Blockchain Investing – A Beginner’s Guide

Do you have a passion for blockchain technology? Are you looking for detailed information about it? With the aid of this guide, you will learn about the benefits and how this technology functions.

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In the field of technology, blockchain is a groundbreaking system allowing participants to share, record, and track transactions in a decentralized way, without the need for a centralized authority. There is no doubt that cryptocurrency has been one of the biggest byproducts of blockchain technology and is considered “a trusted medium”. An initial coin offering (ICO) is a novel form of raising equity funding for startups; newly-minted cryptocurrencies are sold by startups to the public as a means of raising funds. The purpose of this article (Blockchain Investing: A Beginner’s Guide) is to provide valuable insights into this new trend of entrepreneurial finance by discussing blockchain technology, cryptocurrency, and ICOs. This article will help readers gain a better understanding of this emerging financial trend.

Blockchain Investing - A Beginner's Guide

Blockchain Overview

Back in 2008, a developer named “Satoshi Nakamoto” introduced the concept of blockchain technology. Nakamoto (2008) described it as the underlying mathematical underpinning of Bitcoin, a peer-to-peer cash system. Blockchain technology today is no longer just viewed as a platform for cryptocurrency but is also used in a wide range of industries, both financial and non-financial sectors.

A blockchain is a decentralized, distributed ledger that records transactions digitally. The name evolved from Satoshi Nakamoto’s 2008 concept of a “block” and “chain,” in which transactions are grouped into blocks and chained sequentially from one block to the next.

A blockchain is a “transaction ledger” that consists of complete historical details of transactions, as explained by Nofer, Gomber, Hinz, & Schiereck, 2017. Additionally, blockchain is a distributed system, requiring multiple nodes to function fully, and yet, at the same time, it is decentralized, which means that no single node can fully control its entire network. Consequently, there is no need for a central authority, and it is more efficient and secure. Blockchain also provides transparency as everyone on the network has access to the full history of transactions.

Every block in a blockchain not only tracks transaction details and timestamps but also hashes the previous block with a nonce (random number). In order to ensure the integrity of the entire blockchain, blockchain technology uses the nonce for verifying the hash of transaction details. According to Drescher, 2017, a hash value is created by transforming data into a fixed-sized string of numbers and letters using cryptographic hashing. Every transaction of a block is hashed through the Merkle root, which is itself the sum of all the transaction hashes within a block of transactions. The processing process of hashing a block with 200 transactions takes exactly as much effort as hashing a block with only one transaction.

In order to add a new block to the chain, the majority of nodes in the network must agree by a consensus mechanism that both the transactions in the block and the block itself are valid. By consensus, a new block is ensured to contain accurate information and to record the most current transaction. The consensus assures that most validators agree about the ledger’s current status. It also involves rules and procedures shared among several nodes with the goal of ensuring the validity of the ledger. By default, new transactions are stored in a block for a set period of time before the information is added to the ledger, a consensus process must occur (the duration will vary between blockchains, e.g., between 10 to 15 minutes for BTC blockchain).

The Proof of Work (PoW) consensus algorithm is the first and most popular in the blockchain community. Several cryptocurrencies, such as Bitcoin, use the PoW-based algorithm HashCash to generate blocks. HashCash is a PoW-based algorithm that is used to generate blocks by several cryptocurrencies, some of which is Bitcoin. Validating and adding new blocks is only possible through the “mining process”, a procedure in which the protocol rewards the first node (miner) to find the solution to a mathematical problem with a new coin. A miner’s ability to solve the mathematical equation determines the probability of discovering a new block. In the words of Gatteschi et al. (2018), the nodes used the random value to combine with the previous block header and a hash of transaction data to produce the final result.

A node broadcasts its results to other nodes when it discovers a possible solution. Once the majority has agreed on the outcome, the block is updated to the blockchain, with all nodes updating their local copy. In PoW, however, mining becomes more difficult as more blocks are minted, which only makes it more difficult for miners to acquire new coins. To stretch more, PoW has high costs involved in mining, as more powerful, more energy-efficient mining hardware is required to win the mining contest.

Apart from Bitcoin, there are multiple forms of PoW, and software has been developed that uses tokens or blockchains as consensus mechanisms. The Proof of Stake (PoS) consensus protocols of BitShares and Peercoin are good examples. In Proof-of-Stake, mining power (i.e. the power to verify blocks) is controlled by the stake that a miner holds in the cryptocurrency. Unlike Proof of Work, therefore, the protocol rewards miners based on their good works (solving problems and generating new blocks), not on the quantity of work done; Normally in PoS, a node that has more coins (stake) simply has more mining processing power. If a user owns 1% of the coins, he or she can mine 1% of the PoS blocks.

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Asymmetric Cryptography Algorithm And How It Is Used In Blockchain

Blockchain technology also uses asymmetric cryptography, in addition to the previously stated unique characteristics. Asymmetric Cryptography is also known as Public-key cryptography, which enhances user security and protects digital property. With the help of such a function, information can be encrypted, and subsequently, data can be transferred via public and private keys. An individual’s public key represents the address of their account and could be viewed by anyone. Private keys restrict access to an account to only the account holder himself/herself. Like an email address, the public key in the Bitcoin blockchain functions like the Email address, while the private key serves as the password for logging into the email address. Those who have an email address can send and receive emails.

