Blockchain, Crypto and DeFi: Bridging Finance and Technology

Blockchain, Crypto and DeFi

Bridging Finance and Technology

Marco Di Maggio

Copyright © 2025 by Marco Di Maggio. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Preface

Welcome to Blockchain, Crypto, and DeFi, the only guide you’ll need in the rapidly evolving frontier of blockchain technology. This isn’t just another textbook or professional book; it’s your secret weapon to mastering the chaos of cryptocurrencies and the magic of decentralized finance (DeFi) and Web3.

Anyone who’s ever attended one of my lectures or talks knows I strive to make the experience interactive and entertaining. I believe learning should be enjoyable, not a chore. This book carries the same philosophy. Each chapter is crafted with a touch of whimsy—a witty preface here, a sprinkle of humor there—all designed to engage you, the reader, in a dialogue rather than a monologue. So, as you turn these pages, expect to participate, laugh, and perhaps even question as you would in one of my live sessions. Let’s make this journey through blockchain as lively and spirited as a room full of curious minds!

What’s Inside? More Than Just Your Average Geek Speak: Dive into the core of blockchain technology with a structure that’s as layered as your favorite lasagna! We start with the basics, then crank up the heat with in-depth case studies and spicy code examples that are sure to keep you on your toes.

But it’s not all algorithms and geek speak. Prepare for tales of crypto calamities and triumphs, deep dives into the digital dough of NFTs, and real-world revolutions in everything from gaming to governance. This isn’t just about making you blockchain-savvy; it’s about preparing you to partake, and perhaps even pivot, this technological tumult.

Whether you’re a student flirting with finance, an academic hunting for cutting-edge analysis, or a professional itching to decode the cryptic world of crypto, this book has a little something for everyone.

From Zero to Crypto Hero in Three Parts:

Foundations of Blockchain Technology: Ground yourself with the building blocks of blockchain technology. It’s like the ABCs, but for future tech moguls.

The Crypto Universe: Blast off into the cosmos of cryptocurrencies. Learn about Ethereum’s crafty contracts, unravel the mysteries of stablecoins, without overlooking the emerging world of Central Bank Digital Currencies (CBDCs), where traditional finance meets the frontier of blockchain innovation, promising to redefine money as we know it.

Decentralized Finance (DeFi)/Web3: Strap in for a tour through the revolutionary world of DeFi, from lending schemes to yield farming, and discover why your bank is scared. And what the heck an AMM is anyway!

But Wait, There’s More! Real-World Heroics and Code Wizards: Each chapter unfolds like the plot of a thriller, beginning with an appetizer of introductions, moving on to a main course of rigorous analysis with code snippets, and ending with a dessert of real-world Harvard Business School case studies that reveal the business brains behind the brawn.

Already a blockchain buff? Feel free to leapfrog the introductory chapters and dive straight into the deeper waters of The Crypto Universe and Decentralized Finance (DeFi). This book is designed to cater to both newcomers and seasoned enthusiasts, so pick up from where you find the most value and let the advanced topics challenge and expand your understanding.

Frequently Asked Questions

Did I hear blockchain? I was looking at cooking books…

Well, imagine if blockchain could help you monetize Grandma’s secret recipe or even the views on your latest YouTube channel. This technology isn’t just about crafting a perfect soufflé; it’s about adding value to your digital creations and transactions. By the end of this book, you might find the concept of blockchain as tantalizing as mastering the art of making the perfect risotto or turning your passion for homemade tiramisu into a profitable venture. Dive into the world of digital transactions and discover how blockchain can be the key ingredient to enriching your favorite Italian culinary creations and beyond!

You might enjoy Chapters 9, 10 and 14.

I heard my son-in-law bought these cryptocurrencies and he believes he is going to be rich, is he an idiot?

Like all sons in law, he probably is (as a father of two daughters I speak from experience). However, this book will help you understand why this time he might be onto something… or just onto his next wild goose chase. Furthermore, you will be able to show off at the next meet the parents dinner!

As a Wall Street whiz, should I be brushing up on blockchain or just stick to trusty spreadsheets?

While your spreadsheet magic is undeniable, dabbling in blockchain won’t make you a relic of the finance world—just yet. Consider it like learning a new financial spell; blockchain could add some serious sparkle to your portfolio. Dive into the blockchain waters now and you might just surf your way into the future, as the Wolf of Blockchain Street, leading the pack rather than playing catch-up. Who knows, you might even revolutionize those old-school financial practices and give those young crypto-warlocks a run for their money!

You might enjoy Chapters 7, 8, 9 and 12 the most! You might want to skip Chapter 13.

I don’t run a drug cartel—do I really need to know about crypto?

If your idea of cryptocurrency comes from sensational headlines, you might think it’s all covert operations and shady transactions. But think again! Crypto is swiftly becoming as normal as your morning coffee run. This book will peel back the curtain on how everyday activities—buying coffee, booking vacations, and yes, even grandma padding her nest egg—are increasingly powered by crypto. Let’s move past the tabloid tales and dive into the legitimate, surprisingly mundane, and perfectly legal uses of cryptocurrency. It’s time to see beyond the headlines and discover how integrated crypto is becoming in our everyday financial lives!

While it’s true that the juiciest stories about cryptocurrency often involve wild price swings or the occasional scandal (which make headlines for the same reason car chases do!), this book digs deeper. We explore the solid, less sensational side of blockchain and crypto that the New York Times might not cover in their daily drama. So, no need to brace for a rollercoaster of scams and volatility here—just steady, informative insights on how blockchain really works and why it’s more than just headline fodder.

I just mastered turning on a computer; should I even be considering crypto?

From zero to hero—why not? Leaping straight from powering up a PC to decrypting the blockchain might sound like trying to fly a rocket before you can ride a bike, but this book is your rocket fuel!

If you’re eager to dive into the technical depths and maybe even dabble in some coding, we start from the basics and guide you to tech wizardry. There are even additional tutorials on the book webpage.

But hey, if you’re more the laid-back learner, looking to grasp concepts without tangling up in code, that’s cool too. You can easily glide over the tech-heavy bits; we’ll keep your secret. Either way, this journey has a route for everyone.

