Understanding Bitcoin and Blockchain#
1.1 Blockchain ≠ Bitcoin#
First, let's clarify a concept: Blockchain ≠ Bitcoin (and other digital currencies). The two are complementary; blockchain is the underlying technology of Bitcoin, supporting its operation, while Bitcoin is the first application of blockchain technology.
Blockchain is like water; it can carry a boat or cook porridge, and Bitcoin is the boat/porridge. Besides digital currency, blockchain has many other application scenarios.
1.2 What is Bitcoin (System)#
In simple terms, Bitcoin is a decentralized financial system independent of the real world, consisting of the underlying blockchain technology (consensus layer) and the Bitcoin currency itself (incentive layer). In other words, the Bitcoin financial system itself is a blockchain, on which the currency Bitcoin exists.
To avoid confusion, the term "Bitcoin" refers to the Bitcoin system, while "BTC" refers to the Bitcoin currency.
1.3 What is Blockchain#
Blockchain is a tool that addresses the "trust" issue on a technical level, essentially a decentralized (or weakly decentralized) distributed ledger.
The core of blockchain technology is "decentralization." Understanding this concept is a significant step toward grasping the subject.
The financial services we currently use are all "centralized." For example, deposits and transfers involve a central entity like a bank; your household has your spouse as a center, with money managed and recorded by this center. When you want to spend 20 yuan to buy a Zhihu membership, the bank or your spouse must first verify that you have 20 yuan; if you do, they deduct 20 yuan from your account and add it to Zhihu's account.
This means there is a third party between you and your money. Essentially, you do not hold your money; the balance in your account is merely a number displayed by the bank.
The risk here is that you must trust the center. If the bank freezes your money or your spouse forbids you from spending, you cannot buy the membership temporarily; in a worse scenario, if the bank goes bankrupt or your spouse runs away, your assets could be wiped out, and you would be completely unable to buy the membership.
You might wonder if you just hold cash, not depositing it in the bank or giving it to your spouse, wouldn't that be safer?
Not really. The currency we hold is fiat currency, whether it's your bank balance or cash in hand, issued by centralized government institutions. Its value derives from government credit backing; when the government and most people recognize it, fiat currency is money; when they don't, it is worthless. Additionally, government monetary policies can also affect the real value of fiat currency.
For example, during a pandemic, if governments worldwide engage in quantitative easing, meaning they print more money, your money could lose value, and a membership that used to cost 20 yuan might rise to 50 yuan. In a worse scenario, if the government's credit collapses, the fiat currency you hold could become a pile of meaningless numbers or worthless paper, as seen in Venezuela or Zimbabwe.
The concept of decentralization is entirely the opposite: no center, no bank, no spouse.
In the Bitcoin system, all your money exists on the blockchain; this money is BTC, and these coins are not held by any institution but are solely owned by you. The relationship between you and your money is one-to-one, with no third party intervening. If you want to transfer money, you need to authorize it with your "private key," which can be understood as a password directly linked to the money itself, not tied to your bank account. This means that if you lose your private key, there is no bank to help you recover it, and your money will permanently disappear.
So how does blockchain ensure security?
At least with fiat currency, there is a bank to safeguard your money, but with blockchain, no one manages the money. Doesn't that lead to chaos?
Let's look at the actual application scenario: the core purpose of money is to transfer it. Whether shopping, borrowing, repaying, or for other purposes, as long as it involves the flow of funds, it can be categorized as a transfer. As long as the security of transfers is resolved, the security of money is essentially addressed.
The blockchain's solution is straightforward: since having a central institution to keep records poses security risks, let's give you multiple centers. When there are infinite "centers," it is equivalent to having no center, which is "decentralization."
The principle of blockchain is that all users on this chain are "centers," referred to as nodes. Each node has a ledger containing all transactions. When a transfer occurs, these nodes participate in the record-keeping. The system uses algorithms to select a node that records quickly and well to gain the right to keep records. This node will package all transfer records within a certain time frame into a "block" and broadcast it to all nodes. Other nodes will verify and synchronize it to ensure the ledger's consistency.