In a similar fashion, people could send and receive Bitcoin on the Bitcoin blockchain using their private keys. A private key cannot be discerned solely from its paired public key, either. Then, for the integrity of data, every account holder must create a “digital signature” before authorizing any transaction. Users’ private keys are combined with the data they would like to transfer using a mathematical algorithm. In that way, since the private key of the user is now included in the transferred data, accuracy and completeness are ensured.

The Types Of Blockchain

There are three types of blockchains, each with its own characteristics: public, private, and hybrid.

  • Public Blockchain

Ledgers in public blockchains are decentralized and accessible to the general public. Public blockchains, in general, use the PoW consensus mechanism described above. As a result of its high usage, the Bitcoin blockchain has become a public ledger, anyone can access and use it as follows:

  1. Mine Bitcoin and run a Bitcoin full node
  2. Go through the entire ledger and review it
  3. Transact on the blockchain
  • Private Blockchain

There is a central authority tasked with monitoring an entirely private blockchain. Participants must authenticate their identities and be authorized to gain access. Among the most popular examples of a private blockchain is Hyperledger Fabric, which is registered with the Linux Foundation. The network is designed as an access-controlled network that is primarily used by businesses.

  • Hybrid Blockchain

A hybrid blockchain lies between the two extremes, which includes “partially decentralized” blockchains, also referred to as “consortium blockchains”, that “fuse the best features of both the low-trust and the high-trust models”. A common instance of a hybrid blockchain is the XDC hybrid blockchain developed by XinFin. All of its participants can use its network, meaning retail users are free to trade. Xinfin (2018) reports the possibility that institutional participants may in addition set up private subnetworks that will not be visible to all.

The Evolution Of Blockchain

Recently, blockchain technologies have gotten a lot of attention. According to research, the evolution of blockchain technology follows three different tracks:blockchains: 1.0, 2.0, and 3.0.

Blockchain 1.0 includes currency and the development of cryptocurrencies like Bitcoin, which resemble cash or payments. Specifically,

Blockchain 2.0 focuses on smart contracts, which go beyond just a currency.  Smart contracts are pieces of code that are stored on the blockchain. Despite its automatic nature, it would still require certain conditions to be met. As a result, various types of applications could be constructed on blockchains by using this type of contract. In the blockchain 2.0 era, Ethereum is a leading example. The blockchain of the platform could enable decentralized applications (decentralized applications that run on peer-to-peer networks rather than on individual computers). By using its blockchain protocol, different market and financial applications can be created

Among the most prominent examples of blockchain 2.0 comes the DAO project. Digital decentralized autonomous organization, just as its name describes it (the DAO acronym) based on Smart Contracts, utilizing Ethereum blockchain. It is also regarded as an investor-directed venture capital fund that is not governed by a central authority. As an investment, the DAO token will grant all investors voting rights to vote on various projects. The smart contract failed to run smoothly, and the project failed after just a few months. Nonetheless, this project shows the potential flaws of smart contracts and is a great example of how blockchain technology can be applied in real-world ways.

Blockchain 3.0 focuses on applications. A smart contract, allowing for further development and application of blockchain, has opened up the blockchain to sectors other than finance and transaction. Today, this technology is becoming more and more integral to many sectors, including government, education, and more. Various studies have shown that blockchain 3.0 also has a positive effect on both the financial and non-financial industries. Crosby et al (2016) argue that big financial institutions are looking for ways to integrate blockchain into their business practices, rather than considering the technology a threat.

Cryptocurrency In Blockchain

The first application of blockchain technology was the cryptocurrency, which was introduced as a financial instrument. With blockchain technology, cryptocurrencies can provide a distributed system that can be certified and hashable once a payment transaction is generated over the internet. As opposed to conventional fiat currencies that require a central authority (e.g., a central bank) in order for the value of a currency to be guaranteed, cryptocurrencies that employ blockchain technology provide a digital online distributed system of payment certification without a central authority.

Alternative payment solutions have been sought for decades, looking back at history. A digital currency similar to today’s cryptocurrency was introduced back in the 1990s by DigiCash Inc., called eCash. Unfortunately, it was destroyed during the 2000 Internet bubble (Frunza, 2016). In the intervening years, numerous digital payments have been used, including Apple Pay, Google Wallet, and PayPal. Despite this, digital currencies are still interdependent with fiat currencies, and they are mainly used online. The promise of cryptocurrency is that it will create a new type of currency based on blockchain technology that will be supported by cryptographic proof instead of trust. Blockchain technology is often described as “the trust machine” and cryptocurrency is undoubtedly the most notable example.

The promise of cryptocurrency is that it will create a new type of currency based on blockchain technology that will be supported by cryptographic proof instead of trust. Blockchain technology is often described as “the trust machine” and cryptocurrency is undoubtedly the most notable example. It addressed the issue of always requiring a third party when using an alternative payment solution instead of cash. It addressed the issue of always requiring a third party when using an alternative payment solution instead of cash. The number of cryptocurrency types currently exceeds 1000. Of the various cryptocurrencies, Bitcoin stands out as the most popular as it is one of the first cryptocurrencies built using blockchain technology.

