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A Dummies Guide to Bitcoin and Blockchain Technology

18th April 2016

BitCoinBitcoin and Blockchain are two hot topics. Goldman Sachs says the Bitcoin’s underlying technology – Blockchain – “has the potential to redefine transactions” and can change “everything.” But what is Blockchain? And what has it to do with the cryptocurrency Bitcoin?

Bitcoin: the digital currency

Bitcoin is a form of digital currency, created and held electronically on your PC or in a virtual wallet. No one controls it or sees it. Also, Bitcoins aren’t printed by a central bank like US dollars or Euros – they’re produced by people, and increasingly businesses, running computers all around the world, mainly using software that solves mathematical problems.

Bitcoin is the first example of a growing category of money known as cryptocurrency which uses cryptographic methods to create and exchange. Like “normal” money, Bitcoins can be used to buy or sell things online and offline. In that sense, it’s like conventional currency. However, Bitcoin’s most important characteristic, and the thing that makes it different to all conventional money, is that it is decentralised. No single bank, person or other institution controls the Bitcoin network. This puts some people at ease, because it means that a large bank can’t control their money. On the other hand it causes regulators stress, aiming to regulate and screen Bitcoin more rigidly.

Blockchain: the underlying technology sustaining Bitcoin

The first important thing is to understand is that Blockchain – and its broad range of applications – has nothing to do with Bitcoin — at least for most companies and users purposes. Blockchain is the technology running Bitcoin, but it has many other uses too.

In short, the Blockchain provides Bitcoin’s public ledger, an ordered and time-stamped record of transactions (check it out live: https://blockchain.info/). This system is used to protect against double spending and modification of previous transaction records.

Game changing technologies

You might have seen it in some of your PC settings: TCP/IP. In 1974, engineers designed something revolutionary: the TCP/IP Internet network protocol.

TCP/IP was first developed as a way for any computer to connect and communicate with a very early form of the internet. Since then, the project mutated exponentially to allow any computer to communicate with any other computer, finally developing into today’s Internet of Everything.

But for all of this development, the base technologies have remained unchanged. Your IP address still acts like your unique postal address that enables any smart phone, tablet or computer to identify itself on the internet, while the TCP technology guarantees delivery of the data by dividing them into segments. TCP and IP are used in conjunction to increase the probability of the data packet to get from origin to destination.

Building on this mode of functioning is the Hyper Text Transfer Protocol or HTTP, which became a way for web browsers to communicate with web servers. Today, along with HTTP, a whole suite of protocols like DNS work together to provide us with the network experience we are used to today. Search engines, email, web pages, social media and other internet services are all products that have evolved on this framework giving us today’s digital economy.

Just as the TCP/IP-based internet led to a revolution in the way businesses functioned, the Blockchain protocol is repeating the same process all over again. Some even go so far as to say it is like watching the birth of the internet all over again.

What it does and how it works

Let’s say you want to send some Bitcoins to a friend. Every time a transaction occurs between the members of the Bitcoin network, it needs to be

How a BitCoin Transaction Works

verified and validated so as to ensure that your transaction occurred within the network and is between two individual accounts and that there is no risk of double spending. The network for this money is decentralised, meaning there is no middle man like a bank.

This process of verification is carried out by some members of the Bitcoin network called “miners”. Miners use specialised software easily available online, along with the processing power of their computers to verify the transactions from Bitcoins network – kind of your “decentral bank”. This sounds simple enough, but the processing power required to do so is quite enormous. There are critical reports stating that a Bitcoin transaction takes uses 5,000 times more electrical power per transaction than VISA and is not sustainable (see: https://www.rt.com/usa/270550-bitcoin-energy-hog-critics/).

Since the miners are using their bandwidth and electricity to do the verification process, they need to be compensated for this. A whole industry has been created accordingly, with enormous power racks of specialised PCs standing in China, creating Bitcoins.

This is where the Blockchain begins to take shape. Every few minutes a ‘block’ of all the transactions occurring over the Bitcoin network is created by a miner. Essentially the miner has created a verified transaction file which holds a copied record of all the transactions that have occurred in the Bitcoin network over the last 10 minutes. The word to highlight here is ‘verified’.

The miner uses the computational power of his computer to assure all members of the network that each transaction is between two parties only and that there is no problem of double spending one coin. For this effort, the miner is compensated in Bitcoins. This is where the math of Bitcoin and the way that it differs from the normal banking system is visible.