As a computer scientist who devours algorithms for breakfast, will this blockchain book keep me engaged or put me to sleep?

Ah, the perennial fear of the gifted coder—will this be another book becoming a shelf warmer while you nod off from simplicity? Not this time! While we cover the essentials, we quickly dive into the cryptographic abyss that’s as complex and challenging as any problem set you’ve faced. You’ll encounter advanced consensus algorithms, delve into the nitty-gritty of smart contract security, and tackle network scalability issues that are the bread and butter of blockchain innovation. Fear not, we promise no shallow dives here—only deep, technical explorations that will keep even the most avid code wizard wide awake and wired.

Chapters 6, 7 and 8 will be fun for you.

By adopting blockchain, do I become the Tony Stark of my industry, or do I still have to pretend to be an adult at board meetings?

Adopting blockchain might not equip you with an Iron Man suit, but it could definitely give you Stark-level swagger in your industry’s tech scene. However, even Tony Stark had to suit up for those pesky board meetings, right? Don’t worry, though—this isn’t just about adding flash; it’s about adding cash flow. With plenty of real Harvard Business School case studies woven through the chapters, you’ll learn from the top dogs who’ve turned blockchain blips into booming business models. So yes, you’ll still need to act the adult part now and then, but you’ll be doing it with a secret weapon up your sleeve. Let’s turn those boardroom snoozefests into your personal revenue stream brainstorm sessions!

My friend says blockchain is the future, but he still has a flip phone. Should I trust him?

Maybe take his tech advice with a grain of salt—or better yet, give him this book! After both of you have read it, you can decide together whether to join the future or just keep flipping phones.

Why should I trust a book to teach me about blockchain? Aren’t all authors just failed tech entrepreneurs?

Ouch, that hurts! But maybe—just maybe—you might find that some authors can explain complex tech in ways even failed tech entrepreneurs understand.

Is this going to be another book collecting dust on my shelves?

Only if you put it there! Give it a read, and it might just end up as that one book you constantly refer back to—like that one cookbook with the best lasagna recipe.

Will reading this book on blockchain make me a millionaire or just make me feel like I’m missing out?

Ah, the million-dollar question—quite literally! While devouring this book won’t magically fill your wallet with Bitcoins, it’ll definitely arm you with the golden nuggets of blockchain wisdom. You’ll journey through the thrilling highs and the agonizing lows of cryptocurrency markets. Yes, you might kick yourself for not mining Bitcoin when it was just a hobby for computer geeks but remember: hindsight is 20/20 and the next big opportunity might just be a chapter away. So, while I can’t promise you’ll make your first million directly from reading this book, you’ll be well-equipped to spot the next wave of opportunities in the digital currency world. And who knows? With this newfound knowledge, you might just become the savviest crypto investor on the block!

I’ve got a killer blockchain idea but I’m no tech whiz. Is this book my blueprint or just bedtime reading?

You don’t need to be a coding virtuoso to bring your blockchain brainchild to life—this book is your secret weapon. Packed with everything from the ABCs of blockchain basics to the XYZs of executing smart contracts, it’s designed to turn dreamers into doers. We’ll guide you through the techie talk with real-world examples, practical advice, and maybe even a few laughs. By the end, you won’t just be ready for bedtime; you’ll be ready to build, pitch, and launch your blockchain project. Who knows, if your idea is as killer as you believe, I might even invest in your project!

Does it mean you are a crypto bro?

Not necessarily, but if understanding blockchain makes one a crypto bro, then get ready to join the club! We promise, though, no hoodies or obscure tech jargon required.

In fact, while we dive deep into the significant aspects of blockchain, I’ve consciously decided to leave out some of the more fleeting trends, like memecoins. Why? Because while they capture headlines and stir up social media buzz, they often lack the underlying fundamentals that give enduring value to more established cryptocurrencies. This book focuses on substantial topics that provide real insight and utility rather than fleeting amusement. It’s about equipping you with knowledge that stands the test of time—not just what’s trending on Twitter this week.

Is this book going to be obsolete by the time I finish it?

Given how fast the tech world moves, it’s possible. But don’t worry, we came up with a tome so timely that it practically updates itself. (Okay, not really, but it’s as current as you can get without live-streaming the authors.) While the specific technologies and tools may evolve, the foundational principles, strategies, and philosophical underpinnings of blockchain and cryptocurrency we delve into will equip you with a durable understanding. Moreover, I’ve included a section on emerging trends and how to stay updated, ensuring that you remain on the cutting edge even after turning the last page. This book aims to not only educate you about the current landscape but also to develop your ability to adapt as the technology grows.

As a professor, can I seriously consider using this book for a course on blockchain, or is it too cool for school?

Absolutely, Professor! You can use this as a textbook, though it’s not your typical snooze-inducing tome filled with drab theories and forgettable facts. Imagine a textbook that doesn’t just sit on your desk collecting cobwebs but actually gets you and your students excited about learning.

This book is crafted to bridge the gap between high-level academia and practical, real-world application, making it a perfect candidate for your blockchain course. It’s designed to engage students not just with the technical mechanics of blockchain but also through lively discussions, relevant case studies, and even some humor to lighten the mood during those intense learning sessions. Each chapter is peppered with insights and frameworks that are classroom-ready, complete with slide decks to facilitate lectures (available online). It’s ideal for sparking curiosity and fostering a deep understanding of blockchain technology among students who are used to dynamic and interactive content.

It can be used in courses in Computer Science, Technology, Finance, Economics and Business. Depending on your focus and discipline, you can focus on some areas and some parts of the chapters rather than others.

So, rest assured, it’s scholarly enough for your syllabus, yet cool enough to keep everyone awake—no caffeine needed!

As a small business owner, how can blockchain technology benefit my operations?

Wondering if blockchain is just for the big players? Think again! For the small business owner, blockchain can streamline operations, reduce costs through smarter contracts, and ensure the authenticity of your supply chain Imagine giving your transactions and customer data a Fort Knox-style security makeover. This book isn’t just about the whys; it’s crammed with the hows. Dive in to discover a treasure trove of practical ways blockchain can turbocharge your business efficiency and fortify your data defenses, all without needing a Silicon Valley budget!

