BLOCKCHAIN AND ITS

APPLICATIONS
Discipline Specific Elective Sem VIII (NEP UGCF
2022)

UNIT 2: CRYPTOCURRENCY AND DESIGN

A Comprehensive, Exam-Oriented Study Guide

Theory, Real-World Examples, Comparisons, and Exam Preparation

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 Table of Contents

1. Concept of Cryptocurrency

2. History of Challenges of Bitcoin

3. Blockchain / Bitcoin Design Principles

3.1 Performance and Scalability

3.2 Efficiency

3.3 Security

3.4 Governance

3.5 Public Policy and Legal Framework

4. Mining

5. Important Exam Questions (2, 5, and 10 Marks)

6. MCQs and Viva Questions

7. Quick Revision Cheat Sheet

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 1. Concept of Cryptocurrency

Layman Definition:
Cryptocurrency is like digital cash. However, instead of a bank keeping track of who
has how much money, millions of computers around the world keep track of it
together using a shared public ledger (the blockchain). The math (cryptography) makes
sure nobody can cheat, print fake money, or spend the same digital coin twice.

Technical Definition: A cryptocurrency is a digital or virtual currency that is secured by

cryptography, making it nearly impossible to counterfeit or double-spend. Most
cryptocurrencies exist on decentralized networks based on blockchain technology—a
distributed ledger enforced by a disparate network of computers.

Key Characteristics of Cryptocurrency:

• Decentralization: Not issued by any central authority (no central bank or

government).

• Cryptographic Security: Uses public-key cryptography to secure transactions and

control the creation of new units.

• Transparency and Anonymity (Pseudonymity): All transactions are publicly visible

on the blockchain, but the real-world identities behind the wallet addresses are hidden.

• Immutability: Once a transaction is confirmed, it cannot be reversed, edited, or

deleted.

• Limited Supply: Most cryptocurrencies have a hard cap. For example, there will never
be more than 21 million Bitcoins. This mimics the scarcity of gold and prevents
hyperinflation.

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Traditional Fiat Currency vs. Cryptocurrency

Fiat Currency (e.g., INR, Cryptocurrency (e.g., Bitcoin,

Feature
USD) Ethereum)

Central Banks and Decentralized (Consensus

Authority
Government among nodes)

Unlimited (Governments can Limited (e.g., 21 million BTC

Supply
print more) max)

Transaction Speed Slow (Days) due to SWIFT/

Fast (Minutes to Seconds)
(Cross-border) Intermediaries

Transactions can be reversed

Reversibility Irreversible (No chargebacks)
or frozen

Blockchain / Distributed
Underlying Technology Centralized Database
Ledger Technology

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 2. History of Challenges of Bitcoin

Created in 2009 by the pseudonymous Satoshi Nakamoto, Bitcoin is the first successful
cryptocurrency. However, earlier attempts at digital money (like DigiCash and Bit-Gold)
failed. Bitcoin succeeded by solving major historical challenges, but it also faced its own
hurdles over the years.

A. The Pre-Bitcoin Challenge: The "Double-Spending" Problem

Before Bitcoin, the biggest problem with digital money was Double-Spending. Because
digital files (like an MP3 or a JPEG) can be copied and pasted indefinitely, what stops
someone from copying a "digital $10 bill" and spending it twice?

• The Old Solution: Use a central server (like Visa or PayPal) to check every transaction
and deduct the balance. (But this requires trusting a central authority).

• Bitcoin's Solution: The Proof of Work (PoW) consensus mechanism and the public
blockchain. Every node has a copy of the ledger. If Alice tries to spend the same Bitcoin
with Bob and Charlie, the network rejects the second transaction because the first one
is permanently time-stamped in a block.

B. Challenges Faced by Bitcoin (2009 - Present)

1. The 51% Attack Vulnerability: If a single entity or group of miners controls more than
50% of the network's computing power (hash rate), they can manipulate the
blockchain. They could rewrite history, reverse their own transactions (causing double-
spending), and block other people's transactions.
Status: As Bitcoin grew, the network became so massive that a 51% attack is now
practically and economically impossible.

