Welcome back to The Bluffer's Guide to Cryptocurrency - a layman's approach to understanding Bitcoin and Blockchain Technology!
Last week, I took you through a simplified version of how the underlying blockchain technology behind Bitcoin works (promoting you to CEO of your own company in the process!) If you missed it, you can read up about it here.
Now, you lovely people who have tuned in to the series so far sent me some comments, messages and suggestions to put in a 3rd part of Chapter 2 looking at how other emerging blockchain technologies work.
So I will be going through a couple that I know of and using some examples of how this would work in the company I made you CEO of!
Before I begin, I want to emphasise that this is a highly simplified version of what I have learnt from my own research and I'm sharing my learning with you. If you do know this topic inside out, be nice to those who are still learning about this (myself included) and we can grow together.
So with that said, brace yourselves, you might learn something! Shall we begin?
Last week, I promoted you to CEO of your own company, where you had many offices around the country, selling all sorts of products to your customers - Congratulations!
And we made sure all our transactions were recorded and not doctored in anyway by introducing a complex equation and keeping the answers in a safe place so that all the transaction records from your different offices match.
This simplified analogy of matching of records and the method used to ensure your representatives reported the correct transactions is called "consensus".
But there are many different methods of achieving consensus in blockchain technology and I'll cover three below that I know of (although I'm sure there are loads more).
In doing so, I'll use YOUR company as an analogy to illustrate how it works (I hope you appreciate this free business advice by the way)!
Proof of Work
We'll start off with the Proof of Work consensus (used by Bitcoin) because.... well, I have already covered it for the most part!
Effectively, this method is used to make sure that those who are trying to solve the complex equation work really hard in doing so. By working really hard, the computers on the network use up a lot of computing power. Lots of computing power = lots of electricity = lots of cost to pay for running the computer.
But what's the incentive for using up so much computing power?
The computer receives a small payment in the currency of the network it is in PLUS the transaction fees so there is an incentive to stay "true" to the network.
This process is in fact called "mining", a term you may hear a lot more of when you start reading more about cryptocurrency, and the computers used to solve these complex equations are called "miners".
If a miner's answer to the complex equation is different to others, then it can be rejected, which of course is a deterrent to cheating the system because your electricity bill would be high for no reason!
The only way to cheat the system would be to own over half of the network but who has that kind of money lying around to subsidise everything that is needed to achieve this?
In non-computing terms?
Meanwhile, back at your own company (remember the one I made you CEO of?)...
Your representatives who report on all their transactions will receive a small payment (mining) due to using up a lot of brain power to solve this complex equation we gave them to stop them cheating the system.
If the representative tries to cheat the system and get a different answer to the rest of the representatives, then they won't receive any payment and they'd have wasted a lot of energy and time in doing so. Like this guy who now regrets his decision to try and cheat the system...
The only way a representative can cheat the system would be to get their hands on the transaction records from the majority (greater than 50%) of the other offices and work out the complex equation for each of those offices.
As we already alluded to, it takes up a lot of brain power and time to work out the complex equation for the representative's own office so to do it for at least another 5 offices just wouldn't make any sense due to the effort and energy needed.
Advantages and Disadvantages to Proof of Work?
Well, as you may have guessed, a miner has to be heavily invested in this type of consensus, which provides a deterrent to cheating the system. That's one plus point.
Another plus point is that as the network grows, it becomes more secure due to the computing power needed to solve the complex equations and thus becomes impossible to alter the transactions or blocks in the system.
However...this does use up a lot of electricity and energy and as more transactions happen on the network, it can take longer for confirmations of those transactions to occur with each complex equation to be solved.
Proof of Stake
Now, Proof of Stake adopts a slightly different approach to Proof of Work and is used in part by Ethereum (another "major coin" at time of writing).
Instead of asking all the computers in the network to solve a complex equation, one computer is chosen to process transactions and the others will verify.
Sounds a lot simpler right? But there's more... of course there's more!
How can THIS system be trusted?
Well, the computers in the network must deposit some currency in a "virtual safe" and if any of them try to compromise the system, the system says, "thanks for your deposit, I'll take that"!
Therefore, if the computer cheats the system, then the computer loses it's stake and so should deter any wrong doing.
The act of depositing currency in the safe is called "staking", which is why this consensus method is called "Proof of Stake".
If you want a shot at being the chosen computer to process the next block of transactions, it's simple, deposit more currency (increase your stake). Of course, if you get caught cheating, you have more to lose.
Sounds different, can I use it in my company?
Of course you can and here's how it would work.
Instead of asking all representatives to provide transaction histories from their office, you get them to delegate that lovely task to a chosen representative (lucky them).
