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Chapter 1 – Fundamentals of Blockchain and Bitcoin

Bitcoin is a decentralized, deflationary currency aimed at liberating nations from poor monetary policy.
Contents

(1) What is a blockchain?

Let’s start by clarifying what a blockchain is NOT:

  • It is NOT replacing the internet. Rather blockchains aplify the internent by making it more secure.
  • It is NOT an application on the internet, such as Facebook or Amazon.
  • It is NOT bitcoin, but Bitcoin is made from a blockchain.

Let’s dive in further. A blockchain is a digital, universal, decentralized ledger (database) of transactions. A blockchain is globally run and unstoppable. To break this down more:

  • Decentralized because no central authority controls this ledger
  • Universal because everyone can access unaltered data on the blockchain via the internet.
  • Globally run because anyone can help run a blockchain database straight from their computer.
  • Unstoppable because everyone would need to shut down their computers simultaneously to shut down a blockchain.

Fundamentally, blockchains are secure databases that run in parallel to internet applications.  Blockchains are decentralized; thus, any application storing data on a blockchain is called a dAPPs, short for decentralized application.

(2) What is Bitcoin?

Bitcoin is a currency like the US dollar. However, unlike fiat currencies, bitcoin is built on a blockchain. Thus, we can trace every Bitcoin transaction on the online Bitcoin Blockchain explorer. For example, if you search for any BTC wallet address, the explorer will show you all transactions, time stamps, etc., from that wallet.

(2.1) Bitcoin vs. Fiat Currency

  • Bitcoin can’t be manipulated. All transactions are recorded and verified by everyone on the blockchain. It is impossible to trick the blockchain into giving you more bitcoin by changing the data.
  • Bitcoin is unstoppable because it is decentralized. Since there is no single point of control, not even governments can shut it down.
  • Bitcoin is a store of value. There will only ever be 21 million Bitcoin, thus making it a scarce asset. We reffer to Bitcoin as Gold 2.0 or digital gold.

Important fact: Satoshi Nakamoto built the first decentralized transactional ledger using a blockchain. The currency of this blockchain is Satoshis. 100 million Satoshi = 1 BTC.

(3) Running a blockchain

A network of machines maintains a blockchain. For example, miners (powerful computers) run the Bitcoin blockchain. Many people purchase miners and set them up globally — generally where electricity is cheap.

The role of miners is to verify if transactions are accurate. Miners do this by solving a complex math problem. If all miners agree (consensus) that the transaction is valid, it gets permanently added to the blockchain. The process of reaching consensus by doing computational work is a protocol called Proof of Work (POW). Below we will talk about other protocols.

Important fact: All miners have to download an identical copy of the blockchain before they can start mining. New, daily transactions continuously increase the file size of the blockchain.

(3.1) Incentives

Anyone can help run a blockchain. But why would anyone want to? When Satoshi created Bitcoin, he knew he would have to pay miners BTC as an incentive to keep system running.

Fact: Miners are paid 6.25 bitcoin (~220k) for every block (~4k transaction) they verify.

(4) Protocols (POW, POS, POH)

Every blockchain has its unique protocols. Think of protocols as a list of programmed features built directly into the blockchain. In other words, protocols are the guidelines a blockchain follows to achieve its unique goals, be it the speed of transactions or the method of data indexing.

For example, Ethereum utilizes a POW protocol similar to BTC. Ethereum miners have rewarded 4 ETH (~10k) per block. POW blockchains, however, use a lot of energy and raise environmental concerns, as you will see in the next section. As a result, other blockchains started the Proof of Stake (POS) protocol to eliminate miners. Blockchains using POS claim to be environmentally friendly.

Some blockchains, such as Solana, utilize the Proof of History protocol, which verifies transactions faster than POS and POW. In this case, Solana chose to implement the POH protocol because it prioritized lightning-fast transaction speed. However, skeptics have noted Solana’s speed came at the expense of its decentralization. We will talk more about the blockchain trilemma below.

(5) What is a blockchain (Technical)

This part is for anyone who wants to understand the mechanics behind blockchain technology.

The name “blockchain” hints at blocks of data chained together. A block is a group of verified transactions; the hash is analogous to the “chain” that links two blocks together.

(5.1) More about Hashes

A hash is a long series of numbers cryptographically computed from data specific to the blocks it links. A hash is also based partly on the hashes before it. Therefore, changing the data in one block will, in turn, change the hash of that block and every block before it.

(5.2) Security

When block hashes change, the network of miners running the blockchain will detect an irregularity. Miners do this by periodically seeing if their copy of blockchain data matches everyone else’s. The blockchain rejects the transaction when the data doesn’t align with the majority (at least 51%). In other words, 51 percent of the network must compute the same hash for the block to get added to the blockchain.