As an artist peering into the wild world of blockchain, wondering what magic it holds for my canvas?

Buckle up, Picasso!

Blockchain isn’t just flipping finance on its head; it’s sending shockwaves through the art galleries too! Ever dreamt of turning your art into a digital goldmine? Welcome to the era of NFTs (Non-Fungible Tokens), where your creations don’t just hang on walls—they vault into the virtual world, giving you power to mint money directly from your masterpieces. This book is your backstage pass to the blockchain revolution in art. This book will dive into real-world examples of artists who are embracing blockchain to bypass traditional marketplaces, connect with audiences, and secure their artistic creations like a digital Fort Knox. Get ready to paint your portfolio with a splash of blockchain brilliance!

You might enjoy Chapters 9, 10 and 13.

As a lawyer knee-deep in legal briefs, why should I dive into the crypto craze when my clients are bombarding me with blockchain bafflements?

Is your inbox overflowing with clients buzzing about Bitcoin and babbling about blockchain?

This book is your legal lexicon to the labyrinthine world of cryptocurrencies and blockchain. From deciphering the ins and outs of smart contracts to navigating the murky waters of cryptocurrency regulation, you’ll find yourself equipped to not just answer your clients’ frantic phone calls but to guide them through the blockchain jungle with the confidence of a seasoned safari leader. Get ready to transform those puzzling questions into billable hours as you become the go-to legal whiz on all things crypto!

You will definitely enjoy Chapter 11!

As an environmental activist, I’m really keyed up about the energy munching habits of blockchain technologies. Will this book calm my green heart?

Your concern for our planet is bang on—blockchain does gobble up quite a bit of energy. But don’t fret, this book isn’t just about singing praises; it tackles the gritty questions head-on. Leap into sections that break down blockchain’s appetite for electricity, the innovative strides being made to trim down that consumption, and even how blockchain is turning into a tool for environmental goodness. From tracking carbon footprints to enforcing green policies, you’ll see how this tech is not just a challenge but part of the solution. By leveraging its inherent transparency and security, blockchain can track the lifecycle of carbon credits with impeccable accuracy, ensuring every credit is accounted for and not double-counted. So, gear up to turn those worries into action plans with a deep dive into eco-friendly blockchain endeavors!

With so many buzzword-stuffed tomes on the shelves, why should I pick yours? What makes you the expert here?

Great question! In a sea of jargon-heavy reads, why should my book be the one to navigate you through the blockchain universe? Here’s why: I have a PhD at MIT, but I’m not just another armchair theorist. Over the past several years, I’ve been at the coalface, teaching blockchain intricacies to sharp minds at Harvard Business School. This isn’t regurgitated content; it’s a course that’s been honed and refined through rigorous academic scrutiny and real-world applications. I also co-founded the Fintech, Crypto and Web3 Lab at Harvard University.

My work extends beyond academia into palpable industry collaborations that shape how blockchain technology is implemented in real businesses, big and small. I have been an advisor for Coinbase Institute, a board member for Mina Foundation just to cite a few of the collaborations with top projects in this space. I routinely speak to both traditional institutions and investors gatherings to help them innovate in this space. Add to this my portfolio of influential research papers that have moved the needle on digital assets discussions globally.

So, while the bookstore shelves might be groaning under the weight of blockchain guides, mine stands out because it’s built on a foundation of actual teaching, innovating, and collaborating with the best in the business. With this book, you’re not just reading another manual; you’re gaining a mentor who has walked the walk and can guide you step-by-step through the often mystifying world of blockchain.

Acknowledgments

I would like to begin by expressing my deepest gratitude to my long-time collaborators. Wenyao Sha, your insights and contributions to our joint cases and articles about crypto have been invaluable. Nicolas, our stimulating conversations over the years have greatly enriched this book and my understanding of the blockchain space.

I would also like to extend my heartfelt gratitude to Andrew Wu for his invaluable notes, comments, and feedback. Your insights have significantly shaped the content of this book. A big thank-you to Sila Ordu for her support in tailoring the book to students’ needs and for making the coding examples and figures as precise as humanly possible. Your contributions have been essential to this book.

A thank-you to the team at Wiley, especially Bill and Stacey, for deciding with me to take on the Herculean task of speeding things up and setting deadlines so tight that we could have written a thank-you card, but instead, we wrote a whole book. Your confidence in my abilities (and your knack for suspense) ensured I was always on the edge of my seat, turning this endeavor into a thrilling adventure.

Now, to my dear colleagues at Harvard Business School: your unyielding devotion to traditional finance and your allergic reaction to new technologies have been a constant source of amusement and motivation for me. Who knew that your insistence on clinging to the past would make writing this book so much fun?

On a more personal note, I want to thank my daughters, Adriana (murzillo) and Andrea (bubu). You made working from home a joy, especially when you were at school. You turned our home into a vibrant playground of creativity, joy, and chaos.

To my wife, the most important person in my life: I am incredibly lucky to have convinced you to marry me. You’re so amazing that I often feel like I’m suffering from impostor syndrome whenever I remember you’re my wife. Your belief in me, your willingness to dance in the rain, and your ability to keep us smiling through every storm have meant the world to me. Thank you for being my partner in every sense. This book is as much yours as it is mine.

To my father, you have been the sweetest rock, and your unwavering support has always been felt, even from the other side of the world. You’ve shown me what loving someone for more than 50 years looks like and supported me wholeheartedly, even when you didn’t fully understand what was going on. Thank you for being my constant source of strength and love.

And to my late mother, your belief in my abilities has always been a source of inspiration. Thank you for always believing in me, even when I doubted myself. I inherited my passion for teaching from you and can only hope to have made an impact on my students a fraction of the impact you made. I still feel your voice guiding me when I need it most.

Finally, to everyone who’s been part of this journey, if you enjoyed the book, I’m glad I could make you think and smile. If not, consider it a perfect gift for someone you want to confuse about blockchain.

