Cryptocurrency terms to know.
HODL. DApp. Ethereum.
No, these are not words from a newly-discovered alien language. They’re among the many new and key terms in the language of cryptocurrency.
Cryptocurrency isn’t just a novel investment option, and in many ways represents a different world altogether compared to traditional stocks and bonds. Between unfamiliar acronyms, emerging technologies, and keeping up with memes and tweets, just learning the basics takes time, even for seasoned traditional investors.
As with any investment, it’s important to understand exactly what you’re investing in before you start. That’s especially true when it comes to a speculative — and still evolving — asset like crypto.
Crypto Terms You Should Know.
An altcoin is any coin that’s not Bitcoin. Altcoins can be anything from the second-most popular coin, Ethereum, to any of the thousands of coins with very minimal market value. Experts say you should largely stick to the bigger, more mainstream cryptocurrencies as an investment.
The first and most valuable cryptocurrency, launched on Jan. 3, 2009. While its value has climbed steadily since then, it has seen wild fluctuations. In the past months alone, the price of Bitcoin has fluctuated from a record high of $60,000 to below $30,000.
A peer-to-peer electronic cash system that formed from a fork of the original Bitcoin. Where Bitcoin is widely accepted as too volatile to be useful as a currency, Bitcoin Cash is designed to be better optimized for transactions.
Groups of data within a blockchain. On cryptocurrency blockchains, blocks are made up of transaction records as users buy or sell coins. Each block can hold only a certain amount of information. Once it reaches that limit, a new block is formed to continue the chain.
A digital form of record keeping, and the underlying technology behind cryptocurrencies. A blockchain is the result of sequential blocks that build upon one another, creating a permanent and unchangeable ledger of transactions (or other data).
A representative store of digital value that lives on a given blockchain or cryptocurrency network. Some blockchains have the same name for both the network and the coin, like Bitcoin. Others can have different names for each, like the Stellar blockchain, which has a native coin called Lumen.
A popular centralized cryptocurrency exchange. Coinbase made history recently as the first cryptocurrency exchange to go public on the Nasdaq.
Cold Wallet/Cold Storage
A secure method of storing your cryptocurrency completely offline. Many cold wallets (also called hardware wallets) are physical devices that look similar to a USB drive. This kind of wallet can help protect your crypto from hacking and theft, though it also comes with its own risks – like losing it, along with your crypto.
A type of currency that’s digital and decentralized. Cryptocurrency can be used to buy and sell things, or as a long-term store of value.
The principle of distributing power away from a central point. Blockchains are traditionally decentralized because they require majority approval from all users to operate and make changes, rather than a central authority.
Decentralized Finance (DeFi):
Financial activities conducted without the involvement of an intermediary, like a bank, government, or other financial institution.
Decentralized Applications (DApps):
Applications designed by developers and deployed on a blockchain to carry out actions without intermediaries. Decentralized finance activities are often completed using decentralized apps. Ethereum is the main network supporting activities in decentralized finance.
Experts sometimes compare specific cryptocurrencies to real gold based on the way it can store and increase in value. Bitcoin is commonly referred to as digital gold.
The second largest cryptocurrency by trade volume, Ethereum is a crypto network and software platform that developers can use to create new applications, and has an associated currency called ether.
A cryptocurrency exchange is a digital marketplace where you can buy and sell cryptocurrency.
When a blockchain’s users make changes to its rules. These changes to the protocol of a blockchain often result in two new paths — one that follows the old rules, and a new blockchain that splits off from the previous one. (Example: a fork of Bitcoin resulted in Bitcoin Cash).
A fee that developers have to pay to the Ethereum network in order to use the system. Gas is paid in ether, the native cryptocurrency of Ethereum.
The first block of a cryptocurrency ever mined.
Stands for “Hold On for Dear Life” though the term originated from a user typo on a Bitcoin forum in 2013. It refers to a passive investment strategy in which people buy and hold onto cryptocurrency — instead of trading it — in the hopes that it increases in value.
A feature written into Bitcoin’s code in which after a certain number of blocks are mined (typically every four years) the amount of new Bitcoin entering circulation gets halved. The halving can have an impact on Bitcoin’s price.
A unique string of numbers and letters that identify blocks and are tied to crypto buyers and sellers.
A software-based cryptocurrency wallet connected to the Internet. While more convenient for quickly accessing your crypto, these wallets are a bit more susceptible to hacking and cybersecurity attacks than offline wallets — just as files you store in the cloud may be more easily hacked than those locked in a safe in your home.
Initial Coin Offering (ICO):
A way that funds are raised for a new cryptocurrency project. ICOs are similar to Initial Public Offerings (IPOs) of stocks.
