Blockchains, Cryptocurrencies & the New Decentralized Economy: Part 1 — A Gentle Introduction
Blockchain is the most important technology you might not yet understand.
It is building a future that can be more decentralized and democratic, whose beneficiaries could range widely from Syrian refugees to investment banks. The World Economic Forum estimates that by 2027, 10% of global GDP will be stored on blockchain technology.
Rapidly evolving blockchain technology and startups could fundamentally change entire business models, fundraising models, business operations, payments systems, and more. Despite the importance of this emerging technology, much unfamiliarity surrounds the topic.
The purpose of this essay, divided into three parts, is to 1) explain blockchain, cryptocurrency, and recent trends, 2) describe blockchain applications, or “decentralized apps” (DApps) and their tokens, and 3) elucidate how blockchain technology will be used to redesign the Internet and economy of the future.
Blockchain & Cryptocurrencies Explained!
The Bitcoin blockchain launched in 2009 as a peer-to-peer (P2P) digital payment system. Its creator ingeniously derived a system, using computer networks, cryptography, and game theory (now collectively called “cryptoeconomics”) for parties around the world who do not know each other to conduct and record transactions without an intermediary.
The bitcoin “cryptocurrency,” which can also be called a “token,” is the digital currency that users send to transfer value in this payments system.
By circumventing intermediaries, users can send value across borders using the Bitcoin blockchain for extremely low fees (historically less than 50 cents per transaction, regardless of the amount sent).
Blockchain technology’s game theory component is essential: It establishes incentives and disincentives based on pure economic rationality and self-interest for participants to validate transactions in the network and to play by the rules. It underlies the self-regulating mechanisms in decentralized networks and applications.
Game theory also informs the robustness of the network to malicious activity from harmful or adversarial actors within its system. This robustness is usually described in terms of “byzantine fault tolerance” (BFT) or “fault tolerance” and is based on the Byzantine General’s Problem that states that no more than 33% of the network participants can be malevolent to maintain the system’s integrity (in practice, the Bitcoin blockchain’s threshold for fault tolerance is 50%).
The result is that, entirely from the bottom-up and with no centralized coordinator or guarantor, the P2P network runs smoothly and honestly in a “trustless” environment where participants are self-interested and do not know one another.
In fact, during the week ending June 21, 2017, 1.8 million transactions were sent over the Bitcoin network without interruption, constituting $4.4 billion of value (at a $2507 bitcoin price).
In the years after 2009, several less anonymous yet still brilliant engineers have developed alternative blockchain technologies that modify and enhance the original Bitcoin system. The most noteworthy example is Ethereum, which is the second-largest system by market capitalization (defined as the number of tokens in circulation multiplied by their market price).
Cryptocurrencies are the “native” digital currencies that exist in blockchain systems or applications. Whereas the Bitcoin system’s native cryptocurrency is bitcoin, Ethereum’s is called ether.
All blockchains require the use of a digital currency, whether it be their own native cryptocurrencies or an existing one such as bitcoin and ether. There are about 718 cryptocurrencies in circulation as of June 27, 2017.
Cryptocurrencies are necessary to operate blockchain systems, because they are the incentive mechanism for computers (“nodes”) in the network to conduct (“validate” or “verify”) transactions.
Indeed, they are the reason you only pay a tiny fee to send a bitcoin transaction. The Bitcoin blockchain system compensates the nodes maintaining the network 12.5 bitcoins every time they successfully validate a set of transactions in a process called “mining.”
All blockchains or similar “distributed ledger technologies” (DLT) have a common set of characteristics. This is how they work:
- Blockchains are digital ledgers or logs that record electronic transactions that occur between two parties.
- The two parties do not know each other and directly engage in a peer-to-peer network of connected computers.
- Rather than relying on a third-party middleman (ex. PayPal, a bank, etc.), the network collectively reaches agreement (“consensus”) on which transactions are legitimate using a consensus mechanism. By “legitimate,” we mean that, for example, Alice sends money to Bob and does not spend the same digital currency twice (called a “double spend”) or do anything else malicious.
There are several types of consensus mechanisms, each with pros and cons. The main types are “proof-of-work” (the basis for Bitcoin and Ethereum), “proof-of-stake” (eventually the basis for Ethereum), and “proof-of-authority” (the basis for private chain setups). Proof-of-work is very wasteful of electricity, which is one reason people want to adopt other mechanisms.
If you can remember 3 more things, remember these:
- Once the network approves the transactions, the transactions get posted to the digital log. In Bitcoin, attempted transactions are first grouped together in a block, which then gets verified all at once (by the proof-of-work mechanism) and added to a long chain of blocks. This is why it’s called a “blockchain”!
