The Early History of Virtual Currency and Cryptocurrency
Virtual Cash, Cryptocurrency, Bitcoin.
Just what in the world are these things?
Can you hold it in your hand?
Use it to buy your morning coffee?
When I ask an every day Joe about Bitcoin or cryptocurrency, I get answers like this:
“Bitcoin.. isn’t that fake money gamers use to buy things online?”
“Blockchain.. yeah, I haven’t got a clue as to what that is.”
“Isn’t Bitcoin some sort of digital currency used to buy illegal things online anonymously?”
Although the third explanation is half-heartedly true regarding one use case surrounding Bitcoin, it is much more of a game-changer than just a medium of exchange.
Bitcoin and its underlying technologies could potentially be the next big wave since the advent of the Internet. It potentially has far-off implications in the economic, political, and social realms and cause fundamental disruptions in all three areas.
How Online Payments Work Today
Let us go through the steps of how people use their credit or debit cards to purchase items online, say on Amazon, shall we?
After filling up your shopping cart, you type in your credit card details and submit the order. Amazon will take your credit card details and confirm with the system - financial system involving banks, credit card companies, and other intermediaries. It will either confirm or deny your order based on your sufficient or insufficient funds available to you.
Let’s go through the process again but this time using PayPal. PayPal is built using an intermediary architecture. PayPal sits between you and seller and acts as the trusted middle-man. They handle the transaction on your behalf and notifies the seller, in this case, Amazon. PayPal will then settle its balance with the Amazon at the end of each day. The benefits of using PayPal is that you don’t have to provide the seller your credit card details. Unfortunately, using PayPal’s protocols can still leave you vulnerable to hacks and security breaches.
Today, most of us are comfortable providing our credit card information on online stores, restaurants, and travel sites. Most people would agree that the benefits and convenience of online transactions exceeds the risks but1990s, standards for protocol-level encryption were just emerging, and notable security and privacy concerns made consumers deeply uncertain and skeptical.
Whereas members of Generation Z (born between 1995–2005) have never experienced before the modern day world wide web, Millennials and previous generations can, and do, remember a time when the internet was the wild-wild-west. In such a turbulent environment, there was a lot of interest in the stability which intermediary architecture provided.
The Early Days of Payment Processes
In 1994, a company called FirstVirtual utilized payment intermediaries long before PayPal did. When you want to buy something from a merchant, the merchant contacts FirstVirtual with the necessary information of the requested payment. FirstVirtual confirms these details with you and waits for your approval before billing your card.
Two details of how FirstVirtual operated are worth noting:
- All of this back-and-forth between parties happened over e-mail. Web browsers were just starting to universally support encryption protocols like HTTPS, and the multi-party nature of payment protocol added other complexities.
- The customer would have 90-days to dispute the charge, and the merchant would receive the money only after three months.
Today’s transactions are almost instantaneous, but there is still the chance that the customer will complete a chargeback or dispute credit card statements. If that happens, the merchant will have to return the payment to the credit card company.
Let’s take a look at a competing approach to the intermediary architecture, the SET architecture. SET not only allows customers to hide their credit card information from merchants but also allows them to avoid having to enroll with the intermediary.
In SET-based protocols, when customers are ready to make a purchase, their browser passes their view of the transaction details, encrypts it in such a way that only the intermediary can decrypt it, and no one else can (including the seller). As such, customers can be sure that their personal information is encrypted when it is sent to the sellers.
Based on the agreed upon terms between the seller and the intermediary, the seller will blindly forward the encrypted data to the intermediary — along with their own view of the transaction details. At the final stage of the transaction, the intermediary will decrypt the customers’s data and approves the transaction only if their view matches the seller’s view.
SET was a standard developed by VISA and MasterCard, together with many technology heavyweights of the day: Netscape, IBM, Microsoft, Verisign, and RSA.
The Forgotten Digital Cash Company Once Backed By The U.S. (FDIC) Government Insurance
In 1994, the credit card payment processing company, CyberCash, started utilizing SET architecture to provide micro-payment solutions. Through the use of their digital cash product called CyberCoin, users could make small payments such as paying to read an online newspaper article. Although users of CyberCoin would rarely have over $10 in their account on any given day, the company was able to get the FDIC to insure each account for up to $100,000.
In 2000, CyberCash’s computer systems were affected by the Y2K bug which caused their payment software to double-bill some of their customers. A year later, the company filled for bankruptcy and their intellectual property was acquired by Verisign who ended up selling it to PayPal.
Why SET Failed
SET had a fundamental flaw with its technology regarding certificates. A certificate is a way to securely associate a cryptographic identity with a real identity. In order to show up as secure in your browser, a website needs to obtain a certification authority.
To prioritize security over usability, CyberCash and SET decided that not only would processors and merchants in their system have to get certificates, all users would have to get one as well. Users did not react well to this pre-requisite because getting a certificate was arduous and difficult. As a result, the system became a disaster when mainstream users collectively said “no” to any system that requires end-user certificates.
Bitcoin side-stepped this hairy problem by avoiding real-life identities altogether.
Cash, Credit, and Bitcoin
With cash, there are two clear advantages over credit cards:
- Banks cannot track your spending when you use cash.
- Cash allows you to make offline transactions without having to wait for a third-party to approve the transaction.
