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

by Antony Lewis

Economies developed based on mutual trust, gifts and debt or social obligations—‘Have a chicken now, but please remember this for later’. Early communities were small and stable, and individuals tended to grow up with each other and know each other well. Reputation within a community was crucially important, so people didn’t tend to renege on their word. But people still had to keep some sort of record of debts or favours owed.

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.

The world’s oldest central bank, Sveriges Riksbank, was created in Sweden. Initially, the Bank was forbidden to issue banknotes due to lessons learnt from Stockholms Banco, Sweden’s first bank. Stockholms Banco issued Europe’s first banknotes but got carried away and issued more than could be redeemed, a money creation technique known as fractional reserve banking. Stockholms Banco failed when banknote holders wanted the underlying metal coins back. In 1668, Sveriges Riksbank was founded and later, in 1701, it was allowed to issue banknotes, then called credit notes. It gained exclusivity over banknote printing 200 years later in 1897 with the first Riksbank Act.

The game of chance that Bitcoin uses is called ‘proof-of-work’. Each block-creator takes a bunch of transactions that they know about, but which have not yet been included in any previous blocks, and builds a block out of them, in a specific format. The creator then calculates a cryptographic hash from the block’s data86. Remember that a hash is just a number. The rule of Bitcoin’s proof-of-work game of chance says, if the hash of the block is smaller than a target number, then this block is considered a valid block which all bookkeepers should accept87.

Bitcoin’s solution is a market-based approach where people creating transactions add their own voluntary transaction fees, and the block-creators can prioritise those transactions with higher fees over those with lower fees.

Ethereum has a concept of ‘gas’ which is a sort of price list, based on the computational complexity of the different types of operation you are instructing the miners to make in your transaction. Operations include searching for data, retrieving it, making calculations, storing data, and making changes to the ledger.

Blockchains are great for tracking unique digital items that only exist on that blockchain, but not as good when digital and physical worlds collide. Blockchains don’t tell the truth; they just record what someone tells them. Perhaps blockchains could increase certain aspects of transparency in a supply chain, but they are not foolproof and should not be used just because the phrase ‘supply chain’ has the word ‘chain’ in it.

It is still unclear which processes will be significantly improved as a direct consequence of the technology, and which are improved simply by digitising the workflows. Does it matter? In many cases a project might not need a blockchain, but using one might trigger interest and management enthusiasm, and even unlock a budget which might not have been available if the project was just a boring old digitisation project. This is fine, and in this case, I think the ends justify the means. Without some amount of hype to spark the imagination there would be less money to spend on innovating, and therefore potentially less innovation.

Yes, compelling

For public blockchains, it is useful to understand: •Will all parties run nodes or will some trust others? •If the blockchain is backlogged, what impact might have this have on users? •How will the project deal with forks and chainsplits? •How will data privacy be achieved? •How will operators comply with evolving regulations?

For private blockchains, it is useful to understand: •Who will run the nodes? Why? •Who is going to write blocks? •Who is going to validate blocks and why? •If this is about data sharing, why can’t a web server be used? •Is there a natural central authority whom everyone trusts, and if so why aren’t they hosting a portal?