A Beginners Guide To Bitcoin and the Blockchain Technology

Bitcoin and the underlying blockchain technology are democratizing money. Are cryptocurrencies a threat to the traditional banking system?

Sending and Receiving Copies

We have seemingly endless possibilities to send data today. We can send photos via WhatsApp, send invoices by email, download PDF reports from the web. What they all have in common is that we never send out or download the original document. The technology so far was based on sending and receiving copies. While I am able to send you a photo via WhatsApp, the original photo stays on my phone. When I am uploading all my photos to the Dropbox or Google Drive, I am uploading a copy of my photos. So far we never experienced a problem with that as we didn’t run out of storage on our mobiles or laptops.

Copying Money is Illegal (but possible)

Sending copies of our files to somebody else was and is still usual for us. We probably never even thought about this practice. When it comes to money it is another case. We all agree that we better don’t copy our money. Not on the copying machine neither digitally. It is extremely illegal to do so. But it is indeed possible. This is the problem of our current financial system. Criminals are printing false money and cyber criminals are able to spend the same money twice. We all agree that sending out an exact copy of our money simply is not working.

The Double-Spending Issue

When we are talking about copying money it is mainly about the Double-Spending issue. Double-spending describes the risk that digital money can be spent twice. Here is how it works in simple terms: You own $100 of digital money. You pay your $100 Amazon bill by using this digital money. But instead of paying the original amount you duplicate the money by making an exact copy of that digital money (digital token). Now you are able to pay your bill with the exact copy of the $100. You keep the original $100. Congratulations you spend the same money twice.

Prevention of Double-Spending

To prevent double-spending a so-called middleman is used. The middleman is usually a bank. Banks are verifying and settling every single payment. Banks are justifiably generously interested who they are doing business with. This is the reason why, in combination with state regulations, you need to fill out massive paperwork when opening a bank account. But not only a bank may be a middleman. PayPal, WesternUnion, and other financial companies are also a so-called middleman or trusted third party. Institutions like banks are called trusted third party because it allows and is needed for a transaction to take place between two parties. Both parties must, therefore, trust the third party, which is in our case the bank or PayPal. The trusted third party is reviewing and verifying all transactions between two parties to prevent fraud. As a result, money only moves at the speed of banks.

Inefficiency of our current Financial System

If you use your credit card to pay your groceries in the supermarket, your payment will need several days to settle and while doing so it will pass several intermediaries. A MasterCard payment takes on average two days to settle and it includes at least four intermediaries. A credit card payment will be processed by (1) the merchant’s bank, (2) Master Card, (3) a settlement bank, and (4) the cardholder’s bank. As a result payments in our current financial system are expensive and slow. Credit card companies and digital payment processing companies like PayPal are usually charging a flat fee plus 1 up to 3 percent of the transacted value. They are charging monopolistic prices as payments would usually be possible for a fraction of a cent.

As a result, these high transaction costs are excluding a great share of the world population from banking services. Banks see micropayments of less than a dollar as unprofitable and they simply exclude poor people from using their services.

31st October 2008

On October 31st 2008, a genius or a group of geniuses who used the alias Satoshi Nakamoto published a paper called “Bitcoin: A Peer-to-Peer Electronic Cash System”. This scientific paper has been a real revolution as it is introducing a way to exclude trusted third parties or middlemen by building trust based on mathematical principles. This paper has been the birth of Bitcoin and the underlying technology which is called Blockchain opened endless possibilities for a new era of finance and even the whole internet.

Cryptocurrencies

if you don’t know anything about cryptocurrencies, you have probably already heard the term “Bitcoin”. But Bitcoin is just one of many hundreds of cryptocurrencies. There are Bitcoin, Ethereum, Ripple, Litecoin, and many other digital currencies who are all building upon the blockchain technology. While a variety of cryptocurrencies exist, Bitcoin is by far the best known and in terms of market capitalization the largest cryptocurrency. Bitcoin is an electronic payment system based on cryptographic proof instead of trust. What makes Bitcoin so revolutionary is the blockchain technology. Cryptocurrencies such as Ethereum which emerged later used the Bitcoin protocol at least partially for their own payment platforms.