2. Sybil Attacks: A hacker creates thousands of fake nodes to outvote honest nodes and
hijack the network.
Solution: Proof of Work solves this by tying voting power to computational power (CPU/
GPU strength), not just IP addresses. You cannot fake computational power.

3. The Mt. Gox Hack (2014): The largest Bitcoin exchange at the time, Mt. Gox, was
hacked, losing 850,000 Bitcoins. This was not a flaw in Bitcoin itself, but a flaw in
centralized exchanges holding people's private keys.

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 Lesson Learned: "Not your keys, not your coins." It popularized the use of cold-storage
hardware wallets.

4. Forks and Community Splits (2017): Disagreements on how to scale Bitcoin led to
"Hard Forks." A portion of the community split off and created a separate blockchain
called Bitcoin Cash (BCH) which had larger block sizes, while the main Bitcoin
network implemented the SegWit upgrade.

MEMORY TRICK: Challenges of Bitcoin

Don't Steal From Me
(Double-spending, Sybil attacks/51%, Forks, Mt. Gox)

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 3. Blockchain/Bitcoin Design Principles

The design architecture of Bitcoin and blockchains must balance competing priorities. This
is often referred to as the Blockchain Trilemma: balancing Security, Scalability, and
Decentralization. Usually, maximizing two comes at the expense of the third.

3.1 Performance and Scalability

Scalability is the biggest historical bottleneck for Bitcoin.

• The Problem: Bitcoin creates a new block every 10 minutes. The maximum size of a
block is 1 Megabyte (MB). Because of this size limit, Bitcoin can only process about 4 to
7 Transactions Per Second (TPS).
Comparison: Visa processes over 24,000 TPS.

• Why not just make blocks bigger? If blocks are 100 MB, normal people won't have the
storage or internet bandwidth to run a node. Only giant corporations could afford to be
nodes, which destroys decentralization.

• The Solutions:
◦ SegWit (Segregated Witness): A 2017 upgrade that separated the digital signature
data from the transaction data, freeing up space to fit more transactions into the 1
MB block.

◦ Layer 2 Solutions (The Lightning Network): Instead of recording every coffee

purchase on the main blockchain, users open "payment channels" off-chain. They
can transact millions of times instantly with zero fees, and only record the final net
balance on the main Bitcoin blockchain.

3.2 Efficiency

Blockchain efficiency is typically analyzed through energy consumption.

• The Issue: Bitcoin's Proof of Work (PoW) requires miners to solve incredibly complex
cryptographic puzzles. This consumes massive amounts of electricity. The Bitcoin
network uses more electricity annually than some entire countries (like Argentina).

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 • Efficiency Defense: Proponents argue that a large portion of Bitcoin mining uses
renewable energy or "stranded" energy (like flared natural gas) that would otherwise
be wasted.

• Alternative Designs: Newer blockchains (like Ethereum 2.0, Cardano, Solana) shifted
to Proof of Stake (PoS), which removes mining entirely. Instead, validators lock up
(stake) their coins to secure the network, reducing energy consumption by 99.9%.

3.3 Security

Bitcoin is arguably the most secure computing network in human history.

• Cryptography: Uses Elliptic Curve Digital Signature Algorithm (ECDSA) to ensure that
only the person with the private key can spend the funds.

• Hash Puzzles (SHA-256): Changing old data requires recalculating all subsequent
blocks, which requires astronomical computing power.

• Game Theory / Economic Incentives: Miners are rewarded with new Bitcoins for
acting honestly. If a miner tries to cheat, the network rejects their block, and they lose
the millions of dollars they spent on electricity. It is strictly more profitable to play by
the rules than to hack the system.

3.4 Governance

Since no single company or CEO owns Bitcoin, how are decisions made, bugs fixed, or
upgrades implemented?

• Open Source Code: Anyone can read or suggest changes to the Bitcoin Core code on
GitHub.

