What problem does blockchain & crypto solve?
Times they are a-changing…
This song title by Bob Dylan (1965) is most certainly true of the last couple of years.
Blockchain and crypto — when compared to the adoption of the internet or the mobile phone — is the fastest growing phenomenon in the history of humankind. It took 7.5 years for internet users to grow from 130m to 1B, and for 1B active bitcoin users projected in 2025… only 4 years.
In this series of articles, I will help to demystify blockchain and crypto. We’ll cover the what, why, how, who and when. I’ll start with some basic concepts that underpin the whole ecosystem and over the course of the series we’ll dive into the details. I hope to give you a deeper understanding of blockchain and crypto and empower you to have an informed opinion.
So let’s begin… at the end. A means to an end…
What problem does blockchain solve?
We live in a world where we can’t or don’t want to trust other people
- are unidentifiable, and/or
- behave inconsistently, and/or
- seek to harm us or our society
How can we operate in such a trust-less environment? We need a way to decide on actions, and have those actions carried out according to our wishes.
What solution does blockchain offer?
Blockchain provides a decentralised consensus mechanism in a trust-less environment.
A blockchain is a tool that allows us to reach agreement between parties that don’t trust each other. These parties agree to participate in the consensus of the majority, and hence — even though we don’t trust any individual — we trust the majority (51%)to act in the interest of the population.
Consensus is reached by voting and peer-validation. As soon as 51% of participants agree on a state, it is accepted by the chain, any future state will build on the current accepted state.
In a future article I’ll write more about the Byzantine Generals Problem. For the moment it should be sufficient for you to know that blockchain provides a way for you to operate in an ecosystem where, even though you don’t trust any individual, you can trust the ecosystem to behave in a predictable manner.
What makes a blockchain decentralised?
Consensus is achieved by a majority vote of the participants, so having more participants decreases the risk of malicious actions.
To participate in the operation of a blockchain we need to run a node. The number of unique participants in a blockchain determine how decentralised it is, so the more nodes in the ecosystem, the more stable the system becomes.
The decentralised consensus is in stark contrast with centralised forms of consensus such as governments, central banks or even corporations.
How does blockchain work?
A blockchain — also called a decentralised ledger — as the name suggests, is a chain of blocks.
Blocks containing data are like pages in a ledger. The blocks are created in sequence and each block refers to the previous block, hence creating a chain.
The creation of a new block is done by agreement of majority of the participants.
Any bad actor would need to control 50+% of the voting rights in order to corrupt the system. Hence a blockchain with more nodes, operated by more individuals, is more secure.
The resulting blockchain is a ledger containing data that can be trusted, even though we don’t trust individual actors in the ecosystem.
What problem does cryptocurrency solve?
Crypto tokens or coins provide an ownership mechanism in a trust-less environment*.
As I mentioned above, the blockchain provides consensus over what data is written into a block. In the case of a crypto token, we specify the data on the ledger will be “account balances and transfers” (ownership).
We have not yet decided what asset ownership should be recorded… we could track ownership of any asset, physical or digital. E.g. we could record ownership of a property, or in the case of cryptocurrency, we record ownership of a digital currency.
A cryptocurrency uses a blockchain to record ownership of a token, e.g. account 234 owns 1 token. The cryptocurrency also allows trusted transfer of ownership, e.g. account 234 sends 0.25 token to account 456. All accounts and transactions are visible on the blockchain, so we can read the blockchain to determine the account balance or account history.
Anyone with the account address and password can control the account — the blockchain does not store details of account ownership. It’s important to note the account ownership can’t be changed without the owner’s participation (as long as you keep your password secure!)
* technically we should refer to “distributed trust environment”
How do we value a cryptocurrency?
The value [of something] is defined by trust, scarcity, utility and network affect.
- Trust — is the system safe to use and predictable?
- Scarcity — supply vs. demand: do we know the scarcity and is it stable?
- Utility — how will the item be used? store of value, [easy] means of exchange. Can it be bartered for other items?
- Network — is there a vibrant community supporting the [value of] item. Does the item have an accessible marketplace?
The value of a cryptocurrency is determined using the same criteria. While an individual token is simply code on a blockchain, this gives us trust, scarcity & utility. And when a token’s network reaches critical mass, the peer-group decides on value collectively.
Broadening the network to include a marketplace further enhances the value of the token.
How do I manage my cryptocurrency?
Token (coin) ownership is recorded against an account on a blockchain. An account is made up of the account address and a [very secure] password. All accounts are visible on the blockchain.
We can keep our account details in a wallet — a tool that allows easy interaction with a blockchain. A wallet can (should!) also have a secure password. Inside the wallet you add your account address and password to connect the wallet to the blockchain. If you lose your wallet it is possible to recreate the wallet by adding the account and password again.
You can send money from one account to any other account using your wallet. Simply enter the from and to address, and then approve the payment. You can also send tokens to a marketplace if you’re converting from one token to another.
