So, I've been interested in cryptocurrencies for a few months now, but mostly as an investor and gambler. I figured I could trust the smart people of this world to have vetted the technology and I basically gauged the potential for success of a project by what the "experts" had to say. I spent some time today catching up on the technology and I figured I'll share my understanding.
One of the first big words you hear when you first get into cryptocurrencies is block chain technology. For the longest time, I thought it was a synonym for Bitcoin, It is not. So, what is a block chain then?
A block chain is a series of connected blocks where each block contains, a block id, a list of transactions and the previous block's Id. In the case of bitcoin, the block also contains a proof of work (POW), we'll get back to POW later.
Image created by Yevgeniy Brikman
So basically, what you have is a chained ledger of transactions. Nothing too fancy.
Other big words you'll hear a lot in the cryptocurrency world are, decentralized and peer-to-peer network. A peer-to-peer network is created when 2 or more computers are connected to each other and share resources, without going through a separate server computer. A peer-to-peer network can eliminate the need for middlemen and so, it is one way of achieving decentralization, the absence of central authority figures.
Now, what is Bitcoin? Satoshi describes Bitcoin as a purely peer-to-peer version of electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution (no middlemen).
How this works is that, everyone on the peer-to-peer network starts out with a blank chain, and every time a node (computer) wants to perform a transaction, it broadcasts this transaction to the network and magically, everybody's copy of the block chain gets updated correctly.
This magic is where our next big word comes in, Miners. For everything wrong with financial institutions, they performed very important tasks in our financial system and just removing them will not cut it. Someone or some people need to do their jobs. These are the miners.
When nodes publish their transactions, these transactions go into a pending state, and after about 10 minutes, the pending transactions are consolidated by miners. These miners verify that everyone who has performed a transaction within the given time window is authorized to perform said operation. They make sure no one is trying to spend money they don't have or spend the same money twice. After doing this, they convert these transactions into some kind of puzzle. These puzzles usually involve a lot of guessing to figure out, and the chances of guessing the right answer is very low.
This is where Proof of work comes in. Miners basically solve this puzzle by having a lot of computers spend time guessing at the correct answer. The trick to this puzzle is that there are very many options to guess from, but it is very easy to check if a guess is correct. Think about it as a Rubik's cube.
So, once a miner solves the puzzle and verifies that the transactions in the block make sense. He publishes the solution and the new block to the network, the proof that he has solved the puzzle, the proof of work. At this point, other miners run simple tests to verify that the solution is right, once majority of the network agrees that the solution is right, this block gets added to the block chain and every node updates their copy of the chain. Miner have an incentive to solve these puzzles because they get paid for every puzzle they solve.
You might wonder why this makes any difference if we basically just replaced banks with miners. There are many reasons this is different. For one, the barrier to entry for becoming a Miner is much lower than the barrier to entry for creating a bank. Secondly, everyone has access to the block chain so the activities on the block are transparent. Even better, anyone can verify if a block is valid. We the people can audit the Miners.
I'm sure this will trigger some economics and security questions in your mind. Shoot them my way and I'll gladly write a post to answer your questions.