• BIPs (Bitcoin Improvement Proposals): A formal document proposing a new feature.

• The Tripartite Check and Balance:

1. Developers: Write and propose the code changes.

2. Miners: Signal support by updating their software.

3. Full Nodes (Users/Exchanges): The ultimate authority. Even if developers and

miners agree, if the independent nodes refuse to run the new software, the
upgrade fails. This happened during the 2017 block size war.

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3.5 Public Policy and Legal Framework

Because cryptocurrencies bypass traditional banking systems, they present massive

challenges to global governments.

• AML and KYC (Anti-Money Laundering / Know Your Customer): Governments fear
crypto is used for money laundering and terrorism financing. Most countries now
legally require crypto exchanges (like Binance or WazirX) to collect ID proofs from
users before they can trade.

• Taxation: How is crypto taxed? In many countries (like the US and India), it is treated
as property or a digital asset, subjecting it to Capital Gains Tax (e.g., India's 30% tax on
crypto profits).

• Classification: Is it a Currency, a Commodity, or a Security? The SEC (US Securities and

Exchange Commission) largely views Bitcoin as a commodity, but heavily litigates
against other tokens, classifying them as unregistered securities.

• Bans vs. Adoption:

◦ China outright banned Bitcoin mining and trading in 2021.

◦ El Salvador made Bitcoin official legal tender alongside the US Dollar in 2021.

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 4. Mining

Mining is the heartbeat of a Proof of Work (PoW) blockchain. It is the process by which new
transactions are verified, added to the blockchain, and new cryptocurrency is introduced
into circulation.

A. What do Miners actually do?

Miners are essentially auditors. They collect pending transactions from the "mempool,"
verify that the senders actually have the funds (no double-spending), and group them into a
"Block."

B. The Proof of Work (PoW) Puzzle

To add their block to the chain (and claim the financial reward), miners must compete in a
mathematical race.

1. The network sets a Target Hash (e.g., a hash starting with 10 zeros:
`0000000000ab34f...`).

2. The miner takes the data in their block and adds a random number called a Nonce
(Number used once).

3. They run this combined data through the SHA-256 hash algorithm.

4. If the resulting hash is greater than the target, they fail. They change the Nonce and try
again.

5. They repeat this millions of times per second. The first miner to find a hash lower than
the target "solves" the puzzle.

Because hashing is entirely random, solving the puzzle is purely a lottery that requires
massive computational effort. This proves to the network that the miner expended real-
world energy (Proof of Work) to propose the block.

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 THE MINING PROCESS

[Pending Transactions] -> Miner selects transactions -> Creates a [Candidate Block]
|
v
Adds a Random [Nonce]
|
v
Calculates SHA-256 Hash
|
v
[Does Hash start with X zeros?] ---> NO ---> Change Nonce and recalculate!
|
YES
|
v
[Block is broadcast to network] -> Other nodes verify it -> Block added to chain!
|
v
Miner receives Block Reward (e.g., 3.125 BTC) + Transaction Fees

C. Mining Rewards and Halving

Miners receive two incentives:

• Block Reward: Newly minted Bitcoin created out of thin air. This is how Bitcoin's
supply enters circulation.

• Transaction Fees: Fees paid by users to have their transactions processed faster.

• The Halving: To control inflation, the Bitcoin protocol automatically cuts the block
reward in half every 210,000 blocks (roughly every 4 years). In 2009, the reward was 50
BTC. In 2024, it dropped to 3.125 BTC.

D. Evolution of Mining Hardware

Mining difficulty automatically adjusts every 2 weeks to ensure blocks are always produced
every 10 minutes, regardless of how many miners join or leave. Because of this, hardware
has evolved rapidly:

• CPU Mining (2009): Regular laptops could mine Bitcoin.

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 • GPU Mining (2010): Gamers realized Graphics Cards were better at parallel
mathematical calculations than CPUs.

