Blockchain and Bitcoin: Comprehensive Primer and Why You Should Care
With Bitcoin surging over 600% and Ethereum surging over 2000% in the last year alone, it is no wonder many people are asking about the future of cyptocurrencies and blockchain…
What is Blockchain? The History of Bitcoin
Blockchain, to simply put it, is a global distributed ledger system. A global what now? Well let’s first think about the problem that Blockchain was initially trying to solve. The original white paper for blockchain and Bitcoin was written by Satoshi Nakamoto which showed the potential for a decentralized currency. The paper was titled “Bitcoin: A Peer-to-Peer Electronic Cash System” and it explored a theoretical system that can support a decentralized currency. Bitcoin aims to remove the third party entity, the big banks, involved in our everyday financial transations. The paper goes into the problems of trusting a third party validator and the high fees associated with smaller transactions. What Bitcoin aims to do with the blockchain is to create a frictionless peer-to-peer cash system. The underlying bitcoin protocol involves a ledger with everyone’s transactions globally. This means that when you enter into the bitcoin protocol and purchase a bitcoin, you are placed into this global ledger that anyone can see. These numbers on the ledger have no real value other than the trust between two people who are willing to exchange goods & services for a change in the number on their account on the global ledger. The ledgers are maintained by people around the world and thus making the system “decentralized”. The blockchain is the underlying technology used in Bitcoin but the applications for decentralizing the world with blockchain is endless.
Bitcoin: Sending & Receiving
First let’s get into the basic mechanics of Bitcoin:sending and recieving. Sending and receiving a Bitcoin is simply broadcasting a message to the network saying “hey I want to send 1BTC to Sarah’s wallet”. Obviously it wouldn’t be anonymous if boardcasted their name so wallet “addresses” are a long string of unique hexadecimals that help identity who it is without giving away your name. This message to passed through all the nessecary nodes in the network and every ledger gets updated with this information. When the message is broadcast, a “digital signature” will be attached to the message to autheticate that this transaction was broadcasted by the person who owns the Bitcoin. Think of this digital signature as the pin for your credit card or the signature you sign on the reciept. The digital signatures uses a cryptographic function to create a unique signature that is none reversible. Everyone with a Bitcoin wallet has something called a “private key” and a “public key.” The public key is the wallet address that was mentioned in the beginning and the private key is the digital signature to authenticate the transactions. The difference is the public key acts like your public address that people can send things to while the private key is the unique key to your mail box that gives you access. The private key is used everytime to create the digital signature that will be matched at the end of the transaction to confirm its authenticity. Since every transaction message requires the private key to create a new signature, no one can modify transactions or refer to old transactions without having the transaction becoming invalid.
Bitcoin: Wallets
The private key that was mentioned in the last section is simply the “bitcoin wallets” or “cryptocurrency wallets” you hear about. These wallets are not physically storing your coins and tokens but rather they are storing the private keys that grant you access to your Bitcoins. There are three types of wallets that currently exist. There are digital wallets that can be created on your smartphone and computer. Digital wallets are vulnerable to attacks as they are likely connected to the internet and exposed to hackers. A safer way to store your private keys is with either a paper wallet or a hardware wallet. A paper wallet is a free solution to storing your cryptocurrencies safely. They are simply a private key generated that can be printed out or written down on paper. As this method requires you to keep the key on paper, it is not vulnerable to attacks. The safest way to maintain multiple cryptocurrencies is with a hardware wallet. A hardware wallet is simply an encrypted USB that stores your private keys for all your cryptocurrencies. The only way you can access the keys is if you plug it into your laptop and enter in a passcode. This is the best way to keep your coins and tokens safe as no one can access your private keys without physically stealing your hardware wallet. Even if your hardware wallet is stolen, you can recover your private keys with seed codes that were generated when you first setup the hardware wallet.
Cryptocurrency Exchanges
Now the question is where can I get some Bitcoins? Well for the most people, you can get Bitcoins from exchanges. Some notable exchanges include Kraken, Coinbase/GDAX, Poloneix, and Bittrex. Each exchange has different trading pairings so is important to do some research before signing up for an exchange. Most exchanges have limits on how much you can purchase in a day and requires ID verification before you start trading. This is to prevent people from using Bitcoin as a money laundering tool and falls in line with financial regulation. Moreover, fees may vary across different exchanges and across different regions in the world. When assessing exchanges, it is important to look at volume as this will give you the most up to date prices and liquidity. Most of this information about exchanges and their pairings can be found on CoinMarketCap.
What is Mining Bitcoin?
