Contribution to the IAB Europe White Paper: Blockchain Demystified
You can access our case study here.
Section 2: The Crypto Dimension
Blockchain and cryptocurrency have distinct properties and features, and yet, they are intrinsically linked. The term ‘blockchain’ refers to the actual ledger of transactions while the term ‘cryptocurrency’ refers to the digital money used to transact in the blockchain. If we unpack both terms, we can see that the definitions are right there in the names. A blockchain constitutes blocks of data linked together in a chain, ‘block-chain’. Cryptocurrency is a currency that is secured by cryptography, ‘crypto-currency’.
Blockchains that require crypto vs. blockchains that do not
Some blockchains require a native cryptocurrency as part of their core protocols and others do not. For example, consortium (private) blockchains like Corda and Hyperledger do NOT require a cryptocurrency or “coin”. But, public blockchains like Bitcoin and Ethereum do. The reasons for this have to do with the incentives associated with how public blockchains arrive at consensus (how people come to agree on which version of the blockchain is the correct one). We will explain more on this later. But for now, it is enough to know that public blockchains require a native cryptocurrency as part of a larger security mechanism.
As previously described, the blockchain is the ledger that records all of the data. The data is made up of transactions which are subsequently bundled together in blocks. The blocks of data are cryptographically anchored to one another in a chain. This chain of cryptographically linked blocks of data is distributed to nodes. These nodes keep a copy of the blockchain and check the other nodes to make sure their copy is the same as everybody else’s. This is another way in which public blockchains stay secure and tamper resistant.
The blockchain also keeps all users account balances up to date so that if Alice sends 10 Bitcoins to Bob, everybody in the Bitcoin ecosystem knows about it and both Alice and Bob’s account balances accurately reflect this transaction. The state of every user and every transaction since the beginning of the blockchain's history is recorded on the ledger. This guarantees that nobody can game the system by spending crypto they don’t have.
But herein lies a dilemma. How are nodes in a public blockchain ecosystem properly incentivized to keep a copy of the blockchain and to check other nodes? And how are miners incentivized to bundle transactions into blocks and add them to the chain of previous blocks? The answer is cryptocurrency.
Cryptocurrency is the incentive mechanism that keeps public blockchains from falling apart. It is the glue that binds the system together. Without cryptocurrency, there would be no material reason for miners to bundle transactions into blocks and add them to the chain. This is because the Proof-of-Work consensus algorithm public blockchains like Bitcoin and Ethereum currently rely on is purposefully energy intensive. In other words, it is designed so that miners must use hardware devices that consume electricity to engage in the process of adding new blocks to the chain, and this means they incur costs.
To offset these costs and to even make it a profitable enterprise, when miners successfully add a block to the chain newly minted cryptocurrency is awarded to them by the core protocol. In the case of the Bitcoin blockchain, miners are awarded Bitcoin for each new block they add. In the case of the Ethereum blockchain, they are awarded Ether (Ether is also used to pay gas fees that correlate to the number of computational steps required to execute a smart contract or send a transaction).
Bitcoin and Ether are both cryptocurrencies that are native to their respective blockchains. The term ‘native’ implies they serve a specific function defined by and native to the core blockchain protocol. Bitcoin and Ether cannot be created in any way other then what is defined by the protocol rules, and the rules state that Bitcoin and Ether are created and awarded to a miner if and only if the miner successfully adds a new block to the chain. In the Bitcoin blockchain, no other cryptocurrency besides Bitcoin will ever be issued to miners and the same goes for Ethereum miners and Ether.
Bitcoin and Ether are introduced into the market by miners and the cryptocurrency can then be acquired by everyday people to be used as a store of value, medium of exchange, and unit of account. In fact, all digital currencies can be used in this way, but some are better suited than others, depending on the use case. For example, the digital currency, DAI, is a stablecoin that is pegged to the US dollar and so it is well-suited as a payment method for services rendered. Whereas Bitcoin in recent years has become (in most cases) an investment strategy akin to digital gold.
Now that we have discussed cryptocurrencies like Bitcoin and Ethereum that are instrumental to the core protocol and provide the necessary incentives to keep public blockchains secure, let’s take a look at alternative cryptocurrencies more commonly referred to as “tokens”.
The difference between tokens and cryptocurrencies
Tokens such as TRON, ZRX, BAT, and ADT operate one layer removed from the core protocol layer on the public Ethereum blockchain. To analogize, tokens function in the ‘application layer’ of the blockchain. Tokens have nothing to do with keeping consensus, minting new crypto to reward miners, tracking account balances, validating transactions, or any of the low-level maintenance required to keep a public blockchain’s core functionality intact.
Developers of decentralized applications (Dapps) can write and deploy smart contracts to programmable blockchains like Ethereum that assign arbitrary functionality to tokens i.e. the tokens do something specific within the Dapp. Examples of these specifics include, but are not limited to; assigning reputation, granting voting rights, accruing gaming credits, storing digital collectibles, providing governance rights, paying dividends, etc. Tokens can even represent real-world assets such as a Picasso painting or real estate property.
To reiterate, the distinguishing features of tokens is that they can be programmatically assigned whatever value or use case the creator of the tokens decides, and they operate one layer removed from the core protocol layer of whatever blockchain they are built on top of.
On the contrary, cryptocurrencies such as Bitcoin and Ether are inherent to the low-level protocol and are only created as a means to reward miners that add new blocks to the chain. Once they are created, they enter the marketplace where ordinary people can acquire them.
Understanding the differences between blockchain and cryptocurrency is an important step on the path to becoming educated about the technology.
