How Do Blockchains and Bitcoin Work?

Bitcoin is an environmentally unsustainable asset speculation bubble, though many people do not understand the underlying mechanisms for how cryptocurrencies work.

Recently, one of my Twitter followers expressed not understanding how blockchains or cryptocurrency work and asked if I had a source with a good, straightforward explanation. Existing explanations of these topics tend to start from the top down, which requires the reader to have a pre-existing understanding of the technologies involved in order to be able to deeply understand how things function.

Most people are at least broadly familiar with the concept of encryption: data is converted into a form that is unintelligible to third parties. Encryption relies on others lacking the information necessary to convert it back into regular data. An algorithm — in essence, just a series of steps — is applied to transform the data to arrive at its encrypted state. Decryption is simply the process of reversing those steps.

There is also a form of encryption known as “hashing,” which is one-way. The goal, in this case, is not to ever be able to get the original data from the resulting “hash.” However, identical data will always result in the same hash, even when coming from different places. This means, even if we cannot recover the original data, hashes can be compared to verify the integrity or validity of data. If the data changes, the hash changes.

The quintessential example of the usefulness of hashing is password-based login systems. If you store the user’s password as plain data, anyone who can access your database — including hackers! — can see their password. However, if only the hash of the password is stored, when passwords are entered into the login form, those are hashed as well. If the hashes match, the password is correct. In this way, the software can determine if the password is correct without even knowing the password itself.

Here’s a hypothetical. Say you want to share data with other people and let them add to it — but want to prevent them from editing or deleting things once added. Blockchains are designed to solve this problem in a secure way using hashes. Newly added data is grouped into “blocks.” When a new block is added to the blockchain, it becomes a permanent part of the data, never to be deleted or modified again.

Each block contains a hash of the data contained in the block before it. This is how the “blocks” are “chained.” In the case of cryptocurrency, this is used as a way to remain a reliable ledger of all transactions ever made with the currency. Each group of Bitcoin transactions has data that verifies the integrity of the transactions before. One can follow this trail of hashes back to the very first block of transactions in 2008.

Most cryptocurrencies, however, turn this verification process into a rewards-based competition. This is what “coin mining” is. The first to successfully calculate and verify everything for a block of data are given free coins. Rather than mine individually, almost all mining is done by massive groups of people who pool computing resources together. When they “win” a round of mining, the reward is distributed amongst the group. Usually, your share is based on the processing power provided during that block’s calculations.

This has created an arms race scenario, where one must exert more and more processing power to get the same return. Bitcoin uses more power than a medium-sized developed country NOT because that level of processing power is necessary for a cryptographically secured currency. It is entirely because so many people are redundantly trying to do the same calculations as fast as possible.

Typically, cryptocurrencies use a system of completely anonymous “wallets” for tracking coins. Because these are not linked with any personal information, cryptocurrencies have become a popular way to do things like purchase black market goods without a paper trail. However, given you have no way of definitively establishing ownership over a wallet, dealing with theft and fraud is near impossible.

In short, a “blockchain” is a way of structuring data so that it can be added onto but not modified. This enables a trustworthy, shared ledger of all transactions with a digital currency that is incredibly tamper-resistant. For all of the environmental and asset speculation problems surrounding cryptocurrencies, the robustness of their publicly available — yet anonymized — transaction history is unquestionable.

Blockchains certainly have usefulness as a concept, and cryptocurrencies can be designed in ways to not induce extreme energy waste. However, the hyper-competitive way cryptocurrencies like Bitcoin and Ethereum are verified is not even remotely sustainable. We need to decarbonize energy production immediately, and the added energy demand will make that harder.