Most of us have heard about the popularity of bitcoin, but how bitcoin and digital currencies actually work is not as widely known. The technology behind digital currencies like bitcoin and ethereum is called the blockchain. The blockchain is the mechanism that keeps digital currency transactions secure. Quite literally, the blockchain is a public ledger of all transactions and anyone is able to see it and make their own transactions. How this public ledger works is the complete reversal of our traditional banking system and really ushers in a new era of distributed computing.
How Do Traditional Banking Systems Work?
Our traditional banking system is based on a private ledger that only you and your bank share. Let’s say you make a purchase on Amazon. Your bank will act as a third party and send Amazon your money and the transaction is completed. The bank you work with has a database somewhere that you can access with your online credentials, and you can make purchases or deposits with account info or card number.
How is a Blockchain Different?
When using a blockchain system, there is no third party like your bank. The ledger must be public for the security and accuracy of the transactions to work on the blockchain. By making the ledger public, every user “agrees” to the updated version that is essentially a key generated with a complex hash function. This is where the bitcoin miners get involved.
The bitcoin miners are generating this new key with their computing power around the world. The miners generate this new cryptographic hash function once every 10 minutes approximately, and all transactions that happened within that 10-minute window are recorded on the new block. This new cryptographic key is linked to previous chains, which makes it impossible to break because those previous keys would have to be broken and that would require an unthinkable amount of computing power to decrypt.
How is Currency Like Bitcoin Used?
When a person owns a bitcoin or a fraction of a bitcoin, they have a digital signature or key of that bitcoin. Half of the key is private and the second half is public and stored on the blockchain. When you request money or receive money, everybody on the network gets a copy of the requests. Before the completion of each transaction, the participants agree upon a price for the item. This is a key feature in crypto currencies: The users decide on the price of the items, not a third party. If the two users agree that two bitcoins are worth the price of a house, that will be the price of the transaction. Users can decide if they want their currency to represent kilowatts of energy, shares in a company or personal property.
So, what if you want to buy a slice of pizza? Each bitcoin can be divided into one hundred millionths, and each of those parts has its own individual ID number that can be used in a transaction. When a transaction is completed, the second half of your private key is recorded on the blockchain, along with the time, date, participating accounts and the final amount of the transaction. Each node on the network will get a copy of the transaction and the updated blockchain. If somebody tries to falsify or corrupt a transaction, the nodes on the network will not be able to verify and agree on the transaction, and the blockchain will not be able reconcile the new transaction.
The potential for other applications using a blockchain to verify transactions is limitless. Tracking diamonds by using a blockchain could prevent conflict diamonds from entering the market. Human trafficking is another area that could benefit, as 1.5 billion people in the world have no formal identification. Sweden is using a blockchain to help landowners register their property. Musicians can use the blockchain to sell directly to their fans. The blockchain is here to stay and we all need to know how it works.
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