Chapter 1

Chain Reactions: From Basement Miners to Blockchain Revolutionaries

Preface

Greetings, dear reader! Before you dive headfirst into the cryptographic brilliance and digital daring of this book, let’s take a moment to set the stage—or, in our case, prepare the blockchain. You’re about to enter a world where mining doesn’t require a pickaxe, but rather a formidable electricity bill, and hash isn’t something you had for breakfast.

Imagine the blockchain as the bass guitarist in a rock band: immensely powerful, slightly misunderstood, and deserving of a stunning solo. This chapter (and this book) will give it that spotlight, showing how a blend of mathematics, cryptography, and sheer human stubbornness can create a system that’s both secure and as transparent as Grandma’s living room curtains.

Enter Bitcoin, the Mick Jagger of cryptocurrencies. It’s flashy, it’s backed by a mysterious creator (cheers, Satoshi!), and it’s weathered storms to remain at the forefront of digital currency. Introduced in 2008, Bitcoin swung onto the scene with a rebel yell of Who needs central banks?—a sentiment that had traditional financial institutions raising an eyebrow in alarm.

Let’s shift gears to the underground heroes of the cryptocurrency world—miners. These modern-day prospectors are armed with graphical processing units (GPUs) and a relentless pursuit for digital treasure. Mining in the Bitcoin realm isn’t about blasting rock but about racing to solve cryptographic puzzles that would leave even the sharpest minds scratching their heads. It’s a digital gold rush where the tools of the trade are silicon and software, not steel. These miners aren’t digging through dirt; they’re crunching numbers at breakneck speeds, hunting for the next block like fortune seekers panning for gold in a river of data. And yes, occasionally, the quest for crypto riches might just barbecue a graphics card or two.

In the realm of blockchain, consensus isn’t just a fancy word tossed around at boring meetings. Imagine trying to get your entire extended family to agree on a pizza topping and you’ll have a slight inkling of what blockchain goes through with every transaction. You see, every node (a fancy term for a computer connected to the blockchain) has to agree on the legitimacy of the information before it can be etched into the digital ledger. It’s an epic saga of agreement that makes the United Nations look like a casual debate club.

And then there’s proof of work, the Herculean task that keeps the blockchain ticking. Imagine a Sudoku puzzle that, if solved, helps maintain the digital world’s balance. Every 10 minutes, a new block is mined and added, and the grand ledger of Bitcoin marches on. Then there’s proof of stake, which is like the VIP lounge of consensus mechanisms—only the high rollers with the most coins get a say. It’s like saying, The richer you are, the more trustworthy you become, which as any scandalous billionaire will tell you, is obviously true.

From the basics of what a block really is (spoiler: it’s not the kind you stacked as a kid) to tackling the Byzantine generals problem that might have given Alexander the Great a headache, this chapter covers everything you need to know to sound like the smartest person in the room—or at least at your next cryptocurrency meetup.

Initially conceived as a simple ledger for Bitcoin transactions, blockchain technology quickly outgrew its cocoon, bursting onto the tech scene with a proposition that said, Hey, why just reinvent money when we can revamp everything else too?

So buckle up, charge your laptops, and prepare for your mind to be expanded, your wallet to be intrigued, and your worldview to be irrevocably changed. Blockchain isn’t just a technology; it’s a revolution. And as with any revolution, it promises to be one heck of a ride. Let’s get started, shall we?

The blockchain revolution

1. Introduction

The quest for secure and efficient means of digital exchange dates back several decades.

In fact, the roots of blockchain technology can be traced back to the early 1990s, where key cryptographic concepts and digital timestamping methods laid the groundwork for decentralized systems. In 1991, Stuart Haber and W. Scott Stornetta published pioneering research on secure digital timestamping, introducing cryptographic techniques to create tamper-evident timestamps for digital documents. This seminal work formed the basis for secure data authentication and verification.

Ralph Merkle introduced Merkle trees, a data structure that efficiently verifies the integrity of large datasets. Merkle trees became a fundamental component of blockchain technology, enabling secure and scalable data authentication.

Adam Back proposed Hashcash, a proof-of-work system designed to combat email spam and denial-of-service (DoS) attacks. Hashcash required senders to perform computationally expensive calculations to include proof-of-work tokens in email headers, thereby deterring spamming activities.

In 1998, Wei Dai introduced B-Money, a cryptographic currency system that envisioned decentralized consensus and digital signatures as the basis for a peer-to-peer electronic cash system. Around the same time, Nick Szabo proposed Bit Gold, a precursor to Bitcoin, which emphasized cryptographic puzzles and proof of work for decentralized currency creation.

Furthermore, the cypherpunk movement of the late 20th century advocated for the use of cryptography and decentralized systems to safeguard individual privacy and autonomy. Figures like David Chaum, with his invention of cryptographic digital cash, and Wei Dai, with his proposal for b-money, explored ideas that foreshadowed the decentralized currency systems enabled by blockchain.

Several digital currency projects, including DigiCash and E-Gold, attempted to create centralized digital cash systems. These projects faced regulatory challenges and ultimately failed to achieve widespread adoption due to concerns over centralization, regulation, and scalability.

While the term blockchain was not widely used until the emergence of Bitcoin, the foundational concepts of cryptographic hashing, decentralized consensus, and digital timestamping formed the basis for blockchain technology’s development.

The historical evolution before Bitcoin highlights the gradual progression of cryptographic techniques, digital currencies, and decentralized systems that laid the groundwork for the invention of Bitcoin and the subsequent proliferation of blockchain technology.

One thing is crucial, though: the difference between blockchain and Bitcoin. While these terms are often used interchangeably, they represent distinct concepts with divergent implications. Understanding this dichotomy is essential for discerning skeptics and enthusiasts alike.

Blockchain technology is the underlying innovation that powers cryptocurrencies like Bitcoin. At its core, blockchain is a decentralized ledger system that records transactions in a secure, transparent, and immutable manner. As we are going to see, this technology holds immense promise for transforming various industries, including finance, supply chain management, healthcare, and more.

