How a blockchain settles a payment

A cryptocurrency is not a coin in any physical sense. It is an entry in a shared record, called a blockchain, that says which address holds how much. This lesson explains how that record is kept, how a payment on it becomes final, and how Bitcoin, Ethereum and stablecoins differ. It describes the technology; it says nothing about what any of them is worth.

A ledger with no keeper

A bank keeps a ledger of its customers’ balances, and the bank alone can change it. A blockchain is a ledger that thousands of computers, called nodes, each hold a full copy of. No single one of them is in charge. New transactions are gathered into a block, and each block carries a short digital fingerprint of the block before it. Altering an old entry would change that fingerprint and every one after it, so the other copies would reject the altered chain.

The rules for who may add the next block are called the consensus mechanism. They are what replaces the bank’s authority.

How a payment settles

A holder controls coins through a private key: a long secret number. A payment passes through four stages.

• Signed. The sender’s software signs the transaction with the private key. The signature proves the holder approved it without revealing the key.
• Broadcast. The transaction is sent to the network, where it waits with others that have not yet been included.
• Included in a block. Whoever adds the next block chooses waiting transactions, usually those offering the higher fee, and the block joins the chain.
• Confirmed. Each later block built on top is one more confirmation. The deeper a transaction lies, the harder it is to undo.

Settlement here is a matter of degree, not a single moment. Recipients commonly wait for several confirmations before treating a payment as final. Once it is final there is no bank to reverse it: a payment sent to the wrong address stays sent. The fee goes to whoever adds the block, and it rises when the network is busy.

Bitcoin

Bitcoin was described in a paper published in 2008 under the name Satoshi Nakamoto, and its network began running in January 2009. It uses proof of work: computers called miners compete to solve a costly puzzle, and the winner adds the next block. The rules aim for a new block about every ten minutes on average, and they cap the supply at 21 million coins. Bitcoin’s ledger does one thing, which is to record transfers of bitcoin.

Ethereum

Ethereum launched in 2015. Its ledger records balances of its own coin, ether, and it also runs programs called smart contracts: code stored on the chain that moves coins when its conditions are met. Since September 2022 Ethereum has used proof of stake: validators lock up ether as a stake, are chosen to propose blocks, and can lose part of the stake for breaking the rules. A block is added about every twelve seconds, and ether has no fixed cap on supply.

Stablecoins

A stablecoin is a token on a blockchain that is designed to hold a fixed value, usually one US dollar. Most are issued by a company that says it holds reserves, such as cash and short-term government debt, equal to the tokens in circulation. Others are backed by crypto assets, or by a rule that expands and shrinks the supply.

The fixed value is a promise, not a property of the technology. It depends on the reserves being there and on holders being able to redeem. Stablecoins have traded below their intended value in times of stress, and in May 2022 a large stablecoin that relied on a supply rule instead of reserves lost its peg and collapsed within days.

What the chain does not do

A blockchain settles transfers of its own coin. It does not set the coin’s price, which is made wherever buyers and sellers meet, and it does not protect a holder who loses a private key or sends coins to a fraudster.