Core Concept

Core Concept: Blockchains

Cryptocurrencies, and their underlying blockchains, compose a fairly complex set of technologies. It’s worthwhile to have a high-level understanding of some of the core tenets of what makes crypto tick.


Blockchains

Blockchain, as we know it today, is tied to the introduction of Bitcoin in 2009, which was based on a late 2008 paper released by Satoshi Nakamoto. While many argue that Bitcoin isn’t a great blockchain for a number of reasons (such as scalability and extensibility), it started a chain reaction (pun intended) within the technology industry that has yet to slow down.

Core Technology

Blockchains are composed of several different characteristics, but you can effectively think of them as a database, that have been distributed instead of centralized, and which use cryptography to secure the database and associated transactions.

The underlying cryptography ensures several key aspects, including:

  • Immutability, or the ability to prevent changes to any historical data
  • Ownership, or the ability to uniquely identify who owns what
  • Signing, or the ability to authenticate a transaction, such as sending a bitcoin

By relying on these mechanisms, in a large-scale distributed system, blockchain has been able to solve the underlying problem of how to transact digitally, in a safe and secure way, without all the traditional financial intermediaries.

Consensus

In order to process transactions on blockchains, they employ a consensus mechanism used to reach a shared agreement on what changes have occurred on the blockchain, and to commit that in an immutable (unchangeable) manner. The two core consensus mechanisms are Proof of Work, and Proof of Stake.

Black and Yellow Six Step Process Concept Graph (2)

Proof of Work consensus leans more heavily into cryptography, and uses algorithms to generate unique hashes. Systems running these algorithms are generally referred to as miners, and when miners find a specific type of hash (just a long unique string of characters) they are granted the right to commit the next transaction in the blockchain. Additionally, they receive a reward for this process, which both provides incentives to mine new blocks as well as introduces new coins in the network. Over time the size of the rewards often decreases, creating deflationary pressure on the coin. Some people shy away from this style of consensus due to the sheer amount of computing power it requires, and the related downstream environmental impacts.

A major alternative is Proof of Stake, which is gaining rapid adoption in newer blockchains and cryptocurrencies. In a Proof of Stake model, instead of ‘spending’ compute in order for the right to commit the next block in the chain, a certain amount of coins are staked or locked into the network in exchange for the right to commit blocks. Typically these coins are staked in something called a validator which performs the validation of transactions and committing of blocks. Validators are rewarded, in the same way that miners are rewarded, based on the percentage of coins that are staked.

Regardless of the model, consensus mechanisms are a critical function to handle the settlement of cryptocurrencies, and are a key focus on scaling the underlying blockchains and driving part of the economics of the currencies themselves.

Smart Contracts

The basic blockchain mechanism is a fairly powerful construct, however with the addition of smart contracts the capabilities and possibilities are taken to the next level. You can think of smart contracts as a small program, or bit of code, that can run when a transaction occurs on a blockchain.

SMART CONTRACTS 2

More concretely, smart contracts are a set of instructions that can be stored on a blockchain and can be performed when called upon via a transaction. The more instruction data that is required, the larger the transaction fee. Smart contracts can come in the form of dApps, which are a set of instructions allowing users to access some specialized kind of functionality in ‘web3’.

In more advanced forms, a set of smart contract instructions can come together to codify the rules of a digital organization, often referred to as a DAO, or Decentralized Autonomous Organization. The rules of a DAO smart contract can govern everything from membership and voting, to operational workflow and capacity, and effectively merge the idea of a corporation with that of an application.

If blockchains were the first step in turning money into a software base layer, smart contracts represent the next step of turning transactions, businesses, and possibly even future governments into applications which run on top of blockchains.

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