EarlyBird Crypto Education Series Part 3: Breaking Down the Blockchain

This reads in about 6 minutes

Let's talk about the blockchain

The underlying technology that makes crypto “work” isn’t magic... it’s... well, it’s math. It’s a special kind of math called cryptography. Cryptography is basically the study of keeping secrets (and only divulging some part or the entirety of the secret if someone has a key). This is super important for keeping data secure. It was important during WWII and it’s important for protecting people’s information on the internet.

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Fortunately, you don’t need to be a cryptographer, mathematician, or computer scientist to appreciate the design of a blockchain.

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The reason we’re spending some time breaking this down is that if we want to understand whether or not something is a good investment, it’s important to understand how it works (crazy idea, right?!). This helps us evaluate an asset’s risk. Here’s what I mean.

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The “risk” of a high yield savings account

When your bank tells you that they’ll pay you 0.5% to put your savings into a high yield savings account, that might sound better than just keeping it in cash in a checking account (where the annual yield is like, 0.05%). But neither of these options make sense for any long-term savings when we realize that inflation averages out around 2% per year (and looks like it might be closer to 7% this year!!).

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For that reason, holding cash in a savings account only really makes sense for short-term goals (purchases you hope to make in less than 5 years) and for emergencies. Otherwise, you are risking the loss of purchasing power due to inflation.

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While I wish the dollar was a reliable long-term store of value, or that “high yield” actually meant something like 5% or 6% as opposed to 0.5%... it’s just not the case. My point is, even savings accounts have “risk” when you consider your goals and timeline.

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To understand Bitcoin and Ethereum’s risk — the two crypto assets that will initially be offered through the EarlyBird platform — we have to take a stab at breaking down the underlying technology known as “the blockchain”.

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Apologies in advance, I can only provide a cursory explanation in one post — but if your interest is piqued, I encourage you to dig deeper on your own time because it’s a pretty clever bit of technology.

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What does a blockchain do?

A blockchain is, simply put, a technology that keeps track of transactions in the blockchain’s native currency, and guarantees that people can’t spend what they don’t own.

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Bitcoin’s blockchain keeps track of transactions in Bitcoin. Ethereum’s blockchain keeps track of transactions made in Ethereum’s native currency (called “Ether” or ETH) as well as these other things called “tokens”, which can represent all kinds of stuff (NFTs are technically a type of token). More on this in a little bit.

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In other words, a blockchain is the place where transactions in crypto are recorded and value is stored. So it’s kind of like a weird version of a bank plus a payment processor that isn’t owned by anyone. And it’s even weirder because every transaction ever made is available for anyone to see.

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If it’s not owned by anyone, how does it work?

There are three types of participants when it comes to a blockchain:

1. People transacting in the currency (we’ll call them “users”)
2. People hosting a copy of the entire blockchain on their computers (they’re called “nodes”)
3. People doing the work to record new transactions onto the blockchain (they’re called “miners”)
4. Technically there’s a 4th type — the developers who make updates to the technology, but we’re ignoring them for now (sorry, developers).\

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Let’s pretend I’m sending you 0.0001 BTC as a “thank you” for reading our blog

The whole point of crypto is that I can send you something that has value over the internet, without going through a central authority. In this case, you and I are both users. But we rely on miners and nodes to see that the transaction “goes through”. Here’s how that happens.

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1. I authorize a transaction of 0.0001 BTC from my wallet to yours (and sign it with an encrypted digital signature that only I can generate)
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2. Some “nearby” nodes check to make sure I actually have 0.0001 BTC I want to send. If I do, they’ll let the other nodes know that my transaction is valid.
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3. After the transaction has been verified by the nodes, miners will pick it up and add it to a list of other transactions that were authorized around the same time as mine. This list is called a “block.”
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4. In order for the transaction to be finalized, the block needs to get added to the blockchain. Miners are competing amongst each other to earn the right to add the block to the chain. This competition is like a cryptographic version of “guess what number I’m thinking of”. All the miners are using electricity to guess a special number that is unique to the current block.
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5. When a miner successfully guesses a winning number, they get to add the block to the blockchain and also earn a reward in Bitcoin. This reward is called the “block reward” and it's the thing that gets cut in half every 4 years — remember from the last post? The block reward is how new Bitcoin are created. Since mining requires a lot of electricity, the profit from the block reward is the incentive for miners to join the competition.
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6. Once the new block is added, the miner chirps out the updated copy of the blockchain to nearby nodes, who verify that they actually did guess a winning number, and then chirp it out further until every node has an updated copy of the blockchain.
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7. At this point, my 0.0001 BTC transaction shows up in your wallet and everyone can see it there.
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8. And then the process repeats.

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In short, users authorize transactions, miners finalize transactions to the blockchain by competing to add blocks (which results in the creation of new coins), and nodes verify transactions while hosting an entire copy of the blockchain.

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This is an orchestra of decentralized coordination. No single entity controls the process of recording transactions or managing the record of finalized transactions. What we have here is a secure system of managing and tracking the movement of the currency. The system is as strong as its network is decentralized. And these networks are growing larger and more decentralized as adoption increases.

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Bitcoin and Ethereum differences

The process of adding new blocks works a little differently for Bitcoin than it does for Ethereum (and lots of changes are coming to Ethereum in 2022, or so they say). With Bitcoin, blocks are added every 10 minutes and can handle about 1-1.5MB of transaction data (which nets out to about 5 transactions per second). Ethereum’s blocks are added every 10 seconds and can manage about 15 transactions per second.

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These numbers aren’t great (especially when you compare them to Visa’s 1,500 transactions per second), but there are initiatives currently being spearheaded by developers (the 4th group!) to increase the possible number of transactions per second. For extra credit, you can check out the Bitcoin Lightning Network, and Ethereum’s transition to Proof of Stake, Sharding, and the Beacon Chain.

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Another thing about Ethereum

Like I said earlier, Ethereum is also dealing with these things called “tokens”. A token is just a “contract” written in code that entitles someone to ownership over something when certain conditions are met.

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For example, NFTs are powered by the code written into their token. It says, “if I send X amount of ETH to the person who currently owns an NFT that is listed for an amount equal to or lower than the amount I’m sending, transfer the NFT into my wallet”. Since it’s written in code, we call these tokens “smart contracts”.

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We’ll talk more about the risks of these contracts in the coming posts — long story short: “smart contracts” are only as “smart” as the people writing them. And sometimes even the best developers make exploitable errors.

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The Future of Blockchain

Ethereum has demonstrated that there may be a utility for blockchain technology that extends beyond digital currencies. In healthcare, blockchain could provide encrypted medical records. In voting, blockchain could create a secure process through automatic verification via computers, tablets, or smartphones. In business, blockchain could offer innovative supply chain management.

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While these sound promising, decentralized blockchains have major scale challenges to overcome before they can process data at the rate of a global economy. Not to mention...

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The regulatory future is uncertain

It will be interesting to see how governments across the globe attempt to enforce regulations.  While some governments have tried to ban crypto outright (China), others have embraced cryptocurrency as the way of the future (El Salvador). The United States recently announced a major push for crypto regulation as a matter of national security.

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In the best-case scenario, regulatory practices protect investors (especially new ones) from getting scammed or abused by greedy actors. In the worst-case scenario, regulation stifles innovation. Do I know what’s going to happen? No. But as far as the risk is concerned, I’m betting on something in the middle.

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Read Part 4 now...

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