Welcome to Spectacle Investing’s introduction to blockchain technology. This post looks to break down the complexity of blockchain technology into simple, easy to understand bits. For the average person, blockchain technology is surely complex and confusing. There are many concepts and aspects of the technology that are not well understood and therefore I hope to break this down into layman’s terms to the point where any reader can understand. For specific terms that need clarification, please visit Spectacle’s Cryptocurrency Glossary. For critiques, questions and even concerns, feel free to email me at [email protected]
Blockchain technology is a digital, decentralized ledger which is distributed across a network of nodes. For those new to crypto, this probably brings up far more questions than answers, here’s a breakdown of a few key terms.
Decentralized – decentralization is the opposite of centralization which is where a central authority has all the power. Examples of centralization are governments, banks, businesses etc. So decentralization would be an instance where no single individual or authority has control over a network or business. Instead, the users of the network own the network itself.
A good illustration of centralization versus decentralization would be to imagine a centralized Facebook versus a decentralized Facebook. The real Facebook is centralized, Meta(parent company of Facebook) has complete control over your account, what you can post, your data, your content etc. A decentralized version of Facebook would be where the users of Facebook have control over it. The rules of Facebook would be etched into the code that the network was built on, users would own their own data and the platform would be free of censorship as nobody controls the network.
Ledger – Think of a ledger as an Excel spreadsheet. It is a list of all transactions and assets that have ever been exchanged on the blockchain. This is essentially the database of a decentralized network(this is an oversimplification but bear with me).
Nodes – Imagine a Connect the Dots puzzle. Each dot is a node. In cryptocurrency, nodes are computers which support the network through validating and relaying transactions.
Let’s combine these three concepts together. A blockchain is a network of computers, free of any one person or entity’s control, which has a ledger that is shared amongst all of the computers that verify and add new transactions to the ledger.
How Blockchain Technology Works
Now that we have a broad definition of what a blockchain is, let’s discuss how it works.
Blockchains combine encryption with distributed computing to create a chain of unique, encrypted blocks that are connected through hash values.
Encryption – Encryption is the process of encoding information. The data is taken from the original format of plain text and it is converted to ciphertext where the only party that can decipher the encryption is the one with the encryption key. Essentially, encryption protects the data on a blockchain.
Distributed computing – Where a single system is run across multiple computers and is not restrained by geography. This is the foundation of decentralization.
Blocks – The ledger is made up of a chain of blocks. Each block contains a set number of transactions depending on how big the block size is. In Bitcoin’s case, each block contains on average 500 transactions setting the storage capacity to about 1MB. In contrast, Bitcoin Cash, a hard fork of Bitcoin, has a block storage of up to 8MB.
Each block is given a hash value. Hash values are created through an algorithm called a hash function which compresses data into the hash value(64 string of characters). Essentially, the data on a block is contained within a set of randomized characters (hash value). The hash value can be recalculated to the underlying file(data) to determine that the original contents have not been changed but the reverse is not possible.
Now, how are these blocks created? Blockchains use what’s called a consensus mechanism so that all nodes on the network can arrive upon an agreement of what transactions are to be approved and added to the chain. In Bitcoin’s case, that consensus mechanism is Proof of Work(Pow).
Proof of Work is a form of cryptographic proof in which one party(the prover) demonstrates to another party(the verifiers) that a specific amount of computational effort has been completed. In Bitcoin’s case, miners compete to add new blocks to the chain by racing to solve a cryptographic puzzle while expending computational resources to do so. The probability of a specific miner winning the race is equal to the amount of computational energy provided.
In layman’s terms, miners(nodes) of the Bitcoin network expend computational power and energy to compete in the race to solve a cryptographic puzzle. The first node to solve it demonstrates the proof of work to the other nodes so that the work can be double checked and verified. Once all the nodes arrive upon the consensus, the new block is added to the chain and the miner is awarded Bitcoin for solving the puzzle first.
Summary: Let’s summarize all of the above information to get a clear picture of what blockchain technology is. Blockchain technology is a network of computers which distribute a digital ledger containing a list of all the transactions that have taken place on the network. In order for a transaction to be added to this ledger, miners(also known as validators) must arrive upon a consensus as to what transactions are legitimate and should go through.
In Bitcoin’s case, this consensus mechanism is Proof of Work where the miners expend computational resources and energy to solve a cryptographic puzzle in order to add another block of transactions to the chain.
Bitcoin was the first generation of cryptocurrencies implementing blockchain technology. All of this changed in 2013 when Vitalik Buterin conceived of Ethereum and later launched the project in 2015. Ethereum took bitcoin and created a decentralized platform where decentralized applications(dApps) can be built on top of it. Think of Ethereum as a cell phone. It is the underlying foundation of which applications can be built on. Examples of applications already built on and operable on Ethereum include:
Decentralized Finance Applications
Decentralized Music Streaming Platforms
To summarize, Ethereum’s significance stems front the fact that it is a decentralized network in which anybody can build an application on top of which, can then operate within Ethereum’s ecosystem. That being said, Ethereum has struggled with the scalability component of the blockchain trilemma, leading to 3rd generation blockchains.
3rd generation blockchains look to accomplish many of the same goals as Ethereum but operate on different philosophies and look to solve the scalability issue in different ways. Take Cardano for example, a project I’ve been very bullish on since the beginning of 2021. The development of Cardano is first done through rigorous research and an extensive peer review process that has resulted in over 90+ academic papers being written. Ethereum on the other hand is significantly less academic with its approach as they want the development of Ethereum to be quicker. In contrast, you have other 3rd generation blockchains like Solana and Avalanche. Solana focuses on being the fastest blockchain and quickest to market by sacrificing decentralization and as a result security.
