Understanding the Blockchain, Part 1.

E-gold, Napster, and BitTorrent: A brief history of decentralization.

Before you can understand blockchain, I think you have to understand Bitcoin. And before that, it is worth looking at some of the past digital currencies — specifically e-gold.

E-gold, launched in 1996, was the first digital currency to reach scale. The service worked by allowing users to deposit US dollars into an online account that was then denominated by grams of gold. Such an account holder could instantly send their e-gold to other account holders. By 2004, there was over a million accounts.

All was going well with e-gold’s business until the U.S. Treasury Department and the United States Department of Justice stretched the definition of money, specifically the transmission of money, to include the transfer of any kind of value from one person to another, not merely a national currency. Before that change, a money transmitter business was defined as a business that cashed checks or accepted cash remittances to send from one individual to another across international borders, such as Western Union. This change was made in the USA Patriot Act and it crushed e-gold. (You’ll need to understand “Know Your Customer” and “Anti Money Laundering” compliance requirements to grasp why services like e-gold are so difficult to run, legally that is, after this legislation.)

Clearly people liked the idea of digital currencies, safely transferable over the internet, without using banks. But it was equally clear that governments would not want to give up their monopoly over the creation and control of money. We have seen this story play out many times since e-gold’s death. Any central authority that intermediates the transfer of anything resembling money is easy for a government to regulate and/or shutdown.

You can think of Bitcoin sort of like e-gold, minus the company or central authority that issues money and verifies transactions. That crucial difference — exchanging value without a central authority — changes everything. I will come back to why, later. First let’s talk about digital music. For those of us old enough to remember the early days, there is a parallel concept that I think helps to understand Bitcoin (and then we will get to the blockchain). It also hints at what we can expect in the future.

Napster launched in 1999. At its peak it had 80 million active users, exchanging mostly digital music (mp3 files) through personal computers. Napster was called a “peer-to-peer” file sharing service. Yet it wasn’t really P2P, in the networking sense. When someone wanted to download or transfer music they would need to know which computers had what files. And that information was only stored on Napster servers.

Just like e-gold, legal realities forced Napster, the intermediary, out of business. Around that time Bram Cohen, an American computer programmer, released the “BitTorrent” software to share files. His method was superbly clever: instead of centralizing the information and sharing of a file, he developed a method to distribute that data across all the people that have downloaded or are in the process of downloading that file. This has two benefits: 1) You don’t even have to download the entire file before sharing. And 2) as long as one person, anywhere in the world, has that file on their computer, others will be able to download it. Computers connecting in this manner form a decentralized, “peer-to-peer” network and are both technically and legally difficult to shut down because no central computer is required to operate the network.

I encourage you to suspend moral judgement of such a file sharing system and look at what occurred from a technology perspective. It is incredible. Even after 15 years of legal whack-a-mole, BitTorrent is still the most dominant way to exchange digital music. And beyond that, BitTorrent now moves as much as 40% of the world’s internet traffic on a daily basis. Why? Because its decentralized peer-to-peer architecture is economically and technically advantageous for moving any type of data over the internet.

I hope it’s clear now that an alternative digital currency must be decentralized for it to survive outside of and independent of the banking system.

Continue with part 2: How to make decentralized, digital cash.