An important thing to consider is how difficult it would be to attack a network maliciously. For example, let’s say there are 1,000,000 BTC miners. For a hacker to alter a transaction, they must change the blockchain data across at least 51% of the miners on the network. Since taking control of more than 500k miners at once is virtually impossible, the blockchain becomes tamper-proof. Moreover, we can conclude that as more miners join the blockchain network, the more unfeasible it becomes to stage a malicious attack.

You can easily create a hashing algorithm if you know how to code, following this video tutorial. The algorithm will demonstrate hashing in real-time and how it secures the blockchain.

(6) The Trilemma

Security, Scalability, and Decentralization are the three issues all blockchains aim to solve. All blockchains are great at two but lack in the third area. Few blockchains have solved the trilemma.

  • Security refers to how well blockchains can prevent malicious attacks.
  • Scalability refers to a blockchain’s ability to continue functioning as usage increases by orders of magnitude. Most blockchain can handle 1000 people, but how about a billion?
  • Decentralization refers to the ownership of blockchain. As explained above (Security paragraph), as the network of miners grows, the blockchain becomes more decentralized and more challenging for any one entity to take over.

(6.1) Evaluating Blockchains

  1. BTC: The network of thousands of global miners makes BTC one of the most decentralized blockchains to date. While it’s secure, it lacks scalability — evident by the high fees and slow transactions. The Bitcoin Lightning network, as discussed below, solves the problem of scalability, allowing BTC to compete with Visa and Mastercard. 
  2. ETH faces the same problems as BTC but compensates using robust layer two solutions such as Matic (also explained below). Despite this, high gas fees make Ethereum unattractive. 
  3. Solana is the fastest scaling blockchain to date. Transactions on Solana are incredibly secure. Unfortunately, it lacks decentralization. Not only does Solana have very few nodes (more on this below),  the developers run a majority of them, allowing them to shut off the blockchain at will.

(7) Layer Two

To solve the blockchain trilemma, we turn to layer two solutions. Layer two refers to any protocol built on top of a blockchain to increase the security and scalability of the underlying blockchain. A layer two protocol temporarily takes transactions off the underlying chain to process them faster. For example, the Matic Network runs on top of the Ethereum Network. Matic speeds up transactions and reduces gas fees to fractions of a penny.

(7.1) Lightning Network

The Bitcoin Lightning Network (BLN) is another example of a layer two solution that aims to increase the speed and decrease fees. Bitcoin alone can only process an underwhelming 7 TPS. However, as of 2022, BLN can process over 1 million transactions per second (TPS) for pennies— making it faster than any credit card.

(8) Making money mining

Proof of work cryptocurrencies includes BTC, ETH, CKB, DOGE, LTC, ERG, etc.

Let’s stick with Bitcoin. In 2009 a personal computer mined the first Bitcoin. However, as more miners join the network daily, the mining difficulty increases. As a result of increasing difficulty, BTC mining requires a lot of increasingly powerful computers. Although the price of these computers and electricity can become expensive, the price of BTC has exploded from a few dollars to a current high of 70k. Thus, BTC mining will likely remain a lucrative and profitable source of passive income.

(8.1) ASICS

Let’s talk about these super-powerful computers. They are called ASIC miners. ASIC stands for an application-specific integrated circuit. It is a computer optimized to mine specific crypto coins. BTC ASIC miners can cost anywhere from 2k to 20k, depending on the hash rate and efficiency.

Important fact: The more hashes a miner can process, the more powerful it is and the more money it will make. The more efficient a miner is, the more money it can save on electricity.

(8.2) Mining Pools

Once you have your miner, you might consider joining a mining pool. A mining pool is a group of many miners that seek to combine hashing power to increase the pool’s odds of collectively winning the 6.25 BTC block reward. Rewards are split between all miners in the pool. Your share of the block reward is proportional to the work your miners contributed.

If you choose to be a solo miner, the odds of you winning a block reward is slim but still possible. In this case, you would keep the 6.25 entirely if you were to mine it.

Assuming you joined a mining pool, your total profitability will be your miner’s revenue minus electricity cost minus the fixed cost of the ASIC miner. Use this online tool to calculate how long it would take to break even on your miner, given your hash rate, efficiency, and the average price of BTC.

(8.3) Profitability

To give you a general idea of profitability, a BTC ASIC miner with 55 T/H (Terra Hash) of power costs around 5k. Assuming this miner takes around 1500 watts of power and your electricity cost is 10 cents/kWh. The net profit will be around ~$6 a day at the current price of BTC (~35k). You will break even on the miner in 2.3 years. If BTC were to double the price, you would break even in 1.1 years. If BTC were to triple, you would break even in 275 days.

Important fact: If you like the idea of mining, there are services that you can pay to do it for you! There are huge companies, like RIOT, that specialize in mining. You can invest in mining companies on the stock market.

If you don’t have thousands of dollars to invest in miners, there are many other ways to generate passive income with crypto. The following three sections will cover over 20 different passive income strategies.

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