Bitcoins and Blockchains for Mums and Dads: Part 2 — Delving into Blockchain

If you haven’t read part 1 of this series, you can find it here. I promise that very little of this will make sense until you have a good understanding of the basic concepts, so I would strongly advise you to read that first before you move onto this!

Why all the rave?

We now know that Blockchain is a digital accounting ledger that automatically tracks all of the transactions of a currency. The ledger also verifies transactions (more on this later), enabling the creation of purely digital currencies. Although this automation sounds great, it fails to explain writers’ claims that Blockchain may “change the world economy” or be “the greatest shift in technology since the internet”. We must therefore explain more characteristics of this ledger to highlight why this technology is, in the eyes of many, world changing.

A new level of safety

Blockchain ledgers store data about transactions and this data is stored in the public domain — it is accessible from any computer through the internet. Some of the many advantages of this system include the ability to take control of your own data (rather than hand it over to institutions), and the potential for great safety as everyone has similar incentives to protect the validity of the data. Until recently, publicly stored data would be regarded as more of a joke than a world changing system. Imagine if all of Facebook’s collected data was publically available, they would have no business model! Or even worse, if all of your bank transactions could be easily found online, privacy and surprise would be dead!

Blockchain technology has overcome these issues with two key breakthroughs — cryptography (i.e. encryption — similar to how nations encrypted tactical messages during the World Wars to hide information from the other side) and an ingenious verification system.

Let us start with the verification system. When transactions of a digital currency (for example Bitcoin) are attempted, they are automatically sent to the blockchain. A collection of transactions make up a block and computers verify these blocks, rather than the individual transactions*. Looking at this non-technically, the verification system has three key parts. First, the transaction is checked against the ledger to ensure that there is not a double spending issue. Second, a tough mathematical problem is solved by a computer. This requires lots of computing power and thus deters hackers from trying traditional attacks on digital networks**. Finally, public agreement must be reached, which allows for trustless consensus across the network about the true ledger.

Public consensus allows all users of a currency to be working on the same digital ledger and removes the need for trust between individuals and trust in institutions to store our transaction history. In a blockchain, all verifiers and users agree that the longest ledger (in terms of validated transactions) is the true ledger. This system works brilliantly because it means that hackers who create false transactions must verify them and add them to the blockchain quicker than all the other verifiers on the network combined. Only this can make the false ledger become accepted publically.

As an example let us consider this system in a traditional business. Assume a business believes the longest ledger of their transactions is the true ledger. Then for an accountant to “hack” the system and pay himself or herself more money, they must work faster (i.e. add transactions quicker) than all the other accountants combined. If achieved, their ledger would become longer than the true ledger and the other accountants would come to agree this is the real ledger. However, working at this speed is almost impossible and thus the only possible way to “hack” the system would be to convince over 50% of the accountants to work on this false ledger together. We can therefore see that the Blockchain has found a system that enables trustless consensus on the truth and which is much harder to hack than any previous digital datastore.

Publicity and privacy?

As we have seen, a public datastore using the blockchain enables a new level of safety to be reached online. However, we have not yet answered the other issue identified with public databases — why would you want everyone to be able to see all of your transaction data? This challenge is overcome through cryptography (the art of encrypting data).

The challenge we face is very similar to the challenge that an author using a pseudonym faces. They do not want their works to be publically attached to them, to avoid being in the public eye, but simultaneously they do not want others to be able to claim authorship of their work (or in our case, ownership of their money). In order to overcome this issue, the author could have a page at the back of the book that contains the data of who the author is, where they live and the answer to a key cliffhanger in the story, but written in code. In order to crack this code it would be necessary to have a key. Thus, if any dubious individual claimed authorship of the book, journalists, book stores and other interested parties could test their claim by asking them to crack the code and share the details in it. Assuming the true author kept their key a secret, no one else could ever successfully prove that they owned the rights to the book.

Blockchain uses exactly this system, called a dual key system. Every wallet has a public key, which you can share with someone else so that they can pay you. This is a bit like an email address, which you can share so people can email you. The wallet then also has a private key (a bit like a computer generated password), which can be used to decrypt transactions associated with that public key. Assuming you keep your private key a secret, each transaction will only make sense to the individuals involved in it, even though the ledger is completely public. We can have all the benefits of a public ledger (safety, no reliance on institutions, trustless consensus etc.) without having to give up our privacy!***

Automating transactions

As well as the aforementioned many benefits associated with Blockchain technology, there are also benefits from the movement of currency to a truly digital state. A digital currency, like all software, is built in computer code and can be introduced directly into other computer code and software. Consequently, transactions can be simplified, automated and modified through pre-determined logic, rather than working on a case by case basis.

