Blockchain, Part One: What Is Blockchain and How It Works

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If you’ve been on the Internet lately, you’ve probably heard about blockchain.

Some see this new technology as the beginning of a revolution. Others warn that right now, it’s nothing but a great way to lose a lot of time and money.

Where does the truth lie? It’s hard to tell without knowing the future.

So I took it upon myself to sit down with Krzysztof Karolczak, our Head of Service Delivery in Łódź. Krzysztof is a personal enthusiast of the blockchain technology, spearheading the blockchain-related projects at STX Next.

During our conversation, we tried to imagine the blockchain-enabled world of the future. Our talk was fruitful enough to produce a two-part series of blockchain articles.

In this part of our series on blockchain, we answer the following fundamental questions:

  1. How blockchain works

  2. How it applies to currencies

  3. What drives the value of Bitcoin

  4. What impact blockchain will have on some of the industries you’re familiar with

In the second part of our series, we take a look at how your browser experience might change if blockchain becomes part of everyday reality. It's up on the blog already; you can read it here.

But for now, let’s start by tackling the big question...

What is blockchain?

Blockchain is a way to organize data that preserves a chronological sequence of events. This system is distributed and trustless, meaning you don’t need to trust one central entity. The state of a blockchain, the consensus, comes from the people involved in this process.

Blockchain is used to store an immutable sequence of data. Event A was followed by event B, then event C, and so on. That information is stored for as long as there are participants in the network, with each of them storing a copy of the blockchain. It’s extremely difficult to falsify the data without extraordinary amounts of computational power.

The information doesn’t have to be about transactions, mind you. It can be temperature, the location of a package, school grades—anything. It’s a community-confirmed record of chronological events.

Blockchain removes the need for central entities that tell you the state of the objects in question. Instead, a distributed group of independent participants confirms the state of the objects, and the sequence of events that led to this state.

Because of this, blockchain allows you to transit from a trusted system—a bank, for instance—to a trustless system, like the one cryptocurrencies are based on. The effect this can have on the future of technology is profound.

Applying blockchain to currencies

The application of blockchain technology to currencies is clear: you can transfer value without intermediaries and without having to trust financial institutions. This is the promise of cryptocurrencies such as Bitcoin.

Where do miners come into this?

You may have heard of mining Bitcoin. You may also have heard of droves of graphics cards flying off the shelves for this very purpose. (I routinely hear one of our sysadmins lamenting that the crypto craze has devastated the graphics card market.)

So what is mining, actually?

Krzysztof describes it as solving a complex cryptographic puzzle that makes it extremely difficult to alter the events previously contained in a blockchain. Solving this puzzle requires significant computational power—that’s where the demand for beastly GFX cards comes into play.

The computational power spent on mining (producing so-called proof-of-work) safeguards the state of the events and data stored in a blockchain, as introducing changes would require the attacker to have more than 50% of the processing power that the whole network has.

For their participation in creating the consensus, the miners are rewarded with Bitcoin coming from two sources: transaction fees and mining rewards. It’s a win-win scenario: while cryptocurrency flows into the the miners’ wallets, their work also maintains the proper state of events, removing the need for a centralized entity.

What determines the value of Bitcoin?

The value of Bitcoin is driven solely by the demand for BTC, i.e. how much people are willing to pay for it via crypto exchanges.

But the demand does change depending on a variety of factors. Here are three major factors influencing demand for Bitcoin:

1. There is a fixed final supply of Bitcoin.

There will only ever be 21 million BTC mined. After that, you will only be able to get more by trading, and as time goes by, more and more people become interested in owning it.

Something worth mentioning: a common misconception in the US is that you can only buy multiples of Bitcoin. This is false, as Bitcoin is divisible; you can even buy 0.0001 BTC if you’re so inclined.

2. Bitcoin offers a lot of utility.

Once Bitcoin becomes easier to use than wire transfers or credit card payments, it will create endless possibilities for mass adoption.

3. Some of Bitcoin’s demand results directly from mainstream interest and hype.

Positive press can make a token’s value soar within days; negative press can make it tank within hours. High volatility is extremely common among markets in their infancy.