A Bitcoin block is generated approximately every 10 minutes, meaning a node is selected every 10 minutes to record transfers that occurred in the previous 10 minutes. A block is equivalent to a page in the entire Bitcoin ledger, and all blocks are linked together to form a "blockchain."
One characteristic of blockchain is that it can only move forward and cannot roll back. Once written into the blockchain, the content cannot be altered. This means that the BTC you hold can be traced back on the blockchain, allowing you to trace its origin back to the very beginning, which is where BTC was created. This ensures that every BTC held by individuals is authentic and credible, with no forgery. However, it also means that if you mistakenly transfer BTC to the wrong person, you cannot retrieve it unless that person is willing to return it.
What if a node keeps false records? Wouldn't that be disastrous? After all, a single false record could disrupt the entire traceable chain. This introduces an important concept: the "longest chain principle."
During the operation of the blockchain, if a malicious node is selected as a recording node and keeps false records that are inconsistent with others' ledgers, a fork will occur on the main chain, creating two chains: one correct and one incorrect. In such cases, the longest chain principle applies; the chain that gains recognition from the majority of nodes and continues is considered the correct chain, while the other chain is discarded. As long as most nodes are honest, there will be no issues.
1.4 Bitcoin Mining Mechanism#
In the Bitcoin blockchain (system), everyone circulates BTC, but where does BTC come from?
The answer is mining. The total amount of BTC in the Bitcoin system is 21 million, produced solely by nodes mining.
As mentioned earlier, the operation of the blockchain requires countless nodes to participate in record-keeping to ensure the decentralization and security of the entire system. People certainly won't keep records for free, so this relies on rewards for recording, but this reward is only one per block. To obtain the reward, everyone must compete, and this competition process is called "mining." Thus, the essence of mining is "competing for the right to keep records," and nodes are therefore referred to as "miners."
Mining rewards consist of two parts: one is the block reward, which is the only way to produce BTC. The initial value is 50 BTC per block, halving every four years. The third halving just occurred this May, and it is now 6.25 BTC. The second part is the miner's fee, which will be discussed later. Once the 21 million BTC block rewards are mined, the rewards for nodes (miners) will only consist of miner fees.
In simple terms, the block reward is the source of circulating currency BTC in the Bitcoin system and serves as an incentive mechanism for miners. A large number of miners compete for rewards, ensuring the system's security.
In the long run, the higher the price of Bitcoin → the higher the value of mining rewards → the more active the miners → the greater the mining competition → the more secure and stable the system → the higher the social recognition → the higher the price of Bitcoin → the higher the value of mining rewards → the more active the miners...
As mentioned earlier, nodes that record quickly and well gain the right to keep records, meaning they can mine. So how is this "quick and good" defined? This leads us to the Bitcoin mining mechanism.
Before generating a new block, Bitcoin requires miners to calculate a string of random numbers (which can be understood as a mathematical problem). Theoretically, the stronger the performance (hash rate) of the computer hardware (or specialized mining machine) used to calculate the random number, the faster the calculation. The first miner to correctly calculate it can keep records and package this block, receiving the reward.
To keep the generation time of each block (the time taken to solve the mathematical problem) around 10 minutes, the system adjusts the mining difficulty (the difficulty of the mathematical problem) every 2016 blocks (about two weeks) based on the overall network hash rate, preventing an increase in network hash rate from speeding up the problem-solving process.
Now let's talk about miner fees. Miner fees can be understood as transfer transaction fees. Everyone must pay a certain amount of miner fees when transferring in the Bitcoin system. The miner fees generated from all transactions in each block are paid to the miner who mined that block. This design not only provides more incentives for miners but also prevents malicious users from continuously transferring back and forth, slowing down the system's transaction speed.
Miners prioritize processing transactions with higher miner fees. Since each Bitcoin block has a limited capacity (1M), the amount of transaction data it can carry is also limited. Currently, a Bitcoin block can handle approximately 3,000 transactions. If there are tens of thousands of transactions during the current block generation period, some transactions with lower miner fees will be delayed to the next block (or even later blocks) for processing. This situation is known as block congestion. In cases of block congestion, if you want your transfer transaction to be processed quickly by miners, you can only increase the miner fee.
