A Quick Primer on Bitcoins, Blockchains, Cryptocurrencies, and Cryptocurrency Investing
You may be hearing a lot about Bitcoin, blockchains, and cryptocurrencies lately and wondering what they are and if you are missing out on a great investment opportunity.
I will try and clarify these concepts with enough detail to help but hopefully not too much that it bores you. The internet has near-infinite resources to take you as deep as you want to go should you want to research further, if that is the case please let me know and I can point you in the right direction.
A quick disclaimer. This is not investment advice and should not be perceived as investment advice in any way or form. Investment decisions should be discussed with your personal tax, legal, financial, and other advisors. Anything stated here is my personal opinion or perspective, meant for informational and general purposes only, and does not represent the position or the advice of any company, advisor, or entity. Me, or any organization I’m affiliated with, are not liable for any decisions you make regarding cryptocurrencies or blockchains. You should only purchase or invest in cryptocurrencies if you are fully aware of what you are doing and the risks, which are significant and may be difficult to identify.
I do not own any Bitcoin, but I do own Ethereum (ETH), another cryptocurrency. I last owned Bitcoin in 2015, but may purchase or transact in BTC, ETH, or other cryptocurrencies in the future.
Introduction to Bitcoin, Blockchain, and Cryptocurrency
Bitcoin is the most popular cryptocurrency. It is intended to function similar to fiat currencies — fiat currencies are currencies that are controlled by governments. Bitcoin is abbreviated BTC when quoted or discussed.
A block chain is a digital ledger. For now, think of it is a data file on your computer. Each row of the data file is a “block” and in each row there is data about the transactions that occurred in that block.
There are two key characteristics of the classic blockchain,
- Once a block is added to the block chain it is permanent and the information inside of it cannot be changed
- The official source of record of the block chain is not owned by any person, group, or other entity or entities. In classic blockchains, such as Bitcoin, any computer can choose to become a member of the blockchain at any time using free, straightforward software that is easily attained and installed. Becoming a member of the blockchain does not require significant hardware.
Everything done on the blockchain is transparent and easily verifiable by anyone with an internet connection and understanding of the blockchain mechanics. We will see this much later in this writeup.
Blockchains rely on the field of cryptography to ensure accuracy of the blockchain.
Cryptography is a field of science for hiding information. You are exposed to cryptography every day through your computer passwords.
Cryptocurrencies use modern techniques of cryptography to ensure that the blockchain is accurate and never changes over time.
Let’s use a practical example. Imagine you are an artist and you want to create the color purple. We all know that there is only one color combination that makes purple — mixing blue and red.
Now, imagine an alien landed at your door and you gave them a bucket of your purple color that you mixed. They had never seen purple before. They go back to their home planet and try to figure out how to make purple.
They first try to split your bucket of purple in half, but they just have two buckets of purple. They mix some other random colors together, maybe eventually they land on a similar tints of blue and red. Unless they figure out your exact blue and red shades, they will never get your exact purple.
This is an example of a one-way cryptography. Given the exact right inputs, it is easy to produce the exact same output. However, one-way cryptography cannot be reversed; you must know the exact inputs or you will never find the correct output.
Blockchains use one-way cryptography to sign and come to consensus on the exact information in a block.
Imagine the following log of transactions:
- You pay your electric utility $100
- You receive $250 from your uncle
Let’s see how this might work, cryptographically, and then build a quick chain.
One of the most popular one-way algorithms used today is called SHA256. Don’t worry about the details, just know that for anything sent to SHA256,
- you will always get an output that is the same length
- there’s an infinitesimally small probability of getting the same output for any two inputs
- and there’s currently no way to back out the inputs from the output — you could only find the inputs through some manner of trial and error, which currently would take all the computing power in the world potentially millions or billions of years to solve without getting lucky.
Let’s encode our transactions using SHA256. This is very easy using any popular programming language. This example uses a language called Python.
As you can see, all the strings look about the same length and are a jumble of characters. In fact, they are all exactly the same length, 64 characters.
And, if you were to run the input strings through any SHA256 encoder you would get the same exact output — each of these output strings is commonly referred to as a “hash.” Changing just one character of the input changes the output hash so it looks nothing similar to the original without the change.
Below I added a single space to the end of the first transaction string and the output hash has no relationship to the original hash.