At the same time, each representative will put some of their salary in to the pot, which will be taken from them if they try to cheat, thus deterring any naughtiness.
If any of these representatives want to impress you (the CEO) then they can deposit more of their salary to become the chosen one. But if they try and be mischievous... well, looks like they will be having bread and milk for the rest of the month (and hope their dog doesn't eat the whole loaf like this guilty one)...
Advantages and Disadvantages of Proof of Stake?
Well, as you can imagine, without the need to solve complex equations, the transaction times would be a lot faster and there's less cost due to less computing power and energy consumption.
However, is this truly a failsafe way of getting transactions done? The jury may still be out on that but as we'll discuss in later chapters, you can protect yourself by ensuring you're very secure when investing in cryptocurrency.
Sounds a little chaotic and untidy right? Well, you're not far off and it's a very different "blockchain" technology, if you can even call it blockchain!
With Tangle, ANY computer can verify transactions (rather than the chosen one in Proof of Stake, or many computers solving complex equations in Proof of Work).
"How can a transaction be confirmed?" I hear you ask...
Well, let's say that YOU want to make a transaction.
Before you can do this, you need to first verify 2 or more previous transactions on the network. Once you have done that, then another user, who wants to make a transaction of their own, will verify your transaction.
So instead of having a chain of blocks like with Proof of Work and Proof of Stake, there's a tangled web of transactions.
This doesn't sound very secure?
Well, you might be right there as again, the jury is still out on security but there are so called super-users in the tangle network to ensure that the system can be safeguarded from any wrongdoing. However, when the network becomes large enough, this super-user won't be needed anymore... or will it?
How can I use this in my company?
Going back to your company, if you wanted to use the Tangle approach, your representatives wouldn't need complex equations or sacrificing salary to validate transactions.
Sounds less intense already right?
Instead, they would need to verify the transaction records from 2 or more other offices before reporting their own office's transactions to the CEO (you).
As you'd want to make sure that all the representatives are verifying transactions properly, you'd employ a manager for the representatives to ensure that they were following procedures correctly until you grow your business to a suitable size. Maybe not someone as angry as this guy looking over their shoulder but you get the drift!
Advantages and Disadvantages of Tangle?
With this approach, we are talking IMMEDIATE transactions. No waiting around for blocks to be verified and the transactions are free, which means that even very small payments can be made (even less than $1)!
Furthermore, there doesn't need to be a lot of computer power needed to verify the transactions, which would reduce the cost compared to Proof of Work.
However, we touched upon the security issues, which may be a negative to this particular network.
Another important part of blockchain technology is something called Smart Contracts. They're contracts and they're smart.
What does that mean?
Let's start off by thinking of an ordinary (or normal) contract you would sign. For example when signing a leasing contract for a new car.
In this "normal contract" you have two parties (you and the car company) agreeing to some terms and conditions, which are legally bound.
In this fictitious example, you agree to pay every month until the full amount is reached and then you will own the car outright from the car company. If you fail to make payments, they take back the car. If the car company gives you a faulty car, you can reject it and not pay anything.
Please note, ALWAYS check your terms and conditions when you sign an agreement so you know what you're signing up for!
Now, with so-called "Smart Contracts", things are a little easier as they are not legally bound but rather bound by the blockchain. That means that once these Smart Contracts have been digitally signed by all parties, the terms will be carried through regardless.
But again, ALWAYS check what you're signing up for whether it's a normal or smart contract!
We took a bit of a deeper dive in to some of the technologies out there but of course there are so many, this would be a never ending blog!
It's difficult to explain what blockchain technology is in a nutshell and I tried to keep it as non-technical as possible. On the plus side, I've given you some more tips on how to manage your own company!
I hope this puts you in good stead to understand a bit more about how blockchain technology works!
In the next Chapter, I'll be going through how to buy Bitcoin, along with the very important concept of security, exchanges and storing cryptocurrencies.
Now though, it's your turn.
Did you enjoy the article or find it useful?
I'd love to hear from you and if you learnt something new, feel inspired to do some of your own research or felt I didn't cover something well enough, let me know and when I finalise the pdf, I'll make it right!
For now though, take it easy and catch you soon!
The history and technology of Bitcoin
2.1 How and why did Bitcoin come in to existence?
2.2 How does Bitcoin & blockchain actually work (Part 1)?
2.3 How does Bitcoin & Blockchain actually work (Part 2) (you are here)
3.1 How to be secure online with cryptocurrency?
3.2 What are wallets?
3.3 What are exchanges?
3.4 Where can I buy cryptocurrency?
3.5 How to store cryptocurrencies?
Definitions of common phrases
Cryptocurrency News Outlets
Fluctuations in price
Blockchain Platforms for Musicians & Music Fans
8.1 Atom Collector Records