Here’s another concept to understand: "TPS," which stands for transactions per second. According to Bitcoin's capacity of 3,000 transactions per block and a 10-minute block time, the TPS is only 5. In contrast, centralized financial institutions like VISA have a TPS of around 2,000, while Taobao can peak at over 200,000. Bitcoin's financial system pales in comparison, especially when considering the high miner fees.
Therefore, those claiming BTC can become a "world currency" are either naive or malicious. I believe BTC may become a store of value asset like gold in the future, but its practical value is still minimal at this stage. Although there have been many proposals in recent years to solve the TPS issue, such as scaling solutions and the Lightning Network, they have not gained traction recently due to their impact on decentralization. This is also the biggest problem facing many blockchain projects today: balancing decentralization and security while ensuring performance, often referred to as the "impossible triangle."
2. Classification of Blockchains (Public Chains vs. Private Chains / Consensus Mechanisms)#
Currently, there are many blockchain projects on the market, each employing different mechanisms. There are mainly two mainstream classification methods.
2.1 Consensus Mechanism Classification#
The core of mining is competing for the right to keep records (mining) and obtaining mining rewards. The rules for distributing record-keeping rights constitute the blockchain's consensus mechanism. The three mainstream consensus mechanisms are PoW, PoS, and DPoS, along with others like PBFT and Raft.
It's important to note that when you come across an unknown project claiming to use a new consensus mechanism, you should carefully investigate whether it is a scam designed to mislead you. Many scams fabricate a consensus mechanism, using terms like PoA or PoZ, while actually running centralized projects behind the scenes.
① Proof of Work (PoW)#
Most early blockchains, such as Bitcoin and Litecoin, use PoW. Here, "work" refers to the process of miners calculating random numbers. The node that calculates the correct random number the fastest gains the right to keep records, creates a new block, and broadcasts all transactions during that time period. Theoretically, the higher the hash rate of the mining machine, the greater the chance of obtaining record-keeping rights.
The advantage of PoW lies in its high security. Theoretically, only nodes controlling 51% of the hash rate can jointly alter the ledger, which is known as a "51% attack."
The downside is that the mining process wastes computational and electrical resources, and since all miners must participate in calculations and verifications, the efficiency is very low. Although decentralization and security are improved, the painfully low TPS is clearly unsuitable for commercial use.
Additionally, the emergence of "mining pools" has rendered the decentralization aspect of PoW a pseudo-issue.
Mining pools arose due to the increasing difficulty of mining. As mentioned earlier, the theoretical probability of mining in PoW is "your hash rate / total network hash rate." Currently, the total network hash rate is very high, making it difficult for individual miners to mine alone. Therefore, some centralized companies have launched mining pool services, which aggregate the hash rates of multiple miners to increase the probability of mining. When a block is mined, the rewards are distributed according to each miner's hash rate proportion, with the mining pool service provider taking a fee. Nowadays, PoW mining is no longer a competition among numerous miners but has evolved into a hash rate competition among a few major mining pool operators.
② Proof of Stake (PoS)#
The PoS mechanism does not require hash rate mining but selects record-keepers through a process similar to democratic elections. Every coin holder can participate in the election and vote for others. To prevent the abuse of multiple small accounts competing for record-keeping rights, the concept of coin age is introduced.
The system calculates coin age based on the quantity and duration of coins held by users. The higher the coin age, the greater the rights, and the higher the probability of obtaining record-keeping rights. Similar to stocks, those holding more shares have greater voting power.
The PoS mechanism reduces energy waste and improves operational efficiency to some extent, but it can lead to wealth disparity, where nodes with the most coins hold significant power and may dominate record-keeping rights.
③ Delegated Proof of Stake (DPoS)#
DPoS is a variant of PoS, where coin holders do not all participate in the record-keeping competition but elect several representatives who perform the record-keeping.
For example, in EOS, coin holders vote to elect 21 supernodes, and these nodes are responsible for recording and verifying transactions, effectively reducing the number of miners to just 21. Coin holders can replace supernodes through voting at any time, similar to the People's Congress system in China.
DPoS can achieve high performance due to the fewer participating nodes, but it sacrifices some decentralization and security.