• FPGA Mining (2011): Field-Programmable Gate Arrays were customized for hashing.

• ASIC Mining (Present): Application-Specific Integrated Circuits. These are expensive,

massive supercomputers built to do exactly one thing: calculate SHA-256 hashes. You
cannot use an ASIC miner to play video games or run Word; it only mines Bitcoin.

E. Mining Pools

Because the network is so vast, a single person running an ASIC miner in their garage might
statistically only win the puzzle once every 10 years. To ensure a steady income, miners join
Mining Pools.

• Thousands of miners combine their computational power over the internet.

• When the pool wins the puzzle, the Bitcoin reward is distributed proportionally to all
participants based on how much hash power they contributed.

Summary of Unit 2:
Cryptocurrency uses cryptography and decentralization to solve the historic Double-
Spending problem without needing banks. Bitcoin faces design challenges, primarily
the Scalability Trilemma (sacrificing TPS speed for high security and
decentralization). It is maintained by Miners who expend real-world energy solving
SHA-256 hash puzzles (Proof of Work) to secure the network and earn newly minted
coins. Governance is community-driven via BIPs, though governments are heavily
introducing KYC and tax policies to regulate the ecosystem.

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 5. Important Exam Questions

Most Important 2 Marks Questions (Short Answer)

1. What is Double-Spending?
Ans: The risk that a digital currency can be spent twice. Bitcoin solves this using the
Proof of Work consensus mechanism and a public, timestamped ledger.

2. What is a Nonce in Blockchain mining?

Ans: Nonce stands for "Number used once." It is a random number that miners
continually change and add to a block's data to generate a hash that meets the
network's target difficulty.

3. What is the block time and maximum block size of Bitcoin?

Ans: Bitcoin aims to generate a new block every 10 minutes, and the original maximum
block size limit is 1 Megabyte (1MB).

4. What does SegWit stand for and what is its purpose?

Ans: Segregated Witness. It is an upgrade that separates signature data from
transaction data to fit more transactions into a single block, improving scalability.

5. What is a Mining Pool?

Ans: A collaborative group of cryptocurrency miners who combine their computational
resources over a network to increase the probability of mining a block and share the
rewards proportionally.

Most Important 5 Marks Questions (Medium Answer)

1. Explain the 51% attack and why it is difficult to execute on Bitcoin today.
Hint: Define the 51% attack as an entity gaining majority control of the network hash
rate, allowing them to reverse transactions and double-spend. Explain that it is
virtually impossible today because acquiring 51% of the specialized ASIC hardware and
electricity required to overpower millions of global nodes would cost billions of dollars
and immediately crash the value of the coin they are trying to steal.

2. Discuss the evolution of mining hardware.

Hint: Detail the progression from basic CPU mining → GPU (Graphics cards) → FPGA →
ASICs (Application-Specific Integrated Circuits). Explain that as network difficulty
adjusted upwards, generalized hardware became obsolete, requiring specialized,
expensive machines dedicated solely to SHA-256 hashing.

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 3. Differentiate between Traditional Fiat Currency and Cryptocurrency.
Hint: Create a table comparing Authority (Centralized Bank vs Decentralized Nodes),
Supply (Infinite vs Capped), Reversibility (Chargebacks possible vs Immutable), and
Technology (Private Database vs Public Ledger).

Most Important 10 Marks Questions (Long Answer)

1. Analyze the Blockchain Design Challenges focusing on Performance, Scalability,

Efficiency, and Security.
Hint:
◦ Performance/Scalability: Explain the 1MB block size limit leading to ~7 TPS.
Compare to Visa. Discuss solutions like SegWit and Layer 2 Lightning Networks.

◦ Efficiency: Discuss the massive energy consumption of PoW mining and contrast it
with eco-friendly alternatives like Proof of Stake.

◦ Security: Detail how cryptography, hash pointers, and economic game theory
(block rewards vs electricity costs) keep the network highly secure and tamper-
proof.