Bitcoin doesn’t quite offer these two use-cases, but comes close enough to be attractive to its users:
- Although you don’t need to use your real identity to pay in Bitcoin, it is possible to track your transactions on the ledger with clever use of algorithms.
- Bitcoin doesn’t work in a fully offline way either but with no central server, Bitcoin is astoundingly resilient (just like the internet) because of its peer-to-peer network.
Origins of the Cash-based System
To help you better understand how cryptography helped the cash-based system become the legitimate and trustworthy note it is today, let’s understand this through a physical analogy.
Let’s say I start handing out pieces of paper that say:
The bearer of this note may redeem it for one dollar by presenting it to me, with my signature attached. If people trust that I’ll keep my promise and consider my signature unforgeable, they can pass around these pieces of paper similar to bank notes.
Fun Fact: You can trace banknotes back to their origins as promissory notes issued by commercial banks. It wasn’t until governments took steps to centralize the money supply and lawfully required banks to redeem notes that this peer-to-peer network of note exchanging came to an end.
Today, we can beam those pieces of paper electronically with digital signatures, but that runs into one of the most common issues with early day virtual cash concepts, the double-spend problem. Assuming that people can make perfect copies and have no way of telling copies from the original, anyone can essentially make two or more copies of it and distribute it to different people.
The Road to Solving the Double-Spend Problem
One solution was to start putting unique serial numbers into each note you give out. When a person receives a note with your signature on it, they call you on the phone to see if the note with the unique serial number has already been spent.
At this point, they can decide to either accept or reject the note. If they decide to spend the note, you would proceed to record the serial number as spent in your ledger. If they decide to turn around try and double spend the note, it would be rejected. The next recipient would simply need to call you and have you check your ledger for legitimacy and possible double spend.
This method works but hardly efficient in real life scenarios. Add in digital technologies like servers to do the signing and the record-keeping of serial numbers, but that eliminates the anonymous component of the system. For example, when I issue a note to you and I write down the serial number along with your identity, someone else can do the same to you when you redeem it. This means anyone can keep track of all the places where money is being spent down the line.
David Chaum, an American computer scientist and cryptographer, found a way to keep the system both anonymous and prevent double-spending by coming up with the blind signature.
Let’s some up with a scenario when we throw blind signatures in the mix:
When I issue a new note to you, you pick the serial number. You keep it safe on a piece of paper, but hide its contents so that I can’t see it. Then I’ll sign it, still unable to see the serial number. Similar to how you would select a long and unique password for your e-mail, bank accounts, and social media accounts, it is in your interest to keep it safe and secure. I now don’t have to worry that you’ll pick a serial number that’s already been picked. This was the first notable digital cash proposal. It works, but it still requires a server run by a central authority, such as a bank, and for everyone to trust that institution.
In 1989, Chaum took his ideas and commercialized them to form his company, DigiCash. It is worth noting that DigiCash is probably the earliest company to pioneer systems and processes in the online payments space. They had about a five-year head start on other companies like First Virtual and CyberCash.
The actual cash in Digicash’s system was called Ecash and they had another system called cyberbucks. Surprisingly, banks went on to implement Chaum’s technology. This was in the 1990s, a decade before Bitcoin, which might come as a surprise to some Bitcoin advocates who view banks and large institutions as E. Corp (for all you Mr. Robot fans out there).
Ecash is based on Chaum’s protocols. The protocols keep clients anonymous and untraceable so banks can’t trace how they are spending their money. Merchants, on the other hand, aren’t anonymous. They have to return coins as soon as they receive them, so the bank knows how much they’re making, at what times, and so on.
Chaum had several patents on DigiCash technology, most notably the blind-signature scheme that it used. Although this decision by Chaum was controversial in the digital currency space, a group of cryptographers who hung out on the cypherpunks mailing list wanted an alternative.
Cyperpunks was the predecessor to the mailing list where Satoshi Nakamoto would later announce Bitcoin to the world, and this was no coincidence.
DigiCash ended up failing for several reasons.
DigiCash failed to persuade the banks and the merchants to adopt it. At this point in time, Ecash was still a relatively new concept for many people, especially merchants. After the merchant domino fell, the user domino preceded to fall as well.
Worse, it didn’t support user-to-user transaction very effectively. If DigiCash couldn’t get merchants to get on board, there was no other way to bootstrap interest in the ecosystem. In the end, DigiCash was defeated and the credit card companies succeeded.
From the Ashes Arose Bitcoin
Bitcoin ended up solving the user-to-merchant and user-to-user transaction by tossing out the entire notion of categorizing different groups from its protocol. The support for user-to-user transactions played a large role in Bitcoin’s success.
In order to create a free-floating digital currency that is likely to be perceived of real value, some form of scarcity needs to exist within the system. For example, the scarcity of gold and diamonds allows it to be used as a backing for money. In digital currencies, solving a computational problem, which takes a lot of time and energy, is one way to achieve scarcity in the system design. When talking about Bitcoin, we call this “mining.”
I won’t go into how computational puzzles are developed or solved in this post.
Bitcoin succeeded where many other digital currency ventures failed, but it was precisely those failures that finally led to the wild success and popularity of Bitcoin. Bitcoin has several notable innovations including the blockchain and a decentralized model that supports user-to-user transactions.
If you enjoyed this post, check out my article on Artificial Intelligence: for beginners where I explore the what conditions and advances in technology allowed AI to flourish.