But Bitcoin, as you may or may not know, is just the tip of the iceberg. There’s also Ethereum, Litecoin, Ripple, Lisk, NEO, Dogecoin, and hundreds more. Which leads us to the next question...

Why do we have so many cryptocurrencies?

The main reason is that most blockchain projects have a strong incentive to issue their own currency. Through so-called ICOs (Initial Coin Offerings), blockchain projects can collect financing not by offering shares, but by offering tokens.

The thing is, you don’t really need to create a new currency for every project. The need stems from the desire to collect funds easily, which is what these so-called “utility tokens” are for.

On the other hand, some of the tokens you see on the market occupy the same space as Bitcoin, with the goal to improve the processing of payments. Litecoin is one example, promising faster transactions than Bitcoin, while also handling changes to its blockchain in a slightly different way.

In short, whenever a group of people comes up with another way to use blockchain tech, either for finance or to facilitate other services, a new cryptocurrency is sure to follow.

Monetizing decentralized services through utility tokens

Blockchain opens up the possibility to introduce decentralized services of all shapes and sizes.

FileCoin and IPFS

Consider utility tokens such as FileCoin or IPFS, for example. The teams behind these projects asked themselves:

“Why pay Dropbox for storing your files when other users on your blockchain could store them for you? Why not make money off of it, and make it a shared economy?”

As a result, you can now store other people’s files on your hard drive, and gain FileCoin or IPFS for your service.

GOLEM

Another good example is the Polish GOLEM project, which aims to create a supercomputer using consumer CPUs.

GOLEM allows you to “rent out” your CPU for a variety of purposes, including processing protein chains or searching for extraterrestrial life. In return for the contributed CPU power, you receive GOLEM tokens.

The concept is not entirely new if you recall projects like SETI@home or Folding@home, but with blockchain, you now have a whole economy associated with these efforts, and they become a way to acquire more cryptocurrency.

Risks

Of course, there’s more than one way things could go wrong in the decentralized blockchain economy.

For projects like FileCoin or IPFS, for example, the data stored on another user’s hardware would need to be 1) encrypted, and 2) have some redundancy, meaning you’d need dozens of copies across numerous devices. One could argue that no business is without risk, but in such uncharted waters as blockchain, the risk is all the greater.

Investing in blockchain projects and crypto is also risky. As an investor, you see tons of projects and a deluge of cryptocurrencies. Many of these projects will certainly die, and the money you invest in them may be completely lost as the token value drops to nothing.

On the other hand, if the utility tokens associated with a service become overvalued, nobody will use the service. Right now, everyone is just speculating on coins and tokens whose real value may only become known years down the line.

Not that decentralized... yet

Finally, the current cryptocurrencies market isn’t as decentralized as one would wish. To trade crypto, you still need a central entity: a crypto exchange. Using such an exchange, you can trade your regular fiat currency (such as USD, EUR, GBP, or PLN) for Bitcoin or any other cryptocurrency.

Currently, crypto exchanges are a critical point of failure, as the Mt. Gox episode showed in 2014. Mt. Gox was a Japanese crypto exchange that, at its peak, was processing up to 70% of all Bitcoin transactions. Soon after, however, the owners of Mt. Gox filed for bankruptcy when hackers stole ~460 million USD worth of Bitcoin from the exchange.

But the days of centralized exchanges may be coming to an end. With solutions like AtomicSwap hitting their stride, users will be able to exchange crypto directly, leading to truly decentralized exchanges.

Final thoughts—for now

Congratulations! If you’ve read this far, you are now part of the exclusive “I Somewhat Know What Blockchain Is About” Club.

Remember, if any of your friends or coworkers asks you what blockchain is, the shortest—though not the simplest—answer is: a distributed, trustless ledger of events, confirmed and secured through a decentralized consensus algorithm.

So blockchain is a ledger, which may not sound groundbreaking. But it has the potential to change the world.

And that’s exactly what we’re tackling in the second part: the way your world (specifically, your browser experience) might change if blockchain becomes ubiquitous.

This is where we conclude this section, however. Thank you for reading, and see you in the next one!


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Author

Jakub Grajcar

Inbound Marketing Specialist

Author

Krzysztof Karolczak

Head of Service Delivery

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