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Understanding Blockchain Technology Part 1/4 – How Bitcoin Works

written by FuturisticLawyer
September 1, 2020

Blockchain technology has been praised as one of the greatest inventions of our time right next to electricity, radio, and the internet.[1] The technology has the potential to transform nearly all sectors, industries, and businesses. Compared to other modern disruptive technologies such as artificial intelligence, the Internet of Things, and 3D-printing, the concept of blockchain technology is not easy to understand. There are already thousands of articles online that explain blockchain, but without a background in computer science, mathematics, or software engineering, some of the fundamental concepts can easily get lost in technical jargon. In this series of posts, we are going to understand the basics of blockchain, how it works, and why there has been so much hype surrounding the technology in recent years. I will focus on the first generation of blockchain – cryptocurrencies – with a basis in Bitcoin. Smart contracts and other applications of the technology will be addressed in future posts.

The Internet of Value

One way to think about blockchain technology on a more general level, is like a World Wide Ledger or as the internet of value, while the World Wide Web is the internet of information.[2] Anyone can freely download and run the World Wide Ledger on their PCs. The ledger is based on open-source code, so anyone can develop new applications for it as well.[3] On the World Wide Web, you can access data of all kinds, freely, instantly, and across borders and time zones. On the World Wide Ledger, you can exchange values of all kinds in a similar fashion, almost instantly and nearly without costs. Values could be money, loans, deeds of conveyance, insurance policies, intellectual property rights, personal data, voting rights, development aid, and other kinds of values that can be translated into computer coding. Every exchange of value that has ever occurred can be recorded publicly on the blockchain. And finally, the World Wide Ledger is not owned by anyone but is a common property that can be accessed freely.

Replacing Intermediaries with a Peer-to-Peer Distributed Network

The core-value that blockchain technology offers is a secure way to make transactions without the need for a trusted third party. That is revolutionary in itself because, in today’s society, intermediaries are present everywhere. If you transfer money to a friend, the money would normally go through a bank or another financial service like PayPal or Western Union. If you apply for a social welfare payment, the government will assess if you are eligible by gathering personal data about you. If you share a post with your friends on Facebook, the moderators will inevitably look you over the shoulder like George Orwell’s vision of a Big Brother.

On the blockchain, the human intermediaries are replaced with nodes (single computers) in a peer-to-peer network (a network of computers). A peer-to-peer network is decentralized, which means there is no central authority. Instead, the responsibility to manage the peer-to-peer network is distributed among the nodes.

The innovative aspect of blockchain lies in its ability to create and maintain trust and integrity in a purely peer-to-peer distributed network. [4] Because there is no control mechanism, it is impossible to keep track of who enters the network, which means that even malicious peers that want to undermine and exploit the system are free to join.[5] It also means that there is no one to hold accountable in case a technical error on the network should happen. Because the communication channels cannot be trusted in a peer-to-peer network, the idea behind blockchain technology is that it should be trustless.[6] As long as the majority (51%) of the nodes stay honest, the network can be trusted.

How Bitcoin Solved the Double-Spending Problem 

The concept of blockchain became known to the world in the wake of the global financial crisis in 2008 when the anonymous author Satoshi Nakamoto published the paper: “Bitcoin: A Peer-to-Peer Electronic Cash System“.

In the abstract, Bitcoin is described 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.” [7]

The task of creating a currency based on digital information sounds impossible to begin with[8] – certainly without a trusted third party to verify the transactions. In the physical world, banknotes are strongly protected against forgery, as they are equipped with security features such as unique serial numbers, watermarks, and fluorescent fibers.[9] Physical currencies are also protected against double-spending, simply because when the banknote leaves your hands, it is out of your disposal, and cannot be re-used. In the digital world, however, data can be copied and used over and over again without noticeable limitations.[10]

The traditional solution to the double-spending problem would be to introduce a bank as an intermediary. According to Satoshi Nakamoto, “the problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them.“[11]

Blockchains solution is to keep track of ownership in a giant digital ledger. Assuming that the ledger works correctly a hundred percent of the time, the double-spending problem is solved as the transaction history of every coin can be traced. However, if a third party is needed to manage the ledger and create trust, the main benefits are lost.[12] That is why Bitcoin uses cryptographic hash functions, a consensus mechanism known as proof-of-work, and digital signatures to keep track of transactions, instead of a third party.[13] Each of these three concepts will be comprehensibly explained in the next posts of this series.

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Understanding Blockchain Technology How Bitcoin Works

[1] https://cointelegraph.com/news/crypto-and-blockchain-following-in-the-footsteps-of-man-s-greatest-inventions (opened 20-08-2020).

[2] Don Tapscott & Alex Tapscott (2016), Blockchain Revolution: How the technology behind Bitcoin is changing money, business, and the world. Toronto: Portfolio/Penguin, pg. 6-7.

[3] Ibid.

[4] Daniel Drescher (2017), Blockchain Basics: A Non-Technical Introduction in 25 Steps 1st ed. Edition, pg. 33.

[5] Drescher (2017), pg. 35.

[6] Ivan Tech’s video https://www.youtube.com/watch?v=kE51N84hBxU (17-08-2020)

[7] Satoshi Nakamoti (2008), Bitcoin: A Peer-to-Peer Electronic Cash System, pg. 1.

[8] http://www.michaelnielsen.org/ddi/how-the-bitcoin-protocol-actually-works/ (opened 17-08-2020).

[9] Drescher (2017), pg. 48.

[10] Ibid. pg. 49.

[11] Nakamoti (2008), pg. 2.

[12] Ibid., pg. 1.

[13] See http://billybitco.in/ (opened 17-08-2020).

 

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