Bitcoin, cryptocurrencies and blockchain explained

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Imagine you are sitting around a table with a group of people and you have come up with the new currency “thaler”. Each of you has a piece of paper and a pen in front of you. Now you begin to trade among yourselves any goods and services and exchange the only fictitiously existing thalers as means of payment for it. Physical thalers do not exist. If Christian wants to give Jennifer three thalers, he simply shouts across the room, “I’ll pay three thalers to Jennifer!”

Jennifer now knows directly that she has three new thalers. At the same time, everyone sitting at the table who heard about the transaction writes it down on their piece of paper. In this way, the diligent book writers note down all transactions that happen in the room. For example, Christian gives three dollars to Jennifer, Jule gives ten dollars to Tanja, Manfred gives five dollars to Beatrix, Timo gives eight dollars to Tobi, and so on. In between, they always look over their neighbor’s shoulder and check whether his entries are correct. Every ten minutes, the note-takers have to hand in their notes.

The first person who thinks they have written all the transactions correctly on their note stands up and yells across the room, “I’m done!” Now all the other people at the table check to see if the piece of paper does indeed log all the transactions correctly. If it is, everyone confirms that slip of paper is correct, and it is stapled in the middle of the table as the first page in a book. Then the whole game starts all over again.

Trust without a central institution!

By this system it is guaranteed that in the center of the table at any time a book lies, in which all transacted transactions, which ever took place at the table, are noted completely, correctly and confirmed by all participants. There is agreement among all participants at all times that the book is correct, and thanks to this transparency, all participants have confidence in correct accounting and in the common currency system. And all this without any central institution! After each ten-minute round, each participant quickly makes a copy of the book and places it on his or her lap. Even if now the book in the center would get away or would break, there would be thus still enough intact copies of the book, in order to continue the system. So the system runs now always and always further. That’s basically it, now you understand the basics of blockchain!

The “passive users”

As time goes by, more and more people join you in the room who also want to pay with talers. You also accept the newcomers into your talers network, however, not all of them feel like keeping records as well. Therefore we call these people “passive” users. The passive users do not keep a book, but they still trade talers. If the passive user Jan now wants to pay three talers to the passive user Robert, he shouts across the room: “Jan gives three talers to Robert!”

The busy note writers at the table of course catch this and make a note of this transaction. At some point, however, there is a fight in their thaler room! The note writers are tired of writing notes all the time, after all, it costs them time and work, and they could just as easily use the Taler network if they were simply a passive user like Jan and Robert. It’s hard to argue with that, but without proper record keeping there is no trust and without trust there is no stable currency.

The solution: introduce a reward! The note writer who is the first to finish the correct new note gets a new thaler as a reward. In this way, you have also ensured that there is an even growth of talers in your network and that you never run out of money, even as the number of participants grows.

Transactions according to the cryptographic principle

The note writers are now all done with the new note at the same time and shout “done!” across the room – who gets the reward now? Somehow it doesn’t work that way. Therefore, in addition to writing down all the transactions made, introduce another task for the note writers. Not only do they have to write down all the transactions correctly, but they also have to “encrypt” them in a very specific way – in other words, they have to put them into a certain form according to a cryptographic principle. This task can only be solved by trying out many different possibilities. You can imagine this like a combination lock with four digits whose code you have forgotten. The only way to open this lock again is to try all combinations. Eventually, you’ll find the right solution, and the lock will pop open!

It’s the same with our note pens. At some point, someone accidentally finds the right encryption, and the note has the desired cryptographic form. Now it screams “done!” across the room! The great thing about this cryptographic principle is that everyone else can now try out in a flash whether the result is correct. Again, the comparison with the combination lock helps. If you shout across the room: “4213 is the right solution!”, then everyone else can simply enter these digits at lightning speed and try out whether the lock pops open. Within seconds it is clear whether the shouting note-taker has really found the right solution. If he has, he gets his new coin as a reward, and the game starts all over again. This principle, which is based on trial and error, also ensures that the smartest or fastest person doesn’t always win – the math zero can also find the correct solution the fastest through luck. The best chances of finding the right solution are simply those who can try out the most possibilities per second.

How a cryptocurrency works

Analogous to the example with the four-digit combination lock, the classic blockchain technology works for cryptocurrencies like Bitcoin. Only at very high speed, with computers instead of humans, and through an automatic process in the background instead of active writing down. Any human with internet access can install a simple program on his computer. This then makes him part of the crypto network.

Each participant can be either an “active” or “passive” user, so they can choose to be only a user of the network or also an auditor. Passive users can use the cryptocurrency for free, but do not receive any rewards.

Active users, i.e. users and auditors, help maintain the inventory book with the processing power of their computers and are rewarded with new coins. Let’s just play it out again: If user A instructs a transaction to person B, this transaction runs through the crypto network directly from person A to person B and is verified by many other computers connected in the network. Is the transaction correct? If it is, the computers on the network confirm the transaction and the auditors write it to something called a block. This is a kind of file, you can think of it simplified as a digital list, in which all the transactions that have been made are listed one below the other. In addition, the block notes the time at which it was created and the last block before that. The block is the digital equivalent of the note from our thaler example.

Is blockchain technology secure?

Every few minutes, for example with Bitcoin it is always ten minutes, the computers in the network have to store a new correct block. To ensure that not all computers finish at the same time, this new block must be rewritten in a very specific encrypted form that the computers can only find by trial and error. In practice, this means that the computers have to use their computing power! The more processing power a computer has, the more variants it can try out per second, and consequently the higher its chance of being the first to find the new block.

Theoretically, however, with a lot of luck, a “crutch computer” can be the first to find the correct solution, but the probability is very low. Once the computer has calculated a new, correct and complete block, it reports to the rest of the network. In a flash, the other computers now check whether the block is really correct by calculating back.

If it is, the block is saved and the lucky block finder receives new coins as a reward. The new block is “attached” to the last block created before it. In this way, a chain of blocks is created over time, which seamlessly records all transactions made.

The technology owes its name to this chain of calculated and verified transaction blocks: blockchain. Once the new block is found and confirmed, all computers immediately start creating the next block. Quite incidentally and automatically, all computers in the crypto network regularly download the latest version of the blockchain, which means that the latest version of the blockchain is stored simultaneously on thousands and thousands of computers around the world at all times, depending of course on how large the network is. This ensures that no hacker can delete the blockchain or replace it with fake data.

This is because even if he managed to attack some of the computers in the network, there would still be enough intact copies of the blockchain on other computers to spread again within a very short time. This makes hacking, deleting, or manipulating the blockchain virtually impossible. Computers that participate in maintaining the blockchain are called nodes, by the way. They are the places that make the network a functioning network in the first place.