You can try this out yourself at SHA256 Online Encoder (devotter.com) and see if you get the same outputs for the strings presented above.
This output hash from the website, beginning “7a181” is identical to the output hash for the same string I produced using Python.
You can throw any amount of text at the SHA256 encoder, such as a single letter or all the written text in the world, and it will still return a hash of 64 characters that is (considerably) unique down to an individual character. Below, I run the source code for a large web page through the SHA256 algorithm and still (and always will) get a succinct 64 character output.
Coming Back to Blockchain
Imagine two transactions occurred on 1/1/2021 between 9:00 AM and 9:05 AM. We want to store these transactions to a ledger.
This “Block1_hash” is used as input to the second block. I will carry this through to 3 blocks, show how this is done in code, visualize the block, and show how this can be confirmed by anyone with access to an SHA256 encoder.
I added two transactions that occur in block 2 representing 9:06–9:10 AM and then two more transactions as block 3 representing 9:11–9:15 AM.
Hopefully you can see that in the line where the block 2 hash is created it takes the transactions specific to that block — the new transactions — and adds the hash from the prior block.
This is the chain of blocks or the blockchain. Below is a visualization that might make this easier to see.
And, block 2 checks out. That is, I took the hash from block 1 and the two strings that made up the transactions for block 2, and the resulting hash run through the SHA256 encoding website exactly matched the hash produced using Python.
Remember, any slight change to any input (for this example, previous block hash or current block transactions) such as a space, an invisible 0 or 1 in the code, punctuation, or a character will produce a materially different output hash.
In fact, I have a small typo in the first transaction of block 2, “Mom buys a turle for $50” should be “Mom buys a turtle for $50.” If I want to fix this mistake I would have to recreate all of these diagrams and outputs, because I would be breaking the chain at transaction 2. I’ll leave this as an exercise for those that want to explore further.
Bringing it All the Way Back to Bitcoin
Bitcoin is one of the earliest developed and popularized blockchains. If you look at the Bitcoin blockchain, each block stores transactions between “wallets.” That’s it, every block is just a ledger of transactions, where all the transactions are bitcoins. Wallet A sends X amount to Wallet B.
Looking at the actual Bitcoin blockchain (I’m using https://www.blockchain.com/explorer, but you can google “Bitcoin blockchain explorer” and see there are lots of similar sites), each block on the blockchain is about 1 megabyte and takes between 1 min. to 5 min. on average to be added to the blockchain (this is done by miners who are solving a cryptography puzzle, the difficulty of which is tuned to ensure a block is mined approximately every 1–5 min. based on the computational power on the Bitcoin network. I cover this a bit more below).
If I click on the Hash for a block I can see the exact transactions, or movements of Bitcoin, captured in that block.
Let’s look at the ledger entries I boxed around.
Someone that uses the handle, or “wallet,” that begins “33VHPi” created a ledger entry to move .65383967 BTC (nearly $20,000 as of 1/4/2021).
The sent BTC was split between two other people, handles, or “wallets”
- One beginning “3KAeyi” received most of the BTC, .63736145
- And the remainder went to “1GknVE” for .016 BTC
- A very small amount .0004 was held back as a fee to reward the “miner” that solved the cryptographic puzzle for the block first. At $32,000 a BTC, this is about a $13 fee to the participant that solved the puzzle.
Quickly, What is Mining a Block
Let’s say we want to write the transactions inside of block 2 to the blockchain, and they are the only transactions occurring on the network, so they are only the transactions that will go in the current block being mined.
- We launch the software to write to the blockchain on our computer
- This software connects to a random number and selection of other computers on the blockchain
- The software downloads the full blockchain from beginning of time to now, it’s a few hundred gigabytes
- You announce to these computers that you want the transaction recorded, they repeat this transaction to all connections, and this spreads across the entire network quickly
- At the same time, all of the computers on the network are trying to solve a puzzle. A common one is to find a string that can be added to the input strings, that when included, produces a hash with certain number of leading 0s. It’s a matter of trial and error, but it’s much simpler than finding an exact string of 64 characters.
Say the puzzle is to get an output hash that begins ‘de3’, the rest of the hash after the first three characters doesn’t matter.
Miners try random inputs until they get the required answer to the puzzle.
