Bitcoins and Blockchains for Mums and Dads: Part 1 — The Basics

Separating the concepts

Bitcoin is a digital currency — nothing more, nothing less. It has many uses (paying people, buying goods, loans etc), just like a usual currency such as Sterling or the Dollar. However, instead of being linked to pieces of physical paper, it can only be used online.

Blockchain on the other hand, is a much broader concept. It is the technology that makes a digital currency possible and work efficiently.

You have heard of Bitcoin because,, it is currently the most popular digital currency. Similarly, you can name the Dollar due to its wide usage but probably couldn’t name the Burmese currency*. This highlights a common misconception — it is not the only digital currency.

Moreover, as the most popular digital currency right now, Bitcoin is also the most valuable. Like traditional currencies, the value of a digital currency fluctuates with demand for that currency (we will come to how supply changes in the future). Currencies only have value because people believe they have value (a paper £5 has no intrinsic value, just the value that we associate with it) and right now Bitcoin is very valuable as lots of people believe in and have been demanding it.

Each digital currency runs on its own blockchain. Thus, Bitcoin runs on the “Bitcoin blockchain”**. It is this blockchain technology that makes the currency trustworthy and provides many of the advantages of a digital currency over a traditional fiat currency.

Lets get our head around a digital currency through an example

Imagine there was an email currency (we will call it ECoin), where you could pay someone money through sending them an email.

I am struggling for cash at the moment and only own 5 ECoin. If I owed Mum for lunch, I could transfer her 5 ECoin from my digital wallet to her digital wallet by emailing her and this would just replace me handing her a £5 note.

Just after lunch Dad bought me some sweets, also for a value of 5 ECoin. Well then, I can send him an email paying him 5 ECoin just as I paid Mum. But I only had 5 Ecoin to start with!!! Thus, I have just created 5 new ECoin out of thin air, paid both Mum and Dad, changed the overall amount of ECoin, and no one will ever know. This issue, known as the double spending problem, has been key in preventing the development of digital currencies until now.

As well as this issue, there is typically a further question that arises — what is the difference between these payments and an online bank transfer? Well, an online bank transfer is still a transfer of tangible currency at heart, it requires you to send a message to your bank telling them to move some money from your account to another person’s account. The website online is just an interface that allows our bankers to do this more easily and at any point that money is still tied to physical cash. Whereas, with a digital currency payment, I am directly transferring value from my digital wallet to Mum’s digital wallet, no centralised bank account held at a large organisation is involved or needed. The digital transaction is more similar to passing a £5 note directly from my wallet to Mum’s hand than it is to a bank transfer.

A quick summary: Bitcoin is a digital currency. A digital currency is just like a traditional one, except we put value in pieces of data rather than pieces of paper.

So how does Blockchain make this all possible?

Returning to our example, digital currencies need to find a way to account for all the transactions of ECoin so we can check no one is just forging new currency or making fraudulent transactions.

Accounting for transactions is already totally commonplace around the world. In fact, it is a legal requirement in any public organisation. Until now, this has been the job of the accounting department, where every transaction is accounted for in the general ledger of the organisation. For example:

Example ledger

At heart, the blockchain is just a digital accounting ledger. It accounts for every single transaction that takes place in a certain currency. A blockchain cannot exist without a currency, whose transactions it can track. Similarly, a digital currency cannot exist successfully without an accounting technology such as a blockchain. The two concepts are therefore fundamentally linked together.

Continuing with the example, lets now assume that ECoin is accounted for by a blockchain. When I sent an email to Mum paying her 5 ECoin, a record is immediately submitted to the blockchain, and similarly, when I paid Dad, another record is submitted to the blockchain. The blockchain ledger can show that I have tried to pay out more than I own and can reject my second transaction. Thus, by accounting for every ECoin available worldwide, our ECoin blockchain can ensure that all transactions are valid before authorising them.

Who is doing the validation though? Traditionally, we would have auditors validate a single organisation’s transactions because it was not possible to track and validate every transaction of a certain currency. Blockchain ,however, allows every transaction to be tracked and thus we can truly validate the use of a whole currency. Moreover, validation occurs at the point of transaction (every transaction is automatically sent to the blockchain ledger to be validated immediately), not just when we call in the auditors!

A blockchain uses a distributed validation mechanism. Essentially, the digital ledger can be optionally downloaded onto any computer or server owned by someone using that currency, and this server can (using complex maths) validate all the transactions in the blockchain. The digital ledger is distributed among the users of the currency and is validated by the computers of those users. This decentralisation also makes it very hard for a hacker to target the blockchain, as they cannot just target one organisation’s servers, but instead must attack a distributed, intangible network (more on these security features in the future).

Another reason this distributed system is a big selling point of the blockchain is that it removes the reliance of the currency on any one organisation, that could fudge the books (like Enron) or randomly change the amount of currency available (US and UK quantitative easing).

Summary: Blockchain is an automatic accounting ledger. This automation is possible as all transactions happen in the digital, rather than the physical, realm, meaning all transactions can be tracked. Moreover, the accounting ledger is distributed amongst the users of the currency and validated by their computing power, thus protecting the users from hacking and organisational failure.***

It’s a digital ledger, so why do we call it blockchain?

At first glance blockchain seems like a slightly weird and random name for a technology that could potentially underpin the future of payments systems, but in fact, it is very descriptive and largely logical. Breaking it down:

Chain — a chain is a structure that moves in a single direction, for example, from left to right. All accounting systems from the start of time have had a chain structure, where the direction of movement is from old to new. Older transactions are further back in the chain and newer transactions are at the front of the chain. Digital accounting ledgers are no different.

Block — These digital ledgers are broken up into blocks, which hold a number of transactions. For ECoin, lets say that each block contains 10 transactions. If you put all the blocks together, they create the full chain and thus the full ledger. We break up digital ledgers into blocks to reduce the computing power needed to validate the ledger.

Conclusions

What have we learnt:

• Blockchain is the name of a digital accounting ledger technology.
• Any accounting ledger must account for something. Thus, any blockchain will have a currency associated to it, and it specifically accounts for that currency.
• The blockchain accounting ledger is distributed amongst the users of that blockchain’s currency. This distributed system allows for highly safe validation and no reliance on big auditing organisations.
• Bitcoin is the leading digital currency, based on the “Bitcoin Blockchain”. At time of writing, it is the most widely used currency and has grown in value massively thanks to it’s rising popularity (and thus rising demand for the currency).

We can go into a slightly deeper understanding of these digital currencies next time. To this point, there seem to be few obvious advantages to the end user in comparison to online bank transfers or alternatives. However, there are in fact many more differences between truly digital currencies and digital transactions of fiat money!

(Thank you Eleanor !!)

Part 2 is now available here

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*Its called the Kyat, pronounced Chat…

** It isn’t really named this, but it is useful to do so here to clearly draw the link between the currency and it’s associated accounting ledger.

*** At this point, many people may ask “if the ledger is distributed among the users of the network, surely every one of my transactions could be seen by anyone, whatever I was buying or wherever I was sending money”. We will discuss this in a future email, but in short, all the transactions are publicly accessible, but in an anonymous way.