You’ve seen this technology put to use for currencies, collectibles and memes, but to understand Bitcoin, Ethereum, and NFTs and even Doge, we first need to understand what they are built on: a blockchain.
Let’s start by understanding the concept of a Ledger.
Ledgers have been for thousands of years to keep track of accounts and transactions. Whether it was the production of Barley in ancient Mesopotamia, or the ownership of property, to the ownership of people.
A ledger essentially logs transactions, along with other details like amount, the date, and the person who verified it or authorized it. Usually in the form of a signature.
Even then, there were some basic security mechanisms in place: ink can’t be easily erased, pages and entries were chronological so new entries couldn’t be faked.
For years ledgers were books, kept in safe locations and owned by a trustworthy person. You essentially trusted the owner of the ledger to not cheat, or add fake entries or tear out pages.
So there are some terms here to keep a good ledger. Signatures to verify that transactions were real. Trust in whoever keeps the ledger.
This is not too different from our current system. As I swipe to enter the subway, in an instant of a second:
1. The MTA gateway detects a unique code on my card, and sends the info to their bank.
2. The bank uses the MasterCard network to talk to my bank, Bank of America.
3. Bank of America checks their ledger to confirm I have funds to pay.
4. The bank sends a confirmation back, via the MasterCard network, to the MTA bank.
5. The MTA bank confirms to the gateway that this all went well, and I get to cross.
Each bank keeps a general ledger for every one of their customers. You see a glimpse of that ledger when you get your account statements.
As the owner of the account you are signing or verifying those transactions by using your card, which is a password of sorts… or using your actual password for online banking.
We think of this as bills exchanging hands, as physical money moving… but in this day and age, there is no physical money moving from one account to the other. Just a huge ledger keeping track of everything. Numbers being added and subtracted from accounts.
Now your Bank’s ledger is what’s called a centralized ledger. Bank of America owns it, they are the only ones who can make changes to it… and it’s their job to maintain it, make sure it’s not tampered with or deleted. You essentially TRUST your bank to keep a good track of the ledger.
But they do have full control over that ledger so there’s a remote possibility that the bank could make a mistake, or even shut down.
Bitcoin was conceptualized by an anonymous person or group that identified themselves as Satoshi Nakamoto. Part of the myth around Bitcoin is that we still don’t know who this person is, and that makes it cooler. C’mon ain’t that super cool?
Anyway, he, she, they… essentially brought together a bunch of concepts, technologies- such as cryptography… and wrote a white paper that was published in 2009. This was the middle of the real estate market crash, so it inevitably rode a wave of mistrust in the banking system.
So in this whitepaper, this proposed cryptocurrency offered theoretical solutions for many problems with centralized banking. The fees to send money or accept payments, the trust problem with banks, even the Central banks ability to print new money based on political decisions.
So Bitcoin, as a currency that can be used to pay for things… is built on top of a blockchain. And the blockchain is in essence a ledger, just like the one banks keep.
We are going to use the Bitcoin example because it was the first successful implementation of a blockchain, and because it was the cryptocurrency that sparked everything.
The Bitcoin ledger, again, that document that keeps track of every single transaction… doesn’t depend on a single entity, or server, or book: it’s rather- distributed. It was designed as a way to have multiple computers working together, each one of them with a stored copy of the ledger, and with a creative and super secure system to ensure that none of them can tamper with the data.
So this ledger is not just a list of transactions… instead, it’s divided into blocks, which was a clever way Satoshi figured out to allow this to work. Each block contains a batch transactions.
Whenever you send money to someone using the blockchain, what you are essentially doing is adding an entry to the ledger saying that a certain value moved from one account to the other.
In traditional banking, the bank itself is the only entity that can add an entry to the ledger, THEIR ledger; but in a blockchain, anyone can do it, thus making it free… and the technology uses an incredible system to be extremely secure and make sure all transact drions are real.
So In a blockchain transactions are grouped into blocks. On Bitcoin specifically, each block is about 1MB in size, which means that it can store about 2,400 transactions.
A transaction is again, a log or a record saying a certain amount of value moved from one account, to the other. Just like with your credit card transactions, in order for a transaction to be valid, the origin account needs to have enough funds, and the record needs to be signed by the owner of the account to verify it’s real.