The key takeaways are that a blockchain denotes the ledger that stores all transaction history while cryptocurrency is the digital money that is being transacted.
Tokens and cryptocurrencies are similar insofar as they are both digital currencies, but tokens operate one layer removed from the core protocol while native cryptocurrencies are intertwined with the core protocol layer.
Tokens can be programmed to have arbitrary functionality and to work inside of decentralized applications (Dapps). The type of functionality is left to the discretion of the Dapp developer.
Section 6: What Lies in Store
Blockchain technology is making rapid advances on numerous fronts. Top researchers are working tirelessly to solve critical computer science problems that will usher in the next generation of high-transaction throughput, ultra-scalable, public blockchains.
In popular culture, the word “blockchain” is no longer associated with fringe societies operating in the dark corners of the web. It has officially entered the mainstream. Mass media outlets provide breaking news coverage about blockchains daily. Colleges and universities are offering blockchain curriculum. Even the famed CEO of JP Morgan, Jamie Dimon, who made headlines when he denounced Bitcoin as a “fraud” now says he “regrets saying that” close on the heels of the recent JPM Coin announcement.
Answering the question of what lies in store for the future of blockchain technology is really anyone’s guess. Could we have guessed how the Internet would turn out back in 1995? Although the technology is different, the underlying sentiment is one and the same. Many of us immersed in the blockchain space have the same feeling that those early Internet pioneers did, “something major is taking place, but exactly how it will shape up is not entirely clear.” With the benefit of hindsight, we can look back on the developments of the Internet and its linear progression. But those on the frontlines of the Internet were barely able to pop their heads up out of the trenches to survey the landscape before going heads down into their work. The same holds true for the blockchain frontier.
In terms of specific technological breakthroughs that we can look forward to seeing in the near future, solving the trilemma is the most pressing concern for public blockchains. It is where the most effort is being spent on the research and development front.
What is the trilemma for public blockchains?
The trilemma for public blockchains is that at any given time a public blockchain can only achieve at most two-out-of-three of the following properties; decentralization, security, and scalability. The trilemma accounts for why public blockchains like Bitcoin and Ethereum have such pitifully low transaction times (Ethereum handles 14 transactions per second and Bitcoin handles roughly 7).
Trade-offs can be made, for example, the EOSIO blockchain which maxed out around 4,000 transactions per second (TPS) uses a Delegated-Proof-of-Stake (DPoS) consensus algorithm that limits the number of block producing participants to just 21. EOSIO achieves scalability while maintaining security at the expense of sacrificing decentralization.
Overcoming the trilemma
The core developers of public blockchains like Ethereum, Cardano, and Polkadot realize that the only way to achieve mass adoption is by tackling and overcoming the trilemma and that is precisely what they are focused on. By altering the consensus algorithms, developing second layer scaling solutions, and making mission-critical updates to the computation layer, these blockchains aim to break out of the pretzel hold they are currently bound up in.
Ethereum’s transition from Proof-of-Work to Proof-of-Stake
A key part of the Ethereum roadmap is the transition from Proof-of-Work consensus algorithm to Proof-of-Stake (PoS). Proof-of-Stake secures the blockchain by allowing participants (validators) to lock up their native cryptocurrency (Ether) as a security deposit. This grants them the ability to validate transactions and submit new blocks to the chain. If they misbehave in any way, their security deposits are slashed or forfeited altogether. If they behave, then they are rewarded with new coins for adding a block to the chain. The benefits of Proof-of-Stake are faster block confirmation times, greater protection against 51% attacks, and a massive reduction in energy consumption. Ethereum plans to roll out PoS sometime in mid to late 2019. But development updates such as these have been known to get pushed back and so we’ll have to wait and see.
To mitigate issues around scalability, and to maintain security and decentralization, the Ethereum Foundation is working on a Sharding spec that will effectively break up the nodes that are responsible for validating transactions into “shards”. By tasking only a subset of nodes with the responsibility to validate only a subset of transactions, the blockchain can achieve greater transaction throughput. Currently, the Ethereum blockchain requires every node to process every transaction meaning the blockchain can only run as fast as the slowest node on the network. Sharding public blockchains may provide a way out of the scalability part of the trilemma.
Second layer solutions
Second layer solutions refer to reducing transaction wait times and fees through the use of technologies like State Channels, Lightning Network, or Plasma. These technologies allow users to transact with businesses or users repeatedly and in a closed secure environment without needing to pay costly transaction fees to miners for each individual transaction. Users only make use of the core blockchain layer or the first layer when it comes time for settlement which can be done in batches. An analogy often used to describe second layer payment channels is the bar tab. You open your tab at the beginning of the night and order as many drinks as you like. Only when it’s time to close out and go home do you officially get rung up for all of the transactions. There are clever ways to guarantee that nobody can skip out on the bill. If they do, then the counterparty can bring the proof of the previous transaction history to the blockchain for automated arbitration and dispute resolution.
As we can see, there are known problems with public blockchains but researchers are doing their best to come up with sophisticated ways to route around them. Solving the trilemma will be paramount for the future success and widespread adoption of public blockchains. First layer updates like Ethereum’s transition from Proof-of-Work to Proof-of-Stake and Sharding will play a critical role. But second layer solutions like State Channels and Lightning Network will reduce friction for users when they engage in applications that require consecutive transactions in fast order. Second layer solutions will prove especially useful for digital advertising where huge numbers of impressions must be processed in a secure environment. The core blockchain these payment channels are tethered to are always there as a backstop to prevent any fraudulent behavior. It really does become a ‘best of both worlds’ scenario.