Advances in the digital world have given us better accessibility and faster access to information, but it comes at the price of privacy. Blockchain technology and its Bitcoin initiative offer a way to decentralize your data and financial accounts. With the latest Bitcoin craze, there is a mind-dazzling array of information that is scattered around the Internet. How do you make sense of it all? We’ve broken down the basics to help you fully understand blockchain technology and the value of the digital currency.
Understanding Blockchain Technology
Before we get into blockchain technology, it’s important to understand that Bitcoin is not the same as blockchain. The two technologies are often used interchangeably, but Bitcoin is a digital currency built on blockchain technology. Blockchain is a technology that can support the digital currency of Bitcoin, but it can also support so much more.
In the simplest sense, blockchain is a digital ledger. Imagine that you need to keep track of all your financial transactions including debit and credits. Every debit and credit is appended to the previous record, and the end result is the net amount of money that you have in your account. When you purchase a product, you add a debit from your account. Even if you return purchased products to a vendor, your transaction is not edited. Instead, you append a new record to the ledger that indicates a credit for the return. The net result is a zero-dollar change in your account balance, but both transactions are still recorded and stored.
In a centralized database, a debit can potentially be changed by one entity in control of the database. You have no knowledge of who made a change because it’s done by a database administrator behind a firewall. Blockchain offers a way to add accountability and protection from a single entity changing values without your knowledge. It’s a decentralized and immutable database that provides a copy of transactions to every contributing user. These users can’t see your private data, but any changes to your financial transactions are replicated to a public ledger where no single centralized entity can make changes.
Since Bitcoin is built on blockchain technology, you have a digital currency with transactions that cannot be controlled by one person, and this includes attackers that could otherwise debit your account without your knowledge. Since no single centralized database exists, an attacker can’t make changes to your financial account like a centralized bank can, since all users on the blockchain network have copies that reject those changes.
Mining Bitcoin or Any Cryptocurrency
When we discuss digital currency, the initial deployment of a new blockchain requires coins that are often given to the original creator, but you also need additional coins produced by contributing members called “miners.” Miners dedicate their computers (often specialized mining computers) to creating a digital currency.
New coins are created by using a computer (or a pool of computers) to solve a mathematical puzzle. A miner that solves the mathematical challenge is first verified by other miners and — if the solution is correct — given a new coin. A new coin added to the blockchain ledger is distributed to all database holders in the network, so no single entity decides who can add more coins.
As more miners pool together, competition for new coins increases. In addition to new competition, a miner must also consider costs of electricity. Paying more for electricity than the value of new Bitcoins leaves the miner operating in the red, which is therefore financially unrewarding. If you’ve ever thought of mining Bitcoin, you should consider electricity costs before you buy equipment. Each mining machine lists an electrical efficiency value used to determine if mining is worth the cost to run an operation. Calculate the total costs and potential profit to determine if it’s worth buying Bitcoin on an exchange rather than outright investing in equipment and electrical costs.
Proof of Work and Proof of Stake
As with any type of technology open to the public, mining Bitcoin requires cybersecurity integrated into its procedures. Security on a blockchain involves protection from a single entity making changes that could threaten the stability and reliability of the chain. You don’t want one miner gaining control of a blockchain, and you don’t want an attacker making changes to a distributed database. This problem is solved by using two security concepts called “proof of work (PoW)” and “proof of stake (PoS)”.
PoW was introduced to Bitcoin by its original creator Satoshi Nakamoto. Since blockchain’s goal is to stay decentralized, it’s imperative that the majority of contributors to the ledger come to a consensus and stay “honest” when adding blocks. The idea is that the environment offers a “trustless system” due to the nature of decentralizing the database. No single entity can be trusted, so PoW adds a way to establish trust with every new block. With PoW, a “leader” is elected to distribute changes to the blockchain.
Selecting a leader using the PoW method requires hashing algorithms that must be solved to verify that a miner’s new block can be legitimately added. The cost to attack a blockchain and trick all contributors into changing data in the blocks costs too much, so no incentive exists for any one entity to attack the integrity of the chain.
PoW was originally effective, but an increase in computing power made it vulnerable to an exploit called the 51% attack. With enough power, miners can steal currency regardless of a delegated leader. Several cryptocurrencies have already suffered from a 51% attack. PoS was then introduced to acknowledge and provide a solution to vulnerabilities associated with PoW.
PoS requires miners to lock a percentage of their digital currency’s worth to become the next “leader.” A miner can only mine a percentage of currency that he currently holds. The miner would need to obtain 51% of global cryptocurrency value to attack the network, but he would then be working against himself. By invalidating 51% of the blockchain in a PoS, costs are too expensive and would harm the miner’s best interest. This is the theory behind PoS and ensures trust on a trustless network.
Mining cryptocurrency, including Bitcoin, is lucrative, but understanding these concepts can be tedious for a new miner. The cryptocurrency industry is filled with scams, so do your research and understand these concepts before diving in.
Ethereum and Blockchain Technology
Before you dive into cryptocurrency, mining and blockchain, one last concept is essential to your understanding – Ethereum. When doing your research, you’ll undoubtedly come across Ethereum references. Ethereum is also built on blockchain technology, yet its purpose is different from Bitcoin. It can be confusing if you’re new in the game.
Bitcoin was created as a digital currency, but Ethereum utilises its own technology built on blockchain to provide distributed applications. Ethereum developers pay for application transactions using ETH currency (called “gas”) to pay for their transactions. When thinking of Ethereum, think of it as a developer platform used to make distributed applications on a blockchain, with developers paying for their activity using Ethereum’s own digital currency.
Following roaring interest and a boom in the value of Bitcoin, numerous other digital currencies have been introduced. Regardless of the coin, any new digital currency is built on blockchain, which has proven to be a revolutionary solution to much of the problems surrounding privacy and centralized control in traditional banking systems. Whether you decide to mine Bitcoin or any other cryptocurrency, understanding blockchain will help you identify the ones with value and invest in your own solution.