On the Origin of Blockchains: Part IV

James Brodie
Jun 13 · 6 min read

The Genesis of Blockchain

A t this stage, it is worth taking some time to reflect on how the blockchain elements we’ve discussed so far in this series first emerged, in order to understand their limitations and why mutated elements have started to gain traction in other decentralised networks.

To do this, we must go back to 2008, when Satashi Nakamoto released the Bitcoin whitepaper that described a “Peer-to-Peer Electronic Cash System”.

It would be wrong to suggest that everything proposed in the Bitcoin whitepaper was entirely new.

The constitutive parts existed already but it was Satoshi Nakamoto’s genius that brought them all together to create Bitcoin. Money was blockchain’s first “killer app”.

Bitcoin was a convergence of technologies which when combined solved the double-spend problem without the need of a trusted authority or central server.

All of the component parts had previously existed; Secure cryptography hashing algorithms¹ in 1993, proof of work proposed by HashCash² in 1997, timestamped blocks³ in 1991, and even BitGold⁴ in 2005.

Emergence from the Primordial Soup

Bitcoin’s constitutive blockchain elements already existed, they just hadn’t been combined within a “species” yet.

Once combined, they created a species that was perfect for storing and transmitting value to other members of the same species. Bitcoin was the first trustless, permissionless, censorship-resistant, digital currency.

Drawn in by the correct incentive design, participants joined the network, attributing value to bitcoin and creating a widespread currency. Bitcoin had the right properties to create a digital form of money and, after ten years, it has grown to such an extent that its network effect will make it virtually impossible to displace. This is because Bitcoin is a protocol and not a company or application. It will always benefit from its first mover advantage.

Network Diversification

In part III of this series, I described how incentive mechanisms were analogous to growth factors in the biological world. Growth factors stimulate growth and encourage proliferation however they are also responsible for differentiation, and the same is true of these decentralised networks. An example of this is the human immune system where a stem cell is the precursor to all other types of immune cell.

Since the inception of the Bitcoin network, the difficulty of the cryptographic puzzle that rewards participants with bitcoins has increased. To solve it, participants now need to engage specialised hardware known as application-specific integrated circuits (ASICs) in order to mine. ASICs are microchips designed for a very specific use case.

Some network participants have access to additional environmental resources beyond hashpower, such as Fiat currency. These participants could engage in trades with other network participants, exchanging alternative environmental resources for bitcoin. With access to large quantities of environmental resources of value beyond hashpower, participants could downregulate their mining apparatus, whilst still participating in the network.

Participants with different roles and functions contribute to the overall health of the network. This mirrors what is observed in a bee hive or ant colony where members of the same species have different specialities and responsibilities, yet all are encoded within the same DNA.

Bitcoin’s Limitations

However, it’s worth remembering that Bitcoin does have limitations, especially in relation to privacy.

A common misconception is that Bitcoin is anonymous. This is simply not true as every transaction is registered on the blockchain for all to see. If your bitcoin address is attached to your real world identity, such as your email address, any anonymity is lost.

As a result of this limitation, other blockchain elements have emerged to address this issue of privacy, mostly at a transactional level. Networks that utilise these elements can expand into the fundamental niche opened by privacy.

Quite simply, there are regions of the money niche that cryptocurrencies other than Bitcoin are better adapted to because Bitcoin’s limitations extend beyond privacy.

  • Transaction output: In its pursuit of decentralisation, the Bitcoin protocol is very limited in terms of its transactional output (approx. 7 transactions per second) which will always be a source of high fees. Although second layer solutions are emerging (in the form of the Lightning Network) to address this, in its current form, bitcoin has not progressed from a store of value to a medium of exchange.
  • Security model: Proof of Work (PoW) is argued to be the optimum security model for a cryptocurrency. One reason proposed is that miners are forced to sell their bitcoin in order to cover capital expenditure. This prevents them from hoarding it and thereby forming a monopoly, which is a strong critique of Proof of Stake (PoS) systems. Nevertheless there are arguments against PoW, including but not limited to excess energy expenditure and the viability of a fee-based economy once the block rewards expire.

Informing ID Theory’s Investment Themes

Bitcoin demonstrated that a blockchain protocol was sufficient to create a cooperative and mutually beneficial decentralised network . This was very well suited to fill the money niche.

I believe it to be the hardest form of money that has ever been invented. As it matures, it will be recognised as a viable store of value and inhabit a large portion of money’s fundamental niche.

Base layer protocols such as Bitcoin, which have established a network effect, are unlikely to be displaced. This mirrors our use of internet protocols that were developed in the 70s, despite the availability of better protocols. In other words, Bitcoin is not going to be AltaVista’d or Myspace’d.

However, it should also not be forgotten that Bitcoin does not have good transaction capacity and is not a good medium of exchange. It primarily acts as a potential store of value and this leaves space for competition.

Another area of the money niche where Bitcoin could be out-competed is with regards to privacy. There are use cases whereby privacy is needed, and transaction data cannot be shared on an open readable ledger. Simply put, privacy coins will capture market share.

By identifying where Bitcoin’s limitations lie, it is possible to identify projects that may prosper where Bitcoin may fail. There are projects that are able to realise a portion of money’s fundamental niche that is unavailable to Bitcoin.

Continuing ‘On the Origins of Blockchains’

With four parts now complete, this series has laid the groundwork for understanding the potential of blockchain by outlining how blockchain elements (or genes) within a protocol can enable a decentralised network to dominate a fundamental niche.

In this piece, I looked at the example of Bitcoin and how it will increasingly be recognised as a dominant store of value. In the next piece, I will investigate the next generation of blockchains that have been enabled by smart contracts.


References:

[1] Secure Hash Standard, Federal Information Processing Standards Publication FIPS PUB 180, National Institute of Standards and Technology, 11 May 1993

[2] http://www.hashcash.org/papers/hashcash.pdf

[3] https://www.anf.es/pdf/Haber_Stornetta.pdf

[4] https://nakamotoinstitute.org/bit-gold/


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ID Theory

ID Theory is a a London-based long-term cryptoasset investment firm.

James Brodie

Written by

Chief Investment Officer at ID Theory

ID Theory

ID Theory

ID Theory is a a London-based long-term cryptoasset investment firm.