Sites accepting crypto payments will ask you to link your wallet to their payment process.
Please note: Centralised exchanges (Coinbase, Kraken, Crypto.com et al.) hold your crypto in their wallets, on your behalf. In this case you don’t have full custody over your crypto. (I will discuss custody in a future article).
Is it safe and legal to use cryptocurrencies?
In general it is safe to use cryptocurrencies as long as you take some precautions. In some ways it can be safer to have your money in crypto rather than cash or in an account with a bank. One of the main benefits of crypto is the safe portability. In contrast, it is exponentially more difficult to move gold…!
Crypto can be stolen if someone has access to your password (computer virus or hack) or someone could trick you into revealing your password. Remember, if your crypto is gone it’s unlikely it can be retrieved. There is no central helpdesk — so we need to be vigilant and alert to the risks.
Cryptocurrencies are legal in almost all countries. El Salvador recently adopted bitcoin as legal tender alongside the US Dollar and the Colón. While China recently banned the use of all digital currencies, they did not make it illegal to hold crypto. And many countries actively support the adoption of crypto.
Some governments are considering Central Bank Digital Currencies (CBDC). Of course, these CBDCs will be controlled centrally, and hence not be decentralised. (In a future article I will dive into the detail of the role of decentralisation can play in the hedge against inflation).
What are the fees for using cryptocurrency?
Node operators (also called miners or validators) need an incentive to keep their nodes running.
This incentive is granted as follows:
- the miners have a raffle* to decide a winner
- the winner gets to write the next block to the blockchain
- in addition to all the data for the block, the winner adds 1 additional transaction — they can award some token to themselves
- the additional token can be funded from a central pot (inflation!) or subtracted as a mining fee from all the other transactions in the block
In short, we pay the miners a fee when we send a transaction. This fee can vary depending on:
- the time per block (~10 mins for Bitcoin, ~1 min for Ethereum), and
- the number of transactions in the block
Recently (Sep 2021), the average transaction fee for Bitcoin and Ethereum was around USD$2.50. By comparison, Cardano’s average fee per transaction is around USD$0.48 and Solana is USD$0.0001- $0.00025.
Bear in mind that fees are also charged during onramp / offramp. I.e. where we convert from GBP/USD/EUR to crypto and back. I have seen exchange fees of up to 10% especially for coins that are not [yet] popular…
* this is an over-simplification, see the next para for more details
Environmental cost of cryptocurrencies
There is a concern that crypto has a huge environmental cost. This stems from the method used by miners to award the right to write the next block.
proof-of-work vs proof-of-stake vs proof-of-time
Proof of work (POW)
For Bitcoin and Ethereum, the miners have a competition to decide who can write the next block. In the competition, each node must guess the answer to a mathematically difficult task — hence proof-of-work, the miner has proved they did some work. The miner that guesses the correct answer first is awarded the right to create the next block.
It stands to reason those miners with more powerful computers get a better chance of guessing the answer. This drives an arms race to accumulate more computing power, which has an environmental cost.
Proof of stake (POS)
An alternative consensus protocol uses proof-of-stake (e.g. Cardano and Solana). Each staker (also known as validator) locks away some tokens that are allocated proportionate voting rights — like the raffle analogy. The raffle process decides which staker can write the next block, and this does not require huge computing power.
POS protocols are said to reduce blockchain energy consumption by up to 99%, which is a huge benefit to the environmental — and the sustainability of crypto.
POS is not without criticism as it favours stakers with most capital. Remember, the health of a blockchain depends on decentralisation, and hence large stakers could affect a small crypto by controlling more than 51% of the voting rights. I’ll leave the discussion of POS vs POW for a future article where we can really get into the details.
Proof of time (POT)
Solana adopted a mechanism called proof-of-time. Their solution uses an algorithm to determine the exact timestamp of each transaction. The accuracy of the timestamp means we can [almost] do away with blocks… the energy requirement for Solana is slightly higher than simple POS. However the transaction costs are miniscule and the shorter block time allows for a very high transaction per second.
* I am a huge fan of Solana and I’ll dedicate a future article to their solution
You should now have a basic understanding of blockchain and cryptocurrencies. We’ve seen that:
- blockchain provides decentralised consensus
- cryptocurrency provides decentralised ownership
- miners/stakers write blocks to the blockchain
- we use wallets to manage accounts and transactions
- the transaction fee incentivises the miners/stakers
Over the series I’ll be diving into more detail on the various topics in this exiting ecosystem. Still to come, commentary on:
- individual crypto tokens, strengths and weaknesses
- ownership, trading and exchanges
- custody & storage
- The business of crypto and DeFi
- The future of crypto
- What is the metaverse?
- And so much more…
I’m glad to have you onboard as we explore the cryptosphere together. Let me know in the comments which topics we should cover next.
PS: if you enjoyed the article be sure to follow me here or on twitter for future updates!