“The price of bitcoin just went up by over 40 percent in three days! I am jumping on it right now. Do you want to join me?”
This is a conversation between an elderly woman and a young man that I overheard in a train while I was on my way back from an initial coin offering (ICO) event in London. I approached the woman, and asked if I could join her conversation.
She was excited and talked to me about how she could have multiplied her money had she invested her money in bitcoin when it was less than US$0.01 back in 2009 (it was valued at US$8,300 when we were having this conversation).
However, to my surprise, she could not answer a few of my basic questions: What is bitcoin? Why is the price skyrocketing? What is your fundamental reason for speculating that the price will increase further?
She did not seem keen on continuing the conversation with me. Luckily, I had arrived back in Birmingham, and I shook hands with her before getting off the train.
Little did she know that I am a sceptic of the current cryptocurrency environment. The more I understand its technical bits and observe the false hype by attending related events, the more I fear a crash that could wipe out the entire market, which is valued at over US$620 billion.
I will not deny that cryptocurrency could impact humankind tremendously in the next few years. However, it is vital for us to understand its fundamentals before turning our hard-earned cash into virtual currencies.
What is blockchain?
Blockchain technology is the underlying technology for cryptocurrencies. Simply put, it is a decentralised, public ledger of transactions in which everyone in the system has a copy of the whole ledger right from the initial transaction.
Let us begin with an analogy. If I have a physical photo and I send it to you, you are assured that you are the only one in possession of the photo, and I am no longer in possession of the photo.
The ledger system here is simple – plus one photo for you, minus one photo from me. Perhaps we need an intermediary such as a lawyer and photo specialist to make sure that the photo is original and to legitimise the transfer of ownership.
However, the transfer gets complicated when we talk about digital photos. If I transfer a digital photo to you, what assurance is there that I will delete the copy of the digital photo that I have? Often, we tend to send a digital photo to multiple friends of ours without deleting the copy we have, making it no sense for us to attach a monetary value to it.
Hence, if this digital photo needs to be sold, intermediaries step in again to make sure the transfer is done in a secure and legitimate way. The intermediaries will also make sure that the number of digital photos I have is reduced accordingly after the transfer.
Often, these intermediaries use central servers which do the “minus” (debit) and “plus” (credit) for a transaction automatically. These intermediaries provide you and me with the assurance that they will not be biased towards either of us.
Fundamentally, they have built virtual trust by using a central server, and we pay fees in exchange for that.
Only the intermediaries have our ledger of digital photos – which includes all the transactions that have taken place from the beginning with all parties. But this information is too sensitive to be revealed.
An anonymous character called Satoshi Nakamoto came up with a solution this and other problems in a nine-page white paper – a name given to any introductory file in the cryptocurrency and blockchain space – titled “Bitcoin: A peer-to-peer electronic cash system” in 2008.
In the white paper, Satoshi described the technical aspects of bitcoin. What grabbed most people’s attention is when he used cryptography and the concept of a public ledger to solve the problem of double-spending – that is, when the same digital token is duplicated or falsified and spent more than once.
Going back to the example of digital photos, what if all the participants in the “digital photo ecosystem” have a copy of the whole ledger of the digital photo? This would include the details of its production, date of each ownership transfer, as well as details of the account it is transferred from and to.
A new transaction involving the digital photo will only occur if the whole ledger, which is “patched” to it, exists. So, if I forge a digital photo, all the participants in the ecosystem will know about it immediately, and hence they will not buy my digital photo.
Ultimately, we have created a whole ecosystem to replace the intermediaries earlier. However, how would we make sure that all the participants – who number in the millions in the bitcoin ecosystem – agree and allow our transaction to occur in the shortest time possible?
This is where the role of miners come in. Miners are the ones that validate transactions. Fundamentally, they are true replacements of the intermediaries who have been doing this job.
The miners compete with one another to validate a transaction as they are rewarded with bitcoin if they do so. Other participants simply show that they agree to the miners by continuing to conduct a new transaction on the same ledger.
The participants and miners will not validate and agree to a false transaction as participants hold bitcoins – and miners are rewarded with bitcoin – hence, they would not want to carry out an action which is against the whole network, causing the value of the bitcoin to collapse.
If you are transferring the digital photo to another person, that transaction will be recorded after the transaction that occurred previously between both of us. Hence, a chain is formed.
Now, imagine if we have millions of people transferring digital photos to one another. Of course, we can’t afford to validate, agree to and record each of them, one at a time.
So, we record thousands of transactions in a specific time period (20 minutes on average for bitcoin) in a “block”. Collectively, this forms blockchain technology.
Next: The mining process of bitcoin
KAMRAJ SHANMUGANATHAN currently studies in the University of Warwick. He believes that knowledge asymmetry is the root of inequality in this world.