2.2 Public Chain / Private Chain Classification#
Public chains, or public blockchains, do not rely on centralized institutions for issuance. Everyone can write to and read data on the chain, and participants are incentivized to maintain it, achieving true openness, transparency, and decentralization. In simple terms, the use and maintenance of public chains are open to everyone, and they generally issue tokens to incentivize participation in mining. Bitcoin and Ethereum are examples of public chains.
Private chains also use distributed ledgers, but unlike public chains, they are controlled and maintained by centralized enterprises or institutions. Permissions are regulated by the institution, and the public cannot write data, with reading data often restricted or entirely prohibited.
Currently, many major internet companies in China are developing private chains, such as Baidu Super Chain, Ant Chain, and Tencent Blockchain.
If a private chain involves multiple institutions or organizations, it is also referred to as a consortium chain. Broadly speaking, private chains include consortium chains, and if a consortium chain has many participating institutions, it can form a weakly decentralized structure.
Consortium chains are suitable for transactions and settlements between organizations, with Facebook's Libra project being the most well-known example.
Since private and consortium chains are controlled and maintained by centralized institutions, they can eliminate incentive mechanisms, thus achieving a non-token blockchain. Additionally, compared to public chains, private chains have fewer nodes participating in record-keeping, theoretically allowing for higher performance.
3. Knowledge Related to Smart Contracts (Ethereum Smart Contracts / Oracles / Token Issuance)#
The birth of Ethereum brought a significant upgrade to blockchain technology. Before this, most blockchain projects were mere copies and imitations of Bitcoin's code, capable of only simple payment functions like Bitcoin. Ethereum represented a major upgrade for the entire blockchain world, especially with the emergence of "smart contracts," which greatly enhanced the scalability and application range of blockchain technology and was a key factor in triggering the 2017 ICO boom and bull market.
3.1 Smart Contracts and Oracles#
Most public chains that emerged after Ethereum possess smart contract functionality, while Bitcoin does not.
In simple terms, a smart contract utilizes the immutability and traceability of blockchain to automatically execute an event when certain conditions are met.
Since blockchain itself is closed and cannot directly communicate with the real world, when a smart contract needs to obtain information outside the blockchain, it requires the assistance of "oracles." Oracles can be understood as a bridge for communication between on-chain and off-chain.
For example: If Satoshi Nakamoto and Vitalik Buterin make a bet that if the price of BTC exceeds $10,000 at noon that day, Vitalik will pay Satoshi 10 ETH. To prevent default, a smart contract locks 10 ETH in Vitalik's account. At the specified time, the oracle will verify whether the condition is met by querying the price information from an exchange (off-chain information). If the BTC price is indeed above $10,000, the 10 ETH locked by Vitalik will automatically transfer to Satoshi's account.
With smart contracts, many existing centralized product functions can be realized under the premise of decentralization, leading to the emergence of various DApps (decentralized applications), with gambling DApps being the most common. After all, using digital currency for gambling poses lower legal risks, and the characteristics of blockchain and smart contracts can provide complete fairness, which is highly attractive to gamblers. However, it is still not recommended to participate, as many gambling DApps disguise themselves as decentralized while actually being centralized.
This year's popular DeFi (Decentralized Finance) can also be seen as a direction of DApps. Those interested in DeFi, DEX (Decentralized Exchanges), and related content can refer to my previous article.
3.2 Token Issuance via Smart Contracts, ERC20 Tokens#
The most widely used function of smart contracts is token issuance.
Before the advent of smart contracts, issuing a digital currency had a bit of a technical barrier. The most common operation was to copy Bitcoin's code, modify a few parameters like total supply and block rewards, rebrand it, and start mining. The downside of this approach is the need for high promotional and marketing capabilities, as maintaining a complete blockchain is required. If no miners are willing to mine, it is easy to suffer a 51% attack.
With the emergence of smart contracts, issuing tokens has become a foolproof operation. The most common is issuing tokens based on the Ethereum ERC20 standard (there are also ERC721, ERC875, and other standards, but they will not be detailed here). The cost is negligible, and these tokens are referred to as Tokens.
These Tokens do not have their own unique blockchain but share a parent called Ethereum. Relying on the security of the Ethereum blockchain, the project teams issuing tokens do not need to worry about blockchain security or user learning costs; users only need an Ethereum wallet address to store all their Tokens.