While blockchain serves as the foundational technology behind Bitcoin, the cryptocurrency represents just one application of this innovation. Bitcoin was the first decentralized digital currency, introduced in 2008 by the pseudonymous Satoshi Nakamoto. It aims to enable peer-to-peer transactions without the need for intermediaries like banks or governments. Just as email is one application of internet technology, Bitcoin is one application of blockchain technology. Electricity powers various devices and appliances, including light bulbs. Similarly, blockchain technology powers various applications, including cryptocurrencies like Bitcoin.

In conclusion, it’s essential to recognize that blockchain is not synonymous with Bitcoin. While skepticism toward Bitcoin may be warranted due to its volatility and regulatory uncertainties, the underlying technology of blockchain continues to drive innovation and reshape industries worldwide. By understanding this distinction, we can appreciate the broader implications of blockchain technology beyond the realm of cryptocurrencies.

To really explain what blockchain is and how it works, let’s start with the basic definition and then we can unpack its components.

At its core, a blockchain is a digital ledger—a decentralized and transparent record-keeping system that stores information across a network of computers. Imagine it as a shared, tamper-proof database where transactions and data are securely recorded in a series of blocks, forming a chain.

Here’s how it works: when a transaction occurs, such as transferring money or recording ownership of a digital asset, it’s grouped with other transactions into a block. Each block contains a unique cryptographic identifier, known as a hash, computed using a hashing algorithm, a timestamp, and a reference to the previous block, creating an unbreakable chain of blocks. Once added to the blockchain, transactions are irreversible and transparent, visible to all participants in the network.

But what makes blockchain truly groundbreaking is its decentralized nature. Unlike traditional databases controlled by a central authority, blockchain operates on a peer-to-peer network, where every participant (or node) has a copy of the entire ledger. This decentralization ensures that no single entity has control over the data, making it resistant to censorship, fraud, and tampering.

Blockchain technology is powered by consensus mechanisms, algorithms that validate and confirm transactions. Popular consensus mechanisms include proof of work (PoW) and proof of stake (PoS), which ensure that transactions are legitimate and secure before they’re added to the blockchain.

If you got half of that, good for you. To really understand how it works, let’s proceed with a few questions about this definition that should clarify things.

2. Blockchain in 16 Questions

1. Isn’t blockchain just a database like an Excel file?

This is one of the most common questions I get asked all the time.

While both blockchain and traditional databases like Excel files are used for storing and managing data, there are significant differences between the two.

Structure:

Blockchain: A blockchain is a distributed, append-only ledger that stores transactions in a series of blocks linked together in a chronological order. Each block contains a cryptographic hash of the previous block, creating a tamper-evident chain of blocks.

Excel File (Traditional Database): An Excel file is a centralized database that typically organizes data into rows and columns within sheets. It does not inherently provide a built-in mechanism for tamper-evident data storage or decentralized consensus.

Decentralization:

Blockchain: Blockchain operates on a decentralized network of nodes, as depicted in Figure 1, where each participant maintains a copy of the entire ledger. Transactions are validated and confirmed through a consensus mechanism, such as PoW or PoS, eliminating the need for a central authority.

Excel File (Traditional Database): Excel files are typically stored on a single device or server and managed by a centralized authority. Access to the data is controlled by permissions set by the administrator.

Immutability:

Blockchain: Once data is recorded on the blockchain, it becomes immutable and tamper-resistant. Altering or deleting previously recorded transactions is extremely difficult due to the cryptographic hashing and consensus mechanisms.

Excel File (Traditional Database): Data in Excel files can be easily edited, modified, or deleted by users with appropriate permissions. There is no built-in mechanism to ensure the immutability of data.

Trust and Transparency:

Blockchain: Blockchain provides transparency and trust by allowing all participants to view and verify transactions recorded on the ledger. The decentralized nature of blockchain ensures that no single entity controls the data, reducing the risk of manipulation or fraud.

Excel File (Traditional Database): Trust in traditional databases relies on the integrity of the centralized authority managing the data. Users must trust that the administrator accurately records and maintains the data without manipulation.

In summary, while both blockchain and traditional databases serve the purpose of storing and managing data, blockchain offers unique features such as decentralization, immutability, and transparency that differentiate it from traditional database systems like Excel files. These features make blockchain particularly well-suited for applications requiring tamper-resistant and trustless data storage, such as cryptocurrencies, supply chain management, and smart contracts.

Figure 1 Traditional ledger versus distributed ledger

2. What Is a Hash?

Hashing is a fundamental concept in computer science and cryptography. It involves taking an input (or message) and producing a fixed-size string of characters, which is typically a hexadecimal number. The output, known as a hash value or hash digest, is generated by a hash function.

Let’s use the SHA-256 hashing algorithm to hash the This book is fun message.

Here’s the hash value of the message This book is fun computed using the SHA-256 algorithm:

8f5d2b51c115a418b5bf1de20b3926a6c58f0c0250ad5a42280d1f4b9185a9d8

Each character in the string represents a hexadecimal digit, and the entire string represents the unique cryptographic fingerprint or hash of the input message.

It’s important to note that even a small change in the input message would result in a drastically different hash value. For example, changing the message to This book is fun! would result in a completely different resulting hash.

9ae5d60b7d76a5394b6e660a07a181e22ac5b9bfcab3d8d87d0b7f7bb7c770e0

This property of hash functions—producing vastly different outputs for even minor changes in input—is what makes them useful for ensuring data integrity and security in various applications, including blockchain.

These are the things to remember about how hashing works and why it’s important:

One-Way Function: A hash function is a one-way function, meaning it’s easy to compute the hash value of an input, but it’s computationally infeasible to reverse the process and determine the original input given only the hash value. This property ensures that hash functions are secure for storing sensitive information like passwords.

Deterministic: For a given input, a hash function always produces the same output. This deterministic nature is crucial for ensuring consistency and reliability in applications where hashing is used.

Fixed Output Size: Regardless of the input size, a hash function always produces a hash value of fixed size. For example, the SHA-256 hash function, which is commonly used in blockchain and other cryptographic applications, produces a 256-bit (64-character hexadecimal) hash value.