The total amount of Bitcoins that can ever exist is fixed at 21 million. As the quantity of money is fixed, the payment made to the miner is much like mining currency out of a reservoir.

As each transaction in every block is made at a specific time, each block is linked to the previous block of transactions. By grouping these blocks we get what is referred to as the Blockchain. So the Blockchain is like a full history of your regular banking transactions. All Bitcoin transactions are entered chronologically in a Blockchain just the way bank transactions are.

Based on the Bitcoin protocol, the Blockchain database is shared by all participants in a system. The full copy of the Blockchain has records of every Bitcoin transaction ever executed. It can thus provide insight about facts like how much value belonged to a particular address at any point in the past.

This is where the TCP/IP and Blockchain protocols differ: TCP/IP is a communications protocol, whilst the Blockchain is a value-exchange protocol.

Why banks love and fear it

The exciting thing about Blockchain is that you can easily transfer everything from property to stocks and currencies without having to go through a BitCoin and BlockChain Have Divergedmiddle man and clearing institution like SWIFT, but still have the same safety, higher speed and lower costs. And taking out the middleman normally helps both the buyer and the seller.

Now, taking out a middleman is already good for private customers, for example, when it comes to buying a property, but this has a far more extensive impact in the financial space, where billions are transferred daily and bilateral transactions without a middle man can help save millions in the short term. No wonder all big banks are working on the usage of this technology in-house or via external partners or start-up investments. So what are banks doing with it?

BNP Paribas

CitiBank

  • CitiBank, the world’s eighth largest bank, had told the UK government to consider creating its own digital currency through a Freedom of Information Request (FOI). They have been exploring distributed ledger technology for the last few years.
  • It is also revealed that the bank had built three Blockchains and was testing its own version of cryptocurrency named ‘Citicoin’.

Goldman Sachs

  • Goldman Sachs published a report on digital currencies which highlighted the potential of Blockchain technology.
  • Although this report initially dismissed the idea of Bitcoin as a currency and labelled it a commodity, a report produced by equity research analysts the following year noted that Bitcoin and other cryptocurrencies were part of a “megatrend” which could transform the way in which transactions were carried out.

All of these applications pretty much aim at making asset transfers much easier and quicker compared to conventional methods. Bitcoin’s underlying technology is the instrument for this.

While there was spike in demand for Bitcoin during a sovereign debt crisis in Greece (and the anonymous currency is defined by some as the “new gold” – a safe haven currency in volatile times), the interest in Bitcoin from big financial institutions has faded and shifted towards Blockchain technology. This represents both an opportunity and a threat as the core business of trading is made faster, cheaper and more transparent whilst at the same time margin income earned in one of the most profitable business sectors is eroded.

Commercial and industry acceptance

While Bitcoin has natural benefits for the financial space, this is more narrowed down when it comes to industry and commercial usage. Bitcoin has remained an interesting area of FinTech innovation for businesses to capitalise on, but there is also a downside to the high level of anonymity it introduces.

Some of the main benefits of Bitcoin are as follows:

No paperwork

Anyone, from any country, of any age can send or accept Bitcoins within minutes.  There is no ID card, passport proof of or other form of traditional bureaucracy involved in a transactions. Instead, all that a business or customer needs to do to start sending and receiving Bitcoins is to download a Bitcoin Wallet program and generate a Bitcoin Address.

Quick and cheap transactions

The underlying fees of processing a Bitcoin transfer are extremely low compared to conventional methods of moving money.  Accepting credit or debit cards will generally cost 3-5% of the transfer amount, which is much more expensive than a Bitcoin transaction which usually entails a fixed fee of around 0.0005 Bitcoins per transfer, regardless of whether it is national or international.

Standard international wire transfers can take from a few days to over a week to completely process whereas Bitcoin transactions are generally confirmed with an hour.

Irreversible transactions

As existing merchants will be well aware, when accepting credit card payments, or even bank payments, the sender has the ability to reverse or “charge back” the payment. Bitcoin is the only payment method that is 100% irreversible and cannot be charged back unless the money is refunded by the recipient, i.e. the merchant — which is advantageous.

