Introducing Blockchain | Blockchain Basics Part 2
The Double Spend Problem
Historically, when we performed transactions with physical value (gold or fiat), it was a simple mechanism that involved the physical exchange of value in exchange for goods or services.
Definition of ‘Fiat’:
“Fiat money is a currency without intrinsic value that has been established as money, often by government regulation.”
We mentioned in the previous post that these types of instruments are called “bearer instruments”.
Bearer Instruments
“Bearer instruments are assets, where we automatically assume that the person in possession of this asset is the owner and there is no record of ownership.”
As these instruments are physical, it is not possible for this value to be spent by the same party more than once. Once you’ve relinquished physical ownership of this value, it no longer belongs to you.
A very simple example would be the purchase of an apple for a $1 coin; once you have handed the $1 coin over in exchange for the apple, you cannot spend that same $1 again on something else, as you have physically relinquished the value to an alternative owner.
With digital value, this becomes more difficult. You can not physically hand over digital value, so how do you keep track of the true owner of that value? This is a similar conundrum to our discussion regarding assets which can’t really be “physically” handed over (for example property). How do you prove who owns what?
A Property Double Spend Example
If I were to sell my house, (before property registers existed), I could accept $100 from Sally and give her the physical deed to the property. Before moving out, I could then accept another $100 from Bob and give him a forged version of the physical deed to the property. Then I disappear, and leave Bob and Sally to argue over who bought the house first and who is the true owner. I have essentially sold the same “unit of value” twice and a double spend has occurred.
It becomes even more complicated with digital currencies, as not only can we not physically hand over these units, but a user could create digital copies of a digital “unit”, this would dramatically devalue the currency and would result in the ability to spend more value than you truly own.
This problem of users essentially being able to defraud others and spending the same unit more than once, is what we call the ‘double spend’ — when an owner of value can spend the same unit of value more than once, and one or more of the recipients will actually not own the true original unit of value, but a copy.
A Digital Currency Double Spend Example
If I own a unit of digital currency, I could make a copy of the unit and send this to another user (the recipient). The recipient will think they have been transferred the original unit of currency, while in fact, they will only have a copy. Without a ledger that records every single transfer of value, there is no way for the recipient to verify that the ownership of that unit has been transferred into their name.
This is why when it comes to the digital transferral of value, we have always used trusted intermediaries — banks — to manage ledgers which essentially record who owns what. We trust banks implicitly to ensure that no double spends occur; that when party A, pays party B, the correct debits and credits are made, and each unit of value is spent only once.
While the banking system works, it is incredibly expensive, inefficient and creates a dependency on third parties, where ideally there would be none. Payments can often involve multiple transfers, through various banks or third parties, and each transferral incurs a cost of both value and time to the owner.
The Challenge
The challenge was how could a system be designed that eliminated the need for a third party? How could we create a system that could facilitate transfers directly between two people, while providing the recipient with the certainty that the transaction was validated?
Until 2008, this was a major problem that had never been solved, although many people tried to do so. But then Satoshi Nakamoto released the bitcoin white paper, and with it, the description of the first blockchain, that finally provided a solution to the double spend problem.
The Introduction of Blockchain
So what is blockchain? To put it simply, blockchain is a ledger, and a copy of this ledger is held on multiple servers in a network we call a peer-to-peer network. The ledger is decentralised, which means that there is no central authority of the network.
The ledger records a history of time-stamped transactions which once added to the ledger, can never be changed or deleted. Every peer in the network is incentivised in some way to participate in ensuring the validity of the ledger and preventing the double spend problem that had previously prevented the digital transferal of value without intermediaries.
Cryptography is used in a very clever way to firstly, ensure that only the true owner of value can authorise a transaction and secondly, to ensure that if anyone tampers with the ledger it will immediately be picked up. The way it does this is by linking these sequential transactions or groups of transactions together cryptographically, forming a chain of transactions. This gives a blockchain the characteristic of immutability and tamper resistance.
What we have explained so far is incredibly powerful; it provides a way for a group of entities which may not have the same interests, to collectively manage and maintain a distributed database. They don’t need to trust each other, all they need to do is trust the mathematics and code of the software that powers the network. This code and mathematics is usually open source, and this means it is completely transparent.
It is a technological advancement that provides us with a way to eliminate trusted intermediaries who usually prevent the double spend problem.
Once a transaction is validated and subsequently added to the ledger, there is no undoing it or changing the details of the transaction, it is essentially an append only decentralised database.
Everyone who submits a transaction on a blockchain has a public key, which can be compared to an account number. Every transaction submitted to the blockchain includes a digital signature. The digital signature is a special combination of the contents of the transaction and the password, which we call the private key, of the account owner.
This digital signature is incredibly secure and essentially is a very safe way for the network to validate whether the true owner of the public key gave permission for the transaction to occur. If the digital signature is invalid, the transaction is rejected by the network.
What this essentially creates is an ecosystem where no-one needs to trust each other. All we need to trust is the underlying blockchain protocol, the code that makes everything work and the decentralised nature that provides immutability and tamper resistance.
“Blockchains can help us advance from a don’t be evil world, to a can’t be evil world”.
While the initial concept of blockchain was to remove the requirement of a bank in the transfer of value, innovators, computer scientists and entrepreneurs started to realise that this decentralised ledger which Satoshi had originally applied to record digital monetary value ownership, could be used for much more.
This ledger of “value”, could represent a product in a supply and the blockchain could track the movement of value from one entity to another; it could be a security, and instead of requiring a 3–5 day settlement period, we could settle securities trades instantaneously; or it could be a record of digital identity transactions, where only the true owner of that identity can give permission for a transaction to occur.
Since its inception, blockchain has undergone significant development. While the original blockchain was built specifically for the transferal of monetary value, Blockchain 2.0 moved into the deployment of smart contracts, blockchain 3.0 utilised these smart contracts within decentralised applications and blockchain 4.0 sees the actual application and use of blockchain in industries.
In the next article, I’ll be explaining the original bitcoin blockchain and we will try to understand all of the pieces that make blockchain as powerful as it is today.
