September 27, 2024
You’ve probably heard of Bitcoin, Dogecoin, Ethereum, or other cryptocurrencies. You may have heard that these are either 1) tools used by bad people to evade the law or 2) an amazing technology to help us achieve financial independence.
So which is it? Is it good or is it bad? Why is there so much hype or FUD (fear, uncertainty, doubt) surrounding cryptocurrencies. In this 3-part series, we will demystify cryptocurrencies so you can decide for yourself.
In part 1, we will explain how cryptocurrencies utilize blockchain technology to create unique, novel digital assets that are tamper-resistant, decentralized, and publicly accessible.
In part 2, we will explore how to interact with blockchain assets, and how it enable brand new use cases, taking us to the precipice of a new paradigms for our digital lives.
In part 3, we’ll discuss why cryptocurrencies are so polarizing, and also why it will ultimately change our financial and digital lives.
Since the advent of writing, mankind has recorded all types of information. In fact, the earliest records of writing used clay tokens to record specific amounts of livestock or commodities, presumably tracking ownership. These writings, recording information, is a form of database, which is simply a collection of data stored in a specific way.
Databases are a crucial part of our current digital lives as well, storing our order history at Amazon, monetary transactions at Citibank, and even all of the world’s information at Google. Information about us and the world is constantly, incessantly created, updated, and deleted every millisecond, all of which are stored in databases.
Blockchains are, fundamentally, a new type of database structure. Like any other database, it records information. In most cases, it records financial transactions like a transfers of asset(s) between 2 parties: a sender, a recipient, the asset (eg. bitcoin or NFTs), and the amount being transferred.
The difference between blockchains and other databases, is that it is decentralized and doesn't rely on a central entity or authority to update the information. Instead, a large network of computers, distributed all over the world, run software that evaluates and validates every transaction, then collectively “agree” on its validity before recording it onto the blockchain.
Another difference is that the entire transaction history for public blockchains is fully visible, so anyone with an internet connection can view all of the transactions and activities. This is obviously not the case for most other databases, which are private, and only visible to those with the right privileges.
Because blockchain is a public, distributed, record of financial information, it can also be called a "distributed ledger".
So how do blockchains actually work? Let’s dive in.
Let’s use a poker analogy to explain how blockchains work. Imagine you and a few strangers play in a weekly poker tournament, and want to track wins and losses. Because you don't trust each other, each person records information about every round played in their own notebooks.
Blocks: For each round, everyone records each players' bets (outflows) and winnings (inflow) on a page in a notebook. It is recorded as a list of transactions of inflow and outflows from one account to another.
On a blockchain, each record of transaction of inflow and outflows from one party to another is stored in a "block" of data, containing the sender, recipient, and amount. Each block can contain 1 or more of these transaction records.
Chain: In the poker game, players record each round on a separate page, so that each page represents a single round. Since the chip balance carries over from one round to the next, you need a way to ensure that the records reflect the same sequence of the rounds played. So, at the top of each new page, players write a summary which uniquely identifies the previous round, to link them together.
On a blockchain, the software performs a similar task. It uses cryptography to generate a “hash”, or a unique code, of the previous block. Hashing has two important properties:
1) No two hashes are ever the same, and
2) any change, minor or major, to the original data will result in a completely new hash.
Hashing gives each block its own unique digital fingerprint, and makes any tampering of data immediately evident. Since every block has the hash of the previous record, all the blocks are linked to its parent block, forming a "chain". Hence the name: Blockchain.
Consensus: Back to your game. Let's say you want to make sure that everyone's record match up at the end of the game. To do this, everyone checks and verifies each other’s records at the end of every round. Everyone signs off on the accuracy of each other's record before the next round can start.
In blockchain terms, this sign-off process is called "consensus." The software on every node checks each transaction for validity. Once enough nodes validate the transaction, it is added to the latest block. Different blockchains have different ways of reaching consensus, which affects transaction times and time to finality, but for simplicity's sake, we will use this explanation here. We'll explore the different consensus methods in a future article.
So, at the completion of your poker game, everyone should have recorded the same transaction history and signed off by every other player. Each person should be able to start from the beginning of the game, play back every single round in order, and arrive at the same chip balance for all players at the end.
Blockchains operate the same way, except on a much larger scale. Hundreds to thousands of nodes all maintain their own copies of the entire transaction history from the beginning (genesis block) to the latest (current block) record. In addition, all records are publicly available for anyone to view, verify, and validate.
This makes blockchains unique and different from traditional databases in the following ways:
Immutable and Tamper-resistant: Because all records are public and have a unique hash, blockchains are immutable. Any attempts to alter or replace a past block would result in a new hash, breaking the chain (since the original chain recorded the previous hash). This break would be visible across the entire network to every node, causing them to invalidate the attempt.
This immutability ensures the integrity of the stored data, which is particularly valuable in applications where trust and transparency are paramount, such as financial data or personal identity information.
This is different from a traditional database, where an administrator or centralized entity can (maliciously or accidentally) modify data, leading to tampering or corruption of information.
Distributed and Available: Blockchains store a copy of the entire blockchain across a large network of nodes, and each node validates and records every transactions. Even if several nodes go offline, the network remains available as other nodes still maintain, process, and serve the data. Due to the distributed nature of the network, blockchains are very resilient and do not have a single point of failure. Data is always available, up-to-date, and accurate.
This is unlike a traditional database that relies on a central authority to maintain accuracy and availability. The centralized nature of traditional databases makes it prone to malicious attacks, unauthorized access, human error, or just general downtime.
Transparent and Accessible: Blockchain transaction history is publicly visible, so anyone can see historical data without requesting, or requiring, permission. This level of transparency and accessibility allows anyone to perform audits and data analytics on any account. This makes it much harder for an individual, government, businesses, or any entities to misrepresent or lie about their holdings since everything is visible on a public ledger.
In the current financial world, transaction and asset information is not publicly available, so we must trust the entity or third party auditors to provide validation and authentication. This can result in major upheavals, like the Great Financial Crisis of 2008, when it is discovered later, that financial institutions lied about the value of their assets and holdings. Increased transparency can result in more accountability from businesses and less volatility in markets.
Blockchain is a new method of recording data that makes it immutable, available, and transparent without requiring us to trust in centralized agents or entities. These unique properties make new ideas and use cases, such as digital scarcity and true ownership, possible for the first time in a digital world.
In the next article, we will explore how to interact with blockchain assets, and how it gives us new capabilities and personal freedom, taking us to the precipice of a new paradigm for our digital lives.
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