The Basics of Bitcoins and Blockchains: An Introduction to Cryptocurrencies and the Technology that Powers Them

by Antony Lewis

Like physical gold, cryptocurrencies simply exist, and are created or destroyed according to the rules articulated in the code that creates and governs them.

As well as ‘coins,’ units of cryptocurrencies may be described as digital assets. That is, unique data items whose ownership can be passed from account to account. These accounts are technically called addresses,

Unlike cryptocurrencies, these newer tokens are usually issued by known issuers who stand behind them, and the tokens can represent legal agreements (like financial assets), physical assets (like gold), or future access to products and services.

blockchains: replicated databases that act as the ultimate books and records—the ‘golden source’ that represents the universal understanding of the current status of all units of the digital asset.

Bitcoin is a bunch of protocols: rules that define and characterise Bitcoin itself—what it is, how ownership is represented and recorded, what constitutes a valid transaction, how new participants can join the network of operators, how participants should behave if they want to be kept up to date with the latest transactions, and so on. These protocols, or rules, can be described in English or any other human language, but are best articulated in computer code, which in turn can be compiled into software—Bitcoin software—that enacts those protocols, i.e. makes them operate. When the software is run, Bitcoin coins are generated and can be sent from one account to another. These actions are recorded as transaction data, and this transaction data is bundled into bundles or blocks, and linked together to form the Bitcoin blockchain.

Bitcoin protocols are written out as Bitcoin code which is run as Bitcoin software which creates Bitcoin transactions containing data about Bitcoin coins recorded on Bitcoin’s blockchain.

generally accepted academic definition of money usually says that money needs to fulfil three functions: A medium of exchange, a store of value, and a unit of account.

Stability is determined more by the liquidity of a market (how many people are willing to buy and sell at any price point), than the price of an asset.

The two underlying factors in Bitcoin that create demand are: 1.It is the most recognised instrument of value that can be transmitted across the internet without needing permission from specific intermediaries. 2.It is censorship resistant.

So how and why are fiat currencies valuable? Two main reasons: 1.They are declared by law as legal tender, meaning that in that legal jurisdiction it must be accepted as valid payment for a debt. Therefore people use it. 2.Governments accept only their own fiat for tax payments. This gives fiat currencies a fundamental usefulness, as everyone needs to pay tax23.

a currency peg, which we discussed earlier, and means they need to have the gold in their vaults in order to remain credible and promise to let people redeem their notes for gold.

Gold and silver are measured by weight (or mass, to be pedantic). The units are grains and troy ounces. There are 480 grains to one troy ounce, and twelve troy ounces to one troy pound. In standard terms, this means one troy ounce is 31.10 grams, which is about 10% heavier than one ‘normal’ (or avoirdupois) ounce of 28.35 grams.

Fiat money is money that does not have intrinsic value and does not represent an asset in a vault somewhere. Its value comes from being declared ‘legal tender’—an acceptable form of payment—by the government of the issuing country.

Malicious miners can cause a little more impact. They can: •Attempt to create blocks that include or exclude specific transactions of their choosing. •Create a double spend by attempting to create a ‘longer chain’ of blocks that make previously accepted blocks become ‘orphans’ and not part of the main chain. They can realistically only do this if they command a significant proportion of the entire network’s hashing power. But they can’t: •Steal bitcoins from your account, because they can’t fake your digital signatures. •Create bitcoins out of thin air, because no other miners or bookkeepers would accept this transaction.

