The 1+1 of the Blockchain
“The disease of our times is that we live on the surface. We’re like the Platte River, a mile wide and an inch deep” Steven Pressfield
Lately I’ve become fascinated by the concept known as First Principles Thinking.
What is First Principles Thinking? In short- it is taking a complex issue, peeling away all of the embedded assumptions and breaking it down to its most fundamental components.
In school we intrinsically understand that we cannot possibly solve an algebraic equation before we understand basic arithmetic. We first need to know, with every fibre of our being, that 1+1=2, before we can hope to solve for x in a more complex equation, such as 3x=27. When our grade 1 teachers or our parents taught us to calculate that 1+1=2, they were gifting us the first of many foundational principles of mathematics.
If we understand the basic principles in any subject, it is far easier to develop a deeper knowledge in that area. If we do not understand these first principles, there will always be holes in our reasoning. We may still arrive at a solution using analogies and assumptions- But we will find it very difficult to tackle more complex problems later down the road.
One trend I’ve noticed about many top investors and venture capitalists is that they often appear to be history buffs. When asked what their favourite books are, they will often reply with some arbitrary book about the Civil War or a biography of certain historical figures, such as Benjamin Franklin, John D Rockefeller or Martin Luther King Jr.
I used to think “What the f**k does the Gettysburg Address have to do with business models, profit projections, P/E multiples or any of the other things that made these people experts at what they do” It did not seem to have any correlation. I was perplexed to say the least.
But after really thinking about it, my theory is that these top investors love these books so much because they were helping them to build the first principles of their craft. You cannot truly understand the markets before you understand certain core principles, such as human behaviour, historical trends and how true innovators think. These books may have provided them with such knowledge.
Once you understand first principles, then those technicalities, such as P/E multiples, take on much less importance and often become irrelevant. It’s easy to sprout out complex mathematical terms such as Binomial Coefficients and and Cartesian Coordinates, but are these terms of any use if you don’t know that 1+1=2? I don’t think so.
Just a like a tree cannot hope to grow without roots, we cannot hope to grow without rooting our knowledge in the basic elements of our chosen field of interest
When it comes to cryptocurrency investing, I quickly realised that If I was going to develop an informational advantage, I would need to uncover the roots of the field and develop my knowledge upward from there.
Having spent many hours trying to discover these basic principles, it is my opinion that the cryptocurrency field can largely be boiled down to two fundamental truths, which are as follows:
1.All crypto coins have evolved from the first ever fully functioning cryptocurrency- Bitcoin
2. These cryptocurrencies are created on top a revolutionary technology called the Blockchain.
Therefore it makes sense that in order to understand cryptocurrency, we must first understand Bitcoin and more specifically, the Blockchain technology that allows Bitcoin to function.
So lets take a deeper look at this Blockchain
What is a blockchain?
A digitised, decentralised, transparent ledger that records immutable transactions with the use of cryptography. WTF right? That horribly complex definition can be broken down much more simply as follows:
A blockchain is essentially a record keeper of all transactions made between participants in a specific community. These records are distributed to all participants in the community and the records are constantly being updated to reflect each and every transaction that takes place within the network.
Each member of the community has access to entire record book- from the very first transaction to the latest one. This record book also contains certain security measures to ensure that the transactions are accurately reflected and are not being tampered with. That, in essence is the blockchain.
What about the decentralised part?
Traditionally, these records have been kept in a central place, such as a bank or government department. In this way, each and every transaction gets processed and validated by one or more central intermediaries. This model has provided many benefits to society but it also contains some fundamental issues. The fact that much of our sensitive information is kept on central servers has made these intermediaries sitting ducks for large scale cyber hackings. Additionally, inter-bank transfers can take days or even weeks to reflect. Cross border transactions are a particular nightmare and the time and cost of processing often makes them infeasible.
The decentralised nature of the blockchain offers us a way to reduce these vast inefficiencies. Instead of the records being kept in one central location, they are kept by every participant in the community. This means that a central third party is no longer needed to validate transactions. Rather, the transactions are validated by the community itself.
So how does the Bitcoin Blockchain actually work?
This is best explained by way of an example: Michael and Abby agree to a transaction, whereby Michael will buy 10 apples from Abby and in exchange, Michael will pay Abby 5 Bitcoins (expensive apples, I know). Michael announces (by way of an electronic message) to the entire Bitcoin network that he is sending 5 Bitcoins to Abby. He then signs this message with a digital signature.
