Understanding the Blockchain
Yes, and the Bitcoin…
The Double Spending problem
Suppose I had a Ferrari California T. You want that car from me, and you offer to pay me $400 000 cash in exchange.
I accept, thus I hand over the keys to you while you hand over the money to me.
If I now wanted to sell my California T to another buyer, I couldn’t, simply because I didn’t have the car anymore. It is with you.
The world is no longer that simple. We have shifted from simple barter to complex exchanges involving multiple parties all across the globe. The Internet and rise of digital money (ie. 1s and 0s) have allowed us to make transactions without physical movement of cash.
But this presents us with a new problem which is so momentous it deserves its name — the “Double Spending Problem”. And its own Wikipedia page.
Suppose instead, that I had an e-book that you wanted to buy from me. You offer to pay me $20 in exchange.
I accept, thus I attach the e-book in the email I sent you and you transfer me payments accordingly.
Here’s the nub. How would anyone know if I’d simply copy the e-book file, and sell it to another buyer for $20?
The problem with digital information is that it can be replicated easily. Thus, with the same file, I can sell it to multiple buyers and earn hundreds of dollars from a product only valued at $20.
The Solution…so far
In order to ensure that people only spend the money that they rightfully have, one would think of using a ledger. A ledger would account for all transactions between different parties such that it is clear who has what.
Today, the biggest ledger-type system of the world is the institution of banks. Banks are paid to be the “bookkeepers” of Capitalism. When people want to make payment online, they notify the banks which then verifies the transaction and deducts the sum from their accounts accordingly.
Yes, this is only a superficial exercise, since all the banks are doing is changing the 1s and 0s in the account rather than physically moving the money. But it does its job sufficiently well. Constant audits ensure that no one is duplicating their money in banks albeit their simple computer-coded nature.
The Problem with Banks
Speculations have been running wild that the blockchain and cryptocurrency will one day replace banks altogether.
True or not, change should not be brought about for the sake of change.
Let us first examine the problem with banks and why futurist pundits are so certain about their imminent demise.
Firstly, as the the world’s largest ledger’s bookkeeper, banks naturally extract high transactional fees. This concentrates wealth in the sector and widens Gini coefficient gaps for a job that at its core, a 20 year old teen could do.
Why can’t we crowd source this job at a lower cost?
Second, they are inefficient. My opinion is that all large organisations are prima facie slow and ineffectual. Bureaucracy is the largest impediment towards creating a better world. Anyway, it takes time and physical labour to send money from bank to bank as it requires mundane paperwork to be submitted. Remittances are hindered since different ledgers from different banks have to be updated at the same time to ensure reliability.
Why can’t the world just agree on one big ledger so that there isn’t a need for vexatious and pointless coordination?
Finally, money moves at the speed at which the banks move. They are the economies’ most important limiting factor. If the banks one day decide to close shop, soon Capitalism will come crashing down on its own fragile undergirds.
Why can’t we revert back to simple P2P transactions?
It would therefore seem that a necessary evil of digitalising money is the institution of banks and ledgers. We need someone to keep the books. Though this entails many pitfalls and inefficiencies, humanity largely accepted them to date because they have been necessary for the upkeep of digital money.
To summarize so far:
- P2P transactions are simple and easy to carry out.
- They are, however, subject to physical limitations.
- The rise of digital currency is thought to eliminate these limitations.
- However, digital currencies have its own problems — double spending problem.
- A hypothetical ledger to record transactions could be introduced to ensure no double spending.
- Banks have filled in the role of a governing body.
- However, banks bring about their own inefficiencies. They charge a lot, they are bureaucratic and inefficient, they limit the speed of transactions and they are unnecessarily complex.
- However, to date there has been no alternative to institution. The benefits of digital currencies were thus thought to outweigh the inefficiencies of a necessary governing body.
The rise of the Blockchain
Imagine we had a system, where we had both the advantages of P2P transactions and digital currencies, and yet, throw institutions out of the mix. We could engage in verifiable transactions that are straightforward (P2P) yet not have to be limited by physical movement of goods (digital currency). Most importantly, movement of money would no longer be limited by pointless bureaucratic exercises.
Enter the Blockchain.
The Blockchain brings together the best of both worlds. It removes physical limitations of historical P2P transactions by adopting digital currency and the limits inefficiencies of big institutions by decentralising the regulation process.
How does it work?
At its core, the Blockchain is a global, transparent and reliable ledger that dispenses the need for regulatory institutions.
Imagine going to a poker game where everyone forgot to bring money. It is then decided that one player will record down the earnings and losses on a sheet of paper for everyone else. This sheet of paper is placed at the centre of the table for everyone to see, making it hard to forge transactions. Crucially, no one player has monopoly over the ledger — different players are in charge of updating the ledger for different rounds. Thus, all the players have faith in the system to reliably record their earnings. They’d be inclined to join this poker game.