Transactions are payment instructions of specific amounts of Bitcoin (UTXOs) from one user-generated account (address) to another. The transactions are created using wallet software, authenticated with unique digital signatures, then sent to bookkeepers (nodes) who individually validate them according to some well-known business and technical rules. The bookkeepers then add valid transactions to their mempool and distribute them to other bookkeepers that they are connected to. Miners gather these individual transactions into blocks and compete with each other to mine their blocks by tweaking the block contents, specifically the nonce field, until the hash of the block is smaller than some target number. The target number is based on the difficulty setting at the time, which is derived from the time taken to mine the previous set of blocks to achieve a network-wide target frequency of one new mined block every 10 minutes. Miners receive a financial incentive in the form of new BTC and transaction fees which they may credit themselves, to compensate for spending resources to perform the competitive, repetitive hashing needed to create valid blocks. The blocks link to each other in a unique sequence to form a ledger, the Bitcoin blockchain, that is recorded identically almost simultaneously on thousands of computers around the world that run Bitcoin software. If a Bitcoin transaction is not recorded on this blockchain, it is not a Bitcoin transaction. It doesn’t exist. A Bitc...

So whereas Bitcoin’s block size limit is based on amount of data, Ethereum’s block size limit is based on computational complexity.

Because Ethereum’s rate of block generation is much higher than Bitcoin’s (250 blocks per hour on Ethereum vs six blocks per hour on Bitcoin), the rate of ‘block clashes’ increases. Multiple valid blocks can get created at almost the same time, but only one of them can make it into the main chain. The other one ‘loses,’ and the data in them is not considered part of the main ledger, even if the transactions are technically valid. In Bitcoin, these non-mainchain blocks are called orphans, or orphaned blocks, and they do not form part of the main chain in any way and are never referenced again by any subsequent blocks. In Ethereum they are called uncles. Uncles can be referenced by a few of the subsequent blocks and although the data in them is not used, the slightly smaller reward for mining them is still valid.

There are two types of Ethereum accounts: 1.Accounts that only store ETH 2.Accounts that contain smart contracts Accounts that only store ETH are similar to Bitcoin addresses and are sometimes known as Externally Owned Accounts.

Accounts that contain smart contracts are activated by a transaction sending ETH into it. Once the smart contract has been uploaded it sits there at an address, waiting to be used.

fork of a live blockchain, better described as a chainsplit, is more interesting. Chainsplits can happen by accident or on purpose.

An accidental chainsplit is when there is an uncontentious upgrade to the blockchain software and some proportion of the network omits or forgets to upgrade their software, leading to a number of blocks being produced by them that are incompatible with the rest of the network.

deliberate chainsplit occurs when a group of participants of a live network thinks that things should be done a different way from the rest of the participants, and runs some new software with changes to the protocol rules to create a new coin that has a shared history with the old coin.

A soft fork is a change in the rules that is backwards compatible, meaning that blocks created under the new changed rules will still be considered valid by participants who didn’t upgrade. A hard fork is a change in the rules that is not backwards compatible, so that if some participants fail to upgrade, there will be a chainsplit.

Ownership of any cryptoasset, whether it is a cryptocurrency or a token, is vested in the person who has the private key that corresponds to the address with which the token is associated.

tokens recorded in smart contracts on other blockchains, usually on Ethereum’s public chain.

Initial Coin Offerings (ICOs), sometimes called ‘token sales’ or ‘token generation events,’ are a new way for companies to raise money without diluting ownership of the company or having to pay investors back.

Traditionally, a company can raise money in any of three ways: equity, debt, or through the pre-ordering of specific products. They can raise money from a small group of investors as is typical in early venture funding, or from a large number, a style of raising money typically called ‘crowdfunding’ that has become increasingly popular.

In an equity raise, investors pay money to the company in return for a share of ownership of the company. Investors receive a share of company profits in the form of dividends and may get voting rights at shareholder meetings, among other privileges. In a debt raise, investors loan money to the company and may get periodic interest payments in the form of coupons. Debt holders expect to get their capital back at the end of the lifetime of the loan. In a pre-fund or pre-order, customers (note, they are customers, not investors) pay money for a product that they will receive later.

Crowdfunding is a recent phenomenon using the power of the internet where a project or company can be funded by raising small amounts of money from large numbers of people, often through a web or app-based platform that brings together the projects and the investors, or customers.

Companies221 describe a particular product or service in a document called a whitepaper and announce their ICO. Investors222 send funds, usually cryptocurrencies, to the company in return for tokens or a promise of tokens in the future.