Cryptocurrency market capitalization refers to the total value of all the coins that have been mined. You can calculate a crypto’s market cap by multiplying the current number of coins by the current value of the coins.
The process whereby new cryptocurrency coins are made available and the log of transactions between users is maintained.
A computer that connects to a blockchain network.
Non-fungible Tokens (NFTs):
Non-fungible tokens are units of value used to represent the ownership of unique digital items like art or collectibles. NFTs are most often held on the Ethereum blockchain.
Two users interacting directly without a third party or intermediary.
Your wallet’s address, which is similar to your bank account number. You can share your public wallet key with people or institutions so they can send you money or take money from your account when you authorize it.
The encrypted code that allows direct access to your cryptocurrency. Like your bank account password, you should never share your private key.
The pseudonymous creator of Bitcoin. No one knows the true identity of Nakomoto — or if it’s more than one person.
An algorithmic program that enacts the terms of a contract automatically based on its code. One of the main value propositions of the Ethereum network is its ability to execute smart contracts.
Stablecoin or Digital Fiat:
A stablecoin pegs its value to some other non-digital currency or commodity. A digital fiat represents a fiat, or government-backed currency on the blockchain. (Example: Tether, which is pegged to the U.S. dollar)
A unit of value on a blockchain that usually has some other value proposition besides just a transfer of value (like a coin).
Programmer who invented Ethereum in 2015.
A place to store your cryptocurrency holdings. Many exchanges offer digital wallets. Wallets may be hot (online, software-based) or cold (offline, usually on a device).
What is cryptocurrency?
Cryptocurrency refers to a digital currency, secured with cryptography to enable trusted transactions. Blockchain is the underlying technology, functioning as a ‘ledger’ or record of transactions made.
Hundreds of currencies are in circulation, such as Bitcoin, Ether, Monero, etc. Each is designed by one or more brilliant individuals, usually meant to run as a decentralised system so that no single entity can control it.
Cryptocurrency units are usually generated on the basis of an algorithm announced to everyone in advance, by ‘miners’ using powerful computers. Having expended a lot of time and electricity on ‘mining’, these miners can hold on to the units or sell to others.
How is crypto stored?
Let’s look at a national currency like the rupee. It can be deposited in your name at a bank, or privately stuffed into a mattress at home far away from anyone’s eyes.
Similarly, a cryptocurrency can be held on your behalf by a company, usually in your wallet at a crypto exchange online. You could also hold it in without being affiliated to anybody, in a private cryptocurrency wallet.
What is the purpose of cryptocurrency?
As indicated by ‘currency’, they were originally intended to be used in the same way as rupees and dollars are, as a medium of payment between people for products and services purchased.
Consider store reward cards, an alternative physical payment method that is denominated in their own units, and not in national currency. Similarly, cryptocurrency with its own units was meant to enable easy digital transactions online, at lower costs than what conventional banks charged.
Is cryptocurrency used for illegal activities?
Initially with no government control, crypto became a useful tool to escape political censors and repressive regimes, which was an admirable goal. However, crypto eventually became known as a method of transacting for illegal substances on hidden parts of the internet.
Governments discourage such behavior and made use of crypto’s built-in ledger to pursue criminals. With the extent of tracking that is now possible in 2021, it is safe to say that it is difficult to use cryptocurrency for crime. Bitcoin for instance, sees over 300,000 transactions daily on average, with crypto exchange trades accounting for over half of them in the last two years.
How does supply and demand work in the cryptocurrency market?
Some cryptocurrencies like Bitcoin and Ether are designed to have a limited supply. By comparison, real-world currencies like the US Dollar do not have a hard limit on supply. When demand increases, the value of a supply-limited item is expected to increase.
That difference in supply, a high demand for crypto and new ways to profit from rising crypto, have led to a self-perpetuating cycle that drives up the exchange value of major cryptocurrencies.
How to start trading in cryptocurrencies?
Fundamentally, a seller sells their currency to gain cash and a buyer buys expecting to hold the currency until its value increases in dollar/rupee terms.
In mid-August 2021, the total market value of all cryptocurrency exceeded $2 trillion, with Bitcoin alone making up 44% of that. As the graph above shows, a currency can start small and reach very high – but with a number of bumps along the way.
People with a lot of faith in the future of cryptocurrencies subscribe to a ‘HODL’ mindset, meaning ‘hold on for dear life’ to the roller-coaster they expect to ride. They buy and do not intend to sell anytime soon, even claiming that the value of one Bitcoin could rise from $50,000 today to $288,000 in a few years.
Others choose the day trading route – buy a currency, target a profit percentage as low as 2% and sell as soon as that target is reached – sometimes within hours.