Collision Resistance: A good hash function should minimize the likelihood of two different inputs producing the same hash value, a scenario known as a collision. While collisions are theoretically possible due to the fixed output size, modern hash functions are designed to have extremely low collision probabilities.¹

Overall, hashing is a powerful tool in computer science and cryptography, providing a secure and efficient way to represent data in a condensed and tamper-resistant format. Its properties make it essential for ensuring data integrity, security, and privacy in a wide range of applications.

3. What Is a Block?

A block is a fundamental component of blockchain technology, serving as a container for a set of transactions and other important data. It represents a single unit of information within the blockchain network and plays a crucial role in maintaining the integrity, security, and transparency of the ledger. See Figure 2 for a representation of a block.

Figure 2 A representation of a block

Each block typically consists of the following key elements:

Block Header: In blockchain technology, a block header serves as a crucial component of each block. It contains essential metadata about the block, such as its version number, timestamp (indicating when the block was created), and a reference to the previous block in the chain, known as the previous block hash. Now, we saw that a hash is a cryptographic function that takes an input (in this case, the block header’s data) and produces a fixed-size output, which is a unique alphanumeric string representing the input data. Additionally, the block header includes a nonce—a random value used in the mining process. Miners manipulate this nonce along with other block header data to generate a hash value that meets the network’s difficulty target. The difficulty target is a parameter set by the network protocol that determines the level of difficulty required to find a valid hash for a new block. By adjusting the nonce and other parameters, miners attempt to find a valid hash value that satisfies the difficulty target.

Transactions: The block contains a set of transactions, which represent various actions or exchanges of value recorded on the blockchain. These transactions can include transfers of digital assets (e.g. cryptocurrencies), smart contract executions, or any other data stored on the blockchain. Each transaction is cryptographically signed by the sender and includes inputs (references to previous transaction outputs) and outputs (destination addresses and amounts).

Merkle Tree Root: The Merkle tree root, also known as the Merkle root, is a cryptographic hash of all transactions contained within the block. It serves as a condensed summary or fingerprint of the transactions, allowing network participants to efficiently verify the integrity of the block’s data without needing to process every transaction individually.

Block Hash: The block hash is a unique identifier generated by hashing the block header’s contents, including the Merkle root. It serves as the block’s unique identifier within the blockchain network and is crucial for maintaining the chain’s integrity. Any alteration to the block’s data would result in a completely different hash value, making it easy to detect tampering or manipulation.

Together, these elements form a block—a self-contained unit of data that is added to the blockchain in a sequential and immutable fashion. As new transactions are initiated and validated by network participants, they are grouped into blocks and added to the blockchain through a process known as mining (in PoW-based systems) or validation (in PoS-based systems). This continuous addition of blocks forms a chain of interconnected data, creating a secure and transparent ledger that powers blockchain technology. Figure 3 provides an example of an actual block in the Bitcoin chain.

4. What Is a Merkle Tree? How Is the Merkle Root Calculated?

The Merkle tree is a fundamental data structure used in blockchain technology and other systems that require secure and efficient verification of large datasets. Figure 4 provides a representation capturing its structure. Here’s an overview of its structure:

Leaf Nodes: The bottom layer of the Merkle tree consists of leaf nodes. These are the hashed values of the data blocks (e.g. transactions in a blockchain). Each piece of data is individually hashed using a cryptographic hash function, such as SHA-256, to produce the leaf nodes.

Intermediate Nodes: Above the leaf nodes, the intermediate nodes are formed by pairing and hashing the child node hashes. For instance, if there are four transactions, their hashes will be paired and hashed, reducing them to two hashes. This process is repeated, combining and hashing pairs of hashes to form the next level of the tree.

Root Node: The process of pairing and hashing continues upward through the tree until a single hash remains. This top hash is the Merkle root. It represents a summary of all the underlying data in the leaf nodes.

Figure 3 An actual block on Bitcoin blockchain; the header (left) and the body with the transactions (right) (BLOCKCHAIN.COM/https://www.blockchain.com/explorer/last accessed May 22, 2024)

Figure 4 Structure of a Merkle tree

All transactions could have been just hashed into a singular list; however, if this was the case, to find out which specific transaction ID was used to create the hash, we would need to know all the other transaction IDs.

The advantage of Merkle tree is we need to know only some of the branches along the tree to check which specific transaction ID was included to create the root hash.

The calculation of the Merkle root begins by listing all transactions in the block. If there is an odd number of transactions, the last transaction is duplicated to even out the count. Each transaction is then hashed using a cryptographic function like SHA-256, generating a series of hash values that form the leaves of the Merkle tree. These hashes are paired sequentially, with each pair’s hashes concatenated and then hashed together, effectively reducing every two transactions to a single hash. This pairing and hashing process is repeated, continually halving the number of hashes, until only one hash remains. If the number of hashes at any step is odd, the last hash is duplicated to ensure even pairing. The final remaining hash is the Merkle root, a compact and secure representation of all transactions in the block, crucial for verifying data integrity within blockchain technology.

5. Why Are Transactions in Blocks?

Transactions are organized into blocks in blockchain technology for several important reasons.

Efficiency: By grouping transactions into blocks, blockchain networks can process multiple transactions simultaneously, improving efficiency and scalability. Instead of handling transactions one by one, blocks allow for batch processing, reducing latency and optimizing network performance.

Data Structure: Blocks serve as a structured way to organize and store transaction data within the blockchain. We saw that each block contains a header, which includes metadata such as a timestamp and reference to the previous block, as well as a list of transactions. This organized structure facilitates easy retrieval and verification of transactions by network participants.

Security: Bundling transactions into blocks enhances the security of the blockchain by creating a chain of interconnected blocks. Each block is cryptographically linked to the previous one through its hash value, forming an immutable ledger. This linkage ensures the integrity and immutability of transactions, as any attempt to alter a block would require changing all subsequent blocks—a computationally infeasible task.