And there you have it, the Blockchain.
Its that simple. The Blockchain is an open register of all transactions that occur for that application.
It is a simple P2P network. If I wanted to make a transaction with you, I’d simply have to declare it to the community in the Blockchain by submitting our transaction for verification and entry into the decentralised ledger. It’d go something like this:
“Hey World! Cher Yi here! I just bought a car from Tim, so in exchange, I’m going to transfer him x amount of money! All ok?”
“Yup!”, “Yes!”, “Oui!”, “Sì!”
Everyone would know about our transaction, and in theory, if you wanted to, the Blockchain would allow you to track where all the currency in the system is. (In reality, however, Blockchains like the Bitcoin don’t display your name. Rather it generates a unique account number for each person. Thus you could only find out what the account numbers have.)
Moreover, anyone can access the records; it is transparent. Each transaction is also cryptographically linked to adjacent ones such that it is impossible to tamper with the records. Changing one record at the start of 2012 would mean messing with all transactions that have occured ever since — which requires a huge amount of processing power, deterring crime.
- The Blockchain was developed to combine the advantages of P2P and digital transactions.
- It is a ledger recording all the transactions in the system. Transactions involving digital information yet retaining their simple P2P nature.
- It eliminates the need of a centralized governing body by crowd sourcing regulation through mining (explained later).
- It is public and accessible by anybody.
- It is cryptographically secure.
- It is anonymous — account numbers are not linked to personal identities.
Mining and Cryptocurrencies
So what we have now is a wonderful decentralised ledger that is safe, secure, transparent, and simple to use.
One problem, however.
This only solves the “who” of the transaction. It does not give any details about the “when”, which brings us back to the double spending problem. I could send $100 to Jane, and then send the same money to Amy. Jane and Amy would have been fooled to give me their product in exchange, yet there would be no way of verifying who should’ve rightfully received my payment first.
A regulator is still required to not only verify the transactions to ensure no double spending has taken place, but also to time stamp each transaction.
Miners exist in every Blockchain (for simplicities’ sake). To maintain such a huge global ledger, it impossible to dispense with regulators of all kinds. Without regulation, the double spending problem runs afoul.
Miners are the police of this system. What differentiates them from large banks is that they aren’t large institutions — the very entities the Blockchain aims to eliminate. They aren’t big companies with limiting red tape that makes them inflexible.
They are anybody and everybody— including you and me.
When Tim and I want to make a trade for the currency, we submit our transaction to the miners. These miners are then designated to timestamp a set block (hence Blockchain) of pending transactions, verify their legitimacy, ensure all rules are followed before broadcasting it to the ledger and promulgating it for the whole world to see.
How do we make sure that the miners aren’t simply working together with us to cheat the system?
The beauty of the Blockchain is that it doesn’t simply rely on the good will of Samaritarian miners to upkeep their books. It plays on human’s primordial instincts of self-interest and our worship of the gods of Capitalism.
The Blockchain rewards miners for their thorough vettings with what is known as cryptocurrencies.
Let’s be clear. The Blockchain is the technology that will change the world and revolutionise trust. Cryptocurrencies are simply tools that the Blockchain uses to achieve its goal. Despite what it might seem with the intial hype of decentralised payment applications like the Bitcoin, cryptocurrencies are not the raison d’être of Blockchains. It is entirely the other way around. Cryptocurrencies are simply a means to achieve an end of a public transparent ledger.
It is similar to shares and companies. Companies do not exist to IPO and sell their shares. They are in the hunt for growth, and to achieve growth they require money to purchase capital (eg. for R&D etc.). Shares were thus created as an asset class that is used to fund this insatiable appetite of expansion.
Cryptocurrencies were created to maintain the Blockchain.
Proof Of Work
Going back to mining. To ensure that the miners take their job seriously, the system rewards their efforts with cryptocurrencies. However, these cryptocurrencies have no prima facie value — they are an un-established currency of 1s and 0s. No one really believes in their value, thus they have no value.
To solve this issue, the system requires miners to use a large amount of computing power to solve a very complex mathematical problem. The first to solve the problem will be designated as the time stamper for x number of transactions, before being taken over by another miner, who could be located halfway across the world.
Sounds childish, unbelievable, even wasteful?
Think again. To give our hypothetical cryptocurrency value, the easiest way is to exchange it for real world value. That way, an exchange standard is established, and that currency will have “value”. See my other article on the creation of Money for this. Meaning, these miners have to incur a real world financial LOSS, in exchange for the GAIN in cryptocurrencies, such that the cryptocurrencies have real world VALUE.
But how do we create a standard of financial loss that all miners have access to?
Why, Maths of course!
