• Amy Tan

CMI Brief: How Blockchain Works

Conventional money in modern economies can be earned by us or gifted to us, but not created by anything other than a central bank. Modern economies are characterised as being highly centralised, meaning that market actors are unable to create money. The privilege of money creation is hence reserved for a technocratic elite.

This traditional approach to money production has been challenged by the mechanisms of cryptocurrency, namely Bitcoin. Bitcoin employs a specific type of database called blockchain in order to uniquely store information and produce currency. In contrast to the monopolistic structure of standard money creation, Bitcoin can in theory be created by anyone with a computer, via a decentralised system using blockchain.

In order to best understand how blockchain works, it must be placed in the context of Bitcoin production. In order to acquire Bitcoin, it must be ‘mined’ through software which can be run on a computer. Early on in the history of Bitcoin, when few coins existed, an ordinary home computer would have been sufficient for mining coins. However, as bitcoins have grown in value, competition to mine them has grown exponentially, and as a result, the computer processing power required for mining largely exceeds what is possible from a single computer. Nowadays, many powerful computers typically work in tandem whilst consuming vast quantities of electricity to mine Bitcoin economically.

When you run the Bitcoin software, or when you mine, you are maintaining the block chain.

So what actually is a block chain?

PWC helps to clarify this with a succinct definition:

A blockchain is a decentralised ledger of all transactions across a peer-to peer network. Using this technology, participants can confirm transactions without the need for a central clearing authority [such as, for instance, a bank].

So, when a block chain is mined for bitcoins, the records of every recent transaction on the public ledger are being added and verified, compiling all of the information into a ‘block’ unit. A block is a file with a record of recent transactions, not dissimilar to a page in an account book. Each new block is then added to the existing chain – thus creating the block-chain, a record of every transaction made in the sequence that they occurred. Once a block is added it can not ever be changed, meaning that a permanent record exists through blockchain.

To further illustrate the blockchain, we can imagine a record of every transaction in GBP that has ever taken place, and of every pound that has ever been created. As you might imagine, a record of this would be overwhelmingly large. The blockchain acts as a technological version of this exact ledger for bitcoins. It is essentially a comprehensive public record of every bitcoin transaction and of every bitcoin ever created, and is publicly maintained through the process of mining.

How does the blockchain mining process work?

When bitcoins are being mined, each new block on the blockchain contains the solution to a complex mathematical puzzle. Computers all over the world compete to solve this puzzle, and by doing so mine the ‘block’ in order to receive the reward of Bitcoin. A block is typically mined every 10 minutes by professional computing systems which are programmes specifically to mass mine bitcoins. The Bitcoin network automatically adjusts the difficulty of the mathematical problem in each new block to maintain an average of six blocks per hour. If blocks are solved quickly, the puzzles become more complicated, and if they are solved slowly, they become a little easier.

This process is formatted the way it is to signal that money should have a cost of production, it should not be able to be made out of thin air, as has been proven by conventional money makers in crises of hyperinflation. This process is analogous to mining gold and silver. There are opportunity costs in mining and there is no subsequent guarantee that devoting resources to mining will produce metal, so the same logic is applied to bitcoins. Bitcoin is a deliberate digital replication of the real-world mining process.

The number of bitcoins in existence is finite, roughly 21 million are able to be mined. When the quantitative ceiling of bitcoins is reached, miners will no longer be rewarded with new bitcoins, but instead acquire profit through small commissions paid by users every time they send coins to one another, so there is an incentive to maintain the blockchain. Effectively, all of these mining computers are voluntarily competing to maintain the blockchain and keep it secure. The system is self-reinforcing. The network of miners effectively becomes the public record keeper and regulator, imagine a sort of decentralised central bank.

Thus, without the blockchain Bitcoin is rendered useless. Satoshi Nakamoto described Bitcoin in his original posts to be a “currency based on crypto proof rather than on trust”. This is telling as modern money, which is not backed up by a gold standard or any hard collateral as it was in the past, is known by economists as ‘Fiat’ money – Fiat being the Latin word for trust. Although many people are hesitant or doubtful with regards to the stability and legitimacy of Bitcoin beyond its phenomena as a speculative currency, it is undoubtedly characteristic of changing attitudes to conventional economic wisdom and money creation.