Value of Bitcoin

Bitcoin and other cryptocurrencies are not backed by a government, institution, or person. They are also not backed by precious metals such as gold and silver. When we are talking about Bitcoin we are not talking about money in the traditional sense. A bitcoin is basically a piece of computer code with no intrinsic value. Fiat currencies retain their value by governments and central banks. Cryptocurrencies, on the other hand, derive their value from a special field of mathematics called cryptography. The cryptographic system allows that users are collectively verifying who owns what. By solving mathematical puzzles users are securing the network users are rewarded with bitcoins.

Mining: Collecting and Verifying Payments

All payment which is made within the Bitcoin system are collected by miners. Miners are users which use a tremendous amount of computing power to collect a few thousand payments and combine them in a block. Miners are competing against each other to calculate a proof-of-wok. A proof of work is basically a piece of data which is difficult to produce but easy to verify. Think of the proof-of-work as a Sudoku puzzle or with the effort to throw 12 dices all showing the number 6. This involves a lot of trial and error and the proof-of-work is a process of very low probability.

The miner who solves the proof-of-work first is publishing its solution and the mined block is added to a never-exhausted chain of previous blocks. In the case of Bitcoin, it takes miners 10 minutes to solve a proof-of-work. This means that all payment within the Bitcoin network is settled within 10 minutes. The winning miner is rewarded with a fixed amount of bitcoins as the calculation of the proof-of-work takes vast amounts of computing power.

Blockchain: The Worldwide Excel Spreadsheet of all Payments

Every mined block is added automatically to a chain of previously mined blocks. The blockchain is, therefore, growing each time a new block has been mined. Approximately every 10 minutes a new block is added to the blockchain. You can think of the blockchain as a public Excel spreadsheet where every single transaction is automatically and for everyone visible stored. You can always use the blockchain to verify previous transactions or check if your opponent is liquid enough to pay for your services. Ownership if bitcoins is recorded without using and revealing real identities. Think about it as if you are having access to everyone’s online banking just with the names being blacked out. The privacy of payers and payees are protected by using the latest cryptography, this makes Bitcoin transactions in theory equally anonymous as cash transactions.

Note: Recent research shows that it is still possible to find out real identities on the Bitcoin network. Read my article on this topic here.

Decentralization: Democratizing Money

The whole blockchain is stored in a peer network of nodes. This means that anyone who holds a bitcoin also holds the exact copy of the blockchain. This makes it very hard and nearly impossible to change or alter transactions which took place in the Bitcoin system. The decentralized blockchain decouples the need for large monopolistic institutions to establish trust. Every single Bitcoin user has the ability to check and verify every single transaction which ever took place in the Bitcoin network. The simple decentralized architecture of the Bitcoin system democratize money as it excludes mighty financial institutes completely.

Hackers, have fun.

The decentralized blockchain architecture also makes hacking almost impossible or at least endlessly more difficult than hacking its centralized opponent. Hacking, changing, and altering a single transaction would mean that you need to:

1. Hack the block in which the transaction is stored.
2. This implies that you need to hack all other preceding blocks.
3. All these blocks are not stored on a single computer or server but on millions of computers around the world.
4. You would need to hack all computers simultaneously.
5. All blocks on millions of computers are secured by using the highest level of encryption.
6. While you are doing all this you are watched by all Bitcoin miners which represent the largest computing power in the world.

Next Generation of the Internet

We can compare cryptocurrencies and the blockchain technology today to the first computer or the internet in 1990. They were slow and very hard to understand. Guys who started working on computers and the internet were labeled as nerds. Today these nerds are rockstars and they created the world’s largest companies. We need to embrace the blockchain technology and use its revolutionary architecture to improve society and our lives. Blockchain technology has the possibility to democratize not only money but business. It may be implemented in nearly every use case, from smart home technology to the internet of things. Blockchain counterparts of Uber and Airbnb will allow a direct exchange of value and services without the need of a monopolistic organization in between. We need to open our eyes and start imagining what we can create with the help of the blockchain technology.

Emerging technologies like the blockchain, artificial intelligence, augmented and virtual reality are offering chances to all of us. We just need to take this chance and act upon it.

One thing is for sure: Things will change in ways we cannot even predict or imagine.

Learn More

• Read my slightly more technical paper for free: bitcoinpaper.mariusschober.com
• Get the book Blockchain Revolution by Don Tapscott and Alex Tapscott
• Work through the more technical book Mastering Bitcoin by Andreas M. Antonopoulos
• Read the World Economic Forum report “The Future of Financial Infrastructure”
• Check the blog and resources on bitcoin.org and ethereum.org.