Blockchain technology and Cryptocurrencies - How do they work?
In the media, we are inundated with news and articles that mention cryptocurrencies, bitcoin, blockchain, mining. I can tell you from experience that some, either due to lack of time or incomplete information, may not be familiar with the subject, and may not be sure where and who to ask for information. If you are among them, then you are in the right place. The topic is extensive, and I will try to give you a brief overview of what it is all about.
Cryptocurrency (or digital currency) and money
It is necessary to distinguish digital currencies (or cryptocurrencies, which is a general term) from electronic forms of money. An electronic form of money is your bank account in which a certain amount of money is stated and is linked to physical money. Digital currencies are not related to physical money. Physical money (the technical name is FIAT money) is issued by the State, and its value is related to the state of the economy and the way the State manages its economy. Digital currencies are not tied to physical money, they are not backed by a state, public legal entity or economy, they exist only in digital form and are not tangible, their value depends on investors, information (including rumors in the media), the network on which they exist and the people behind it, and their supply and demand for them, so their value (expressed in recognized world currencies) varies significantly. Since they are not backed by any government, and are not affected by borders between countries, their value is equal worldwide.
Are cryptocurrencies Money?
No. Cryptocurrencies do not meet the definition of money under International Accounting Standards, however tax authorities and legal regulators have their own views on cryptocurrencies and place them within their legal frameworks. Trading cryptocurrencies is considered a financial transaction, according to by the judgment of the Court of Justice of the EU in case C-264/14, dated 22 October 2015.
Blockchain technology
Blockchain and cryptocurrencies are directly related to each other. In a nutshell, blockchain is a ledger, like a company's analytical balance sheet. It consists of blocks that contain records of all transactions in digital form, and the blocks are interconnected. Each block has a unique identifier that is directly linked to the unique identifier of the previous block, and thus forms a chain. This ledger is decentralized, meaning it is not in one place but is stored on all the computers of the users of the blockchain network. Most of the ledgers are public, but there are also those that are not public. In the image below you can see the principle of how Blockchain technology works:
Blockchain technology has outgrown its roots – cryptocurrencies – and now finds potential application in various areas, from financial and transportation services, the energy sector, contractual relations to program code. However, there is also a lot of uncertainty, which I will write about at the end of the article. In order to introduce cryptocurrencies to you, it is necessary to further introduce blockchain technology and vice versa. The first and most famous cryptocurrency is Bitcoin, and the entire process will be described to you through it.
How did it all start?
A person (or group of people) named Satoshi Nakamoto (a pseudonym) took advantage of existing cryptographic technologies and in 2008 published a “whitepaper” (a guide explaining the entire idea of cryptocurrencies) which he sent by email to people from the cryptographic community. The following year, the computer program that runs Bitcoin (the first cryptocurrency) was published, and interested people began to mine the cryptocurrency with their computers and the computer program that runs Bitcoin (more on that later), and thus began the entire cryptocurrency system. Today there are around 1800 active cryptocurrencies and 1670 "dead coins".
What is Bitcoin? And mining?
Bitcoin is officially conceived as a system in which transactions take place between end users, independent of banking and financial institutions. Each transaction is recorded and verified by a computer program and the technological system itself - Blockchain (chain of blocks). As I stated before, the blockchain is a record book of ALL "coin" transactions (even though they are not money) - in this case Bitcoin - and the transactions are compiled into blocks that use cryptographic validation to link the blocks together (hence the name blockchain or block chain). Each block refers to the previous block and identifies the previous block, therefore the ledger is permanent (and always increasing), and any attempt to change or delete a previous transaction (already in the chain) would immediately alert all participants in the network (the next block is tied to the previous one that is being changed). The transaction ledger is not located in one place, but everyone who has Bitcoin has their own copy of the ledger that is synchronized among everyone in the network. Anyone who wants to can get a copy of the ledger. The network consists of Bitcoin Nodes, which are actually computers that run the Bitcoin computer program and participate in processing transactions. As of September 25, 2021, 11,734 nodes, i.e. computers spread throughout the world, participated in the network (the largest number in the USA and Germany, over 1,800 each). Nodes are responsible for maintaining the network, it can be anyone, and there is no fee for this. What does the whole process look like? When a user sends a transaction (Bitcoin) to the recipient, it is sent to a pair of nodes that check the validity of the transaction before sending it to the next nodes, and so on until all nodes in the network are notified of this new "pending" transaction. Each node has an identical copy of the book of ALL transactions EVER and checks that the Bitcoin that is "pending" was not created outside the system, i.e. forged. The "pending" transaction is located in a mempool (pool) in which there are about 10,000 such transactions at any given time. This is where Bitcoin Miners come in, which are actually specialized nodes that download blocks of "pending" transactions, randomly guessing large strings of numbers until they guess the correct solution that unlocks the next block. That solution is, as I mentioned, linked to the previous block. When they guess the correct solution to the cryptographic problem, the initial transaction has become "Confirmed" and has entered the transaction book and the recipient can receive it. Then the entire network sees that the sender sent the transaction, the validity has been checked by all nodes, the miners have confirmed it. The first miner to find a solution receives a reward in the form of Bitcoin from the network, but also a fee from the sender so that the transaction is confirmed as soon as possible (if you want to make a transaction quickly, you need to pay a fee for your transaction to be included in the first next block). Satoshi Nakamoto (a person or group) set the rules of the network - the final number of Bitcoins is set at 21 million, and every 4 years the reward for miners is reduced by half. In 2021, the reward for 1 block is 6.25 Bitcoins (this much is added to circulation with each block). Now you know how they are created. There are currently 18.8 million Bitcoins in circulation and according to these rules, the full number will be reached in 2140. One Bitcoin consists of 100 million satoshis or sats (like a lipa in kuna). Mining today is mainly done by mining pools and companies, since mining requires expensive specialized equipment and a lot of electricity. A Bitcoin transaction can require up to 5,000 times more electricity than a VISA bank card transaction. Many criticize cryptocurrencies for their high electricity consumption and environmental impact. For comparison, the Bitcoin network consumes 129 TWh of electricity per year and Norway 124 TWh.