In spite of the fact that most cryptocurrencies are only clones of Bitcoin, there are still some that are made with significant improvements and contribute significantly to the development of cryptocurrencies in general. It is estimated that 350 billion US dollars are worth all cryptocurrencies in May 2018. When compared to national currencies, which are backed by faith, economic strength, gold reserves, and tax revenues, cryptocurrencies are valued based on these factors:

  1. Unlike conventional currencies, cryptocurrency allows for low-cost transfers (no foreign exchange bank fees) while also allowing for high-speed transfers.
  2. The demand for using cryptocurrencies because of their low charges creates financial inclusion since there are people without bank accounts who remain interested in using cryptocurrencies due to their low charges.
  3. Different opportunities can be opened at a global level through Blockchain and the trust of innovation and technology.

Blockchain technology has developed over the past few years, with some platforms allowing Dapps and smart contracts to be developed. Ethereum and Waves are two such platforms. The blockchain allows logic to be incorporated, such as an automatic process that is executed only when certain conditions have been met. A blockchain protocol can also be used to create different tokens. In most cases, smart contracts are executed with tokens. In other words, a token could not only be used to trade, but it could also serve other functions. For the creation of new tokens, Ethereum is the most popular blockchain platform; most of the tokens that are created on it are compliant with the ERC20 standard (a list of rules that Ethereum tokens have to adhere to).

By agreeing on a standard, tokens can be easily traded between one another and recognized. The market value of a token is typically determined by the services or benefits that the token provides. The Binance platform, for instance, has the capability to process 1,400,000 orders per second. The Binance Coin (BNB) token is also based on the Ethereum blockchain with ERC20 standards.

Benefits And Downsides Of Blockchain Technology

Several advantages of the blockchain-based technology have been revealed during its development and are summarized as below:

  1. Its decentralization eliminates the need for a central authority to control the system, and its trustless nature eliminates any third parties in the transaction.
  2. Transparency and visibility of every transaction are available.
  3. Automating activities is possible with smart contracts.
  4. The distribution of the system makes it more resilient to failing components and attacks due to the system’s nature of containing multiple components. A cyber attack or failure will therefore be difficult.
  5. Under certain circumstances, transaction costs could be lower and times could be quicker than with a traditional system.

Blockchain is more likely to pose a challenge. The following disadvantages are also associated with it:

  1. Comparing it to the traditional existing banking system in some cases, such as when transferring money within the same bank, it would potentially be more expensive and take longer to transfer money due to its high energy consumption and constant updates to the mining and storage hardware. Due to the fact that mining is more like a race between nodes, in which the fastest will win, the more powerful equipment with a high hash rate has a higher chance of winning. A digital storage device is also needed for data replication.
  2. The huge amount of power used in blockchain has the potential to cause environmental problems. The network is peer-to-peer in nature. Therefore, the functional integrity of the system requires running a number of servers/computers.
  3. However, since the system is distributed, there remain a few security issues and threats from stealth and cyberattacks. Blockchain is primarily in danger from a vulnerability relating to 51%. Hackers can take control of the entire blockchain due to the 51% vulnerability in the consensus mechanism of the blockchain. (Li, Jiang, Chen, Luo, & Wen, in press). Security of private keys is another major risk. Blockchain considers a private key to be the user’s identification and security credential. Consequently, if a hacker steals a user’s private key, their account may be compromised by others. Further, blockchain is based on a decentralized network, making it impossible to recover any hacked information on a blockchain account. Not only the blockchain itself is susceptible to hacking, but also the team of individuals who work on the project, such as community administrators, could be vulnerable to being hacked and leaking confidential information.
  4. As everyone could access the entire blockchain, full transparency may also negatively impact user privacy.
  5. The inability to modify smart contracts can expose them to cyber attacks, especially under certain circumstances. These issues cannot be fixed unless the existing data is transferred as part of new contracts.

Blockchain technology is also used in the creation of cryptocurrencies, such as Bitcoin. As well as the risks of the technology, it has its own set of challenges. Weaver (2018) notes that risks may arise in several different ways:
Firstly, there may be technical risks for the participants. Like with Blockchain technology, hackers or thieves can have access to cryptocurrencies and move money once they have access to a private key. In spite of the fact that people may store their coins on their system, cryptocurrencies are intrinsically connected to the internet. There are still instances where the internet can be breached by theft.

Secondly, Participants are exposed to economic risks. Inasmuch as cryptocurrencies are only worth what somebody is willing to pay, the price at which the actual value of cryptocurrencies can be accurately determined is highly volatile and susceptible to sudden collapses in valuation.

Thirdly, government intervention, central agencies, exchanges, and worms pose systemic risks to the cryptocurrency ecosystem. It is true that cryptocurrencies cannot be censored by central authorities or governments, but the rules of cryptocurrencies can still be altered by the authorities.

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