Imagine Harry loses a bet to Sam for $20.
If they are face to face and Harry has a twenty, he can just give it to Sam.
But if Harry is in New York and Sam is in Los Angeles, this exchange gets a little more complicated. Now, an intermediary is needed. Harry could mail Sam the money, but it would take several days to arrive. Sams winnings could be wired through Western Union or MoneyGram. Most likely, Harry will go to his bank and send Sam the funds through a bank transfer. There may be some fees involved and it may take a few hours, but there are some national banking chains that can instantly migrate funds for free.
However, if Sam were in Hong Kong, this adds several more layers of complications to the trade. Now, Harry’s American bank must contact Sam’s Chinese bank. The funds have to be sent internationally, often at high rates. Then, the USD20 must be converted to the local equivalent. Add another fee. Finally, the Chinese bank will have to clear the transfer, which will likely take several days, before Sam can claim his prize. It may cost more than the bet just to send the money overseas.
What if there were a way for Harry to send Sam $20 without a middle-man, anywhere across the globe almost instantly?
This is precisely the solution presented in the Satoshi Nakamoto white paper, and so the blockchain was born.
Blockchain technology allows for transaction data to be stored on a digital ledger, secured by a public cryptographic key system. The data is converted using hash algorithms and compiled into a structure called a “Merkle Tree.” Once a certain number of transactions have been reviewed and accepted, a new block is created. New blocks record the timestamp and transfer information, as well as the hash of the block that came before it, forming a chain. The blockchain runs on a network of computers working to verify and process the block data in a process called “mining.”
Individual connections to the network, or “nodes,” use processing power to transfer, verify and create blocks. The first successful public blockchain rewards what is now called Bitcoin (BTC). When a Bitcoin block is created, the first node to provide proof-of-work is rewarded with ownership of the private key, which denotes possession. Mining a Bitcoin rewards 12.5 BTC, with a reduction planned for the future. Bitcoin has a cap of 21 million blocks/coins. However, each block can be broken down into fractional proportions. The smallest amount, 0.00000001 BTC, is called a satoshi and can be exchanged as a currency. Since timestamp data is included in the hash, “double-spending” is eliminated by a network-consensus of the order of transactions.
Nodes operate programs that work to verify the accuracy of each block, using complex algorithmic cryptography. Every time a new block is made, the entire chain is re-validated. This makes the blockchain impractical to hack, since an attacker would have to recreate the whole chain before a new block is made. It is essential that the networks be spread across a large number of nodes, otherwise the control over the currency is no better than current banking systems.
Banks are trusted to make financial transactions for us, to keep the monetary system honest. But that presupposes the banks are trustworthy, and as we’ve seen more and more, they obviously are not. The real genius of cryptocurrency is the publicly accessible ledger. As each block is verified, the hash information is made available for review. Anyone can look at this information on various block explorers online. This removes the need for trust and automates transactions over a decentralized network.
Why is this important?
Because now, Harry can send $20 from his wallet directly to Sams wallet, without having to go through a third party. Moreover, if Sam tries to claim he never got the money, Harry can prove otherwise. So, who needs to trust a bank anymore?