What is Bitcoin?

The SHORT ANSWER?

Let’s start by considering a simple financial transaction.

When you go to the store to spend money using your debit card, what happens?

Whether you tap, slide or insert your card, a debit card transaction is one where your money goes from your account to the merchants’, as validated by your bank. This can happen because your card is linked to your account and the merchant’s machine can communicate the transaction to your bank to request the appropriate funds. Your bank then determines the transaction is valid and that you have the funds and voila, the merchant gets his money to his account.

This works because the bank is compelled by government laws and regulation to properly validate and account for this transaction.That being said, with increasing levels of technological complexity and political instability, this has proven to be fallible. Indeed, the process is dependent on people following these laws and regulations. #2008 What Blockchain proposes is a shift from validation by people to validation by algorithmic processes.

Thinking back on your transaction at the store; what that money really is, is a combination of the transactions leading to that amount being in your account. The addition and subtraction of income, costs, purchases and so on. As such, by creating a distributed ledger of this ebb and flow of money, the blockchain is able to create a verifiable trail of transactions that allows for the validation of your transaction without the need for a bank. In short, instead of accounting for the granular matching of transactions, blockchain looks at the network of transactions to validate individual ones.

So how does BLOCKCHAIN work?

Innovation in financial services is hardly a new practice. Despite being as old as time it is now more complex than ever. Money has always evolved, from cowrie shells, to early coins, to paper money. In fact, debt itself was at one point a financial innovation around 5,500 years ago.

Looking at blockchain, the story is mixed. Indeed, the distributed ledger technology, the underlying technology behind crypto assets, offers essentially two services: one well-known, one innovative.

The well-established service is record-keeping through a ledger. The innovative service lies in the distributed consensus mechanism. This mechanism defines how the community comes to a consensus in updating the ledger (i.e., adding new blocks in the blockchain). This is imperative to avoid dissent about the correct state of the blockchain and possible manipulation by any individual. (The Byzantine Generals problem - Byzantine Fault Tolerance)

In most cases, this consensus is built on a cryptographic proof of work and is open to all (as in Bitcoin and Ethereum), while others restrict it to permissioned users (as in R3 Corda) or use cryptographic proof of stake to secure the state of the blockchain. In a proof of stake system, the creator of the next block is determined by a randomized system that is, in part, dictated by how much of that cryptocurrency a user is holding or, in some cases, how long they have been holding that particular currency. Instead of computational power, as is the case in proof of work, the probability of creating a block and receiving the associated rewards is proportional to a user’s holding of the underlining token or cryptocurrency on the network.

Here is an example from Lisk’s database, a leading platform cryptocurrency:

"If a set of potential validators was made up of Adam, who is holding 40 tokens, Fil with 30, Tomek with 20 and Daniel with 10, there will be a 40% chance of Adam being chosen to validate the block and Daniel 10%, with Tomek and Fil on 20% and 30% respectively."

This is made possible because of some key technology underlying blockchain: hashing, public-key cryptography, peer-to-peer (P2P) networking.

Public-key cryptography is fundamental to understanding virtual currencies. Encrypting with a password is single-key. Dual-key encryption uses two keys. If one key is used to encrypt, the other key can be used to decrypt, and vice-versa. BUT, the key that encrypted CANNOT decrypt. This is how public-private keys work. They are symmetrical, but only the private key can decrypt the data.

In a P2P network, the user utilizes and provides the foundation of the network at the same time, although providing the resources is entirely voluntary. Each peer (a “peer” being a computer system on the network) is considered equal and are commonly referred to as nodes. A peer makes a portion of computing resources such as disk storage, processing power or network bandwidth, directly available to other participants without the need for any central coordination by servers or stable hosts.

This method of transferring information is a huge improvement because data is not held in one centralized point, making it far less vulnerable to being hacked, exploited or lost.

It is also critical to understand the underlying economic mechanisms embedded in the technology and any specific application. The consensus mechanisms used in blockchain applications prevent cheating by creating competition over who (a “miner” in cryptocurrencies such as bitcoin) can validate and add a block of transactions to the blockchain. (i.e. PoW) A block – containing a digital signature, timestamp and relevant information – is then broadcast to all nodes in the network.

Next up, we will go deeper on the subject of mining. Stay tuned for the next article release!

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