What’s a digital signature?
A digital signature is very similar to a handwritten signature, in that it is completely unique to the person that is signing the message. However a digital signature is much more difficult to forge than a handwritten signature. When each participant enters the Bitcoin network, they are given a unique private key as well as a public key. As the names suggest, the private key must be kept private and the public key can be freely distributed to the public.
You can think of the public key as being analogous to your bank account number and the private key as your secret password that you need in order to gain access to your funds.
Now back to Michael and Abby. In order for Michael to sign the transaction, he needs to combine the transactional message with his private key (that only he knows). The system puts these two elements through a mathematical function to create his personalised digital signature. This signature changes for each transaction that is signed and therefore it cannot be copied or forged.
Abby can then verify that the funds have come from Michael by combining his signature, with the transactional message as well as his public key. The system puts these 3 elements through a different mathematical function, which will simply deliver a true or false answer. If the answer is true then Abby can be sure that these Bitcoin come from Michael and he has signed the transaction to authorise it. This is in essence how Bitcoins are transferred over the internet.
The double spend problem
However there is one more major problem that needed to be solved before this Bitcoin system could ever work. If Michael was a fraudster, he could broadcast two conflicting messages to the network as follows:
- Michael sends 5 Bitcoins to Abby
- Micael sends those same 5 Bitcoins to another address that he personally owns
Abby may see the first message before she sees the second message and she will think that the transaction is legitimate. She will therefore happily send the 10 Apples to Michael. However some other people on the network may see the second message before they see the first message. If the majority of people saw the second message before they saw the first message, they would believe that the transaction to Abby is invalid and disregard that first message. Michael will then have the apples as well as his 5 Bitcoin, which is clearly not fair.
Blockchain and Proof of Work
To get around this problem, the Bitcoin system puts all of the transactions into a pool, called the pool of unconfirmed transactions. There will then be people in the network called miners, who will scoop these transactions up (including the one from Michael to Abby) and place them into a block. In order for a block to be confirmed as valid, the different miners will all compete furiously against one another to obtain a solution to a mathematical problem. The first person to obtain the solution will receive a prize, in the form of shiny new Bitcoins (to be discussed further later)
Once one miner has come up with the correct solution, the block will be added to the chain of all the other blocks. This chain started with the very first block (otherwise known as the Genesis Block) and has been linked inextricably to every other subsequent block.
This is why it is called the blockchain- it is essentially just a chain of blocks.
When Abby sees that the transaction from Michael has been added to the chain, she can be pretty sure that Michael has not tampered with the transaction. This is because the whole Bitcoin network has done the work to prove that the transaction is valid. This concept is called Proof of Work.
As the transaction from Michael moves further down the chain, the probability that the transaction is valid becomes even stronger. For Michael to tamper with the transaction he would have to personally re-do the work for that block as well as all subsequent blocks, before the entire rest of the Bitcoin network can solve another block. This is completely infeasible and would cost millions of dollars in hardware and electricity. The expenditure that it would take for Michael to pull something like this off does not justify the theft. It is much more economically feasible for him to play by the rules.
Incentive for Miners
As mentioned above, in order to incentivise miners to do all this hard work, the miner who solves the mathematical problem is issued with brand new Bitcoin. When Bitcoin first started, the lucky miner who solved the problem was issued 50 new Bitcoin (worth about $680,000 at today’s exchange rate). However this reward halves approximately every 4 years, and the reward is now 12.5 Bitcoin for every problem solved (worth about $170,000 at today’s exchange rate). As you can see this is a substantial reward but it also costs a lot of money in the form of hardware and electricity in order to compete with the rest of the community and try win the prize.
And that, my friends, is essentially the blockchain in a nutshell
This article has really just scratched the surface, but it is my hope that I have delivered the kind of ‘1+1=2’ explanation that will inspire people to look more deeply into this technology.
As we enter into the 2018 year, it feels to me like the world is approaching a new era. The blockchain era. How long will it take to become fully embedded in society? I am not sure. But the wheels are definitely in motion.
The internet has allowed us to share our information with the world, while the blockchain has allowed us to securely transfer value with anyone in the world. Together, these two elements offer us the potential to become a seamless worldwide network. As with any innovative technology, the blockchain will face speed bumps along the path to adoption. But I’ve got no doubt that we, as a global community, will be able to navigate those speed bumps with aplomb, and in the process make the world a more connected place.
