Friday, May 12, 2017

Summary of bitcoin and its underlying technology-blockchain, by Henry Zhang, Impact Investing Intern. University of Toronto.


Everyone’s probably heard of “bitcoin,” but many only have the vaguest idea about it and little understand the underlying technology. Even fewer realize the true impact this technology may have on the future.
Bitcoin is a cryptocurrency. A cryptocurrency is a digital program or asset designed to work like currency. It seeks to have the following properties: a store of value, a unit of account, and a medium of exchange  Bitcoin is the most popular cryptocurrency of the seven hundred out there. Other major cryptocurrencies are Ethereum, Ripple, and Litecoin.

Cryptocurrencies work via a system of paired-public, private keys - randomly generated numbers. Each user in the cryptocurrency network has a unique pair of public and private keys. The public key is a string of numbers available to everybody on the network. They are used for encryption. The private key is only available to an individual. It is used for decryption of the paired public key. The bitcoin transfer mechanism works as in the following example: user A wants to give user B 100 bitcoins. Those 100 bitcoins initially have user A’s public key “tagged on” to it, indicating that they belong to user A. Through the transfer command, User B’s public key replaces user A’s public key. (note: every coin in the system is tagged with a user’s public key, since every coin is owned by someone. The actual transfer is validated by user A’s private key and signature. All user B has to do is decrypt the code, using his/her own private key, to receive the bitcoins.


Bitcoin, along with all other cryptocurrencies, rely on an innovative technology known as blockchain. While blockchain is an application of TCP/IP internet technology, it has the potential to be as big as the internet itself.

To understand blockchain and truly appreciate its potential, let’s first talk about the double spending problem with digital currency. With physical money, if you want to spend a hundred dollars but only have fifty, unless you want to go to jail (rob a bank or a person, etc.), you cannot create fifty dollars out of thin air. Only a central bank has the right to create money. This is how you are held accountable-when you only have fifty dollars in physical money, the max you can spend is fifty dollars and not a penny more.

But digital money you can literally create out of thin air, because no one holds you accountable. The double spending problem is precisely what blockchain prevents, and does so without the need for a central authority or central bank.

A blockchain is a constantly updated, complete and full record of transactions, it is, by essence, a full ledger. Think of it as a big Excel spreadsheet. Each row has a column that contains a security code (hash) validating that the row is legitimate. When one page gets filled up, it is considered a "block," and another "block" is started in a new tab. What’s beautiful about this is that the validity of the transactions is certified not by a central authority such as a bank, but instead, by the “consensus” of blockchain computer network nodes. A node is a device connected to the blockchain network, usually a computer or a terminal. Every node on the blockchain network has a copy of the entire blockchain, or record of transactions. This is the same copy of the blockchain that everybody has.

When a user on the blockchain network tries to modify the blockchain in a way that is fraudulent, his/her request will be denied because his/her copy of the blockchain will not match everybody else’s. In fact, what’s recorded in the blockchain is analogous to words carved onto the stone: it is nearly impossible to change the historical records (further discussion on this topic in the next section). It is this mechanism that means everybody is in charge of the ledger but nobody is in charge of it all at once. This preserves accountability and, in the end, qualifies bitcoin and other cryptocurrencies as acceptable money.

Bitcoin Mining

But that is not the whole story to the bitcoin network. The accountability is further enhanced by what are known as bitcoin miners. Think of bitcoin as a gold mine. The way bitcoins are created is no different from the way gold is extracted from the ground - workers mine it.

Fiat currency is government established money that is valid by law. Bitcoin, unlike fiat currency, is not issued by a central authority. No single entity is in charge of creating bitcoins. Instead, individuals have an incentive to “mine” it out of a “pool” of unpredictability. Just like a gold miner’s shovel does not know if it will strike gold with each and every use, a bitcoin miner does not know with certainty that they will receive bitcoins for each and every effort. It is only by the constant application of effort that one can receive coins.

