The Blockchain For Dummies Guide — Part 5
RECAP: In Part 4, we pulled together everything we learned previously about blockchain and we saw how it provides us the advantages of authenticity, non-repudiation, and immutability over a normal database. We learned how these elements when taken together lay the foundation for being able to track things with real world value. But what kinds of things? Can money itself be tracked on a blockchain?
In this post, we’ll going to talk about how blockchain lays the perfect foundation for a digital payment system.
We’ll also briefly talk about traditional currency, how it came about, what gives it value, and the bare minimum we need to create a digital currency.
So as we discussed in Part 4, blockchain gives us some distinct advantages that allow us to track and audit the history of specific data. We can further track the origin and ownership of that data to actual things with real world value, like cars, property, or title.
But remind me..why can’t we do this now with a regular database?
Because of the nature of digital information. If I send you a picture (.jpg) of my vacation via email, I’m not sending you the exact picture I have…my computer makes a copy of that file and sends you the copy, that way you can have the photo without me losing it.
You can further send that to someone else and then someone else and each time a copy is made. So we’ve gone from having one .jpg file to having several.
For pictures of my vacation, this copying is fine. But if I was sending you a digital dollar that just kept on multiplying like that, the inflation rate would be astronomical and it would eventually become worthless.
The key factor in what makes something valuable is its scarcity.
Scarcity In The Digital World
With digital information, scarcity is never an issue. Its very easy to make digital copies of something which is why back in the early 2000’s, free music sharing from services like Napster and Kazaa was such a detrimental thing to the music industry.
The music industry lost control of the distribution of digital media, so the sales of physical music albums declined by half over the following ten years.
When it comes to the real world, the transfer of something from one person to another means that one person is gaining the thing while the other person is losing it.
If I give you a $1 bill, you are plus $1 and I am minus $1. This has been the basis of all commerce, trade, and transactions for millennia. Its the very reason why anything has any perceived value at all.
So recall that blockchain gives us a way of tracking the movement of specificdata with its full audit trail. If I sent you a picture of my vacation and we agreed on it as a form of payment, blockchain provides us the key ingredients to ensure the rest of the world knows you are plus that specific picture and I am minus that specific picture.
So we now have a mechanism for controlling the inflation of digital information, we have the rails in place for a payment system to ride on, but we need something more for it to be an effective means of payment.
We need a currency, but what do we need for an effective currency anyways?
What Makes An Currency
Currencies have been around for millennia as a way of representing transferrable value between parties. If you’re a chicken farmer, I’m a potato farmer, and Anna is a hairstylist and we’re all going to barter with one another for chickens, potatoes, and haircuts, we’d constantly need to figure out how many potatoes are equivalent to a haircut and how much each of those is worth in chickens, all based on supply and demand.
Rather than doing that for every good and service in a normal economy, it makes more sense to establish a common liquidity pool in the form of a currency, that way every good and service can trade against one currencyversus every good and service in the economy.
But what is a currency? What do we absolutely need to make sure trade runs smoothly without impairing anyone’s value.
It turns out we need five qualities to have an effective currency. In order to have an effective currency, we need something that is scarce, fungible, divisible, durable, and transferable.
Scarcity is self-explanatory. Our currency needs to be issued in a fixed amount or at the very least (as in the case of most sovereign currencies) in a controlled amount.
Fungible means that all forms of the currency are interchangeable. In the case of a $1 bill, if I have a brand new $1 bill versus an old $1 bill, it doesn’t matter, they’re both still worth a dollar.
Divisible means I must have the ability to subdivide the currency. This gives us the ability to make change in transactions.
Durable is self-explanatory, my currency has to have staying power. The reason fruit is not an effective form of currency is because it rots and decomposes.
And finally, it needs to be easily transferrable. The reason people don’t transact in gold bars is because they’re heavy and hard to carry around (not to mention difficult to divide).
Cryptocurrencies
So it turns out, the form of a currency is less important than the fact that the currency contains these five special qualities. Whether its made of metal, paper, cloth, or digital hashes — a currency is a valid currency if it meets the above five criteria, and cryptocurrencies do meet those criteria.
In Part 6, we’ll talk about what cryptocurrencies are, how they work, and how they combine with blockchain to make a working and effective payment system.
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