Blockchains, Bitcoin and cryptocurrencies have garnered a lot of attention over the past several months. (Note: The industry’s standard usage is that the capitalized Bitcoin refers to code, whereas lowercase bitcoin refers to the unit of currency. For the sake of clarity, this article will refer to the currency as Bitcoin tokens throughout.) When Ethereum’s ether token soared from $8.29 on Jan. 1, 2017, to over $400 in June, public interest also exploded. Despite exponentially increased buzz around these concepts, most people fail to understand what they are, how they work and what purposes they serve. This article will give readers more information on blockchains, Bitcoin and cryptocurrencies.
First, cryptocurrencies are simply digital or virtual currencies that use cryptography for security. Cryptocurrencies such as Bitcoin tokens are supported by blockchain technology, which, in its most general sense, is a peer-to-peer, decentralized, encrypted ledger used to maintain a continuously growing list of essentially immutable records. Thus, one can record any type of transaction to a blockchain, not just monetary transactions. Some ledgers are public and open-source (“permissionless blockchains”), meaning that the blockchain code is publicly available for anyone to study, change and distribute. Other ledgers are private or “permissioned blockchains,” open only to select computers. In either blockchain structure, the code requires computing a large volume of complex math problems in a very short time. The code is dispersed among computers (called “nodes”), which process the transactions by running the code and, in the process, create (or “mine”) new tokens.
After a transaction is processed by a node, the transaction must then be broadcast to other nodes for validation and approval. Once validated and approved, that transaction is grouped together into a block of transactions, which is added (or “hashed”) to the blockchain ledger. Each block is hashed chronologically and linked to the previous block (hence, the use of the term “chain”) by way of timestamp. Miners are incentivized to hash only valid transactions, as they are rewarded only once their block is validated. Fraudulent blocks are rejected by the other nodes, which results in no reward for the miner.
Theoretically, adding to or altering a recorded transaction would require changing a previous block. This means that a computer would have to run the long and complex encryption, change that block, then run the encryption and change every subsequent block before a new block is completed and hashed to the blockchain. Simply put, altering or creating a new transaction requires so much computing power, electricity and effort that in effect blocks cannot be altered after they have been hashed. As a result, blockchains are practically un-hackable from a data security standpoint. Users are typically recorded on blockchains by use of a pseudonym, which provides a level of privacy. These features provide trust through transparency, as users can rely on historical cryptographic proof of transactions, rather than needing a trusted third party, and can do so in a somewhat private manner.
The Bitcoin ledger is open-source and requires transactions to be validated by at least 51 percent of system nodes (the “consensus protocol”) before a block can be added to the blockchain. Bitcoin code also prevents one from double-spending Bitcoin tokens by essentially divesting a sending-user of her tokens when the transaction occurs. Bitcoin tokens and other similar cryptocurrencies are often referred to as “protocol tokens,” as they are bootstrapped by their own system and essentially function only as a currency.
Bitcoin tokens are an alternative to traditional fiat currency issued by central authorities and governments. They are faster and impose fewer fees than usual ACH bank transfers or credit card payments, especially on international transactions. Bitcoin also allows consumers without access to traditional banking to reach a broader financial market by offering a mobile platform for storing and transacting money. Today, there are more than 1,000 cryptocurrencies, with a total market cap of nearly $100 billion as of this writing. The Bitcoin token is just one of these cryptocurrencies.
Cryptocurrencies offer functions beyond acting as currency, such as entry tokens to blockchain-based land registries in underdeveloped countries (see generally www.bitlandglobal.com) or recording self-executing “smart contracts” (see generally www.ethereum.org). In effect, these application tokens act as a pseudo-arcade token and are used to gain access and/or record transactions to their respective blockchains. These tokens are used not only for their application purposes but can also serve as a mechanism for a given company to raise capital by way of token sales and initial coin offerings.
Public interest in blockchains, Bitcoin and cryptocurrencies has intensified in recent months, but many still fail to understand what they are, how they work and what purposes they serve. At their core, blockchains offer the potential to store countless types of transactions, monetary or otherwise, although their current primary use is in support of cryptocurrencies such as Bitcoin tokens. Although Bitcoin tokens are used as a unit of exchange, other cryptocurrencies continue to develop as efforts to offer a variety of applications beyond substituting for currency. The public interest in blockchain technology and its applications promises to bring broad changes to the way consumers do business, purchase goods and interact.•
Mr. Gorham is a senior associate in the Indianapolis office of Frost Brown Todd. The opinions expressed in this article are those of the author.