Cryptocurrencies— What’s all the hype?
Unraveling the Tech behind Cryptocurrencies
In 2009, a mysterious whitepaper was released for Bitcoin, the very first application of blockchain, by an anonymous user known by the name Satoshi Nakamoto. Satoshi Nakamoto wasn’t just the creator of Bitcoin, but the creator of this concept of using chained blocks to verify transactions. In 2015, the Ethereum network went live, a network developed by Vitalik Buterin. It ultimately became the second-biggest cryptocurrency.
We’ve seen these applications of blockchain consume the media for the past decade or so. Everywhere we look, we see the same headline over and over again: “19-year-old in Texas became a Child-Millionaire with Bitcoin” That being said, what’s all the hype? How are we able to create a currency with so much monetary value, a currency that materially doesn’t exist?
To understand this, let’s understand the evolution of currency…
The Evolution of Currency
Phase 1: Trade
Before this concept of currency was invented, the world was structured around trade. If I wanted to “buy” a certain item off of somebody else, I would be trading an item of the same material value with them.
There was 1 primary problem with this system: For a trade to occur, both items would have to be something the other wants. If I really needed a certain item, having another item with the same material value simply isn’t enough.
Phase 2: Material Currency
Here’s where currency came into play. The type of currency I’m talking about is a little bit different from the type of currency we know today. This type of currency still had material value. For example, rather than trading any given item of my own, I could trade a pound of silver.
Even if the recipient had no need for the pound of silver at that given moment, this construct allows for assurance that this form of currency can be used at a later date, incentivizing trade with it.
Phase 3: Bank Notes
Here’s where the concept of material value is replaced with monetary value. Rather than trading a pound of silver that holds a given material value, the introduction of banks allowed for people to trade banknotes that have a certain value if traded with one another.
The value for this form of currency is one that’s agreed upon by our government and banks. The fact that the government says it has value, ultimately means it has value. It’s a system based on trust.
Phase 4: Online Currency
This is the phase that we’re currently in, a phase driven by technology and online currency where we can’t physically see our money most of the time. For example, I could have a spreadsheet that says I have x amount of money. If I were to buy a product for $10 on Amazon, my bank would add the entry: -$10 on my spreadsheet and Amazon would add the entry +$10 on their spreadsheet.
That being said, these spreadsheets are centralized. All these transactions are centred around various banks or governments, once again leading into the concept of trust.
Phase 5: Cryptocurrencies
The primary difference between Phase 4 and Phase 5 is a leap into a world of decentralized digital currencies. This basically means that we don’t have all of these different banks running all of these different spreadsheets for millions and millions of people. Instead, there isn’t a middleman. We no longer have to trust anything other than the cryptography on the blockchain.
Instead of multiple banks keeping separate records, there’s just one single record or spreadsheet that stores every single transaction. This is known as a ledger. For cryptocurrencies, this ledger is completely public and stored on the blockchain. We’ll see soon why we need the blockchain and how we actually use the blockchain to ensure the safety of our digital assets.
Decentralized Record of Transactions
All cryptocurrencies are based on the foundation of a public distributed ledger of transactions, aka the blockchain. If you don’t know what those words mean, bear with me, you will soon enough! This ledger is shared and immutable. To elaborate on the first part, while there’s only one ledger being updated during transactions, every user on the network has a copy of this single ledger. This means that the amount of digital assets in a given wallet isn’t actually stored on the blockchain — it’s calculated by adding up all of the chronological transactions on the blockchain.
To explain how this ledger works, suppose that Joe Biden wants to give Donald Trump 5 ETH out of pure pity for losing the 2020 election. When this transaction takes place, every copy of this ledger gets updated. This transaction is signed with a digital signature.
Keys and Digital Signatures
Safety is CRUCIAL when it comes to blockchain. In fact, the pure safety of the blockchain is the reason why it’s such an influential technology. Safety is ensured through the use of individual keys known as Public Keys and Private Keys, used in conjunction to create Digital Signatures.
