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, comprising 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, "Bitcoin" in the following text 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 at a technical level, essentially a decentralized (or weakly decentralized) distributed ledger.
The core of blockchain technology is "decentralization"; understanding this is already a significant step into the field.
The financial services we currently use are all "centralized." For example, deposits and transfers have a central bank, your home has your wife as the center, and all money is managed and accounted for by the center. When you want to spend 20 yuan to buy a Zhihu membership, the bank or your wife must first check if you have 20 yuan. If you do, they deduct 20 yuan from your account and add 20 yuan to Zhihu's account.
This means there is a third party between you and your money; you essentially do not hold your money. The balance in your account is merely a number displayed by the bank.
The hidden danger here is that you must trust the center. If the bank freezes your money, or your wife does not allow you to spend, you cannot buy the membership temporarily; in a worse scenario, if the bank goes bankrupt or your wife runs away, your assets could be reduced to zero, and you would be completely unable to buy the membership.
You might wonder, can't you just hold cash, not deposit it in the bank, and not give it to your wife, making it safer?
Actually, that's not the case. The currency we hold is all fiat currency, whether it's your bank balance or cash in hand, issued by centralized government institutions. Its value comes from government credit backing; when the government and most people recognize it, fiat currency is money; when they do not, it is worthless. Additionally, the monetary policies implemented by the government can also affect the real value of fiat currency.
For example, during a pandemic, if governments around the world engage in quantitative easing, essentially printing more money, this can devalue your money. A membership that originally costs 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 opposite: no center, no bank, no wife.
In the Bitcoin system, all your money exists on the blockchain, and this money is BTC. These coins are not held by any institution but are owned solely 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 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 the blockchain ensure security?
At least with fiat currency, there is a bank to safeguard your money, but on the blockchain, no one manages the money. Isn't that chaotic?
Let's look at the practical application scenario; the core use of money is simply—transfers. Whether you are shopping, borrowing, repaying, or engaging in other financial activities, as long as it involves the flow of funds, it can be classified as a transfer. As long as the security of transfers is resolved, the security of money is essentially resolved.
The solution provided by blockchain is very simple and straightforward: since having a central institution to keep accounts 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 that includes all transactions among users. When a transfer occurs, these nodes participate in bookkeeping. The system will use an algorithm to select a node that records quickly and accurately to gain bookkeeping rights. This node will package all transfer records within a certain period into a "block" and broadcast it to all nodes. Other nodes will verify and synchronize to ensure the ledger is consistent.
The time to generate a block in Bitcoin is approximately 10 minutes, meaning every 10 minutes, a node is selected to record the transfers that occurred in the previous 10 minutes. A block is equivalent to a page of the entire Bitcoin ledger, and all blocks are connected to form a "blockchain."
One of the characteristics of blockchain is that it can only move forward and cannot roll back. Once something is written into the blockchain, it cannot be altered. This means that the BTC you hold can be traced back on the blockchain, allowing you to trace its origin all the way back to where it was first created, ensuring that every BTC held by individuals is authentic and credible, with no forgery. Of course, this also means that if you mistakenly transfer BTC to the wrong person, you cannot get it back unless that person is willing to return it to you.
But what if a node records false accounts? After all, a false account could cause problems for the entire traceable chain. This introduces an important concept: "Longest Chain Principle."
During the operation of the blockchain, if a malicious node is selected as a bookkeeping node and records false accounts that are inconsistent with others' ledgers, a fork will occur on the main chain, resulting in two chains—one correct and one incorrect. In such cases, the longest chain principle will apply: whichever chain gains the recognition of the majority of nodes and continues will be considered the correct chain, while the other chain will be discarded. As long as the majority of nodes are honest, there will be no issues.
1.4 Bitcoin Mining Mechanism#
In the Bitcoin blockchain (system), everyone circulates BTC, so 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, to ensure the decentralization and security of the entire system, countless nodes must participate in bookkeeping. People certainly will not do this for free, so bookkeeping rewards BTC, but this reward is only one per block. To obtain the reward, everyone must compete, and this competition process is called "mining." Therefore, the essence of mining is "competing for bookkeeping rights," and nodes are thus 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, halved 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 accurately have bookkeeping rights, meaning they can mine. So how is this "quick and accurate" defined? This leads us to the mining mechanism of Bitcoin.
Before generating a new block, Bitcoin requires miners to calculate a string of random numbers (which can be understood as a math problem). Theoretically, the stronger the performance (hash rate) of the computer hardware (or specialized mining machines) used to calculate the random number, the faster the calculation. The first miner to correctly calculate it can record the accounts and package the block, receiving the reward.