The Ethereum Foundation, their associated blockchain ledger and digital currency (called Ether), are leading innovators in this space.**** Their major innovation comes through “Smart Contracts”. These are simply pieces of code that enable transactions of Ether (their digital currency) to occur under predetermined conditions, thereby automating large amounts of contractual obligation. For example, businesses could be built upon the Ethereum network that create contracts for building projects. Building projects tend to have long, complex contracts with payments split over time. Smart contracts could allow for payments to automatically complete when certain building milestones are hit, ensuring that trustless agreements can occur and reducing the number of expensive legal fights associated with contractual debate.

This is just one example of the benefits of a digital currency. Throughout the economy, digital currencies will enable us to cut out middlemen and ensure direct transactions between vendors and purchasers. Many agencies, law specialists, and others will face new competition from technical firms automating their roles through smart contracts and other innovations in transactions.

Broadening the definition of currency

However, this is just the beginning of smart transfers. Note how throughout this article, I have discussed how blockchain technology enables us to account for transactions, rather than just payments. This is because these digital “currencies” can actually represent anything — from chairs to health records, votes and more.

Blockchain technology allows for a new form of database to develop. It stores data about transactions in a safe and unalterable fashion. It may allow us to develop portals to vote online, enable businesses to track inventory item by item as it moves along the supply chain or allow smart appliances to speak to each other in an automatic and trackable way. This is why writers about the topic are so excited — the possible applications appear almost endless.

Let’s take a step back

I hope that it is starting to become clear why entrepreneurs, academics and large corporates are all extremely excited about the possibilities of blockchain technology. Everyday, writers rave about a new possibility springing up using this technology on a daily basis, and large corporations announce that they are building a blockchain.

I do not disagree with these thinkers, but I think it is important to remember that there are many issues that have not yet been addressed. Much of the writing in this space focuses on the possibilities rather than potential hurdles to overcome. We must not forget that successful technological breakthrough also requires changing regulation, rebalance of power and acceptance by the masses (not just the early adopters). There are many questions still unanswered. For example, scaling Bitcoin has led to complaints about its effect on the environment (due to the power needed to verify transactions), so can we really move to a single currency system? Moreover, how can you tax transactions between two parties for, say, a house if the money never passes to a centralised institution?

These are among the many questions that I will delve deeper into in future articles. The message here nevertheless stands strong — blockchain is a world changing technology. However, nothing can change the world without serious thought by regulatory, political and business leaders. These are the questions we must start to ask when analysing businesses working in this space*****.

(Once again, thank you Eleanor !!)

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* Computers that are setup to verify blocks are said to “mine” the blockchain. The owners of these computers are then rewarded for using their computing power to “mine” the blockchain by being paid in a digital currency when they successfully verify a block. This reward system is very similar to the traditional work of mining gold, but physical effort to earn pieces of gold is replaced with computing effort to earn pieces of currency.

** For the Bitcoin Blockchain, this is called Proof of Work. Proof of Work is important to the security and stability of a blockchain network, but can have scalability issues. Other alternatives are therefore being tested on newer currencies than Bitcoin. However, the key behind all of these is a tough maths problem that the mining computer must solve.

*** If you have seen the word cryptocurrencies being thrown around, you now understand why we call digital currencies based on a blockchain a cryptocurrency — all the transactions are encrypted! Technical people just love making extra jargon.

**** There are many other innovators who deserve mention here but for simplicity Ethereum is the popular name at the time of writing and is the second or third largest currency behind Bitcoin. For those not deeply involved in the space, it is thus a good area to appreciate.

***** At the time of writing, Iota (another digital currency focused on smart appliance transactions) has gone through a 70% increase in price in just 24 hours. The boom has come on the back of it’s announcement of partnerships with leading firms such as Microsoft and Fujitsu. This demonstrates that analysts understand the importance of Blockchain technologies integrating with existing market structures and businesses, rather than being made under an idealist vision where the world’s whole economic structure is changed.