Untangling Cryptocurrency and Blockchain: An Introduction to Fundamental Concepts

The word blockchain has become synonymous with one of its most popular applications — cryptocurrencies. For a layperson, blockchain immediately conjures an image of the Bitcoin cryptocurrency. Perhaps if they are more knowledgeable, they might mention other popular cryptocurrencies such as Ether and Tether. While cryptocurrencies are inextricably linked with their underlying technology, the blockchain, it is important to know the difference between the two to fully understand their respective roles and potential applications. Understanding the distinction between blockchain and cryptocurrencies is especially crucial for government heads, regulatory authorities, and business leaders who might be willing to capitalize on the popularity of blockchains due to recent events such as the US establishing a strategic Bitcoin reserve.

The seminal whitepaper on Bitcoin describes it as a peer-to-peer electronic cash system. In computing or networking, the term "peer-to-peer" refers to a decentralized network where the participants (peers) directly interact with each other to collectively perform an action or task. Thus, Bitcoin is the system/technology/network that enables peer-to-peer transfers without the need for a trusted central authority such as banks to validate transactions. Instead of a third party that provides the infrastructure for conducting financial transactions, transactions are verified, executed, and ordered via the blockchain. Before continuing further, it is important to consider that the unit of value (cryptocurrency or native token/coin) in the Bitcoin blockchain is also referred to as Bitcoin. Other blockchain projects use different names for the blockchain (e.g. Ethereum) and native cryptocurrency (e.g. Ether); a native token or cryptocurrency is a blockchain's inherent digital currency.

A blockchain comprises of a network of nodes which follow certain cryptographic protocols to maintain a public history of transactions. A node is an entity or device responsible for managing the network and is allowed to join or leave the network at will. The term blockchain describes how transactions in this system are organized i.e. the transactions are ordered (listed) in blocks and each block references its previous block hence creating a chain of blocks. The diagram below shows a simplified structure of a block where each block stores the previous block's hash, nonce (number used only once), and a list of transactions. The block hash can be thought of as the block's unique digital identifier where certain information such as the timestamp, previous block hash, and the nonce are passed as input to a mathematical function called the hash function to generate the hash.

A user wishing to transfer Bitcoin to another user submits their transaction to a node on the network. Transactions have to be constructed according to the specifications defined in the Bitcoin protocol. Through an algorithm referred to as the consensus mechanism, the network nodes collectively agree on the blockchain state (snapshot of all the data stored on the blockchain at a given moment) and append a block to the blockchain. Bitcoin uses the Proof-of-Work consensus mechanism where nodes or miners compete to solve a cryptographic puzzle in order to add a block; the node which solves the puzzle first for a certain time period is granted the right to append a block and rewarded with a specified amount of Bitcoin. In Proof-of-Work, the nodes are trying to guess the value of a nonce which successfully fulfills certain conditions when passed as input along with other information to the hash function.

While there over an estimated 1000 blockchains operating currently, the relevance of the Bitcoin blockchain cannot be understated as most blockchain projects build on the foundations established by the original whitepaper. While newer blockchains introduce new features and protocols, the core principles introduced by Bitcoin continue to influence the design choices. Due to their data structure and emphasis on trust-less consensus, blockchains are characterized by transparency, immutability, and decentralization. As transactions are recorded publicly across a distributed ledger/database, anyone can access the entries leading to greater transparency. Any modifications to the ledger cannot be achieved without the consensus of a majority of the network nodes and it is nearly impossible for malicious attackers to gain control of the network. Hence, a transaction is considered to be immutable once it is incorporated into a block and that block added to the chain. Finally, no single entity can control the network due to the high hardware requirements imposed by the protocol which leads to a decentralized network. While these three properties are desirable, Bitcoin only supports peer-to-peer transfers of the native token. What if you wanted to deploy a social media network or manage real estate on blockchains?

Ethereum was envisioned as a general-purpose blockchain that can support code execution. One of the most notable features of Ethereum is the introduction of smart contracts that allowed business logic, written as code, to be executed automatically once certain conditions are fulfilled. Smart contracts had a transformative impact on the blockchain ecosystem as nearly any application from supply chain to healthcare could be built on top of blockchains. This also enabled the launch of new cryptocurrencies on those blockchains that support smart contracts reducing the need for developers to build a new blockchain from scratch. An example of cryptocurrencies that operate alongside native tokens are stablecoins such as Tether (USDT), USDC, and Dai. As evident by their names, stablecoins are cryptocurrencies who's market value is pegged or tied to a a reference asset such as the US dollar or gold.

While it is understandable that cryptocurrencies and blockchains are often conflated with each other, it is important to remember that cryptocurrencies are one of the applications or use cases of blockchains. Blockchains are a system or network for maintaining a growing chain of blocks where data (transactions) is organized immutably and collectively by network nodes. Although the focus of this article was mainly on Bitcoin and its underlying structure and properties, new blockchains have been released that introduced new optimizations and features. Therefore, after understanding core blockchain concepts, it might be worthwhile to explore current and new blockchain projects.