To keep the generation time of each block (the time to solve the math problem) around 10 minutes, the system adjusts the mining difficulty (the difficulty of the math 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, which can be understood as transfer 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, each Bitcoin block can accommodate about 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, let's introduce the concept of "TPS," which refers to transactions per second. Based on Bitcoin's capacity of 3,000 transactions per block every 10 minutes, the TPS is only 5. In contrast, centralized financial institutions like VISA have a TPS of around 2,000, and Taobao can peak at over 200,000. Bitcoin's financial system pales in comparison, not to mention the high miner fees.
Thus, those claiming BTC can become a "world currency" are either naive or malicious. I believe BTC may become a value-preserving 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 and the Lightning Network, they have not gained traction recently due to their impact on decentralization. This is also the biggest problem with many blockchain projects today: ensuring decentralization and security while failing to balance performance, known as the "impossible triangle."
2. Classification of Blockchain (Public Chain vs. Private Chain / Consensus Mechanism)#
Currently, there are many blockchain projects on the market, each adopting different mechanisms. There are mainly two mainstream classification methods.
2.1 Consensus Mechanism Classification#
The core of mining is competing for bookkeeping rights (mining) and obtaining mining rewards, and the rules for distributing bookkeeping 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 is important to note that when you discover an unknown project claiming to use a new consensus mechanism, you should carefully investigate whether it is a scam to lure your funds. Many scams fabricate a consensus mechanism, using terms like PoA-PoZ, while actually running centralized projects behind the scenes.
- Proof of Work (PoW)
Most early blockchains, such as Bitcoin and Litecoin, use PoW. Here, "work" refers to the process of mining machines calculating random numbers. The node that calculates the correct random number the fastest obtains bookkeeping rights, 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 bookkeeping rights.
The advantage of PoW is its high security; theoretically, only nodes controlling 51% of the hash rate can jointly modify the ledger, which is known as a "51% attack."
The downside is that the mining process wastes computational and electrical resources. Additionally, 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.
Moreover, the emergence of "mining pools" has made the decentralization attribute of PoW a false proposition.
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 a group of miners to obtain a higher probability of mining. When a block is mined, the rewards are divided according to each miner's hash rate proportion, with the mining pool service provider taking a fee. Today's 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.
- Proof of Stake (PoS)
The PoS mechanism does not require hash rate mining but selects bookkeepers through a process similar to democratic elections. Every coin holder can participate in the election and vote for others. To prevent the abuse of numerous small accounts competing for bookkeeping rights, the concept of coin age is introduced.
The system calculates coin age based on the amount of coins held by users and the time they have held them. The higher the coin age, the greater the rights, and the higher the probability of obtaining bookkeeping 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 disparities, where nodes with the most coins hold significant power and may dominate bookkeeping rights.
- Delegated Proof of Stake (DPoS)
DPoS is a variant of PoS, where coin holders do not all participate in bookkeeping competition but elect several representatives who will perform the bookkeeping.
For example, in EOS, coin holders vote to elect 21 supernodes, and the work of bookkeeping and verifying transactions is entirely done by these nodes, meaning there are only 21 miners. Coin holders can replace supernodes at any time through voting, similar to the People's Congress system in China.
DPoS can achieve high performance due to the fewer participating nodes but sacrifices some decentralization and security.
2.2 Public Chain / Private Chain Classification#
Public chains, or "public chains," do not rely on central institutions for issuance. Everyone can write to and read data on the chain, and participants are incentivized through coins 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 coins to incentivize participation in mining. Bitcoin and Ethereum are examples of public chains.
Private chains also use distributed ledgers, but unlike public chains, private chains are controlled and maintained by centralized enterprises or institutions. Permissions are regulated by the institution, and the public cannot write data, with reading data generally restricted or outright denied.
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 has multiple institutions or organizations participating, 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 weak decentralization.
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 the incentive mechanism, thus achieving a non-coin blockchain. Additionally, compared to public chains, private chains have fewer nodes participating in bookkeeping, 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 merely copies and imitations of Bitcoin's code, capable of only simple payment functions like Bitcoin. Ethereum, however, represents a major upgrade for the entire blockchain world, especially with the emergence of "smart contracts," which greatly enhance the scalability and application range of blockchain. This was also a key factor that triggered the ICO boom and bull market in 2017.
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 the blockchain itself is closed and cannot directly communicate with the real world, smart contracts need the help of "oracles" to obtain information outside the blockchain. Oracles can be understood as bridges for communication between on-chain and off-chain.
For example: If Satoshi Nakamoto and Vitalik Buterin bet that if the price of BTC exceeds $10,000 at noon that day, Vitalik must pay Satoshi 10 ETH. To prevent default, the 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 functions of existing centralized products can be realized under the premise of decentralization, leading to the emergence of various DApps (decentralized applications). The most common are gambling DApps, as using digital currency for gambling carries lower legal risks. 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 but are actually centralized.
