In my previous post, I tried to show that the main point of BTC was that it is not backed by a government and not regulated by a central bank. But also that that is actually where the value lies. Consequently, this means no central authority can control BTC’s volume: no one can print more than BTC’s limited amount (once all of the BTC are mined, that is). If you haven’t read this post, I highly recommend you do! After all, you shouldn’t learn the “how?”, if you don’t know the “why?”.
(this post was first posted on my wordpress blog)
No centralised bank? Who checks the system?
So now the question becomes: isn’t it unsafe if it’s not regulated? If there is no centralised authority that keeps track of who owns how many BTCs, how is this governed in a decentralised way? Well, quite simply stated: everybody governs. Anyone can govern the transactions including, you, me and all the Karens, Gregs and Chads you know.
Allow me to explain this by explaining the difference between cryptocurrencies, bitcoin (BTC) and blockchain. BTC is an example of a cryptocurrency, as is Ethereum, Cardano, and thousands of others. At this point, however, BTC is still the most prominent of all cryptocurrencies although this could change at some point in the future *cough* Ethereum *cough*. The common ground that all cryptocurrencies share is that all the transaction information is cryptographically coded in a unique digital fingerprint, called a hash.
Not this type of hash, obviously (source: cannabislightshop.nl).
So after mentioning cryptocurrencies and bitcoin, the elusive blockchain remains. Well, the blockchain is the mechanism that BTC uses to govern all transactions. Someone described it at some point as a public excel sheet: think of it as a google documents excel sheet where everyone can edit. However, only you can edit your column (because you have a private key that allows you to do this). If you want to buy 0.01 BTC from me, we can both agree to this, and 0.01 BTC is deducted from my balance, and you get 0.01 BTC.
A visual example of the public sheet: Jeff initially had 0.15 BTC but gave it all away, because he's a good guy like that. Or he sold it to Chad, Karen and Greg for smelly fiat cash, which he got in return. Of course he wouldn't do this for his own benefit. No, he would donate that fiat money to the homeless. Because he's a good guy like that (source: Regular Jeff).
This transaction is then coded in a hash, called a block, and it will look something like this: 7ae26e64679abd1e66cfe1e9b93a9e85. All the transactions of each passing 10 minutes are compiled as a hash on that block and verified by all computers that engage in the blockchain network. Basically, this block consists of a hash of 10 minutes-worth of transactions, but also includes the hash of the previous block in the chain (also worth 10 minutes of transactions). So in short: every block is a hash containing = the last 10 minutes of transactions + a hash of the previous block.
A visual representation of the blockchain system: every block is codified into a hash, which is included in the next 10 minutes worth of transactions as well (the next block) (source: Regular Jeff).
Why 10 minutes?
Simply because it’s vastly more efficient than having to encode every single transaction every second by everyone in a separate hash. The resulting new block in the blockchain also contains the information of all the preceding transactions, ever, so it’s a chronological sequence of all the transactions done by anyone. People can then decode every hash (each block) with a public key and see what the individual transactions are.
In the words of our public Excel sheet metaphor: you can edit your balance in the excel sheet, as long as someone else takes the exact opposite amount (you sell, they buy, or vice versa). It requires the confirmation of two parties to edit both balances in the Excel sheet (they both have to use their private keys to access their own column in the excel sheet). The transaction happens and then, every 10 minutes the Excel sheet gets saved and we put a URL link in the public Excel sheet to the last save file. This way, everything is transparent.
Only I can edit my balance? I’ll just increase it!
So now that you know the first steps of how it works, you might ask: “But Jeff, can I not just edit my own column with my private key and re-write my own balance to become a millionaire?” Nope! You should imagine the 10 minute block as a vote: everyone puts in a vote and the majority rules which block is correct. So if you’re the only one that has your balance as 1 000 000 BTC, but everybody else agrees that your balance is 0.005 BTC, people will quickly find out. In fact, if the content of a hash is altered, the resulting hash will be different, making it easy to spot malicious actors as their hash will be different. In excel sheet files: your URL, linking to a sheet with your 1 000 000 BTC, will have a different URL name than all the other 99% of the people.
A physical version of BTC, which really has no value (source: apparata.nl).
Voting? I’ll create a majority and increase my balance!
“Haha, but Jeff, I have a loophole, I’m going to be rich: I’ll just make extra digital addresses to vote! For instance, if 4 million other addresses verify the BTC blockchain, can’t I just make 4.1 million addresses that confirm my 1 000 000 BTC balance, because then I would have the majority.” I get it, you want to create so many addresses as to become the majority. Then you would just vote for your hash (block), meaning the majority (which is now you) accepts your block. Clever! Unfortunately, you can’t really do that, because you have to take the money from someone else: there is only a limited amount of BTC in circulation (21 million), so any transactions have to be a zero-sum game: +X for you = -X for someone else. And you can’t force BTC off someone else’s account, they also have their private key which they need to confirm the transaction.
Can't change my balance? I’ll reverse my spending!
“Well, Jeff, that’s cool, but I have an alternative idea, what if I just use my 5 million addresses to vote for a block that excludes my last spent 1 BTC?” I get what you’re trying to say, dear intelligent – yet slightly shady – reader. But this is where the real interesting, game theoretical part of BTC comes into play. It’s not as easy as just making 5 million addresses, because you need to work for the system before you can engage with the network: quid pro quo. You have probably heard of BTC mining. This is where your computer needs to solve a complex mathematical equation, something like a riddle. It takes energy to do this, because solving the riddle requires processing power and that means you’re paying for all of that energy. This is incredibly difficult to do 5 million times and not lucrative at all, disincentivising you to create extra addresses easily and preventing you to cheat the system. Better luck next time, Danny Ocean.
This is why the typical BTC consensus mechanism with its mining is called Proof of Work (PoW): you have to work for your money. PoW was actually invented in the 90s to combat spam email. The idea is, if you require people that send you an email to solve a small mathematical equation, your friends will surely do this, but your beloved Nigerian Prince will not do this. It’s not worth his time, he just wants to send 10 000 emails at the same time with the minimal effort required.
In fact, all the computers that verify transcations are miners, and all of you together have to complete a single task, all at the same time. Solving this puzzle takes exactly 10 minutes, but not everyone will be lucky to solve it in time (it is completely random). After 10 minutes, the lucky few get to the answer and create the following block in the blockchain. They also receive a specific amount of BTC as a reward for solving the puzzle. That’s good, because it compensates for your energy usage and pays you an extra bonus at the same time. All the other miners (even the unsuccessful ones) can then verify the transactions and reach consensus – as long as it doesn’t look fishy. If it looks fishy (because you changed the older hashes, thereby changing the current hash), then the validators (the miners) will reject your block and choose that block which does get the majority of the vote.
A malicious actor in the system is easily recognised by others, as long as it is in the minority (source: "NFTs, Blockchain and Crypto. Explained" by "What I've Learned")
So now we know how the system is foolproof and how BTCs are actually created: as a result of this mining process. You can see why this PoW process is called mining: it’s similar to gold mining. As the BTC miners produce more BTC, there is more BTC on the market which can be traded for anything anyone is willing to trade for it, even our smelly fiat currencies like $$$ or €€€. This might seem like inflation, but in the next post, I will explain why this is not really the case.
And there you have it, that is how BTCs are created, how they are traded, who keeps track of the blockchain system and why no one can cheat or create BTC. In my next crypto post, I will delve into the more juicy details of BTC: its mysterious creator, its hurdles, and its limited availability.
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