledger keeps an unmanipulable and unalterable record of all transactions. It can be applied to thousands of use cases, with potential applications including transactions, healthcare records and voting amongst many others.
Ok. So how does it actually work?
You can think of blockchain technology as being made up of four basic components:
- Consensus mechanism: The consensus mechanism can be thought of as the technology by which each of the various blockchains work: it ensures that the next block in a blockchain is the one and only version of the truth. It is programmed into each blockchain protocol (e.g. Bitcoin or Ethereum) and is responsible for verifying and updating transactions on the digital ledger
- Digital ledger: The digital ledger is a continually updated database of all transactions on a blockchain. The ledger is comprised of blocks of transactions chained together, so it keeps getting longer as more blocks get added to it. These blocks represent the digital assets the blockchain is designed to process. The longer the chain gets, the more expensive it would be to manipulate it (to the point where it would not be beneficial to do so).
- Digital asset: Cryptocurrency, such as Bitcoin, is an example of a digital asset and is a medium of exchange that is created and stored electronically in the blockchain. However, ledgers can record any type of unit if configured to do so and cryptocurrencies are not the sole type of unit. The digital assets are mined and owned by network participants
- Network participants: Network participants are the people/computers using the blockchain who can view past transactions and verify new ones
Let us take Bitcoin as an example. The original protocol of Bitcoin, as designed by Satoshi Nakamoto (although it has seen upgrades and changes since the original release), is the consensus mechanism which, amongst other things, specifies that the reward of mining will halve every 210,000 blocks (which is c. 4 years). The digital ledger is the entire sum of all transactions carried out by this consensus mechanism which can all be viewed publicly at a site such as BlockExplorer. Bitcoin is the asset itself used (note that other blockchains may be used to transfer assets such as real estate or fiat transactions - each blockchain can use a different asset) while the miners are the network participants for Bitcoin. These entities are running a piece of software on their computers which is essentially attempting to solve a mathematical equation; once a block is solved (each block takes roughly 10 minutes to be solved) then the successful miner will be rewarded in the form of Bitcoin.
How does a Bitcoin transaction differ to a normal banking transaction?
An example of a traditional bank transaction would be:
- I send money to my bank
- My bank sends money to my friend’s bank
- My bank shows the money being withdrawn (Ledger 1)
- Their bank shows the money being deposited (Ledger 2)
- I trust my bank to maintain their records accurately, and they trust their bank to maintain their records accurately.
Using blockchain technology you can have a trusted transaction:
- Between two parties who may not know each other
- Without a third party
- That is automated and reduces the risk of human error
What happens if there is a disagreement on a transaction?
There can be no copy of the asset being sent because the digital ledger cannot show the same asset twice but it is possible for there to be a disagreement on the ledger. This can happen when a % of the network participants (when we talk about network participants it is more referring to miners – more on them later – than people in this thread who trade the currencies) disagree with the version of transactions on a ledger. Ultimately this is decided by how many people disagree with it.
Where it starts to get difficult is when significant numbers of miners disagree with the accepted status quo. In this case, we either end up with a stalemate or we end up with what is called a ‘hard fork’. This is where the blockchain splits in two. An example of this is the split of Ethereum which, following the Dao Hack in 2016, split into two different currencies – Ethereum (ETH) and Ethereum Classic (ETC).
What are the benefits of Blockchain?
If the Internet digitalised communication, blockchains digitalise trust.
The most obvious immediate benefit of blockchain technology is that it can eliminate inefficiencies in existing financial markets and drive faster, lower-cost transactions. Sending assets becomes easier and cheaper – there is a near zero cost of transactions.
However, blockchain has a huge range of use cases. A couple of these include:
- Secure digital voting: Blockchain can ensure voters can check their vote was successfully transmitted while remaining anonymous
- Health system: Again, numerous use cases but a blockchain would be able to store and transfer medical records securely
- Gambling: Numerous use cases but blockchain can generate verifiably random numbers/outcomes or can verify payments from customers etc
These are just three examples of the thousands of potential use cases.
Part 2 will explain what cryptocurrencies are and go into detail on the two most prominent examples, Bitcoin and Ethereum.