Consensus Mechanisms: Blocks play a crucial role in the consensus mechanisms of blockchain networks, such as PoW and PoS. Miners or validators compete to validate transactions and add new blocks to the blockchain. By organizing transactions into blocks, consensus mechanisms incentivize network participants to collectively agree on the validity of transactions and maintain the integrity of the ledger.

Incentive Structure: In many blockchain networks, miners or validators are rewarded with transaction fees and newly minted coins for successfully adding a new block to the blockchain. By grouping transactions into blocks, blockchain networks create a predictable reward structure for participants, incentivizing them to contribute to the security and stability of the network.

Overall, organizing transactions into blocks is a foundational aspect of blockchain technology, enabling efficient processing, secure storage, and consensus-driven validation of transactions within decentralized networks.

6. What Is a Node and a P2P Network?

In the context of a peer-to-peer (P2P) network, a node refers to any device or computer that participates in the network by running network software and maintaining a copy of the network’s shared data. Nodes play a crucial role in facilitating communication, validating transactions, and maintaining the integrity of the network. Here’s how nodes operate in a P2P network:

Network Participation: Nodes join the network voluntarily by running compatible software that allows them to communicate with other nodes. Each node has its own unique identifier, typically in the form of an address or public key, which distinguishes it from other nodes in the network.

Data Storage: Nodes maintain a copy of the network’s shared data, which may include transaction records, smart contracts, or other information relevant to the network’s purpose. In a blockchain network, for example, nodes store a copy of the blockchain ledger, allowing them to verify transactions and participate in the consensus process.

Communication: Nodes in a P2P network communicate with each other through a protocol, which defines the rules and procedures for exchanging data and maintaining network integrity. By sharing information with other nodes, such as transactions or new blocks in a blockchain, nodes ensure that the network remains synchronized and up-to-date.

Validation: Depending on the network’s design, nodes may be responsible for validating transactions and ensuring their integrity before they are accepted and added to the network’s shared data. In a blockchain network, for example, nodes participate in the consensus process by verifying transactions, solving cryptographic puzzles (in PoW systems), or staking cryptocurrency (in PoS systems) to validate transactions.

Relaying Transactions: Nodes relay transactions and blocks to other nodes in the network, helping to propagate information efficiently across the network. This ensures that all nodes have access to the latest data and can participate in the network’s operation.

Resilience and Redundancy: P2P networks are inherently decentralized, meaning that no single node or entity controls the network. This decentralization provides resilience against attacks or failures, as the network can continue to operate even if some nodes are compromised or go offline. Additionally, the redundancy of having multiple copies of the network’s data stored on different nodes helps prevent data loss and ensures the network’s integrity.

Overall, nodes are the building blocks of P2P networks, enabling decentralized communication, data storage, and consensus among network participants. By working together, nodes help create a robust and resilient network infrastructure that powers a wide range of decentralized applications and services.

7. What Is a Consensus Mechanism?

A consensus mechanism is a set of rules or protocols used by decentralized networks to achieve agreement among participants on the validity of transactions and the state of the network. Consensus mechanisms are essential for ensuring that all nodes in the network reach a common understanding of the shared data and can collectively agree on the next steps in the network’s operation. Consensus mechanisms are necessary for several reasons.

Decentralization: Decentralized networks, such as blockchain networks, lack a central authority to dictate the validity of transactions or resolve disputes. Instead, decisions about the network’s operation must be made collectively by network participants. Consensus mechanisms provide a way for nodes to reach agreement on the state of the network without relying on a central authority.

Security: Consensus mechanisms help protect the network against malicious actors or attacks by ensuring that transactions are validated and added to the network’s shared data only if they meet certain criteria. By requiring a majority of nodes to agree on the validity of transactions, consensus mechanisms help prevent double-spending, fraud, and other security vulnerabilities.

Immutability: Consensus mechanisms contribute to the immutability of decentralized networks by ensuring that once a transaction is confirmed and added to the network’s shared data, it cannot be altered or removed without consensus from the majority of network participants. This immutability is crucial for maintaining the integrity and trustworthiness of the network’s data over time.

Scalability: As decentralized networks grow and handle increasing transaction volumes, consensus mechanisms must be scalable to accommodate the network’s needs. Efficient consensus mechanisms enable networks to process transactions quickly and securely, even as the network expands in size and complexity.

Incentives: Many consensus mechanisms incorporate economic incentives to encourage network participants to act honestly and contribute to the network’s operation. For example, in PoW systems like Bitcoin, miners are rewarded with newly minted coins and transaction fees for successfully adding new blocks to the blockchain. These incentives align the interests of network participants and help maintain the network’s security and integrity.

Overall, consensus mechanisms are a foundational component of decentralized networks, enabling secure, transparent, and trustless transactions without the need for a central authority. By establishing rules for decision-making and incentivizing honest behavior, consensus mechanisms ensure the smooth operation and resilience of decentralized networks in a wide range of applications and industries.

8. How Does Bitcoin Fit into This?

Bitcoin is a specific application of blockchain technology, and it plays a central role in the broader ecosystem of blockchain-based systems.

Bitcoin introduced the concept of blockchain technology to the world through its white paper published by Satoshi Nakamoto in 2008. The Bitcoin blockchain serves as a decentralized ledger for recording transactions of the digital currency, Bitcoin. Bitcoin demonstrated the viability of using blockchain technology to create a decentralized, peer-to-peer electronic cash system. It proved that transactions could be securely recorded and verified without the need for a central authority.

Bitcoin operates on a decentralized network of nodes, where transactions are verified and added to the blockchain through a consensus mechanism known as proof of work. This decentralized nature ensures that no single entity controls the Bitcoin network.

Bitcoin transactions involve the transfer of value (Bitcoins) between addresses on the blockchain. Each transaction is recorded in a block and secured through cryptographic hashing, making it tamper-resistant and immutable.

In summary, Bitcoin serves as a pioneering example of how blockchain technology can be applied to create decentralized digital currencies and payment systems. Its innovative design and decentralized architecture have influenced the development of numerous blockchain-based applications and platforms across various industries.