Now, as transactions are made between accounts, they are broadcast to all computers in the network and each one of the computers in the network begin grouping them into a new block.
So let’s see how a new block is created. The first thing the computers do is get the code of the last block in the network, that way we know they are linked between each other, thus giving us a chain.
As transactions are received by the computers on the network, they begin listing them inside this in-progress block. Once the block is finished, they send it to the rest of the network so that instead of pointing to the previous block, they link to this new, latest block in the blockchain.
Now, if creating a block was easy, different computers could create multiple blocks at the same time, broadcast them, and the blockchain would become forked: there would be no way to know which of the forks to follow.
So by design, creating a new block needed to be hard. Just like each transaction needs to be verified by the sender of the money, each block needs to be verified by the creator with a process that’s intentionally very difficult. Creating a block needs to be deliberately hard so that only one block is created at a time.
On Bitcoin, this is done with a system called proof of work.
So as the in-progress block begins filling up with transactions, the computer creating that block automatically begins trying to solve a puzzle. This is where cryptography comes in.
Again, what the network wants is for this computer, or any computer in the network… to have to go through a lot of work to create a block. But we also don’t want other computers to have to go through that work to check that block to ensure it’s valid.
For this, a cryptography formula is used. In the case of Bitcoin it’s an function called SHA256, which is used for a bunch of other things. Your browser is using it now to connect to this website. Technically, it’s called a Hash function.
So if you take the information in this in-progress block- everything in it: the number of the block behind it, every transaction, every and run it through a SHA256 formula, a number will come up.
That number is unpredictable and random. It’s made up of 1s and 0s, and it’s 256 characters long. Changing any value inside the block will produce a new number, not just with one digit different, but all 256 digits different. Since the number is unpredictable, changing something could give you one of billions of possibilities. Just really advanced math stuff, though very easy to calculate for a computer.
So In order to create a block and prove that it wasn’t easy- the computer creating the block needs to find a way so the result of this operation starts with 30 zeros. That is, attaching a number at the end of all the rest of the data in the block, so that the result of the SHA starts with 30 zeros.
And here’s the trick: there is nothing you can do to calculate that number In reverse. We can know the formula of the SHA256 but it can’t be reverse engineered. Nobody has solved it, at least and it’s unlikely that anyone will. The only way to find that add on number is to try one, and then another, and then another, until you can find one that gives you the 30 zeros.
On average, you have to test about a billion numbers in order to get a result. And this is a lot of work, even for a computer- because it’s so many unpredictable options that getting that number right is almost like winning the lottery. The plan here was that a computer should take a few minutes to solve this.
Now why would anyone burn out their computer to log transactions, try random numbers to find a random number to complete that formula?
Because when you create a block, there’s another benefit to it: you can create money for yourself. Remember this is a ledger, not a money printer. The ledger records transactions between accounts.. So if all accounts are in zero, where do the values that populate the accounts come from?
If you transfer money from an account that doesn’t have the funds, the network will reject the translation. So where do the coins come from?
Any transaction that creates new money is rejected, by design. Except for one.
The creator of a block can add a reward for themselves: create new coins in the supply of money and out to their account. That’s called a reward and it’s the reason why this process we just described is called MINING.
Computers are essentially performing repetitive, boring, basic work, to find a magic number that has a reward.
Once the block is created, it gets broadcast to the network. Once half of the computers in the network adopt it, add it to their own copy of the blockchain, and start mining the next block, then this block is considered ‘confirmed’ and it’s for all sorts and purposes, unchangeable.
Remember, each block contains the hash of the previous block. That means that if someone tried changing something in a block made days ago, it would mean that the hash of this block would change, which would change the hash of the next block, and the next. All blocks would need to be recalculated.
That is the main reason why a blockchain is such a trustworthy way to store data.
Satoshi predicted, of course, that computers would get more advanced as time went by, or that more people would be joining the network and that more computers would be trying to solve this puzzle at the same time.
So as the network grows, the difficulty is adjusted automatically by changing the number of zeroes required on the proof of work. The more zeroes, the harder the number is to find.