Both keys serve individual purposes. A public key serves as our wallet address. This is what’s used if we want to send/receive digital assets in the form of cryptocurrency. A private key is what proves that we’re the owner of the public key. As suggested, public keys are keys that everybody can see, and private keys are keys that only you can see.
Digital Signatures prove that the transaction is legit. For example, Joe Biden would send the 5 ETH alongside a digital signature, proving that this is a legitimate transaction. These signatures are generated by inputting the private key and transaction message into a function. The output of this function is the digital signature for this transaction. Every transaction has a different digital signature because the transaction message itself is unique for every transaction.
Verification
Just to recap, Biden has sent a request to the blockchain to send Trump 5 ETH with a uniquely generated digital key. Now, we need to verify that Biden is the true owner of the private key used to access the wallet. Through using the transaction message, the digital signature, and the public key, a verification function validates the fact that Biden actually owns the private key.
To go even deeper on all of this, let’s understand the blockchain…
The Blockchain…
A blockchain is… well… a chain of blocks. Blocks are essentially containers for certain types of data. Each block is given a unique identifier known as a hash. Any given block contains a timestamp, the hash of the previous block, and a variable known as a “number only used once” or a nonce.
What is a Hash?
The hash of a block is used to mark each individual block and ultimately hold the blockchain together (I’ll get into that soon enough). The way that a hash is generated is by taking all of the contents inside of a block, putting them together into a single string, and running it through a complex (but efficient) algorithm known as the Securing Hashing Algorithm (SHA-266).
The output is always a string of length 64 with a possibility of 2²⁵⁶ outputs, an incredibly large number. Since the output is a direct result of the inputs, two blocks that have the exact same inputs will have the exact same hash. Some people worry that two of the same inputs will result in the same hash or output. While this is theoretically possible, it’s virtually impossible in a practical sense.
Hashing in Action:
Input: Aayush -> Output: 472a7cff5209e968092fbde7d05e3de12d4c76a649a439b749d25ad2c332f57e
Input: Ayush -> Output: 3dc65557684378192fff62e7179e6490febacaa532ca4c49f363db8f267fb547
As you can see, a single change in letter completely changes the hash, making this algorithm incredibly secure.
A Chain of Blocks
Since each new block contains the hash of the old block, these blocks are essentially chained to one another. Each block is connected to the block before it, and after it. This excludes the very first block, known as the genesis block.
Why does this matter?
We know that blockchains are immutable, but what’s stopping somebody from going in and changing a block? Blocks are connected with one another, which means that if one block were removed from the chain, every other block after it would break as a result of the domino effect.
If you recall back to the hashing section, whenever the data within a block undergoes even the smallest of changes, its hash changes drastically. If the hash of a previous block gets changed, the next block is no longer connected since its “previous hash” datapoint no longer points to the right block. The rest of the network can now be warned that something is going on that shouldn’t be happening, allowing the changes made to this block to be rejected.
This means that there’s almost nothing hackers can do to infiltrate this system… kind of… but I’ll let you in on that secret later.
Centralized vs Decentralized
The blockchain is a decentralized network. Everybody who’s on the network has a copy of the network due to the fact that blockchains are distributed. If one computer or node was to go down, then the rest of the notes would be able to make up for it since every single node is connected.
However, in a centralized architecture, this isn’t the case. Here, every node is connected to one central node as opposed to each other. If that single node goes down, the network crashes. Think about robbing a bank. If the defences on the bank are to fall, the network gets destroyed.
The blockchain isn’t just decentralized, it’s distributed. This means that every single node is connected to every other node. To shut down a network as such, at least 51% of the nodes in a blockchain would need to be infiltrated. This type of network may also be referred to as peer-to-peer.
Who Keeps the Blockchain Safe?
The blockchain has a consensus mechanism that keeps it safe. There are two primary types of consensus protocols: Proof of Work (PoW) and Proof of Stake (PoS).
