If you agitate your memory from the last few years, you’d remember how people were hyped about Bitcoin for its “get rich quick” scheme and many people were convinced of investing in it. If you were thinking to throw your hat into the ring but now regret that you didn’t grab that shimmering opportunity, don’t worry, because you shouldn’t. The stats state that only a handful of wallets were widened after careful and early investment. That said, I still believe that Bitcoin or as a matter of fact any other popular cryptocurrency is worth investing in for various other reasons that I have discussed in my other article here.
The ever rising popularity of cryptocurrency over the years has brought forward a very interesting concept from 1993, the underlying technology of Bitcoin which makes it very unique from other currency formats. It’s the Blockchain Technology which tackles the problems with the traditional money keeping and transfer process. Blockchain is defined, according to Merriam Webster, as “a digital database containing information (such as records of financial transactions) that can be simultaneously used and shared within a large, decentralized, publicly accessible network.” Unlike our centralised financial system where banks and government hold the major power and responsibilities for storing transaction data, creation of money and handling the inflation, Bitcoin is handled autonomously by modern technologies like blockchain, p2p networking, Hashing, etc. All of these drastically reduces human intervention and consecutively reduces blunders, evil practices and corruption.
I’ll try to explain the functioning of blockchain and its surrounding terminologies by framing a small scale network system, comparing it to real-life scenario.
Let us consider a case where you (friend A) and your three friends (B, C, and D) want to transact money without the need of using paper money all the time. So, your group creates a small network where you all start an account with an initial transactional amount and maintain a personal transaction tab or ledger. These ledgers will record every transaction history that has been carried out by the members in the network. For accurate and timely updates, you four made a rule which says that the person initiating a transaction should tell the other friends about the details of the transaction he is about to make. This way, he doesn’t need to send any physical notes unless they want to convert it into cash.
Let us, for example, consider that you (A) want to send Rs. 50 to your friend D. All four of them have Rs. 100 as an initial amount in their account. What you have to do is announce in the network that you are sending that amount to friend D. Everybody will update their ledger with a statement somewhat like ‘A gives D Rs. 50; A has Rs. 50 left; D has Rs. 150 in total.’ You’ll keep updating your ledger chronologically whenever you’re reported for a transaction. Once the limit of your ledger is exhausted, you’d want to add another tab to continue recording the deals and link this with the previous ones by, for example, numbering each ledger so that you don’t lose grasp on all the details. Here, each tab is synonymous to blocks and all the ledgers from the start is blockchain.
The problems with this mode of money transaction is its too simple and unsafe. Anyone from the network can broadcast false information partially to few users and can benefit from double spending. Anyone can tamper with the transaction data or even send transfer requests putting some other user’s name. The system pretty surely will fail and bring more bad than good. So, how are these problems dealt with in real life?
In real-life scenario, your small network will actually be a part of a bigger network consisting of thousands of familiar users, equally contributing to make the system work. Taking the bitcoin cryptocurrency into consideration, 1 bitcoin can be divided into 100,000,000 sathoshis. Suppose you want to send 50,000 satoshis to your friend D. You will use your digital wallet to generate a transaction to D and to broadcast it to other members (usually known as nodes). The nodes accept and validate your transaction request and is added to the ‘mempool’ for getting verified. Mempool is a bunch of unverified transactions. Miner nodes are special nodes which carry out the verification process in return of some reward. Each miner has their own parameters such as fee amount and preferred transaction size; One of the miners will pick up your bunch of transactions. Transaction requests might either be rejected or selected based on blockchain protocol rules, which includes verifying digital signatures signed by A, the input value exceeding the output value and that no one has spent the satoshis previously. The job of the mining node is to verify the above protocols and to find a nonce for all the transactions it has verified and put it in a block.
Block is a collection of transactions arranged in chronological order along with other data like software version, timestamp, previous block ID and transaction ID.
Nonce is a special number added to the block to produce a 256-bit hashing code which needs to follow the cryptocurrency parameter that gets updated after a certain number of blocks have been added. (For e.g. In Bitcoin, it might require the output hash to start with 30 zeroes to get accepted).
256-bit hashing code or SHA 256 is a special number that contains 256 characters generated by an algorithm. No matter how big the input is, the output generated will always be of 256 characters and is impossible to determine the input values with the output hash.
Your transaction gets verified by one of the mining nodes. The miner which does the work faster gets to add the new block to the set of previous blocks connected in a chain format, hence blockchain. The miner is awarded with a transaction fee assigned by the transactor. Plus, few Bitcoins are created and awarded to the miner. This way new bitcoins are added to the network. These are known as Coinbase transactions. But the number of Bitcoins awarded is reduced over time; the number halves every 210,000 blocks (about every four years). The award of new Bitcoins ceases when the number of Bitcoin reaches 21 million, which will occur in approximately 2140. From this time forward, the reward for mining will revert to only transaction fees.
The block is then distributed among all the other nodes in the network and other nodes receive, verify the block parameters and the recorded transaction and validate the nonce. Then the block is added to the existing blockchain and is published to the network. Now the transaction is verified.
This process carried out by the miner is known as ‘proof of work’. This also has various problems like, currently the annual energy it consumes to mine blocks is nearly 67 TwH which is approximately equivalent to 20% of Britain’s total energy consumption. This demotivates new miners to enter the market. The PoW consensus can be defeated if a single node with huge resources takes over the majority of mining power. Subsequently, they get the power to validate fraudulent transactions and mine blocks faster than other faithful miners. In that scenario, forks are created. Forks are created in the chain when blocks with disagreement are appended to the chain. These forks are created when fraudulent blocks are distributed or new software updates or rules haven’t been adapted by all the miners creating the nodes. Bitcoin accepts the chain which is the longest and reject the smaller chains.
Alternative method of reaching consensus is Proof of Stake (PoS), where validators (analogous to miners) are randomly chosen to verify the transaction data and mint them in a block against a certain amount of coin they put on stake as a security deposit. If the validator validates wrong or fraudulent transactions, a certain amount will be deducted from their deposits. The higher the stake, the higher the chance to get to mint a block. This process is much more efficient than proof of work. Less energy is wasted to create and append a block into the blockchains and is more decentralised than PoW, since in PoW, people team up to use their resources together. This lead to centralisation of validating nodes, which can result to corrupt activities.
Blockchain and cryptocurrencies still seemed to be a dangerous and unknown platform to completely trust in. Yet, many companies and banks are adapting to this technology and improving upon it.