Bitcoin went up, bitcoin went down, bitcoin went up again, the Chinese have imposed a ban on it… that’s most of the things we hear about Blockchain. Therefore, when we hear about it we immediately picture in our heads a cybercriminal in the worst case or a speculator in the best.
But this technology goes far beyond its ability to hide from law enforcement (it’s actually pretty bad at that) or to speculate with. This article is dedicated to explaining the basics of how this technology works, and what are its main benefits.
Back in 2008, the world economy was going under the most severe financial crisis since the great depression. This crisis was created by the mala praxis of several financial institutions, which ended up creating an enormous hole in the world economy. At that time, an anonymous person or group of people called Satoshi Nakamoto decided to create Bitcoin, a payments system alternative to the one held by banks and central banks that had created so much damage at the time.
But the challenge was pretty big, we often assume that money has value, but we don’t think about all the things that need to happen for that money to be worth something.
Money like USD, Euros or Swiss Francs has value because they are backed up by the size of their respective economies, the power of their respective governments to charge taxes, and the prestige of their central banks. However, Bitcoin was intended to be an international system, it should be decentralized so nobody had control, and of course, didn’t have any capacity to take taxes.
The solution was that, in order to have any value, the total supply of bitcoins should be fixed so it wouldn’t have the inflationary problems that any currency suffers when money is printed out of control. In this way, there will never be more than 21 million bitcoins, so as demand goes up and supply stays, the same, the value should go up in general, as has happened (this is not financial advice, don’t buy any asset without fully understanding the risks)
But there was a problem, contrary to physical objects, any digital item can be copied indefinitely so that if bitcoin was something similar to a banknote with a reference number, anyone that had that bitcoin could copy it a million times and she suddenly would have a million bitcoins. That's not a feature you want for a currency, especially since we have stated that we want to have a fixed supply of it.
Government currencies solve this issue with the collaboration of banks, settlement entities, and everything under the supervision of the central bank. Bitcoin was not intended to have these institutions, so it was designed to be a decentralized network, in which a series of participants called “miners”, process transactions making sure that nobody spent more bitcoins than they had previously received.
When miners are sure that transactions are legit, they include the transactions in a shared database, and after some time, the transaction is fixed and the receiver will be able to spend that money as well.
But wait, what if one of the miners is actually a bad actor and introduces fraudulent transactions? To solve this problem, to be included in the shared database, it has to be accepted by more than half of the total number of miners on the network.
But wait, what if some bad actor created a lot of miners in order to become the majority of the network? Here is the key to why Blockchain is called that way, it is a Chain of Blocks. In Bitcoin, each block consists of a bundle of the transactions made every 10 minutes or so, which miners take and use to solve a complex mathematical problem that takes a lot of energy and computational power.
The first Miner to solve the problem gains a prize, but if the miner has solved it by introducing invalid transactions, the other miners won’t consider it valid and thus the “bad” actor will lose both the prize and the money spent on solving the problem. For this reason, no bad actor is interested in manipulating bitcoin, because it would lose more money than it could make. This makes the network an extremely secure way to store value without the intervention of any central entity, as everything that is written in the blockchain is confirmed by the majority of miners.
The last main fact you have to be aware of while dealing with blockchain is that contrary to banks, miners don’t have access to your identity while you’re using the network. The only way the network knows that you are you is by a public and private key pair. You can imagine the public key as being your email address, which everyone can know, and your private key as your password, which you’d better keep secret if you don’t want bad actors to mess it up.
The difference between public-private key pairs and the email example is that your keys are a string of numbers and characters which you’re not supposed to remember. That makes them far more secure, so nobody can guess it (as with your password) but at the same time, as you’ll not remember it, you’d better keep it in a safe place. This is extremely important since if you lose your private key you’ll lose your money (there is no Forgot your private key? option in bitcoin) additionally, if someone steals your private key, the network won’t be able to see the difference between the bad guys and you, so you could lose your money as well.
Well, that’s an overview of how bitcoin works, and that’s mostly applicable to the most important blockchains out there, but what does this technology offer us in the real world?
Well, being a decentralized and uncensored payment system is merit on its own. It’s a much cheaper and faster way to move money across borders compared to normal systems. It's also a hedge against hyperinflation given that, even if its price is much less stable than Euros or USD, it’s more stable than some other currencies used in places where access to stable currencies is limited such as Venezuela or Argentina.
But the real potential of this technology is not on its mere use as a currency, but on what you can do with that currency. You can create Smart Contracts, in which based on certain conditions, an amount of money is transferred to an account or another. That’s just like a normal contract, but in a normal contract, its execution depends on the will of the parties, and eventually, only a court can compel them to comply with the contract. Smart Contracts, on the contrary, are executed automatically by the blockchain itself, thus being a perfect way to prevent fraud, but also to avoid incurring lengthy and costly legal battles.
Many networks offer Smart Contract capabilities, but by far the most widely used is the Ethereum Network. The Ethereum network was specifically designed to allow many kinds of smart contract applications, and currently hosts a myriad of Decentralized Finance apps.
However, blockchain technology still has its drawbacks. For starters, it’s hard to get used to it, and its security depends on how well you store your private keys. Additionally, the mining process described above is very electricity-intensive and this is very damaging for the environment, that’s the reason why Etherum, for example, is migrating to Eth 2.0 which is based on a Proof of Stake mechanism that is more efficient and that we will explain in a further article.
Other problems remain as well, such as the difficulties to scale the networks, and the ever-changing transaction fees, there are many solutions to these problems, some blockchains opt to make a compromise between decentralization and scalability, others are creating layer 2 solutions, that provide the best of both worlds, but this technology is still on development and, yes, we will discuss it further in another article.
To summarize, Blockchain allows us to store value safely thanks to its distributed and immutable nature, but it also allows us to allocate that value depending on pre-established conditions, which is perfect to create contracts that execute automatically, saving tons of money and resources on legal claims. The technology is far from perfect right now but is developing in a way that makes clear that it’s going to be a part of our financial future.