Blockchain mining

Miners are block creators that constantly update the blockchain with new records of transactions.  In order to ensure the validity of the blockchain, miners compete to create what is known as a hash. A hash is the outcome of a block that is being modified using a specific mathematical formula - the hashcash “Proof of Work” function.

Technically speaking, the blockchain isn’t a full layout of all the blocks but a chain of hashes. A hash has some interesting properties. It is easy to go from a block to hash through the formula, but practically impossible the other way around. It is a one way street. This has the benefit of also preserving the historical record of the blockchain, since it is hard to even figure out the records of transactions. Another interesting property of the hash is that it is unique. The slightest change in a block will change the hash completely.

Now in order to create a hash, merely having the block itself is inefficient (the average block takes approximately 10 minutes to create), two additional ingredients are needed: 1.) information regarding the previous hash, and 2.) a computationally complex math problem (Proof of Work function). The former is what keeps everything in sync, and the latter is what keeps supply in control. When a hash is successfully produced and attached to the blockchain, it is “mined”.

Bitcoin Mining (again)

The miner gets a reward of a certain number of bitcoins. The problem is that computers nowadays can easily complete the first two steps: it is estimated that all bitcoins could be mined in ten minutes if it was that simple (the maximum amount of bitcoins that can be mined is 21 million). The complex math problem that needs to be solved prohibits this from happening.

To solve this problem, massive computational power and time is required. This way, the miner’s earns a reward only if he or she is lucky enough to be the first one to complete the next hash. This requires time, special equipment, and electricity. The whole reason for all of this is to make sure the blockchain stays intact, since miners are constantly, unintentionally making sure that no one is committing fraud.

As mentioned before, there is a limit to the number of bitcoins that can be mined (21 million). As more and more people join the mining business, the complexity of the proof of work mathematical problem grows and it becomes harder and harder to solve. Not only is the reward reduced, but there are fewer bitcoins in total to be mined. This is all controlled by an algorithm that was set at the very beginning of the bitcoin blockchain process.

Industry structure and the current situation

Though still in its early stages, blockchain technology is already being applied in different fields- identity and content management, social and browsers etc., beyond cryptocurrency. Currently, block chain has flourished in the following markets directly or indirectly related to cryptocurrencies:
  • Wallet & Money services-these companies primarily develop software to store and secure cryptocurrencies
  • Exchanges & Cryptocurrency Trading-these companies that build exchanges and trading platforms for cryptocurrencies
  • Merchant Services-companies that primarily develop cryptocurrency and blockchain solutions for merchants and sellers
  • Cryptocurrency Mining-companies that build hardware and software that help mining cryptocurrencies
Here are other areas where blockchain has been applied:
  • P2P Market places and P2P lending-Peer-to-Peer market platforms where users can exchange goods directly without an intermediary
  • Enterprise services and Currencies-Companies that primarily develop blockchain operating systems for various enterprise usages
  • Social and Browsers-Companies that primarily build secured web browsers
  • Storage, Security & Regulatory-Storage companies that primarily store data with blockchain-secured technology
My thoughts

I went through the basics of blockchain and it's most widely used and known application: bitcoin and cryptocurrencies. Though I feel I’ve dissected the underlying mechanism and principles of the bitcoin blockchain down to a pretty fine level (not completely, more work needs to be done in order to fully understand how the bitcoin blockchain operates), analysis is needed on the risk side of things-such as current and potential problems with the technology, government regulation, and other internal or external weaknesses and threats. Also, the industry and the current market situation need further and finer analysis to answer questions like:
  • who are the dominant players in each market, 
  • what are the potential applications of blockchain besides the ones that have been listed, 
  • what are the market caps of the different cryptocurrencies and blockchain itself. 
Even better would be to include an analysis of the commodity side of bitcoin:
  • what are the factors that are propelling the rapid rise in the price of bitcoin, 
  • what actually effects the price of bitcoin, and 
  • what is the future of bitcoin.
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