To draw a simple analogy, issuing a blockchain is like building an independent e-commerce platform, where you are responsible for everything from technology to operations, and you must attract users, which incurs high customer acquisition costs. If something goes wrong, the entire platform could collapse. In contrast, issuing a Token on Ethereum is like opening a store on Taobao, where you do not have to worry about the infrastructure, and users can shop at your store as long as they have a Taobao account, resulting in lower costs and backing from a large platform. Due to these advantages, the vast majority of air coins on the market today are ERC20 Tokens.
3.3 Developing Public Chains and Mainnet Launch#
If issuing a coin is merely to represent a certain right or value, then using smart contracts to issue a Token is sufficient. This ensures that these coins exist permanently and cannot be altered, while also adhering to the principles of decentralization and transparently displaying data. For example, many exchange platform coins are ERC20 tokens on the Ethereum chain.
If there is a need that exceeds the functionality of smart contracts, such as wanting to surpass Ethereum, then one must independently develop a public chain.
Developing a public chain generally requires a longer time frame. Many public chains initially issue a Token on other public chains to raise funds or conduct futures trading. Once development is complete (mainnet launch), the Token is mapped and migrated to its own chain.
Taking EOS as an example, before the EOS public chain was completed, the EOS coin existed as an ERC20 token on Ethereum. Users traded ERC20 tokens on exchanges, and after the mainnet launch, they could exchange their ERC20 tokens for EOS mainnet coins. Only then did they truly hold EOS; prior to that, they only possessed an officially recognized symbol representing EOS.
3.4 Fundraising Methods (ICO, IEO)#
Developing a public chain requires funding. If there is no financial backer, the only option is to raise funds from the public or institutions. If traditional crowdfunding methods are used to directly raise fiat currency, there are policy risks related to illegal fundraising. Therefore, ICOs are commonly used in the cryptocurrency space to raise funds.
ICOs borrow the concept of IPO (Initial Public Offering) from the stock market, meaning "Initial Coin Offering." Compared to traditional enterprises, ICOs are essentially startups directly raising funds for listing. Project teams typically use white papers to introduce project concepts and roadmaps, often inviting prominent figures to endorse them. If investors are optimistic, they can invest using mainstream digital currencies (usually Bitcoin or Ethereum), and the project team will issue tokens to the investors. If these tokens later get listed on exchanges, investors can trade them; if they fail to get listed and the project fails, the tokens in investors' hands will become worthless.
The ICO boom in 2017 led to a frenzy in the digital currency market, with numerous air coins flooding the market. Driven by wealth effects, the FOMO sentiment was intense, and many current cryptocurrency veterans entered the market during that time. On September 4, 2017, China issued an ICO ban, which gradually brought this bubble to a halt.
IEOs are a variant of ICOs, understood as "Initial Exchange Offering." The main difference from ICOs is that fundraising occurs on exchanges, adding the endorsement of the exchange, which ensures that tokens can be quickly traded after fundraising, providing a degree of safety for investors. Selling platform tokens by various exchanges can also be seen as an IEO.
IEOs were particularly popular in 2019, with Binance's Launchpad and Huobi's Prime being examples of IEOs or similar events, often requiring a lottery or drawing to participate.
Both ICOs and IEOs are effective fundraising methods, but due to the prevalence of trash projects in the cryptocurrency space, most fundraising is used for harvesting, and new investors are advised against participating.
4. Digital Currency Wallets and DApps#
4.1 Decentralized Digital Currency Wallets#
A digital currency wallet is a tool for storing digital currencies, with basic functions including generating (creating) wallet addresses and private keys, receiving payments, and transferring funds. A digital currency wallet is merely a tool; all information within the wallet is stored on the blockchain. The Ethereum wallet address generated in Wallet A can also be used in Wallet B.
To draw a simple analogy, your Ethereum wallet address is like a bank account number you opened at China Merchants Bank. You can bind this bank account number to Alipay or WeChat for transfers. This account is unrelated to Alipay or WeChat; its information is stored in the China Merchants Bank system. Similarly, your Ethereum wallet address and assets are independent of the wallet software you use, directly connected to the Ethereum blockchain.