It’s important to understand that with the current state of blockchains, there are no clear solutions, only tradeoffs. Each blockchain operates with its own philosophy and base layer protocol. Therefore, comparing blockchains to one another is comparing apples to oranges. Example: Bitcoin and Ethereum accomplish two separate things, Bitcoin being the revolution of Money and Ethereum being the leading blockchain in the revolution of finance and the internet.
Why is Blockchain Technology Important
With an understanding of how blockchain works, lets discuss why this technology is revolutionary. To recap, blockchain technology is a network of computers(nodes) that share a distributed ledger of recorded transactions and information. It allows humans to transact and cooperate at a large scale without a third party middleman to assume the role of authority. The most fundamental problem blockchain technology solves is the byzantine general problem.
Up to this point, humans have cooperated by having a third party middleman to facilitate cooperation amongst one another. The issue with this is that we as a society have to place trust in these middlemen without verifying their actions or intent. Take a store like Wal Mart. I have no ability to verify where Wal Mart’s inventory comes from, the level of pesticide content in the food etc. Same issue with my bank and my government. There’s no verification or transparency to what my government spends taxpayer money on. I also have to trust that the government and the bank will keep my funds safe, keep the economy stable, keep inflation low and to trust them with my money. The 2008 Financial crisis demonstrated to the world that placing trust in institutions is not sustainable.
This recession spawned Bitcoin and the first iteration of blockchain technology combined with a digital currency which will result in 4 separate revolutions: Money revolution, Finance revolution, Internet revolution and Governance revolution. I’ll go over the basic impacts of each revolution and what it means, a more in depth analysis on each revolution will happen in separate blog posts at a later date.
Revolution of Money
This is indicative of the move from fiat currencies to crypto currencies or in the long-term debt cycle; from fiat money to hard money. Blockchain and by extension cryptocurrencies are a new form of money, one that is programmable and composable. Society’s current system consists of value transfer being done through top down control of nation state governments. Governments and their central banks manipulate their fiat currencies through monetary and fiscal policy, typically to the detriment of the people who rely on these currencies to be a store of value.
Cryptocurrencies like Bitcoin have built in monetary policy that can’t be changed as the max circulation of Bitcoin is capped at 21 million coins, with the last coin to be released in 2140. A new form of money where the monetary policy is built into the currency, and no nation-state government, corporation or individual can prevent the transactions on the network is a revolution all in itself.
Decentralized Finance, also known as DeFi, is the blockchain technology movement that is rapidly disrupting the financial sector. Blockchain technology promises sovereign banking for the individual thereby replacing the banks and rent seekers of this industry. Defi is already available and functioning but can be clunky to use for the non early adopters. In the near future, mortgages, loans, personal banking etc. will all be done through DeFi and smart contracts, the subtraction of banks and rent seekers will take the profits normally accrued to them and give it back to the people.
Not only will Defi be quicker, cheaper and accrue more value to the users by subtracting the rent seeking middlemen, it also has the promise of inclusivity. There are currently 2 billion unbanked people in the world, unbanked meaning these individuals have no economic identity. They don’t have credit, access to traditional financial resources, proper identity etc. This is largely due to lack of infrastructure in their given country and DeFi solves this by being decentralized infrastructure built on the internet thereby being equally accessible to anyone with an internet connection. In traditional finance, banks offer better promotions and deals to their high networth clients. In networks operated on code, their is no favoritism to be exploitated.
Web3.0 is the next wave of the internet where decentralized networks, digital assets and interoperability are the keystones. The current version of the internet is Web 2.0 where companies own all the data, content is highly susceptible to censorship and networks are siloed from one another. Web 3 is the promise of:
- trustless networks
- open source
- permissionless networks
- censorship free
- users owned networks
- digital assets(NFTs)
This is the largest revolution of the 4 which blockchain technology enables and the one that will take the longest to come to fruition. The revolution of governance will be seen in the internet revolution and finance revolution but most importantly, it will result in the inevitable collapse of nation states. This is an extensive topic I can write on but a quick summary would be that the creation of decentralized currencies allows the individual to opt out of traditional government and finance. The more a country tries to control its people, the more individuals will opt out of that countries financial structure resulting in taxes dropping and the nation states’ power evaporating.
Apart from the slow death of nation states, governance as a whole will be revolutionized due to the large scale cooperation without an intermediary which blockchains provide. Decentralized networks solve the byzantine general problem where strangers can now cooperate in mass without needing to trust one another as the network itself has trust built into it.
Although this post has only briefly touched on the intricacies of blockchain technology and the revolutions it enables, a clear picture of its implications has been drawn. Decentralized networks will provide equal access to financial services on a global scale, censorship resistant networks, open source, trustless and permissionless systems with sound and long term economic models built in. All of this won’t happen overnight. There are many barriers and challenges blockchains need to overcome, the blockchain trilemma being the most prominent one currently(achieving scalability without sacrificing decentralization and security).
Regardless of its current state, the future companies, organizations, governments(governance) and internet will be built on blockchains. This technology is currently inferior to current systems in the scalability department but is vastly superior in its promise of equality, composability, and the level of cooperation it enables.
I spend an extensive amount of time researching various blockchains and crypto related projects to determine which are the most likely to be scalable, secure and have high adoption rates. For analysis of these projects and disruptive industries, make sure to subscribe and follow me on Twitter.