With cryptocurrencies you can trade with other users of the same, you can buy and sell them in exchange for money, and you can also pay at points of sale that allow this, but there are not many such points of sale. Currently, around 15,000 points of sale accept Bitcoin payments, while Ether (the second most popular cryptocurrency) is accepted by around 3,000 points of sale. In contrast, VISA payments are accepted by 46 million points of sale and Mastercard by 37 million. In Croatia, there are an increasing number of physical cryptocurrency exchanges (mostly in Zagreb and a few on the coast) that offer Bitcoin-for-money exchange services and vice versa. The main arguments in favor of cryptocurrencies are direct transactions between users, avoiding intermediaries such as banks and other financial institutions and thus reducing costs, speed of transaction execution, anonymity, transparency, the ability to track transactions, a permanent and immutable ledger, and the impossibility of counterfeiting cryptocurrencies. Transferring funds between different countries can be done in a short time, unlike the days or more that certain international transactions can take to complete. In reality, some of these arguments are not fully satisfied. For example, avoiding transaction fees and speed of transaction execution, since miners need to pay a fee to complete the transaction as quickly as possible. Anonymity, as one of the arguments, also does not hold, because all transactions are (ever) recorded in a ledger that anyone can obtain. Rare are cryptocurrencies that can be characterized as completely anonymous, such as Monero, since it is based on a different technology.
The EU has recognized the possibilities of blockchain technology in which it wants to be a leader, and for this purpose the European Commission has adopted a strategy to achieve this. In the period 2016-2019 alone, support in the amount of €180 million was granted. Since 2018, all EU members (+ Norway and Liechtenstein) have formed the EBP (European Blockchain Partnership) with the aim of building the EBSI (European Blockchain Services Infrastructure – nodes that will support the EU blockchain network). There are currently 25 active nodes and 11 nodes in the process of being set up. The network is intended for public administration, communication of business entities with public bodies and EU citizens. The potential application of blockchain is in various areas, from financial and transport services, energy sector to contractual relations and others. Developed as the underlying technology of cryptocurrency, it has outgrown its roots. Further application of blockchain technology was first seen with the development of the Ethereum blockchain platform in 2013. Although this system also has its own cryptocurrency, Ether, what makes it stand out is the ability, in addition to numerical records, to also record program code in the ledger, which is called a "smart ledger". contract". This allows, for example, to send a certain amount of cryptocurrency on a certain date. Another example is the purchase of travel insurance that is recorded in the blockchain. The so-called smart contract will check if there has been a flight delay and, if so, automatically transfer the insured amount to the user . Sounds great? This brings us to the problem of regulating the technology – how and who do you turn to if said “smart contract” fails? As a result, organizations and individuals have been exploring blockchain in recent years and looking for ways to implement and regulate the technology. A well-designed blockchain network in theory can process 10s of thousands of transactions per second and cost 0.00001c each, unlike the Bitcoin network where a transaction can cost $2.5. It is a well-known joke that the most used software for blockchain development is PowerPoint. The big obstacles are the fact that it is an extremely complex technology, the implications of the regulation and use of the technology are unknown, and there are great challenges of application. Let's say that now the technology is regulated and there are positive legal regulations. We see that today large corporations, and even public bodies, often do not follow the Law, and mostly without consequences. Who guarantees that in the event that the technology fails, I will receive payment of the insured amount for the canceled flight, when the obligations are not kept even by those who primarily should? I personally believe that circumstances will become normal and laws will be respected, without exception, and modern technologies will be at our service, instead of governing us. Until then, I record my contractual relations on a piece of paper.