How to trade in cryptocurrencies in a safe way?
For beginners in the crypto market, experts advise investing only as much money as you’re willing to lose. The reason is, crypto trading marries the ‘irrational exuberance potential’ of a conventional stock market to the regulatory uncertainty of crypto.
Also, hackers have shown that anything financially valuable on the internet is a juicy target. However, crypto exchanges that hold user wallets try to stay safe by employing armies of security experts and paying ‘bug bounties’ to external consultants who identify vulnerabilities.
What questions should I be asking about crypto?
The first question one may have to address is which currency to buy. The biggest one, Bitcoin, would be a good starting point to begin investing right away.
One could later branch into other coins and tokens as per observations/confidence. As with stocks, researching the cryptocurrency of choice is always helpful.
The second question is adopting a safe trading method. To begin with, a simple ‘buy and hold’ may be preferable. Long term investors could carry over the ‘rupee cost averaging’ (RCA) low-risk strategy from the stock market.
An example of RCA would be setting a budget of $100 a month, and buying crypto for exactly that much regularly each month, regardless of price dips or peaks. After gaining confidence, many more strategies could be used.
The third question would be choosing a crypto exchange. Picking a well-known exchange backed by big names internationally, one that is likely to still be growing 2-3 years later could allow peace of mind that one’s investment is safe. The most used and trusted exchange is Coinbase.
After gaining confidence, one could consider comparing exchanges on factors such as currency pairs offered, transaction costs, ease of transaction, security, leverage availability, futures, NFT purchases, earnings from DeFi lending, and so on.
How do I make money by trading cryptocurrencies?
There are three things to be aware of when one is ready to take profits on investment. Like all business, trading in crypto has additional expenses to keep in mind.
First of all, exchange transaction fees that apply to all actions between infusing cash and exiting investments at a profit.
Secondly, unexpected movements in price could mean holding onto crypto for longer than initially expected.
Thirdly, taxes that fall due at the end of the year. Depending on income tax bracket, people may have differing minimum profit targets. Frequently forgotten until the end of the financial year, keeping this factor in mind could help one enjoy their gains in moderation.
What is blockchain? The technology behind cryptocurrency, explained.
Blockchain is the core technology behind bitcoin and thousands of cryptocurrencies and has promising potential beyond digital currencies.
Blockchain technology might be one of the most-hyped innovations of the 21st century. Developed to support bitcoin, blockchains now power thousands of cryptocurrencies, and developers are working on integrating the technology into businesses, including medicine, art and finance.
To understand the growing interest, it can be helpful to understand how blockchain works, why it has value and what makes it different from other internet technologies.
Blockchain: A definition
A blockchain is a digital ledger of transactions maintained by a network of computers in a way that makes it difficult to hack or alter. The technology offers a secure way for individuals to deal directly with each other, without an intermediary like a government, bank or other third party.
The growing list of records, called blocks, is linked together using cryptography. Each transaction is independently verified by peer-to-peer computer networks, time-stamped and added to a growing chain of data. Once recorded, the data cannot be altered.
While popularized with the growing use of bitcoin, ethereum and other cryptocurrencies, blockchain technology has promising applications for legal contracts, property sales, medical records and any other industry that needs to authorize and record a series of actions or transactions.
How it works: Blockchain explained
Using the bitcoin system as an example, here’s how blockchain — also known as distributed ledger technology — works:
The purchase and sale of bitcoin is entered and transmitted to a network of powerful computers, known as nodes.
This network of thousands of nodes around the world vie to confirm the transaction using computer algorithms. This is known as bitcoin mining. The miner who first successfully completes a new block is rewarded with bitcoin for their work. These rewards are paid with a combination of newly minted bitcoin and network fees, which are passed on to the buyer and seller. The fees can rise or fall depending on the volume of transactions.
After the purchase is cryptographically confirmed, the sale is added to a block on the distributed ledger. The majority of the network must then confirm the sale.
The block is permanently chained to all previous blocks of bitcoin transactions, using a cryptographic fingerprint known as a hash, and the sale is processed.
The concept of blockchain technology first appeared in academic papers from 1982, in a dissertation discussing “the design of a distributed computer system that can be established, maintained, and trusted by mutually suspicious groups.” But it was a 2008 paper by the pseudonymous Satoshi Nakamoto titled “Bitcoin: A Peer-to-Peer Electronic Cash System” that brought an academic theory into real-world use.
Blockchain technology: Pros and cons
Using bitcoin as an example, here are some of the pros and cons of how blockchain technology works when applied to cryptocurrencies.