Another important difference is that the amount of coins that get created is limited. The ledger started with a balance of 0 for everyone. For the first few blocks, the reward for solving the puzzle was 50 Bitcoin. Every single coin in circulation today was created this way: mined by a miner, and then sold or transferred to someone else.
You can actually go and look at the first block in the Bitcoin blockchain. It points to the previous block which is block 0, it has no transactions, because nobody was using it yet, and it had a 50 BTC award for the miner who found it.
The reward for finding a block decreases with time. Right now it’s at 6.25 BTC per created block, which means that by 2140 all the bitcoins allowed will have been mined, and no new ones can be created: inflation is not possible. The supply is limited to 21,000,000 coins.
Now, at the very beginning nobody would pay anything to own a unit of this. Someone decided to put a spare computer to mine, wasted a bunch of electricity in exchange for nothing. Numbers on a screen, or technically numbers in a ledger.
But as people began TRUSTING the system, they began assigning value to the numbers in that ledger. Real world value. Dollar value to having an account number with Bitcoin.
This was cents on the dollar for the first few years, but as you probably know, a Bitcoin is now worth about $30,000.
This is very much a supply and demand game, like the stock market. People assign value to these things and pay other people who own them. If people’s trust in the system goes up, value goes up.
Mining has become a profitable business too, but not as profitable as you might think. The award for finding a block today is 6.25BTC, which is not far from $200,000 at the current exchange rate. The challenge is the network is so big, your chances of finding the solution to the puzzle with your old laptop are close to zero.
The Bitcoin mining industry looks like this. Thousands of computers testing values to find a solution to the puzzle. Doing this in the US, for example, would lose you money- because your power bill, and the cost of the computers would not be compensated by the rewards you could get.
A lot of mining happens in Iceland, because of the naturally cold weather, and cheap, geothermal power.
But there are a couple of problems that Satoshi did not address.
First, it’s this power consumption. 0.55% of the world’s power consumption is now used for Bitcoin mining. A lot of that is happening in countries where energy does not come from clean sources, becoming a serious contributor to our greenhouse gas emissions.
The worst part of this is that these are computers doing silly operations. Testing a billion numbers to be able to find one that works.
More on the technical side, there’s a problem of scalability. If you account for the size of the block and how hard it is to find one, you’ll see that the blockchain is limited to about 2,400 transactions every 10 minutes. By comparison, Visa can process about 1,700 transactions per second, which makes your swipe at the turnstile very fast, unlike Bitcoin which can take minutes or even hours to confirm a transaction.
Another problem is speculation. Who is to say how much a Bitcoin is worth? The market determines that, just like with any other currency… but Bitcoin’s price is so unstable, so volatile it can’t really be used as a currency. It went from $60K to $30K per Bitcoin in a matter of weeks.
If used as a currency the price of goods and services would need to change to make up for these fluctuations. Even the machines that are sold specifically designed to mine Bitcoin, are sold in fiat currencies.
So to become a currency and be used for payments, Bitcoin needs to have a more stable price. It makes no sense as a currency if it’s purchasing power can half in a matter of weeks. Also, the network needs to support many more transactions per second.
Other people defend bitcoins potential as a store of value, like gold. Gold is the most traditional store of value: there’s a limited supply of it on the planet and it has problems like security. Bitcoin is potentially safer than that, but once again, until price volatility is solved, it can’t really become that.
The reality is Bitcoin today is mostly a speculative asset. One that many people buy for the odd chance of the price going up : it is a bit of a bet and a gamble.
But this video was not about Bitcoin, it was about the blockchain- and that is probably the most important, higher potential part of this.
Just on currencies, The bitcoin blockchain was the first to gain popularity… but there are other blockchains like Litecoin or Dogecoin. They are completely separate blockchains, with a different ledger, with its own set of rules and algorithms.
The fact that the Bitcoin blockchain whitepaper proved to be successful, the fact that people adopted it and started using it and the assigned value to these coins- opened a whole world of developers and cryptographers who decided to put their computers to mine, or to develop applications on top of the blockchain, or to invent new variations of the technology that could be put to other uses.
Two fantastic examples of this are Smart Contracts and NFTs. Let us know if you’d like us to cover those.