The popular DeFi (Decentralized Finance) this year 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 emergence of smart contracts, issuing a digital currency had a certain technical threshold. The most common operation was to copy Bitcoin's code, modify a few parameters like total supply and block rewards, repackage it, and directly issue it to start mining. The downside of this approach is that it requires high promotional and marketing capabilities, as maintaining a complete blockchain is necessary. If no miners are willing to mine, it is easy to suffer a 51% attack.
After the emergence of smart contracts, issuing tokens has become a foolproof operation, with the most common being coins issued based on the Ethereum ERC20 standard (there are also ERC721, ERC875, and other standards, which will not be detailed here). The cost is negligible, and these coins 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 parties issuing tokens do not have to worry about blockchain security or user learning costs; users only need an Ethereum wallet address to store all their Tokens.
To put it simply, issuing a blockchain is like building an independent e-commerce platform, responsible for everything from technology to operations, with high customer acquisition costs, and a single mistake could lead to the collapse of the entire platform. Issuing a Token on Ethereum is like opening a store on Taobao, where the infrastructure does not need to be managed, and users can shop at your store as long as they have a Taobao account, resulting in low 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 are immutable, 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 are demands that exceed the functionalities of smart contracts, such as wanting to surpass Ethereum, then an independent public chain must be developed.
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.
For example, in the early stages before the EOS public chain was completed, EOS coins existed as ERC20 tokens on Ethereum. Users traded ERC20 tokens on exchanges, and after the mainnet launch, users could map their ERC20 tokens to exchange for EOS mainnet coins. Only then did they truly hold EOS; prior to that, they only held a symbol officially recognized as 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 may be regulatory risks of 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 parties 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 party issues coins to the investors. If these coins later get listed on exchanges, investors can trade them; if they fail to get listed and the project fails, the coins in investors' hands will become worthless.
The ICO boom in 2017 saw a surge of air coins in the digital currency market, driven by the wealth effect, leading to intense FOMO (Fear of Missing Out) in the market. Many current veteran investors entered the market during that time. On September 4 of that year, China issued an ICO ban, which gradually brought the bubble to a halt.
IEO is a variant of ICO, understood as "Initial Exchange Offering." The biggest difference from ICOs is that fundraising occurs on exchanges, adding the endorsement of the exchange, ensuring that after fundraising, trading can quickly occur on the exchange, providing a degree of safety for investors. Selling platform coins by various exchanges can also be seen as IEO behavior.
In 2019, IEOs were particularly popular, with Binance's Launchpad and Huobi's Prime being examples of IEOs or similar IEOs, with full attendance, requiring lotteries or drawings for opportunities to participate.
Both ICOs and IEOs are effective fundraising methods, but due to the prevalence of garbage 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#
Digital currency wallets are tools for storing digital currencies, with basic functions including generating (creating) wallet addresses and private keys, receiving payments, transferring funds, etc. 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 put it simply, the wallet address you generate on Ethereum is like your bank account number at China Merchants Bank. You can bind this account 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 unrelated to the wallet software you use but are 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 akin 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 similarly to the private key.
A keystore is a file derived from 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, the 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 wallet's private key; instead, it is managed by the platform. 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 encompass completely 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 official, while the latter is launched by third-party companies. As long as both are open-source, there are generally no issues.
By "Wallet Size," they can be divided into full wallets (full node 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 disk space. Miners need to use full 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 that are online, such as wallets used on connected mobile phones or computers, which are convenient but carry the risk of theft.
Cold wallets are completely offline wallets, providing 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 later, it cannot go online 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 now choose to store user assets using a cold-hot separation method for security, placing most assets in cold wallets.
5. Cross-Chain#
Cross-chain refers to the realization of information interaction or value transfer between multiple blockchains. The implementation of cross-chain is quite complex, and the current mainstream approach is to achieve bidirectional anchoring through sidechain relays for value transfer. Cosmos and Polkadot both use this method.
Due to the extensive content related to cross-chain, this article will not elaborate further. Interested readers can refer to previous articles:
A Beginner's Guide: Easily Understand Blockchain Cross-Chain Application Scenarios and Technical Implementations
6. Model Coins and Funding Schemes#
Currently, most digital currencies on the market are essentially air coins, lacking real applications to support their market value. Therefore, some project parties 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, thinking they are part of the blockchain revolution, only to end up losing everything.
Model coins are just a catchy term; they are essentially "funding schemes." The typical pattern is that new users pay for the returns of old users, supplemented by a referral model. When the influx of new users' funds can no longer support the returns of old users, the scheme collapses. Yes, this is essentially a pyramid scheme, and because it uses digital currency, it becomes particularly difficult to trace after the collapse.
Even if you have not been involved in the cryptocurrency space, you may have heard of notorious funding schemes like Huoniu, PlusToken, Qubao, and Myle 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 interesting funding scheme tactics. The people designing these schemes are truly creative, and much of the magical nature of the cryptocurrency space is due to their efforts.