While the U.S. dollar is issued by the Federal Reserve, no government agency issues or controls bitcoin and other cryptocurrencies. This also means that the ability of any one government or agency to determine the fate of a public blockchain is eliminated. The lack of intermediaries reduces cost, as the fees associated with third-party transactions also are eliminated. Another byproduct of how blockchain works is time efficiency — the blockchain is open for business 24 hours a day, 365 days a year, unlike banks and other intermediaries.
Transparency plus anonymity
All transactions on the Bitcoin blockchain are recorded on computers across the network. Transactions are completely transparent because the address and transaction history of bitcoin wallets, which hold the cryptocurrency, are publicly viewable, but the owners of each wallet connected to those public addresses are anonymous and not recorded.
Accuracy and security
Because the transaction involves little human interaction, there is a lower risk of error. Each transaction must be confirmed and recorded by a majority of the network nodes, which makes it vanishingly difficult to manipulate or alter information. This also prevents anyone from spending a bitcoin more than once.
Public and private blockchain applications
Blockchain technology creates efficiencies that potentially extend far beyond digital currencies. For example, bitcoin is on a public blockchain network, meaning anyone can join. But many applications for business can be created on private blockchain networks, where organizations can control who joins:
Blockchain supply chain: Companies such as IBM Blockchain are already providing private network solutions using blockchain technology to more accurately track product supply chains. For example, companies can use the technology quickly find out where recalled food products have been shipped and sold.
Health care records: Deloitte Consulting has suggested that a nationwide blockchain network for electronic medical records “may improve efficiencies and support better health outcomes for patients.”
Smart contracts: With blockchain technology, contract terms can automatically be changed or updated based on hitting a predetermined set of conditions.
Digital elections: Some developers are working on blockchain technology to be applied to elections.
Property transactions: Proponents say blockchain technology can be applied to a wide range of asset sales, be it real estate, autos or investment portfolios.
Opportunities for the under-banked
In countries and regions with poor or corrupt financial institutions, cryptocurrencies based on blockchain protocol allow the transfer and holding of cash that bypasses unscrupulous third parties.
Criminals like crypto
Like a lot of new technologies, some of the first adopters have been criminal enterprises. They use cryptocurrencies such as bitcoin both as payment because of the privacy it provides and to target holders of bitcoin for scams. For example, bitcoin was used by consumers of Silk Road, a black market online shopping network for illegal drugs and other illicit services that was shut down by the FBI in 2013. In the recent ransomware attack on Colonial Pipeline, the company paid $4.4 million in cryptocurrency to unlock its computer systems.
Meanwhile, bitcoin investment scams have skyrocketed in tandem with its recent historic rise. The Federal Trade Commission reported nearly 7,000 people lost $80 million from October 2020 through March 2021 in schemes touting quick returns, a nearly 1,000% rise in reported losses year-on-year.
Blockchain cryptocurrencies are highly volatile
Some people wonder, "Is blockchain a good investment?" That depends on your investing goals and your risk tolerance. The popularity of cryptocurrency exploded in 2021, as bitcoin hit a record spot price of nearly $65,000 in April. But owing to its inherent volatility, the price of bitcoin dropped nearly 50% by early June — then began to climb again.
Crypto use is still niche
Many more exchanges, brokerages and payment apps now sell bitcoin, and many companies such as PayPal and Microsoft accept bitcoin for payment. Still, purchases with blockchain currencies such as bitcoin remain the exception, not the rule. Also, the sale of bitcoin for purchases on cash apps such as PayPal requires users to pay capital gains taxes on the bitcoin sold, beyond whatever state and local taxes are paid on the product or service.
Bitcoin mining takes energy
The process of bitcoin mining uses a network of high-speed computers that consume a lot of energy. If the bitcoin system were a country, it would be the 34th biggest consumer of electricity, behind the Netherlands and ahead of the Philippines, according to the University of Cambridge Electricity Consumption Index. Tesla CEO Elon Musk announced in May 2021 that the carmaker would no longer accept bitcoin until the cryptocurrency can find ways to reduce its carbon footprint. Developers of other blockchains have come up with less energy-intensive options.
Bitcoin blockchain is slow
The bitcoin blockchain can process about seven new transactions a second. By comparison, credit card giant Visa says it can process 24,000 transactions per second, according to the company. That presents the bitcoin system with a scalability problem. Other forms of blockchain-based cryptocurrency are working on this problem. An eagerly anticipated upgrade of the Ethereum system, known as Ethereum 2.0, is expected to be capable of handling 10,000 transactions per second, up from its current rate of 30 per second.
