Cryptoasset Primer 2: The Lay of the Land

This is the second post on the basics of Blockchain and Cryptoassets. You can find the introduction here. 

One of the best things about learning about cryptoassets is that there is so much to learn, with new ideas being rolled out on a seemingly daily basis. One of the hardest things about learning about cryptoassets is that there is so much to learn, with new content being added on a seemingly daily basis.

In this section we are going to review the basic terms. We posted a similar piece a few months back which we will go through again here and flesh out some of the details.

At the root of all this is the Blockchain. After ten years of hype, we have found that this term has become loaded with meaning and contention, but it is a very simple concept. A blockchain is just a form of database, a way of storing data. More specifically, it is a decentralized, distributed ledger.

Let’s break that down. A ledger is simply a list of transactions. A bank account summary (or your check book if you still have one of those) is a ledger. It lists transactions, $10 to the grocer, $40 to the dry cleaner, a deposit of $1,000. That’s all that a blockchain is, a list of transactions.

However, most databases tend to be stored in a single place.  Your bank balance is stored in some hard drive at your bank’s data center. The blockchain is distributed across the Internet. Anyone can get a copy of the entire ledger going back to the first Bitcoin transaction in 2009. Anyone working on or interested in seeing a blockchain ledger can get a copy of the database. This helps (a bit) to make it hard to alter the ledger, because changing a balance is not as a simple of hacking your bank’s database, no one can forge the history of transactions because everyone has a copy to compare. So the ledger is distributed.

It is also decentralized meaning that no single entity can control the ledger. If your bank decides to muck about with your bank balance, they can because they control the ledger storing all the past transactions. To contest this mucking you would have to rely on third parties to help – lawyers, regulators, investigative reporters, etc. No single entity can control a blockchain because: a) it is fully distributed; and b) the network has to agree on any new transactions. One of the innovations of a blockchain is the clever way in which this agreement takes place, which we will return to in a moment.

Let’s look at it in different way. Databases are pretty simple things. You can really on do two things with them – read and write. You can look up entires and you can write new entries. A blockchain allows for anyone to read it, it is distributed. Writing to the block chain is controlled by ‘the community’ (we will get into this), but is ultimately controlled by a clever algorithm that ensures everyone reaches ‘consensus’ before anything is written or changed in the ledger.

As should be clear by now, the heart of the blockchain is the mechanism by which ‘writing’ to the ledger is controlled, or rather how it is agreed upon.

To greatly oversimplify, when someone wants to enter a transaction into the ledger, they broadcast it to a network of computers distributed across the Internet. Most blockchain systems then have some system for this whole network to verify the transaction, typically meaning that one party is transferring something to another and verifying that the sender actually possesses what they are sending and that they are willing to give it up.

Then there is a crucial step. The transaction is signed cryptographically and formally added to the full ledger. This ‘cryptographic signature’ sounds like an intimidating term and it scares away many, but it is fairly straightforward. Again, to greatly oversimplify, the transaction is encoded using a robust but well-known algorithm. We will not go into details here, but there are several good web tutorials to explain the whole process. For our purposes, the main point is that the mechanism used to ‘write’ a transaction into a blockchain ledger requires a lot of computing power.

This computing power is important because it means that there is a real cost in writing to the blockchain. This leads to the final key piece of most blockchain systems – incentives. Since the whole system relies on someone in the network performing some fairly intense computations, it requires some form of compensation. Typically, this incentive is in the form of a token or coin, which is often described as a digital currency.

So a blockchain system is composed of entities or individuals who put computers to work for the whole system. These are usually called ‘miners’, and the compute process is known as ‘mining. This reward mechanism has emerged as incredibly powerful way to coordinate activity across these distributed ledgers. Since the whole ledger is signed cryptographically, it is effectively impossible to forge or alter the history of the ledger. The cost of compute needed to alter a blockchain is meaningful and there are many miners all competing to provide that needed resource.  It requires an immense amount of compute power to make any changes to the blockchain. Since there are many miners all operating at once competing to earn the token incentives, it is effectively impossible to forge the history of the ledger.

To sum up, a blockchain is a list of transactions. By nature of the ledger being fully distributed it is possible for everyone to read the database. Writing to that database is computationally expensive, making it very hard to tamper with. And the whole system has a built-in rewards system to incentivize participation.

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