September 15, 2016

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Understanding Blockchain-Part 2

The global financial system serves billions of people, processes trillions of dollars and supports a global economy worth more than $100 trillion.

Today, when a customer taps his or her credit card on a card reader to buy a Nero coffee, money passes through no fewer than five different intermediaries before reaching Nero's bank account. The transaction takes seconds to clear but days to settle. As the former CEO of Citigroup, Vikram Pandit said, "The advent of technology essentially took paper-based processes and turned them into semi-automated, semi-electronic processes but the logic was still paper based".

On the blockchain, the network both clears and settles peer-to-peer value transfers, and it does so continually so that its ledger is always up to date. If banks harnessed that capability, they could eliminate an estimated $20 billion in back-office expenses without changing their underlying business model, according to the Spanish bank Santander, though the actual number could be much greater. The first era of digital economy was sparked by a convergence of computing and communications technologies. This second era would be powered by a clever combination of computer engineering, mathematics, cryptography, and behavioral economics.

Satoshi Nakamoto sought not only to disintermediate the central banking powers but also to eliminate the ambiguity and conflicting interpretations of what was happening. Let the code speak for itself, let the network reach consensus algorithmically on what happened and record it cryptographically on the blockchain. Satoshi leveraged an existing distributed peer-to-peer network and a bit of clever cryptography to create a consensus mechanism to craft Bitcoins for the blockchain, explained below.

To achieve consensus, the bitcoin network uses the proof of work (POW) mechanism. Since we can't rely on the identity of the miners to select who creates the next block, there is a puzzle created that is hard to solve (that is, it takes a lot of work), but easy to verify (that is, everyone else can check the answer very quickly). Participants agree that whoever solves the problem first gets to create the next block. Miners have to expend resources (computing hardware and electricity) to solve the puzzle by finding the right hash, a kind of unique fingerprint for a text or a data file. For each block they find, miners receive bitcoin as reward. The puzzle is mathematically set up to make it impossible to find a shortcut to solve it. This is the reason why, when the rest of the network sees the answer, everyone trusts that a lot of work went into producing it. This puzzle-solving is continuous— to the tune of 500,000 trillion hashes per second. Miners are looking for a hash that meets the target. It is statistically bound to occur every ten minutes on average. Miners gather all the pending transactions that they find on the network and run the data through a cryptographic digest function called the secure hash algorithm (SHA-256), which gives a 32-byte hash value as output. If the hash value is below a certain target (set by the network and adjusted every 2016 blocks), then the miner has found the answer to the puzzle and has 'solved' the block. Unfortunately for the miner, finding right hash value is very difficult. They have to try many times to find the right answer. According to the data collected till the end of 2015, the number of hash attempts is 350 million trillion on average. That’s a lot of work!