So far, we have solved the problem of authenticating transactions, but timing of these transactions is still a critical problem. In blockchain, it is a lot more complicated to determine timestamps as there may be network delays that allow individuals to lie about transaction timing and effectively allow them to double spend. This is where mining comes in as a way to let the world decide where transactions should go in the chain. When a transaction is broadcasted onto the network, they will all go into a pool of pending transactions where miners solve cryptographic problems for a chance to link their choice of transaction to the end of the chain. The problem involves a cryptographic hash that is a function that can only be solved through trial and error. The answer for the function is irreversible, which means the output cannot be put back into the function to get the original number. This system helps organize transaction and validate old transactions as they are added to the chain.
Moreover, mining is used as a tool for voting on the network. Let’s say you join the Bitcoin network and request a copy of the transactions. You get sent a few different sets of ledgers but you have no idea which one is correct. Majority voting can help solve this issue and since voting requires individuals to solve cyprographic problems, it is unlikely that an individual can out vote everyone.
Finally, mining is the primary way for Bitcoins to enter into circulation. Everytime a transaction is added to the chain by a miner, the miner is rewarded with a small amount of Bitcoin that is created out of thin air. As more and more miners enter the system, it becomes increasingly hard to solve the cryptographic problems. This is designed to control the supply of Bitcoins enter the system in a given time. The maximum amount of Bitcoins that can be created is 21 million and it is projected to reached that in 2140.
The Future of Mining: Proof of Work vs. Proof of Stake
Recall the the last section where we talked about the idea that mining requires a computer to work through complicated hashing functions to decide who gets to link the next transaction to the chain. This “work” that the computer puts in determines the output of the coins being created in the system. The more power or“work” the computer puts in, the more bitcoins enter the system. This idea of coin creation is called the “Proof of Work” concept and it is the underlying protocol that makes Bitcoin creation fair. This method has worked fairly well in making sure Bitcoins are not created too quickly and ensuring inflation levels of the coin are stable, but Proof of Work is slowly becoming a hindrance on the growth of Bitcoin.
Let’s take a current example of the difficulty it is to mine an entire block on the Bitcoin network. The current Bitcoin Difficulty Value is currently at 460,769,358,091. The difficulty determines the average number of hashes needed to mine one block. A minimum difficulty of 1 corresponds to ²³² = 4x10 ³⁹ hashes, so we need an average of 4x10 ⁶¹¹ * 4x10 ³⁹ = 2x10 ⁰²¹ hashes to mine a block. Now look up the hashing power of the hardware you are working with. For exmaple, a Core i7 2600 CPU can do 23.9 MHash per second, or 2x10 ³⁷ hashes per second. 2x10 ⁰²¹ / 2x10 ³⁷ = 8x10 ⁷¹³. That is the average number of seconds your computer will need to mine one block. It is about 2.7 million years. Not to mention, as more and more powerful hardware enter the network, the difficulty of mining a Bitcoin increases. This is partly the reason why it is ineffective to start mining Bitcoins with your computer at home. Most miners use specialize ASIC hardware that is more energy efficient and designed solely for hashing.
But even with ASIC hardware and the cheapest electricity in the world, there will come a time when mining Bitcoins is too expensive for anyone to do and profit from. Even if fees rise to help compensate for the miners work, the fees would be too high incentivize anyone to transact on the Bitcoin network. This is a major scaling problem that Bitcoin currently faces because when miners decide to stop mining, the Bitcoin network, along with its millions of transactions, comes to a halt. A proposal has been made to shift to a Proof of Stake model which tries to solve the issue. Instead of hardware prowess equaling hashing power, the “Proof of Stake” model relies on the amount of Bitcoin someone owns as a means of hashing power. More Bitcoin you own, the easier it is to mine. This method encourages people to have a stake in the network they are mining in and not abuse their mining power. Right now a majority of Bitcoins are mined by few individuals, giving them close to unlimited power to control voting on the protocol. Some other cryptocurrencies like BlackCoin, OKCash, and Hyper have already implemented the Proof of Stake model and has seen some success but on the contrary, new problems arise from the Proof of Stake model that wasn’t an issue before. Some people argue that early adopters that owns a large stake in the Bitcoin network will have a majority control of the decisions made in the protocol, making it difficult for newcomers to mine without paying a high price of entry.