9. Who Are Miners? And What Do They Do?

Miners play a crucial role in blockchain networks, particularly those that use PoW as their consensus mechanism, such as Bitcoin. Miners are individuals or entities (often specialized computer systems known as mining rigs) that participate in the process of validating and confirming transactions on a blockchain network. In decentralized blockchain networks, anyone can become a miner by dedicating computational resources to solve cryptographic puzzles and add new blocks to the blockchain.

Miners collect and validate pending transactions from the network’s mempool (pool of unconfirmed transactions). They verify that each transaction adheres to the network’s rules and has sufficient fees attached to incentivize miners to include them in the next block.

Miners group validate transactions into a new block and create a block header, which includes information such as a timestamp, a reference to the previous block, and a nonce (a random number).

Miners compete to solve a computationally intensive mathematical puzzle based on the block header and the content of the block. This process, known as proof of work, requires miners to find a hash value that meets a predetermined difficulty target.

The first miner to solve the puzzle broadcasts their solution to the network. Other miners verify the solution and then add the new block to their copy of the blockchain if it is valid.

10. Why Are They Doing All of This Work?

Miners are rewarded for their efforts with newly minted cryptocurrency (in the case of Bitcoin, miners receive newly minted Bitcoins) and transaction fees included in the block they mined. This reward serves as an incentive to secure the network and validate transactions.

In the case of Bitcoin, initially, the block reward was 50 Bitcoins per block, but this reward undergoes a halving approximately every four years (or every 210,000 blocks). This halving mechanism is designed to gradually reduce the rate at which new Bitcoins are created, mimicking the extraction of physical gold, which becomes harder to mine over time.

Halving events are critical junctures in Bitcoin’s monetary policy. These events ensure a decreasing rate of Bitcoin issuance, creating a deflationary pressure on the cryptocurrency. There have been four halving events to date:

First Halving (2012): Reduced the block reward from 50 to 25 Bitcoins

Second Halving (2016): Reduced the block reward from 25 to 12.5 Bitcoins

Third Halving (2020): Reduced the block reward from 12.5 to 6.25 Bitcoins

Fourth Halving (2024): Reduced the block reward to 3.125 Bitcoins

Is the blockchain going to stop working if the rewards are too low or non-existent? No.

In addition to the block reward, miners also collect transaction fees attached to each transaction they include in the block. These fees serve as an additional incentive for miners to prioritize transactions with higher fees attached.

In summary, miners play a critical role in the operation of blockchain networks by validating transactions, creating new blocks, and securing the network through the PoW consensus mechanism. Their efforts help maintain the integrity, security, and decentralization of the blockchain network.

11. Putting All of These Elements Together, How Does PoW Work?

To understand why PoW works the way it does, let’s introduce the problem it tries to solve. It is usually described as the Byzantine generals problem, a thought experiment that illustrates the difficulties of achieving consensus in a distributed network where participants might fail or act maliciously. The scenario involves several generals, each commanding a portion of the Byzantine army, who need to agree on a battle plan. However, they can communicate only via messengers, and some of the generals or messengers might be traitors trying to prevent consensus. In the context of blockchain, nodes in the network can be thought of as generals who need to agree on the current state of the ledger (the battle plan). The traitors in this scenario could be nodes that attempt to disrupt the network by not following protocol rules, submitting false transactions, or colluding to rewrite parts of the blockchain.

Byzantine fault tolerance is a property of a system that allows it to continue functioning correctly even if some of the participants (nodes) fail or act maliciously. A system is considered Byzantine fault tolerant if it can handle up to a certain number (usually less than one-third) of faulty or malicious nodes.

PoW makes Bitcoin Byzantine fault tolerance. In a PoW system, network participants called miners compete to solve complex mathematical puzzles. These puzzles require significant computational power to solve but are easy to verify once a solution is found. Miners aim to find a special number, called a nonce, that, when combined with the block’s data and hashed, produces a hash value below a certain target threshold. See Figure 5 for a process chart of a PoW chain.

For example, imagine a miner is trying to solve a puzzle by finding a nonce that, when combined with a block’s data (which includes transaction information, a timestamp, and a nonce), produces a hash value starting with a certain number of zeros. The miner iterates through different nonce values until they find one that meets the target difficulty level.

Miners use a cryptographic hash function, such as Secure Hash Algorithm 256-bit (SHA-256), to hash the block’s data and nonce. A hash function takes an input (in this case, the block’s data and nonce) and produces a fixed-size output (the hash value). It’s essential that the hash function is cryptographically secure and produces unpredictable outputs.

Figure 5 Proof of work simplified process chart

For example, when a miner hashes a block’s data and nonce using SHA-256, they get a unique hash value. We saw that changing any part of the input, even a single bit like a small change to a transaction (e.g. Marco receiving 10 BTC rather than 1 BTC), will produce a completely different hash value.

The difficulty target is a parameter set by the network protocol that determines the level of difficulty required to find a valid hash for a new block. The target is adjusted periodically to ensure that new blocks are mined at a consistent rate, typically every 10 minutes in the case of Bitcoin. For example, if the difficulty target is set so that a valid hash must start with four leading zeros, miners must find a nonce that, when hashed with the block’s data, produces a hash value with at least four zeros at the beginning.

Once a miner discovers a valid hash value that meets the difficulty target, they broadcast the solution to the rest of the network as proof of work. Other nodes in the network can quickly verify the validity of the solution by hashing the block’s data with the provided nonce (they all observe the same inputs so can verify the output of the SHA-256 function) and confirming that the resulting hash value meets the difficulty target.

Once a valid solution is verified by the network, the new block is added to the blockchain, and the miner who found the solution is rewarded with a predetermined amount of cryptocurrency (e.g. Bitcoin) and any transaction fees included in the block. This process incentivizes miners to invest computational resources and contribute to the security and operation of the network.

In other words, Bitcoin achieves Byzantine fault tolerance for the following reasons:

Network Agreement through Computational Work: PoW requires nodes (miners) to solve complex mathematical puzzles that consume significant computational resources. The solution to these puzzles, known as proof of work, is easy to verify by other nodes but hard to produce. This mechanism ensures that any participant who wants to add new blocks to the blockchain