4.2 Wallet Address, Private Key, Mnemonic Phrase, Keystore#
When generating a wallet, a wallet address and a private key will be created. The wallet address is equivalent to a bank account number.
The private key is a fixed-length, hexadecimal, randomly generated string of characters corresponding to the wallet address. Possessing the private key allows access to all assets in the wallet and enables wallet recovery in other wallet software (which can be understood as logging into the wallet account). Due to the decentralized nature of blockchain, the private key cannot be recovered if lost.
A mnemonic phrase is generated from the private key, typically consisting of 12 English words, making it easier to read and used in the same way as the private key.
A keystore is a file obtained by encrypting the private key with a password. To recover the wallet, both the keystore file and the password must be provided.
4.3 Classification of Wallets#
Broadly speaking, digital currency wallets can be divided into centralized wallets and decentralized wallets. For example, asset accounts in centralized exchanges like Binance and Huobi can be understood as centralized wallets. The characteristic of centralized wallets is that users do not control the private keys; instead, the platform manages them. The wallet assets displayed on the platform are merely a string of numbers, similar to depositing money in a securities exchange.
Narrowly speaking, digital currency wallets do not include asset accounts provided by centralized institutions but only contain fully decentralized wallets based on blockchain. They can be classified as follows:
By "Issuing Institution," they can be divided into official wallets and third-party wallets.
The former is launched by the project’s official team, while the latter is launched by third-party companies. As long as both are open-source, there is generally no issue.
By "Wallet Size," they can be divided into full-node wallets (heavy wallets) and light wallets.
The former saves and synchronizes all information from the entire blockchain network, equivalent to the entire ledger, occupying a large amount of hard drive space. Miners need to use full-node wallets to synchronize data while mining. The latter only saves and synchronizes data relevant to itself. Currently, most third-party wallets and mobile wallets are light wallets.
By "Network Status," they can be divided into hot wallets and cold wallets.
Hot wallets are those connected to the internet, such as wallets used on connected mobile phones or computers. They are convenient but carry the risk of being hacked.
Cold wallets are completely offline wallets, offering greater security. The simplest way to create one is to use an unconnected phone to generate a wallet address and private key. When a transfer is needed, it cannot connect to the internet but must use offline signing methods.
Currently, all hardware wallets sold on the market are cold wallets, which are easier to operate than creating cold wallets yourself.
Most exchanges choose to store user assets using a cold-hot separation method for security reasons, placing most assets in cold wallets.
5. Cross-Chain#
Cross-chain refers to the realization of information exchange or value transfer between multiple blockchains. The implementation of cross-chain is relatively complex, and the current mainstream approach is to use sidechain relays for two-way anchoring to achieve value transfer. Cosmos and Polkadot both use this method.
Due to the extensive content related to cross-chain, this article will not elaborate on it. Interested readers can refer to previous articles:
A Beginner's Guide: Understanding Blockchain Cross-Chain Application Scenarios and Technical Implementations
6. Model Coins and Ponzi Schemes#
Currently, most digital currencies on the market are essentially air coins, lacking real applications to support their market value. Therefore, some project teams use models to attract funds, thereby inflating coin prices and harvesting investors. Many newcomers are drawn in by high returns and overwhelming low-quality promotions, investing money, believing they are part of the blockchain revolution, only to end up losing everything.
Model coins are just a catchy term; they are essentially "Ponzi schemes." The typical pattern is that new users pay for the returns of old users, supplemented by a recruitment model. When the influx of new users' funds can no longer support the returns of old users, the scheme collapses. Indeed, this is essentially a pyramid scheme, and because it uses digital currency, tracing it after the collapse becomes particularly difficult.
Even if you have not been involved in the cryptocurrency space, you may have heard of notorious Ponzi schemes like Fire Bull, PlusToken, Qubet, and Meile Short Video. If you encounter recommendations for such projects, it is advisable to ignore them. If your family has been brainwashed into believing in these projects, I can only wish you good luck.
In the future, if given the opportunity, I will discuss some entertaining Ponzi scheme tactics. The people designing these schemes are truly ingenious, and much of the magical nature of the cryptocurrency space is due to their efforts.