The future of blockchain technology
While the bitcoin system is the best-known application of blockchain technology, there are thousands of cryptocurrencies that are built on the back of this emerging technology. While it remains to be seen if bitcoin will succeed in supplanting other forms of traditional payment methods, the applications of blockchain technology are growing fast, and proponents say they may lead to dramatic changes across industries.
How does blockchain work?
How Does the Blockchain Work?
Blockchain technology explained
Blockchain technology is probably the best invention since the internet itself.
It allows value exchange without the need for trust or a central authority. Imagine you and I bet $50 on tomorrow’s weather in San Francisco. I bet it will be sunny, you that it will rain. Today we have three options to manage this transaction:
We can trust each other. Rainy or sunny, the loser will give $50 to the winner. If we are friends, this could be a good way of managing it. However, friends or strangers, one can easily not pay the other.
We can turn the bet into a contract. With a contract in place both parties will be more prone to pay. However, should either of the two decide not to pay, the winner will have to pay additional money to cover legal expenses and the court case might take a long time. Especially for a small amount of cash, this doesn’t seem like the optimal way to manage the transaction.
We can involve a neutral third party. Each of us gives $50 to a third party, who will give the total amount to the winner. But hey, she could also run away with all our money. So we end up with one of the first two options: trust or contract.
Neither trust nor contract is an optimal solution: We can’t trust strangers, and enforcing a contract requires time and money. The blockchain technology is interesting because it offers us a third option which is secure, quick, and cheap.
Blockchain allows us to write a few lines of code, a program running on the blockchain, to which both of us send $50. This program will keep the $100 safe and check tomorrow’s weather automatically on several data sources. Sunny or rainy, it will automatically transfer the whole amount to the winner. Each party can check the contract logic, and once it’s running on the blockchain it can’t be changed or stopped. This may be too much effort for a $50 bet, but imagine selling a house or a company.
This article explains how the blockchain works without discussing the technical details in depth, but by digging just enough to give you a general idea of the underlying logic and mechanisms.
The Basics of Bitcoin
The most known and discussed application of the blockchain technology is bitcoin, a digital currency that can be used to exchange products and services, just like the U.S. dollar, euro, Chinese yuan, and other national currencies. Let’s use this first application of the blockchain technology to learn how it works.
“Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.”
— Marc Andreessen
One bitcoin is a single unit of the Bitcoin (BTC) digital currency. Just like a dollar, a bitcoin has no value by itself; it has value only because we agree to trade goods and services to bring more of the currency under our control, and we believe others will do the same.
To keep track of the amount of bitcoin each of us owns, the blockchain uses a ledger, a digital file that tracks all bitcoin transactions.
Fig. 1 - Bitcoin ledger digital file simplified
The ledger file is not stored in a central entity server, like a bank, or in a single data center. It is distributed across the world via a network of private computers that are both storing data and executing computations. Each of these computers represents a “node” of the blockchain network and has a copy of the ledger file.
If David wants to send bitcoins to Sandra, he broadcasts a message to the network that says the amount of bitcoin in his account should go down by 5 BTC, and the amount in Sandra’s account should increase by the same quantity. Each node in the network will receive the message and apply the requested transaction to its copy of the ledger, updating the account balances.
Fig. 2 - Transaction request message simplified
The fact that the ledger is maintained by a group of connected computers rather than by a centralized entity like a bank has several implications:
In our bank system we only know our own transactions and account balances; on the blockchain everyone can see everyone else’s transactions.
While you can generally trust your bank, the bitcoin network is distributed and if something goes wrong there is no help desk to call or anyone to sue.
The blockchain system is designed in such a way that no trust is needed; security and reliability are obtained via special mathematical functions and code.
We can define the blockchain as a system that allows a group of connected computers to maintain a single updated and secure ledger. In order to perform transactions on the blockchain, you need a wallet, a program that allows you to store and exchange your bitcoins. Since only you should be able to spend your bitcoins, each wallet is protected by a special cryptographic method that uses a unique pair of distinct but connected keys: a private and a public key.
If a message is encrypted with a specific public key, only the owner of the paired private key can decrypt and read the message. The reverse is also true: If you encrypt a message with your private key, only the paired public key can decrypt it. When David wants to send bitcoins, he needs to broadcast a message encrypted with the private key of his wallet. As David is the only one who knows the private key necessary to unlock his wallet, he is the only one who can spend his bitcoins. Each node in the network can cross-check that the transaction request is coming from David by decrypting the message with the public key of his wallet.
When you encrypt a transaction request with your wallet’s private key, you are generating a digital signature that is used by blockchain computers to verify the source and authenticity of the transaction. The digital signature is a string of text resulting from your transaction request and your private key; therefore it cannot be used for other transactions. If you change a single character in the transaction request message, the digital signature will change, so no potential attacker can change your transaction requests or alter the amount of bitcoin you are sending.
