General Ignorance of Bitcoin
Last week I was having dinner with friends when one of them said, “has everyone got their Bitcoin investments sorted out?”. This comment resulted in a conversation about the merits of such an investment. Opinion was divided with some thinking that there was much more growth while others felt it had reached its top. To my surprise, I had absolutely no opinion on the subject, this was very unusual for me and it was worrying!
My knowledge of Bitcoin had some limits, it’s a digital currency and it has been making some big gains. I didn’t really understand much more than that about them, let alone the broader Cryptocurrency market. Also, I hadn’t really considered that people outside the tech world were thinking of them as an investment option. Why would they?
Concerned by my ignorance, lack of opinion and general skepticism I decided to explore the world of cryptocurrency. Here’s what I found out, Part 1 of our four part series.
The Origins of Cryptocurrency
The original and best known of the cryptocurrencies is Bitcoin. Created by Satoshi Nakamoto in 2008 it came about as a byproduct of him creating a peer to peer electronic cash system. Many people had already tried to create such a decentralized digital payment system and failed. Nakamoto had not set out to create a currency though it became key in making his system viable.
Since then Bitcoin has grown dramatically. From being worthless in 2010 to almost $5,000 per token in September 2017 and a market cap value of over $70billion. It has been a volatile journey with setbacks along the way and a tremendous amount of momentum. Cryptocurrency pioneers have brought us 30+ new options have since then each with varying degrees of success. We will look at this in further detail in a later post from this series.
What makes a currency?
Any currency should exhibit the following characteristics:
- Scarcity – There should be controls on creation and a finite supply.
- Exchangeable – It should be exchangeable for other goods, services and currencies.
- Divisibility – It should be divisable into smaller and smaller portions.
- Durability – It should stand the test of time, not wear out or disappear.
- Transferability – It should be easily transferrable between owners.
Bitcoin certainly has all these characteristics, though other cryptocurrencies may struggle with exchangeability to differing degrees.
What is a Cryptocurrency?
To all intents and purposes a cryptocurrency is a definable number of entries in a database that no one can change unless certain conditions are met. This is certainly the foundation of any currency.
A cryptocurrency consists of a peer network, each with a complete record of every transaction ever made. This means that they also have a record of the balance of every account.
The Mechanism of a transaction
In order to send cryptocurrency you need two things. These are an address and a private key. An address is a sequence of random letters and numbers. The private key is also a series of letters and numbers which unlike the address remains a secret.
A transaction shows that Chris has given Sarah 2 units of currency. This iinvolves three key pieces of information:
- Input – This shows the address where Chris received the units from in the first place.
- Amount – In this case it would be 2 units that Chris is sending to Sarah.
- Output – This is Sarah’s cryptocurrency address.
Chris signs this information with his private key he will then broadcast it to all the peers in the network. The entire network knows about the transaction immediately transaction and if everything is in order it will receive confirmation. This will not happen immediately on average it is usually about 10 minutes though it could be less or much longer.
The importance of confirmation
This is a key concept to all cryptocurrencies and without confirmation a transaction is pending. Without this validation, a transaction is at risk of forgery. Confirmation sets a transaction, no one can change it and is no longer susceptible to fraud. It is now part of the indelible record that peers share across their network known as the “blockchain“. Miners carry out the process of confirmation and it ensures that a transaction is legitimate.
The blockchain is the general ledger for every transaction that has taken place in a particular cryptocurrency. A “Block” is the term for a list of transactions occuring within a certain timeframe. Miners must confirm these transactions and write them into this general ledger (i.e. blockchain) on every node in the network. As a reward for this the miner receives tokens of cryptocurrency.
The main cryptocurrencies employ this method to stop any individual from exerting undue influence over them. In theory, anyone can be a miner as there is no authority to delegate this task in a decentralized network. Miners have limited power to determine the transactions that they confirm. Also, a miner is unable to confirm a transaction which they identify as invalid. This adds security to the overall system and helps to prevent against miners abusing their role or colluding.
The Process of Mining
Basically, the miners must solve a puzzle to create new currency and the difficulty of this puzzle uses computing power. This limits the amount of currency that a miners can create at one any time.
Confirmation can only take place once the miner has identified a cryptographic marker connecting the new block to the previous. Using a mathematical formula a miner turns the new blosk into something else. The output of this process is a hash and they store it along with the corresponding block. Each hash is unique and if anyone were to alter even one character in the block the hash is totally different.
To produce a new hash a miner uses the data within the new block and the hash from the previous block. This guarantees the legitimacy of every block and all subsequent ones. The uniqueness of each hash makes alterations to the data it evident to everyone.
Proof of Work, Hash & a Nonce
As previously mentioned miners are rewarded for confirming the validity of a block. Producing the hash for the block is key to this process, though it must meet a predetermined criteria. It’s not a case of any old hash will do. If it does not meet this criteria then they must carry out the process process again and again until it does. This is known as “proof of work” and without it a miner will not receive their pay.
Miners should never change the transaction data within a block and they are unable to change the hash from the previous block. To change a hash so that it meets the specific criteria they must use a third variable piece of data. This is something they call a “nonce” though this has a very different meaning in the eastend of London. The miner will keep changing the nonce in the formula until they have an acceptable hash for the new block.
Miners are competing against each other to complete this process first, so they can claim the reward.
Fork in the blockchain
In 2013, a glitch occurred in this system when miners who had updated to a newer software version created blocks. These blocks were seen as invalid by miners who were using the older version of the software. This created a split in the blockchain as some computers accepted the blocks and continued to build the chain. At the same time others didn’t recognize the blocks and continued to build the chain without them. The two chains meant that the same funds were being spent differently in each chain, this was a major issue. The main exchange at the time halted bitcoin deposits.
The situation was resolved by miners downgrading to the older software version in order to unify the blockchain. Bitcoin users’ balances remained relatively unaffected and the situation was resolved in hours. The suspension resulted in a 23% fall in the value of bitcoin which quickly recovered after the situation was rectified.