- The blocks are linked together using cryptography, so that you cannot surreptitiously edit or tamper with the transaction data on a block once the block is added to the chain (or more precisely, once a subsequent block is added to the chain after it).
- The transaction details are transparent and verifiable by the public. However, the identities of the buyers and sellers are hidden behind their public usernames, which are long alphanumeric addresses. Here’s a window into the Bitcoin blockchain. The simultaneous transparency of transactions and masking of identities is why blockchains can be used to both anonymously buy drugs and obediently report to regulators.
Note that some blockchains can restrict transaction visibility and participation to designated parties; these are called “permissioned” or private blockchains. Many large companies are very interested in these private blockchains, in part because they do not want proprietary or competitive data to be public. The R3 Consortium of most major banks in the world (which raised $107 million in funding in May) has developed a private blockchain system called Corda that just entered beta phase — so has the Linux Foundation (with major support from IBM) with the Hyperledger Fabric.
Another exciting innovation is Zcash, which allows you to hide details of transactions such as the sender, receiver, and amounts (using zk-SNARKs) while operating on a public blockchain. JPMorgan just announced a big partnership with Zcash.
Robust and Secure Networks
In addition to offering a mechanism for peers to transact directly for free without knowing or trusting each other, data held in blockchains are robust and secure. This is because:
- Using cryptography, transaction information is recorded in a way that is permanent and tamper-evident. As a result, we can call the blockchain “immutable.” System attacks are extremely difficult. For Bitcoin and other “byzantine fault tolerant” networks, the most prominent way that data on the blockchain can be manipulated is with a concerted attack by a majority of the network participants, called a “51% attack” (there are different types of attacks requiring different levels of participation to succeed). Further, experts agree that the quantum computers of the future will be able to break today’s cryptography schemes.
- The blockchain record is downloaded on thousands of computers around the world that are participating in the network. These computers constantly sync, or update, the record for new transactions. As a result of this wide data distribution, data storage is robust and there is no single site of failure that attackers can target. To delete the blockchain you would need to destroy the thousands of computers in the system all around the world.
In summary, data are not stored in concentrated sites, but rather on a log that is downloaded on thousands of nodes and constantly syncing. New data locks onto the log in blocks that are connected by cryptographic hash pointers referring to preceding and subsequent transactions on the ever-growing “chain” of transactions.
Ethereum is a promising and exciting blockchain technology with a wider set of capabilities than the first-generation Bitcoin system.
Whereas Bitcoin has narrow programming leeway (some compare programming capabilities to that of a graphing calculator) and is essentially a ledger of payments between parties, Ethereum’s programming language can be used to quickly build new applications.
Ethereum’s programming language, Solidity, is easy to use and versatile. It is “Turing complete,” meaning that it is capable of approximately simulating the computational aspects of any other real-world general-purpose computer language, which leads to more sophisticated applications.
As part of the Turing completeness of Ethereum’s Solidity programming language, anyone can build conditional contracts (using “if/then” and other logic statements) that execute autonomously. The coded contracts are called “smart contracts” and can execute previously agreed upon terms.
Smart contracts are a big deal: They can be considered legally enforceable and can benefit countless industries by removing time and human error from contract processes.
Note that because the contracts are on the Ethereum blockchain, their code is open-sourced; public visibility motivates developers to be extremely cautious about their code so that it is not exploited by hackers to attack the program.
In combination with high quality developer tools and core components (Truffle, Metamask, uPort and others) and substantial industry support (Ethereum Enterprise Alliance, along with Brooklyn-based venture studio ConsenSys), Ethereum shows great promise and popularity within the community.
Ether cryptocurrency is required for the execution of code and smart contracts on the Ethereum blockchain. Users must spend a small amount of ether, called “gas,” to incentivize the network to conduct and verify transactions and run smart contracts. These “gas” transaction execution fees are the intrinsic use of ether.
Most cryptocurrencies have an intrinsic use, which is to access or employ the blockchain system or application (discussed in greater detail in Part 2).
Numerous non-governmental, governmental, and for-profit institutions are actively investing in blockchain R&D to power the future. Institutions spanning the United Nations, IMF, EU Commission, U.S. Dept. of Homeland Security, and National Science Foundation are investing in blockchain research initiatives.
Furthermore, many governments and central banks are interested in introducing digital currencies; Vladimir Putin, the Monetary Authority of Singapore, the People’s Bank of China, Bank of Canada, Bank of Japan, and more have been investigating digital currencies.