Fig. 3 - Digital Signature transaction encryption simplified
To send bitcoin you need to prove that you own the private key of a specific wallet as you need the key to encrypt your transaction request message. Since you broadcast the message only after it has been encrypted, you never have to reveal your private key.
Tracking Your Wallet Balance
Each node in the blockchain is keeping a copy of the ledger. So, how does a node know your account balance? The blockchain system doesn’t keep track of account balances at all; it only records each and every transaction that is verified and approved. The ledger in fact does not keep track of balances, it only keeps track of every transaction broadcasted within the bitcoin network (Fig. 4). To determine your wallet balance, you need to analyze and verify all the transactions that ever took place on the whole network connected to your wallet.
Fig. 4 - Blockchain Ledger
This “balance” verification is performed based on links to previous transactions. In order to send 10 bitcoins to John, Mary has to generate a transaction request that includes links to previous incoming transactions that add up to at least 10 bitcoins. These links are called “inputs.” Nodes in the network verify the amount and ensure that these inputs haven’t been spent yet. In fact, each time you reference inputs in a transaction, they are deemed invalid for any future transaction. This is all performed automatically in Mary’s wallet and double-checked by the bitcoin network nodes; she only sends a 10 BTC transaction to John’s wallet using his public key.
Fig. 5 - Blockchain transaction request structure
So, how can the system trust that input transactions are valid? It checks all the previous transactions correlated to the wallet you use to send bitcoins via the input references. To speed up the verification process, a special record of unspent transactions is kept by the network nodes. Thanks to this security check, it is not possible to double-spend bitcoins.
Owning bitcoins means that there are transactions written in the ledger that point to your wallet address and haven’t been used as inputs yet. All the code to perform transactions on the bitcoin network is open source; this means that anyone with a laptop and an internet connection can operate transactions. However, should there be a mistake in the code used to broadcast a transaction request message, the associated bitcoins will be permanently lost.
Remember that since the network is distributed, there is no customer support to call nor anyone who could help you restore a lost transaction or forgotten wallet password. For this reason, if you are interested in transacting on the bitcoin network, it’s a good idea to use the open source and official version of bitcoin wallet software (such as Bitcoin Core), and to store your wallet’s password or private key in a very safe repository.
But Is It Really Safe? And Why Is It Called Blockchain?
Anyone can access the bitcoin network via an anonymous connection (for example, the TOR network or a VPN network), and submit or receive transactions revealing nothing more than his public key. However if someone uses the same public key over and over, it’s possible to connect all the transactions to the same owner. The bitcoin network allows you to generate as many wallets as you like, each with its own private and public keys. This allows you to receive payments on different wallets, and there is no way for anyone to know that you own all these wallets’ private keys, unless you send all the received bitcoins to a single wallet.
The total number of possible bitcoin addresses is 2¹⁶⁰
This large number protects the network from possible attacks while allowing anyone to own a wallet.
With this setup, there is still a major security hole that could be exploited to recall bitcoins after spending them. Transactions are passed from node to node within the network, so the order in which two transactions reach each node can be different. An attacker could send a transaction, wait for the counterpart to ship a product, and then send a reverse transaction back to his own account. In this case, some nodes could receive the second transaction before the first and therefore consider the initial payment transaction invalid, as the transaction inputs would be marked as already spent. How do you know which transaction has been requested first? It’s not secure to order the transactions by timestamp because it could easily be counterfeit. Therefore, there is no way to tell if a transaction happened before another, and this opens up the potential for fraud.
If this happens, there will be disagreement among the network nodes regarding the order of transactions each of them received. So the blockchain system has been designed to use node agreement to order transactions and prevent the fraud described above.
The bitcoin network orders transactions by grouping them into blocks; each block contains a definite number of transactions and a link to the previous block. This is what puts one block after the other in time. Blocks are therefore organized into a time-related chain (Fig. 6) that gives the name to the whole system: blockchain.
Fig. 6 — The block chain sequence structure simplified
Transactions in the same block are considered to have happened at the same time, and transactions not yet in a block are considered unconfirmed. Each node can group transactions into a block and broadcast it to the network as a suggestion for which block should be next. Since any node can suggest a new block, how does the system agree on which block should be the next?
To be added to the blockchain, each block must contain the answer to a complex mathematical problem created using an irreversible cryptographic hash function. The only way to solve such a mathematical problem is to guess random numbers that, combined with the previous block content, generate a defined result. It could take about a year for a typical computer to guess the right number and solve the mathematical problem. However, due to the large number of computers in the network that are guessing numbers, a block is solved on average every 10 minutes. The node that solves the mathematical problem acquires the right to place the next block on the chain and broadcast it to the network.