This mathematical problem is (theoretically) solveable by anyone with a laptop. It is simply but extremely rigorous; it requires a huge amount of trial and error that only computers with large amounts of processing power can achieve. The financial loss sustained by miners is the capital of their problem solving device (usually consisting of lots and lots of processors in what is known as a cryptocurrency mine) plus the electricity bills, which can amount to LARGE sums.
As you can see, it becomes in the miner’s economic interest to carry out timestamping reliably as it would result in faith in that Blockchain and a rise in the value of the ensuing cryptocurrency (which they possess). Its Capitalism and self-interest at its best.
Once these miners have solved the maths problems, and carried out their duties as a timestamper faithfully, they will receive crypto coins. These can then be exchanged back for real world currency to pay for their financial loss. This also allows the cryptocurrency to go into circulation, and eventually, creating a market worthy of trading and speculation. A new money has been born.
But at its core, every single crypto coin out there came from the same process — mining (I’m over simplifying here, but this is the main gist of it all). Miners maintain the ledger. As a reward, they receive crypto currency. But a real world financial loss has to be implemented to ensure that it is in the economic interest of the miners to do their job properly.
Beautiful, isn’t it?
Putting greed to good use.
The Bitcoin and the others
In 2008, in the eve of the world’s greatest financial crisis, an anonymous entity Satoshi Nakamoto published a paper explaining how to make electronic payments without the need for regulators like banks or PayPal.
It is the first decentralised application aka blockchain proposed. Bitcoin is a blockchain for payments; ie. the ledger is used to record monetary transactions. As a result, one could go on to say that the cryptocurrency is the reason for the Bitcoin’s blockchain’s existence.
Though that may be true, what was truly remarkable about Satoshi’s thesis was that it was the first of its kind. It ushered in a new era of decentralised applications. Many realised the possible utopian implications of this new technology and wasted no time in jumping onto the hype train.
There even exist a decentralised application for decentralised applications. I’m sure you’ve heard of Ethereum. Ethereum is essentially a “blank slate of code” which provides a foundation upon which other techies can build their blockchains upon.
Of course, with the creation of a market for a new asset class, there is bound to be speculation and trading. Look at Bitcoin. Prices rose from $400 in Jan 2016 to about $6500 today. That’s insane. Ethereum is still low at $300, but (personally) I believe it’s on the rise. A recent announcement even shed light on Bitcoin’s future. CME CEO: “Bitcoin Futures Could Begin Trading As Soon As December”.
Amidst all the bullish trading and optimistic hype, its hard to remain focused on the what market pundits are betting on: the Future. Cryptocurrencies are NOT the future. They are a proximate but necessary consequence of the Blockchain.
Or are they?
(Disclaimer: the following are my personal rants)
Is there a need to create the cryptocurrency for the Blockchain to succeed? Why can we not use fiat currency to reward miners for vetting transactions? Would it not achieve the same effect?
A sinister answer I can think of is that the creators of the Blockchain weren’t prepared to invest real money to pay off the miners. They might not have enough, if that Blockchain goes viral. Thus, they simply created a new asset class. Ethers and Bitcoins are but lines of codes. In paying off the miners, the system only need generate new lines of code to reward them. The founders wouldn’t have to invest anything but time into developing this code. And the miners gladly accepted. And people gladly paid $8000 for a few lines of code in hopes that the bubble will continue to expand. All in the name of faith of a technology that has the potential to revolutionise the way we think of transactions of all sorts.
(I might be completely wrong here though, would someone please correct me if so? Appreciated)
Isn’t it really all too surreal that many people are placing their bets in a market that seems aimed at perpetual growth, when in fact the very asset that they are betting on are based on lies, and damned lies? The lie that a few lines of code equals to $8000?
Humans have an uncanny ability to create, and believe, in myths. The myth of money, of credit, of crytoassets, of democracy, of patriotism, of liberalism, of freedom. Maybe that’s what got to us to where we are today. The Anthropocene. Maybe.
But less we forget, let us remind ourselves that these are myths.
For those of you who skipped to the end:
- P2P transactions are simple but physically limiting.
- Digital transactions are quick but bureaucratically limiting.
- The Blockchain combines the advantages of both P2P and digital transactions by removing the need for institutions.
- It is a simple ledger of transactions that is upkeeped by private neutrals known as miners.
- The ledger is transparent, public and secure.
- This ledger can be used to record all sorts of transactions. Monetary (the famous (Bitcoin), music royalties (Mycelium) etc.
- Miners are in charge of vetting transactions. After incurring a real financial cost, they are designated to timestamp a block of transactions. They are rewarded with cryptocurrencies.
- This gives the currency real world value and ensures miners are self-motivated to do their job properly.
- Miners then exchange their currency for fiat currency to pay off their financial losses. This causes the currency to be circulated.
- As a proximal consequence, hype over the future of Blockchain inspired the development of cryptocurrency markets for speculation.
Thanks for reading!