Accessible explanations of blockchain and cryptocurrencies
With all the recent talk about cryptocurrencies, the recent price fluctuations of bitcoin over the past two months, and all the fuss about it on Tiktok, an article in simple terms explaining exactly what cryptocurrency is and why some people think it’s necessary has never been more needed.
It’s not really possible to explain why bitcoin exists and what makes it possible without accounting for blockchain too. So, here are simple definitions of each, and simple explanations about why they were both invented.
Why was blockchain invented?
A blockchain is a special kind of database that holds blocks of data about specified information. In the case of cryptocurrencies, blockchain entails what are effectively units of data about the transfer of currency.
Blockchain was invented in 2009 by the enigmatic and mysterious king of cryptocurrencies, Satoshi Nakamoto. It was originally invented to support the first, and most well-known cryptocurrency, bitcoin. Since 2014, innovators have been trying to use the technology in various industries.
The inventions of bitcoin and blockchain were inextricable, and one cannot be fully understood without understanding the other. The most basic reason blockchain and bitcoin were first invented was to bypass the need for financial institutions to mediate transactions as a third-party. The inventor(s) of blockchain and bitcoin explains this in their first white paper.
Blockchain enables two people to transact directly with each other, rather than having their transaction arbitrated by a third-party trust. The advantages of enabling two people or organizations to deal with each other directly include, firstly, lower transaction costs, since the mediator, usually a financial institution, does not have to be compensated for their work.
Secondly, a peer-to-peer transaction technology such as blockchain enables higher values of transactions to be processed, since commissions that raise costs no longer need to be paid to the third-party. Lower value transactions are also made easier with peer-to-peer transaction technology. Finally, blockchain can transfer currency much faster than banks.
As Satoshi Nakamoto explained himself to justify the invention of and the need for blockchain and associated cryptocurrencies,
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
How does blockchain work?
The reason people usually need financial institutions to mediate transactions is so that ownership of the currency can be established against past records to ensure legitimate transfer. However, as explained above, using third-parties to arbitrate transfers of currency is inefficient, slow, and unreliable.
To let two people transact with each other electronically while bypassing the problems associated with third-party financial arbitrators, you need a currency that can be traded without depending on an institution like a bank. Bitcoin was the first currency to use blockchain technology.
Blockchain is the technology that enables these transactions to take place without a third-party mediator. Blockchain is essentially a data storage system. To understand the relationship between blockchain and bitcoin, we simply need to understand the kind of data which is contained within each block. With cryptocurrencies, blockchain is used as a storage facility that contains the whole transaction history of the currency. This history includes the details of every transaction ever made with the currency.
When financial institutions oversee transactions, they essentially verify that entity A rightfully owned the currency before transferring it to entity B. When a transaction is made, the financial institution authorizes that the transfer of this bit of currency from entity A to entity B, is legitimate.
Blockchain solves the usual need for two parties to entrust their transaction to be verified by a third-party financial institution, by referring to the historical information stored about the currency being traded. Blockchain is a technology that, through its structure, verifies these transfers itself.
The nitty-gritty details about blockchain
Exactly how the technology works involve some quite complicated computer science. But to crudely explain it, every time a currency transfer is made using blockchain, its precise details are stored. Think of the blockchain itself as a string of sets of digital storage units that are all connected together.
However, the storage units themselves have to exist somewhere in space: the spaces the blockchain exists on are commonly called nodes. These nodes take the form of electronic devices, like laptops and computers. Each individual node contains all the data history (in the case of cryptocurrency, this set of data is referred to as the ledger) stored on the blockchain.
For a transaction to be verified across the peer-to-peer network, the ledger must be identical across at least 51% of nodes. If one node is infiltrated by, say, a hacker, and tries to make an illegitimate transaction, all the other nodes in the network look at their transaction histories to identify whether the activity taking place on this node corresponds with any others. If it does not, the transaction is refused. This prevents fraudulent currency transfers.
For a successful hack to take place, the hacker would have to control and edit the information stored on the blockchain across the majority (51%) of all nodes. Given the number of nodes, over 100,000, it would be near-inconceivable for one person to seize control of such a high proportion of all nodes. These nodes enable blockchain to function in two vital ways, which give it an edge as a technology useful for transferring currency.
Firstly, it exists as a place where all the data about past currency transfers (typically called the ledger) can exist (typically called nodes). Secondly, because this transaction history is stored in so many different places at once (across so many different nodes), even if the ledger is accessed and edited in one location, it exists unaltered in many more places at once.
If someone tries to steal bitcoin from others, they have to change the data on the blockchain. Because the data about past currency ownership and transfer is held across so many different nodes, even if the blockchain’s data is edited on one node, the alteration a hacker tries to make will be refused by the node network, since the new information won’t match that held by other nodes.
This property is referred to as decentralization. That blockchains used for cryptocurrency exchange can be decentralized provides them with greater security, when compared with traditional financial institutions.
Satoshi Nakamoto puts it better than I ever could, offering an elegant, eloquent, and accessible explanation:
We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power. The network is robust in its unstructured simplicity. Nodes […] vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them […] rules and incentives can be enforced with this consensus mechanism.
What is bitcoin and why was it invented?
Bitcoin is comparatively straightforward to explain. Bitcoin is simply one of many cryptocurrencies that are used to exchange value by parties. You can think of it as you do any other kind of currency — it is just a means of transferring value between people, organizations, businesses, and so on, that holds relative value when compared with other goods and currencies.
Whereas conventionally, currencies are exchanged between parties via banks, bitcoin was created independently from any state or financial institution, existing as an entity traded globally over the blockchain. In real terms, bitcoin is basically just data you can buy and trade, which has a market value. It was invented as the first currency that could be exchanged with blockchain.
Now, of course, there are many other cryptocurrencies that use blockchain technology. These are often referred to as alt-coins. They’re essentially just other forms of cash — the really important innovation was blockchain.
Summing up blockchain & cryptocurrency
Blockchain was invented to facilitate transactions between two parties without the need for a third-party, like a financial institution, to mediate the transfer of currency from one to another. It was developed to counteract the inefficiencies of prevailing banking systems, which are costly and slow.
The cryptocurrency was invented to function simply as a currency that could be traded using blockchain, providing, as it were, proof-of-concept. The first cryptocurrency, and currently the most valuable, is bitcoin. Since blockchain’s and bitcoin’s conception, many more cryptocurrencies have popped up.