And what if two nodes solve the problem at the same time and send their blocks to the network simultaneously? In this case, both blocks are broadcast and each node builds on the block that it received first. However, the blockchain system requires each node to build immediately on the longest blockchain available. So if there is ambiguity about which is the last block, as soon as the next block is solved, each node will adopt the longest chain as the only option.
Fig.7 - End of chain ambiguity logic
Due to the low probability of solving blocks simultaneously, it’s almost impossible that multiple blocks would be solved at the same time over and over, building different “tails,” so the whole blockchain stabilizes quickly to one single string of blocks that every node agrees on.
A disagreement about which block represents the end of the chain tail opens up the potential for fraud again. If a transaction happens to be in a block that belongs to a shorter tail (like block B in Fig. 7), once the next block is solved, this transaction, along with all others in its block, will go back to the unconfirmed transactions.
Transactions in the Bitcoin blockchain system are protected by a mathematical race: Any attacker is competing against the whole network.
Let’s see how Mary could leverage this end-of-chain ambiguity to perform a double-spending attack. Mary sends money to John, John ships the product to Mary. Since nodes always adopt the longer tail as the confirmed transactions, if Mary could generate a longer tail that contains a reverse transaction with the same input references, John would be out of both his money and his product.
Fig. 8 - Mary’s double-spending attack
How does the system prevent this kind of fraud? Each block contains a reference to the previous block (see Fig. 6). That reference is part of the mathematical problem that needs to be solved in order to spread the following block to the network. So, it’s extremely hard to pre-compute a series of blocks due to the high number of random guesses needed to solve a block and place it on the blockchain. Mary is in a race against the rest of the network to solve the math problem that allows her to place the next block on the chain. Even if she solves it before anyone else, it’s very unlikely she could solve two, three, or more blocks in a row, since each time she is competing against the whole network.
Could Mary use a super fast computer to generate enough random guesses to compete with the whole network in solving blocks? Yes, but even with a very, very fast computer, due to the large number of members in the network, it’s highly unlikely Mary could solve several blocks in a row at the exact time needed to perform a double-spending attack.
She would need control of 50 percent of the computing power of the whole network to have a 50 percent chance of solving a block before some other node does — and even in this case, she’d only have a 25 percent chance of solving two blocks in a row. The more blocks to be solves in a row, the lower the probability of her success. Transactions in the bitcoin blockchain system are protected by a mathematical race: Any attacker is competing against the entire network.
Therefore, transactions grow more secure with time. Those included in a block confirmed one hour ago, for example, are more secure than those in a block confirmed in the last 10 minutes. Since a block is added to the chain every 10 minutes on average, a transaction included in a block for the first time an hour ago has most likely been processed and is now irreversible.
Fig. 9 - Blockchain transactions security
In order to send bitcoins, you need to reference an incoming transaction to your own wallet. This applies to every single transaction across the network. So, where do bitcoins come from in the first place?
As a way to balance the deflationary nature of bitcoin due to software errors and wallet password loss, a reward is given to those who solve the mathematical problem of each block. The activity of running the bitcoin blockchain software in order to obtain these bitcoin rewards is called “mining” — and it’s very much like mining gold.
Rewards are the main incentive for private people to operate the nodes, thus providing the necessary computing power to process transactions and stabilize the blockchain network.
Because it takes a long time for a typical computer to solve a block (about one year on average), nodes band together in groups that divide up the number of guesses to solve the next block. Working as a group speeds up the process of guessing the right number and getting the reward, which is then shared among group members. These groups are called mining pools.
Some of these mining pools are very large, and represent more than 20 percent of the total network computing power. This has clear implications for network security, as seen in the double-spend attack example above. Even if one of these pools could potentially gain 50 percent of the network computing power, the further back along the chain a block goes, the more secure the transactions within it become.
However, some of these mining pools with substantial computing power have decided to limit their members in order to safeguard overall network security.
Since the overall network computing power is likely to increase over time due to technological innovation and the increasing number of nodes, the blockchain system re-calibrates the mathematical difficulty of solving the next block to target 10 minutes on average for the entire network. This ensures the network’s stability and overall security.
Moreover, every four years the block reward is cut in half, so mining bitcoin (running the network) gets less interesting over time. To encourage nodes to keep operating, small reward fees can be attached to each transaction; these rewards are collected by the node that successfully includes such transactions in a block and solves its mathematical problem. Due to this mechanism, transactions associated with a higher reward are usually processed faster than those associated with a low reward. What this means is that, when sending a transaction, you can decide if you’d like to process it faster (more expensive) or cheaper (takes more time). Transaction fees in the bitcoin network are currently very small compared with what banks charge, and they’re not associated with the transaction amount.