It is likely that nearly every major multi-national corporation has begun looking at or investing in blockchain technology, from Walmart to Western Union. In brief, using blockchain allows businesses to remove the need for central parties or brokers in various processes, eliminating the fees, human error, time, and security risks that they entail.
IBM and Microsoft have established “Blockchain-as-a-Service” businesses, while major consulting firms including Deloitte, Accenture, and KPMG are building blockchain practices. BCG’s 2016 report “Thinking Outside the Blocks” smoothly summarizes the relevance of the technology while guiding readers through its potential corporate uses.
Meanwhile, remarkable (although very volatile) returns in cryptocurrencies such as bitcoin and ether are driving public attention to the assets as speculative investments:
Year-to-date as of June 27, 2017, the price of one bitcoin has risen 148% to about $2400, while the price of one ether has risen an astonishing 2900% to about $240. The total market cap of cryptocurrencies is about $98 billion. These figures vary widely with the volatile pricing dynamics.
Market Cap of Cryptocurrencies Approximately $100 Billion
Cryptocurrencies have also been grabbing headlines as a new source of startup financing. Total fundraising to blockchain startups from “ICOs,” or initial coin offerings (discussed below), has exceeded $600 million so far this year, surpassing levels of investment funding raised from venture capital (VC) firms. This figure includes the staggering $150 million fundraising round by Israel-based startup Bancor on June 12, 2017, which was filled in less than three hours.
Initial Coin Offerings: Democratized Fundraising
ICOs have proven to be an incredibly rapid new means of fundraising, as evidenced by multiple strong issuances this year. They potentially democratize fundraising, allowing non-traditional upstarts without traditional equity and with open-source production to raise millions of dollars.
Impressively, ICOs draw on the community of blockchain enthusiasts and cryptocurrency investors to crowdfund projects. In this way, they democratize the venture capital process.
In fact, while ICOs are completely open to the public, most VCs are not legally able to participate due to agreements with LPs that limit the types of securities in which they can invest.
As industry thought-leader Jamie Burke put it, “The day when VCs were the elusive elite and primary source of capital for startups has ended. When a startup (Brave) can raise $35m in 30 seconds without any dilution, the genie is out of the bottle and it isn’t going back in.”
Note that strong demand for ICOs in May and June 2017 has led to a “crowding out” of small investors in favor of large “whale” investors who can receive priority allocations. Some challenge whether this undermines the democratic nature of ICOs.
Strong ICO interest has also led to complications and volatility in the price of ether. Many ICOs require investment in the form of ether, which drove unprecedented demand for the asset in May and June 2017. The price of ether reached new highs (above $410) in the week of June 18 during the Status token ICO, until congestion and service disruptions on exchanges led to downward price pressure and even a “flash crash” of ether on the GDAX exchange to $13. These pressures may have also exposed limits in the current Ethereum network. In the final week of June, the price of ether fell to the $200-$300 range.
Regulation and Investment Risk
As of June 27th, cryptocurrencies are not considered public or private “securities.” They are not yet regulated by the SEC, and they do not have standardized features. Some offer features similar to distributions or coupons, some offer voting rights, and most offer neither.
The SEC would like to ultimately regulate ICO participation, as it does with other forms of crowdfunding, to protect retail investors from scams and losses. Currently, ICOs and tokens are not required to provide disclosures or a prospectus. Some are also not based on sound business models. With escalating hype and public awareness, more industry outsiders are investing in ICOs and tokens. Without the safety measures and transparency normally demanded by SEC regulation, investors are at risk.
Blockchains and other distributed ledger technologies have a variety of positive features and can be applied to countless industries and uses to improve efficiency, security, and operations. Cryptocurrencies such as bitcoin and ether are required to execute transactions and operate the networks. They are also investable assets and sold to the public to raise capital. As such, they constitute a new form of crowdfunding and startup fundraising. Blockchain cryptocurrencies are also a new type of alternative investment, one that is not yet SEC-regulated and that can pose risks to imprudent investors.
Most industry observers agree that we are in the early days of a complete restructuring of numerous processes and operations to be decentralized and on the blockchain. “This is like the Internet in the 1990s” is commonly exclaimed.
Blockchain VC and thought-leader Olaf Carlson-Wee has stated, “We’re absolutely still in the infrastructure building phase. But I do think within one to two years, we’ll start to see the first viral applications that are user facing.”
In Part 2 of this essay, we explain “decentralized applications,” which are apps built on blockchain technology that redesign the delivery of products and services, hopefully in the interest of the user and public.