The Scaling Problem: Forking the Blockchain
Voting is an integral part of the decentralized blockchain protocol that is in most crypocurrenies. It democratizes how the protocol should operate as oppose to actions being decided by a central body. The problem that the Bitcoin protocol currently faces is as more and more people join the network and conduct transactions, more information is being sequeezed into each block. Currently, each block in Bitcoin chain is 1MB in size and generated roughly every 10 minutes. This creates a problem when transactions levels have increased significantly in the last year and thus creating bottlenecks. Many have proposed different solutions to the problem. On one side, Bitcoin Core Camp has proposed the idea of Segregated Witness (SEGWIT) while on the other side, Bitcoin Unlimited Camp, they proposed to increase the block size to 5–10MB. In a regular central system, only one idea will prevail, but in blockchain, chains can be split or “forked” into two separate chains with two separate protocols. This is what happened on August 30 2017 when the Bitcoin chain split into two coins: Bitcoin (BTC) and Bitcoin Cash (BCH). BTC supported the idea of SEGWIT which removes signature data from the blocks and uses witnesses as the transaction signature. BCH supported the idea of bigger block sizes carrying more transaction data per block. By splitting the chain and protocol, miners can support whichever protocol they believe in by mining and verifying transactions on the chain of their choice. The success of a protocol is democratized and innovation can flourish.
The Story of Mt.Gox: A $460 Million Dollar Diaster
Mt.Gox was one of the biggest Bitcoin Exchanges in 2013, handling over 70% of the world’s transactions. In February of 2014, Over $460 million dollars worth of Bitcoin disappear off of the exchange, accounting for approximately 7% of the circulating Bitcoin supply in the world. Bitcoin prices crashes and Mt.Gox files for bankruptcy a week later. Mt.Gox was a combination of poor management, neglect, and raw inexperience. New evidence in 2016 surfaced from security company WizSec has led them to conclude that “most or all of the missing bitcoins were stolen straight out of the Mt. Gox hot wallet over time, beginning in late 2011.” (WizSec)
Ethereum: Smart Contracts and Decentralized Apps
Although this is primer is primarily focused on Bitcoin, it is worth speaking briefly about Ethereum and the future of where blockchain is headed. Ethereum was created by Vitalik Buterin, a Russian-Canadian student from the University of Waterloo, in late 2013. Bitcoin is and will continue to be one of the most dominant cryptocurrencies in the world for decades to come but many smaller developers that have come after Satoshi have proposed new and innovative ways to apply the blockchain technology to decentralize the world. Bitcoin was primarily designed as a coin to either hold value or be used in a transactional nature. Ethereum, on the other hand, uses blockchain to create a protocol that enables users to create smart contracts with each other as oppose to limiting itself to just currency. Just this simple idea of smart contracts unlock a world of possibilities and applications for developers in the future. A smart contract enables users to draft virtual automated contracts that can be triggered when the task is completed. For example, I can issue a contract for 10 Ethereum tokens to have some code written for me. The smart contract is sent to another individual and once this task is completed, the individual is paid. An analogy of the smart contract technology is a vending machine that takes coins. You put the coins into the machine to unlock the ability to make a selection. Next, you type in the code to select the item you desire and the order is automatically executed.
So why does Ethereum’s smart contract matter? It is important because it stands to disrupt the current internet model. The Ethereum protocol with its smart contract technology allows developers to created Decentralized Apps (DApps) which can functional be used to distribute their own Ethereum-based (ERC-20) tokens for their own purpose. There are currently hundreds and thousands of ERC-20 based tokens in circulation and functions range from decentralizing real estate contracts to building a network of decentralized super computers. Cloud storage and servers may become obsolete as more and more companies realize the potential of using a decentralized server under Ethereum. Ethereum unlocks the potential for anyone to participate and innovate effortlessly with the blockchain technology and distribute tokens to people who want to participate and support the projects.
These tokens are part of the Initial Coin Offering (ICO) craze that has taken over the market in the last couple of months. The market is complex and irrational and requires a whole other blog post to explain, so I will not be going into details on it.
So why does this all matter?
It is important to think about our current system of finance and money and whether this is sustainable into the future. The current US dollar, the most widely use currency in the world, is backed by the US government, and known as fiat currency. Before 1971, the supply of US dollar was primarily control the supply of gold in reserve. During the gold standard era, the money we held had intrinsic value and someone could walk into a bank and trade in their dollar bills for a piece of gold bar. Many argued this was a smart choice to have currency tied to a physical object with intrinsic value but the problem with gold was that it isn’t as rare as people think. The idea of fiat currency is tied completely to the strength of the government and the viability of the entity going forward. The trust in government has faded significantly since the 2008 great recessions and the rise of Bitcoin matters. It signals changing sentiment in what individuals believe money to be. If you aren’t able to trust your own government, you may as well put your money elsewhere. Bitcoin relies heavily on the trust of each other as oppose to a central governing body. It democratizes the way currency is held and it gives power to the people who hold the currency to decide the future. I see little merit in carrying large amounts of US dollars if it continues to be devalued by inflation year over year. This doesn’t mean that Bitcoin will take over the world as there are still many issues with the protocol. People around the world will continue to use their countries legal tender and so will I, but the idea that Bitcoin or any other cryptocurrency may one day change the way we think about money is not too farfetched.