Proof of Work
The first consensus protocol was proof of work. Proof of work basically just means that these miner nodes have to solve a complex mathematical problem. However, all of these miners are competing against each other. Once this problem is solved, the miner that solved this problem broadcasts the answer to the rest of the blockchain for verification.
This allows for new blocks to be verified before being added to the blockchain. Back to our Biden-Trump example, Biden’s request to send 5 ETH to Trump would be verified by miners before this block is added to the blockchain. Once the miner has solved the problem, this block is then added to the chain.
So What Problem are Miners Solving?
Let’s say we have our given problem string. The problem is asking for us to concatenate a nonce (essentially a variable for a number) that outputs a hash with a certain amount of leading 0’s.
For example, let’s say I have the string “hello” which outputs the hash “2cf24dba5fb0a3…” Suppose that the problem is asking to convert this hash into one that has 5 leading 0’s. In this scenario, the solution would be to solve for x where the input is: “x” + “hello” and the output is: “00000________” where the values after the 0 can be anything.
This problem is so incredibly complex that the only way to solve it is through pure trial and error. However, this isn’t just any kind of trial and error. To find the solution, we would have to run through over 1 TRILLION COMBINATIONS of x’s. Normally this would take an incredible amount of time, even for the best processing power in the world. However, since there are so many nodes who are trying to solve the problem, it doesn’t actually take long. Bitcoin blocks take around 10 minutes and Ethereum blocks only take an average of 14 SECONDS!
Incentivizing Mining
Why would miners want to mine anyways? You might’ve heard of the fact that mining cryptocurrencies requires a significant amount of CPU/GPU power (depending on the cryptocurrency), and also a LOT of money in electricity costs. That being said, every transaction on the blockchain costs a certain fee known as a gas fee. These gas fees are essentially the payment method for incentivizing miners to keep the blockchain running.
That being said, PoW is an incredibly inefficient method to verify transactions in the blockchain. In fact, Bitcoin mining for one hour uses the same amount of electricity that could power a typical American home for 6 WEEKS!
This major flaw with the proof of work consensus protocol led to the development of proof of stake in 2012.
NOTE: A safety concern with the PoW consensus protocol is the fact that in theory, it can be hacked. If 51% of the computing is taken over in a PoW network, then it’s possible to allow fraudulent blocks within the network. This is a possibility since Mining Pools exist in which miners come together and pool their resources to increase profitability. This means that a single pool can potentially take over more than 51% of computing power, a major risk.
Proof of Stake
The PoS consensus protocol uses different types of nodes than PoW known as “validators” as opposed to “miners” These validator nodes are elected through “staking” their own cryptocurrency.
These validators validate these individual blocks. If the validator node validates a fraudulent block, the staked crypto gets taken away. This creates a strong incentive to “play by the rules”
The incentive to become a validator in the first place is due to per transaction profit. Similar to miners, validators are able to profit.
Proof of stake holds major environmental and safety benefits. For a blockchain using a PoS consensus protocol to be hacked, 51% of the cryptocurrency within that chain must be acquired. For large cryptocurrencies like Bitcoin and Ethereum, this could cost HALF A TRILLION DOLLARS! It becomes evident that it’s a lot easier to acquire 51% computing power than 51% of crypto in circulation, making it overall safer.
Why do Cryptocurrencies have Monetary Value?
As we’ve seen, the blockchain is THE safest way to store any type of data. The transparent and reliable nature of the blockchain makes it much more appealing to users than major things such as banks.
The large community invested within cryptocurrencies provides it with a monetary value. The value of cryptos themselves are dynamic and change with various aspects such as supply, demand, competition, and regulation.
Regardless, a large community has come together for the development of this currency with an agreed-upon value. Sure, it’s not largescale, and it probably won’t overcome regular fiat currencies (government-regulated currency).
That being said, it’s proven this concept of using large communities to create peer-to-peer-based technologies such as blockchain. Bitcoin and Ethereum are incredible examples of proof-of-concept for the use of blockchain to solve some of the world’s biggest problems with a decentralized solution.
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