- At this point, I would share my solution to the block chain network. I would share my block, which contains the transactions, and the solution to the puzzle (in this case “adamwas”).
- This would be picked up by the other miners on the network, who can instantly verify that they have at least the same transactions waiting to be mined and that the puzzle answer works.
My solved block, with its transactions, gets added to the blockchain, forever, and I get rewarded with the bitcoin for mining that block.
If someone else solved the puzzle before me, they would announce the solution and I would pick it up the answer and verify it is correct. That person would get the miner reward, and we would all move on to solving the next puzzle together.
Any transactions that were not in in the solved or “mined” block are queued for a future block and are not considered transacted — this is one source of the delay for transactions when using the blockchain.
A computer on the Bitcoin blockchain generally holds the entire chain from the beginning of its creation (these are referred to as full node). Therefore, the amount of Bitcoin assigned to a particular address is just the aggregation of its entries on the blockchain, it’s always transparent and accurate.
INVESTING IN CRYPTOCURRENCY
There are an endless number of cryptocurrencies and their closely related alternative, cryptocurrency tokens. The nuances of differences between each cryptocurrency or token is beyond the scope of this write-up. For introductory purposes and the mechanics of acquisition, trading, or selling, the distinctions are not material.
Should you choose to get involved with owning cryptocurrencies or tokens you should understand the specifics of the crypto you are looking to invest in, as there may be materially different value drivers.
Bitcoin is the most popular cryptocurrency by far, and it is relatively simple in terms of understanding and its use cases. For example, some cryptocurrencies are built on networks that the ledger can cause the networked computer to perform computations before writing the blocks (you may have heard of smart contracts, this is far beyond this write-ups scope) whereas the Bitcoin blockchain is a simple ledger.
Therefore, I will limit this discussion to Bitcoin investing.
Due to Bitcoins popularity, it has become highly accessible and easy to acquire. You can now log in to PayPal and purchase Bitcoin as easily as buying an extension cord from Amazon.
I personally have little comfort with any of arguments for how to value Bitcoin.
Some folks have gotten very rich, very quickly by buying Bitcoin, and some people have lost a lot of their investment quickly by buying Bitcoin.
I would argue, at its core, it is a very risky investment choice, relatively speaking. Cryptocurrency investing has and continues to produce many extreme losers alongside extreme winners.
I have not seen a convincing approach to determining expected return, and the volatility of returns is relatively very high compared to other investment choices.
Below are two of the most popular arguments for investing in Bitcoin:
- Some people consider Bitcoin a good diversification asset for a portfolio of investments. Historically, the returns of Bitcoin and other cryptocurrencies have low correlations with other asset classes. However, as Bitcoin and others become more broadly owned by traditional investment participants such as large funds and institutions, their correlations with traditional investment asset classes will most likely increase.
- Some people consider Bitcoin a good hedge against inflation. There is a finite and constrained supply of Bitcoins. Therefore, if the supply of the fiat currencies, such as the U.S. dollar, are increased, then each Bitcoin should be worth more dollars.
It is worth noting that the history of Bitcoin related to other asset classes is still too fresh to consider either of these points matters of fact.
Ultimately, investing in Bitcoin or other cryptocurrencies is a bit of a guess of how the cryptocurrency world will evolve and the continued growth and acceptance of a decentralized currency.
If you are considering investing in cryptocurrencies, make sure to discuss with your advisors. Make sure you understand the risks. You could easily lose 100% of your investment by misplacing a password or secret code, and no one might be able to ever help you retrieve it or could be held liable for the loss.
Bitcoin and other cryptocurrency investors commonly refer to themselves as part of the HODL crowd. This stands for Hold On for Dear Life. It’s worth keeping this in mind if you decide to buy BTC as an investment.
If you are set on buying Bitcoin, the easiest way to get involved these days, and relatively safer since you don’t have to worry about managing a cryptocurrency wallet, is through a merchant such as PayPal.
However, merchants such as PayPal do charge fees that you can avoid by learning more and getting more technical. Knowledge about wallets and cryptocurrency exchanges will go a long way if you want to seriously understand cryptocurrencies and associated markets.
I would suggest starting with the PayPal approach to acquire your first cryptocurrency, and starting with a small investment.
Hope you enjoyed this write-up. Happy New Year!