Part 1: How do they work?
2017 has seen an explosion in the growth and awareness of Bitcoin and Blockchain. Unfortunately, while many people have heard of the words few really grasp the concepts, and fewer still understand their business value.
In 1989 Tim Berners Lee and his team at CERN created the HTTP protocol and in the process unlocked the internet for the man in the street. The day before this happened information was always localised and contained in a single unit like a letter, book, or fax. As the internet moved into the public sphere one of the first applications that gained widespread use was email. Do you recall those early conversations when some tried to explain how email worked to a planet full of letter senders?
Email works by taking the communication and breaking it up into multiple small pieces and sending them into the vast network of servers across the world. The message pieces or packets move through this network toward the destination account where they are reassembled seconds later and presented in the same format as the sender saw on their screen. In the early 1990’s this digital alchemy was confounding to most and left many individuals cynical and unbelieving despite the evidence in front of them that it worked, and despite the most simple (or complex) explanations given. Blockchain and Bitcoin are the email and internet of the post-information age.
Before we jump into these elements, one final preface. In the world of internet search Google has become the verb by which we describe all search. Whether we are using Bing, Yahoo, or any other search engine we still say that we are going to “Google” it. In the same way, Bitcoin and Blockchain have become synonyms for two technologies that have many more players. Bitcoin is the everyday label for cryptocurrencies, and Blockchain is the generic label for distributed ledger technology.
The Blockchain, or distributed ledgers, does to transactional information what the internet server infrastructure did for email. At its heart, the Blockchain is a ledger like any other that records transactional information. The major difference is that it doesn’t sit in one physical place but is distributed across tens of thousands of computers across the world.
Every ten minutes or so the ledger pulls together the most recent transactions into a “block” of information. But, this block is very noisy and mixed up. Imagine standing at the door of a busy restaurant and trying to listen to any conversations happening inside. From the door, it is one garbled cacophony of voices. Take a ten-minute recording of the noise and that is the same as a block because all of the activity in the environment from ALL of its users has just been bundled together.
This block of transaction data is sent to the tens of thousands of computers around the world linked to that particular ledger. These are small highly efficient and singularly focused machines using a special algorithm that they apply to the data. All of these machines begin to work the data together. Using the restaurant noise illustration, they essentially take the noisy recording and begin to disentangle individual conversations in the room so that they can be heard. The algorithm secures and encrypts the resulting transactional information so that only authorised individuals/machines/accounts can read it. A lot like your email whizzing through cyberspace – anyone who has access to a server can see any email communication that comes across it, but only the sending and receiving machines have the ability to decrypt the info and read it. Anyone can see the information contained in a block, but only authorised individuals can read it.
The 10-minute block of transactions is then connected to the preceding 10 minute’s record, and will likewise be connected to the succeeding 10 minute’s record…. making a chain of blocks, or a Blockchain of authenticated and encrypted transactional data. Using our restaurant analogy, it is the linking together of lots of 10-minute recordings so that a whole evening of conversations may be listened to as one seamless stream.
The blocks are saved and distributed across tens of thousands of machines around the globe. If one machine or record is compromised the fundamental integrity of the Blockchain remains due to the distributed nature of the recording process.
The process of disentangling and authenticating the information in a block is called “mining”. There is a payment of 25 Bitcoin generated by the algorithm per block of information. The 25 Bitcoins are distributed across the machines that authenticated the block and deposited into a “wallet” for use in any environment that will accept them (more on that in part 2 of this series).
To understand this process it is easier to think of gold than money. We get gold by accessing a body of ore under the ground. How does the gold in a gold bar or piece of jewellery get there?
- Dig holes in the ground,
- Blast underground rock into pieces,
- Haul it to the surface,
- Crush the rock into powder,
- Add cyanide and other chemicals to the rock,
- Remove the metal,
- Put it into a furnace,
- Pour out the gold,
- Use the gold for economic or decorative purposes.
In the process outlined above did we ever create the gold? No, it was always there we simply used a process to unlock it from the rock and repurpose it for our needs. In the underlying algorithm that created the Blockchain 21 million Bitcoin were embedded as the reward for the authentication process. They aren’t created at the end of each 10-minute cycle, like gold they are merely released from the underlying “ore”/algorithm.
Over time as we mine gold we need to dig deeper and deeper to get to additional ore bodies – the Mponeng gold mine in South Africa is the deepest mine in the world operating 3.9 km below the surface. There is an extra cost in reaching these deeper bodies, with the price of gold determining whether it is economically viable to keep incurring the additional cost. A similar dynamic has been built into the Bitcoin mining algorithm. The bitcoin algorithm has a built in process called “halving”. Every 210,000 blocks the reward offered for authenticating each block is halved, essentially requiring twice as much effort for the same reward.
The biggest input cost for mining is the cost of energy so halving impacts the network by making it less economically viable to mine in some parts of the world than others as the Bitcoin payment generated may be less than the cost of energy consumed to authenticate the block. This is where the rapid increase in the price of Bitcoin comes into play.
There is a basic supply and demand dynamic around Bitcoin. Like gold, there is a limited amount in circulation so the more demand there is for it the higher the price moves. As countries like Japan and online platforms like eBay and Amazon begin to allow payment for normal goods in Bitcoin the demand for available currency increases and the price rises – causing some to buy Bitcoin for its investment, not trading value, and like gold just hold it, effectively decreasing the amount in circulation and pushing the value up even more.
The rising value of Bitcoin offsets the erosion of halving and in the process generates a thriving and functional financial ecosystem that obeys all of the rules of basic economic theory, while fundamentally discarding them at the same time.
The Internet of Money
In summary, what cryptocurrencies like Bitcoin and distributed ledgers like Blockchain have done is that they have created what is essentially the internet of money…. and, when money changes – EVERYTHING changes.
Note: This series of articles is written to understand the basic concepts in play and not meant to deal with more detailed information like Hash, Difficulty, etc…..
Part 2 and 3
In the following articles in this series we will look at some of the dynamics happening within this space, some of the key platforms, what is being built on these platforms, and what value they add to business today. TomorrowToday Global tracks trends related to the future of work, so we will also look at the future of this internet of money.