However, there are a number of drawbacks to Bitcoin:

Black market use

Recently there has been a new form of malware known as a ‘ransomware’ which essentially encrypts all files stores in affected PCs and extorts users into transferring Bitcoins to an address in order to regain access to their own data. This is quite a sophisticated scam with little chance of getting the people behind it due to the structure of the currency. This contributed to Bitcoins image as a hacker’s currency. See also: https://en.wikipedia.org/wiki/CryptoLocker

Volatility of Bitcoin remains a problem

While you can be quite sure that your Euro, US Dollars or Yen will not heavily fluctuate within a short period of time, this is not the case for Bitcoin since it is purely demand and supply driven. This can mean that a Bitcoin that was worth an equivalent of US$1,000 a week ago is now worth US$500 or US$2,000. This makes it interesting for speculators in the market but harder for businesses or personal accounts to use Bitcoin as an investment or transactional service.

Historical movement in the closing price of a Bitcoin against the USD

Historical movement in the closing price of a Bitcoin against the USD

Volatility has increased over time

Volatility has increased over time

A number of eminent companies now accept Bitcoin payments including Microsoft, Dell, Wikipedia, Twitch, Greenpeace, Expedia and PayPal.

  • At Microsoft users can buy apps, games and more for Windows, Windows Phone and Xbox using Bitcoin.
  • Greenpeace and Wikipedia accept donations via Bitcoin.
  • PayPal probably does not like Bitcoin as the Bitcoin network is in direct competition to its scope of business. There is also a contradiction in the protocol which underlies a PayPal transaction – where a buyer is able to always initiate a chargeback with PayPal as the mediator – as compared to a Bitcoin transaction – which is irreversible unless instigated by the seller since the there is no middleman to arbitrate a dispute. There is also the cost factor per transaction.

However, PayPal seems ready to use Blockchain. “We’ve entered a period of unprecedented disruption in payments and financial services driven by the mass adoption of mobile technology and the digitisation of cash,” said PayPal CEO Dan Schulman in a statement. This might also help PayPal to achieve more efficient and low-cost transactions. See more.

The future : Blockchain 

Although the advent of Blockchain will soon become a decade-old milestone, it can be argued that the technology is still in its early stage of growth.Blockchain Apps End User View

Even though this, like TCP/IP, might be one more virtual processes that just “runs” on your PC, it is possible that we are at the brink of another technological revolution that will impact our real lives in the future in a far more extensive manner than most technological or commercial innovations of yesteryear.

Possible applications are presently getting deployed by numerous companies from start-ups to big corporations. Financial institutions were fast in identifying the potential of the technology. ‘Smart contracts’ that run on Blockchain technology enable bilateral trade bringing benefits to banks as well as customers.

The future : Bitcoin

As with Blockchain, the early ecosystem of Bitcoin was filled with inefficient companies and poor custodians. The recent Mt. Gox Bitcoin debacle resulted in individuals losing millions of dollars collectively. The illicit marketplace, Silk Road, made people believe that Bitcoin was only used for purchasing drugs, weapons and other contraband.

Yet the currency is growing and that perception is changing. Regulators are ramping up pressure on Bitcoin miners and exchanges to explore effective ways to ensure the cryptocurrency fulfils its intended role in the long run. This also means that there will be pressure on the merchants accepting it and users paying with it.

But old exchanges are dead or dying. The next stage of exchanges, such as Coinbase, takes both security and regulation seriously. Millions of dollars are spent on security analysts and lawyers to work with regulators and authorities. In many cases, companies that are incapable of building out their own secure platforms rely on BitGo, the leading provider of security software in the Bitcoin space. The companies built on top of its technology have sent over US$1 billion in transactions and not a single penny has been stolen.

Further, the number of users on the network and the number of transactions they send are growing. Start-ups are enabling people to buy goods on Amazon via Bitcoin. Others use it as a medium of exchange for micro-transactions.

Bitcoin is also experiencing a ‘positioning’ crisis. Should it be a competitor to Visa, MasterCard and PayPal as a platform for transactions to take place or should it be a settlement layer with all the major transactions done on a second layer? Can Bitcoin remain decentralised and censorship-free if it scales up to cater to the mass-market?

Nonetheless, the future for Bitcoin looks bright due to its many benefits for the user and merchant. However, the cryptocurrency and its underlying ecosystem is tasked with proving its fit with the users’ ecosystem in a manner in which he or she can easily and safely use Bitcoin. One thing is for certain, Bitcoin and Blockchain are setting the stage for the next global revolution in currency, trading and commerce.

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