2. Describe the complete process of Mining in a Proof of Work blockchain. Include

the concepts of the Mempool, Hash Target, Nonce, and the Block Reward.
Hint: Detail the step-by-step lifecycle: 1) User broadcasts transaction. 2) Transaction
waits in Mempool. 3) Miner picks transactions and creates a candidate block. 4) Miner
begins the PoW race, repeatedly changing the Nonce to hash the block data. 5) Miner
finds a hash starting with the required number of zeroes (Target Hash). 6) Block is
broadcast, verified by nodes, and appended. 7) Miner collects Block Reward and
transaction fees. Discuss the Halving event.

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 6. MCQs and Viva Questions

Multiple Choice Questions (MCQs)

1. The process of verifying transactions and adding them to the public ledger is called:
a) Spoofing
b) Staking
c) Mining
d) Hashing

2. Which consensus mechanism does Bitcoin use?

a) Proof of Work (PoW)
b) Proof of Stake (PoS)
c) Proof of Authority (PoA)
d) Delegated Proof of Stake (DPoS)

3. The "Halving" in Bitcoin occurs approximately every:

a) 2 years
b) 4 years
c) 10 years
d) Once the last Bitcoin is mined

4. What is the primary purpose of KYC/AML regulations in cryptocurrency?

a) To increase transaction speeds
b) To improve blockchain scalability
c) To prevent money laundering and identify users
d) To reduce electricity consumption

5. Which of the following is considered a "Layer 2" scalability solution for Bitcoin?
a) SegWit
b) Increasing block size to 100MB
c) The Lightning Network
d) ASIC miners

Viva Voce Questions (Oral Exam)

Q: Professor: "Since Bitcoin has no CEO, how are decisions made to upgrade the
software?"

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A: Student: "Bitcoin relies on decentralized governance. Developers propose code changes
through BIPs (Bitcoin Improvement Proposals). However, developers have no power to
force updates. The miners must adopt the code, and most importantly, the thousands of
independent Full Nodes run by users and businesses must agree to run the new software. It
is a system of checks and balances."

Q: Professor: "Why do we say mining is essentially a lottery system?"

A: Student: "Because the SHA-256 hash algorithm is deterministic but unpredictable. There
is no mathematical formula to predict what Nonce will produce a hash lower than the
target. Miners must simply guess blindly, millions of times per second. Whoever guesses the
correct Nonce first wins the block reward, making it a computational lottery."

Q: Professor: "If a miner has a supercomputer, why can't they mine all the blocks
instantly?"

A: Student: "Because of Difficulty Adjustment. The Bitcoin protocol automatically adjusts the
difficulty of the mathematical puzzle every 2016 blocks (about 2 weeks). If global computing
power increases, the puzzle gets harder to ensure that, on average, a block is still only
produced every 10 minutes."

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 7. Quick Revision Cheat Sheet

⚡ ONE MINUTE REVISION ⚡

• Double-Spending: The pre-crypto problem of spending the same digital dollar

twice. Solved by PoW and decentralized ledgers.

• Bitcoin Trilemma: You can only have 2 out of 3: Security, Scalability,

Decentralization. Bitcoin chose Security and Decentralization, making it unscalable
(slow).

• Scalability Solutions: SegWit (optimizes block space), Lightning Network (Layer 2

off-chain channels).

• Governance: Open source. BIPs (Improvement Proposals). Controlled by a balance

of Developers, Miners, and Nodes.

• Legal/Policy: Governments enforce KYC (Know Your Customer) and AML (Anti-
Money Laundering) on exchanges. Taxes apply to capital gains.

• Mining: Securing the network by solving math puzzles (PoW).

• Nonce: The random number miners guess to solve the hash puzzle.

• Block Reward: New coins given to the winning miner. Halves every 4 years.

• Hardware Evolution: CPU → GPU → FPGA → ASIC (highly specialized

supercomputers).

• 51% Attack: Hypothetical attack where one group controls >50% hash rate to
double-spend and rewrite history. Nearly impossible on Bitcoin today.

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