Blockchain Benefits and Challenges
Now that you have a general understanding of how the blockchain works, let’s take a quick look at why it’s so interesting.
Using blockchain technology has remarkable benefits:
You have complete control of the value you own; there is no third party that holds your value or can limit your access to it.
The cost to perform a value transaction from and to anywhere on the planet is very low. This allows micropayments.
Value can be transferred in a few minutes, and the transaction can be considered secure after a few hours, rather than days or weeks.
Anyone at any time can verify every transaction made on the blockchain, resulting in full transparency.
It’s possible to leverage the blockchain technology to build decentralized applications that would be able to manage information and transfer value fast and securely.
However, there are a few challenges that need to be addressed:
Transactions can be sent and received anonymously. This preserves user privacy, but it also allows illegal activity on the network.
Though many exchange platforms are emerging, and digital currencies are gaining popularity, it’s still not easy to trade bitcoins for goods and services.
Bitcoin, like many other cryptocurrencies, is very volatile: There aren’t many bitcoins available in the market and the demand is changing rapidly. Bitcoin price is erratic, changing based on large events or announcements in the cryptocurrencies industry.
Overall, the blockchain technology has the potential to revolutionize several industries, from advertising to energy distribution. Its main power lies in its decentralized nature and ability to eliminate the need for trust.
New use cases are arising all the time — like the possibility of creating a fully decentralized platform that runs smart contracts like Ethereum. But it’s important to remember that the technology is still in its infancy. New tools are being developed every day to improve blockchain security while offering a broader range of features, tools, and services.
How does crypto mining work?
In short, crypto mining is how new units of cryptocurrency—usually called coins—are created. As you can imagine, this type of mining doesn’t involve callused hands gripping pickaxe handles. Instead, it’s computer processors that do all the hard work, chipping away at complex math problems.
Of course, you may wonder why these digital currencies even need to be mined: after all, it’s make-believe money with no backing except what people will pay for it. Real currency, the kind backed up by governments, can be created by turning on a money printer, so it stands to reason that crypto could do the same.
The fact that supply couldn’t be restricted was the main hurdle for cryptocurrency for years: there were many ideas on how to create digital coins, but no way to ensure people wouldn’t simply duplicate them at will. Without an authority like a central bank—an institution that regulates the flow of currency—it becomes very tricky to manage the supply of any currency.
This issue confounded the creators of digital currencies for decades until Satoshi Nakamoto (most likely a pseudonym) invented something called the blockchain. The full theory of how these work is pretty complicated—we go into more depth in our article on explaining the “blockchain”—but the easiest way to explain it is to picture it as a chain.
In this metaphor, each link is a block, and each block contains a set amount of cryptocurrency. For example, one block has 6.25 Bitcoin in it. To unlock a new block you need to solve a complicated mathematical equation, which validates the block and adds it to the chain. Also, because the blocks are chained in a linear fashion, you have to go from one to the next, you can’t pick one at random.
How Crypto Mining Works
To unlock a block in the chain, you need to validate it by solving a complicated equation, usually in the form of something called a hash. A hash is a random set of characters and numbers which, with the right key, reveals the original message; it’s a basic part of cryptography and is where the “crypto” part of “cryptocurrency” comes from.
In a way, crypto mining is really just solving these incredibly complicated mathematical puzzles. Do it fast enough, and the reward is a coin. If you’re slower than the competition, you don’t get one. This method is called “proof of work.”
However, hashes are, by their very nature, incredibly complicated puzzles to solve. The phone or laptop you’re most likely reading this article on would probably take millions of years to solve one.
Of course, if you don’t have a supercomputer, you can always build one. Plenty of people interested in making money from cryptocurrency—Bitcoin in particular—have started doing so, often by connecting several devices to each other to create powerful networks that can combine and amplify the processing power of each individual device.
The most powerful single component you can use in this case is a graphics processing unit, or GPU, the part of your computer that gives you the nice shiny graphics—if you’re on an advanced computer, that is. They’re generally more efficient and powerful than their cousin the central processing unit (CPU), and putting enough of them together gives you some serious computing oomph.
This brings a new kind of equation into play, one where several savvy individuals calculated that the price of GPUs times the cost of electricity came out a lot less than what one Bitcoin would bring in. This created a kind of arms race where these outfits would create bigger and better rigs to beat their competitors.
On top of the competition between these groups, there is also the problem that each next block is more complicated to solve than the last, a failsafe built into the blockchain to prevent it from being all unlocked at once.