Two Things You MUST understand about Blockchain & Crypto

Blockchain is such a vast topic and there is much written on it. So, in this article, I want to cut the jargon and keep it simple. The purpose of this article is to help the readers bust two myths:

1. Blockchain in not bitcoin

2. Cryptocurrencies are not currencies

What is Money, if not just a Medium of Exchange

Like any story starts with a prelude. Ours will too. Before we start discussion on Bitcoin & Blockchain, let’s understand what money is. Until 1861, Gold coins were used as a medium of exchange, as we thought it was an incorruptible metal, could not be created & had limited supply. We considered it to be of great value & pegged the value of every other resource & service to it.

Then in 1861, United States printed its first paper currency, which was backed by gold. Now instead of carrying bags of gold, you could carry these paper notes which represented the value of gold backing it. It created Gold Standard.

A 100 years later, in 1976, the Gold Standard ended, and the paper money was decoupled from Gold. Shortly after this, investors lost faith in the global monetary system & fled all paper currencies during 1978 to 1980. Gold saw its biggest rally ever. The situation is not much different today. Whenever, there is pressure on monetary systems, currencies devalue & gold appreciates.

This brings me to my first point. In today’s fractional banking system, where bank holds only 3% of deposits, there is no real asset backing a paper currency. Its value is only as good as what we collectively believe it to be. At its core, it is just a medium of exchange.

My second point is why do we really need banks. Above everything else their core function is to act as a Trusted Third Party which keeps a record of how much paper money we have and maintains a trusted ledger of all our transactions to avoid any disputes. We generally believe that banks are safe, but they are not. If tomorrow, there are no deposits & 10% withdrawals, there will be a run on the bank & you’ll lose your money.

Can we replace money with a digital currency without a bank?

Let’s say there is a group of people called Satoshi, who lose faith in central banks & paper currencies during the financial crisis of 2008. They decide to create their own currency, a digital gold of sorts, which has limited supply, which cannot be faked & which is generated in a manner that is deflationary. In addition, they decide to maintain the record of transaction on their own.

To accomplish this at scale, they use three innovations from the field of mathematics & computing:

a) Hashcash

b) Public Key Cryptography

c) Distributed ledger

Hashcash: Hashcash was invented in 1997. It’s basically a hashing algorithm that takes any data & converts it into an “acceptable” hash. If you change even a single character in the input data, the hash will completely change. It requires a lot of computation power to create this “acceptable” hash but very little to verify it. To create a tamper-proof ledger, you take a block of transactions, let’s say block 1, create an ‘acceptable’ hash of it, and circulate this hash over the network for everyone to verify. Everyone verifies & the hash is confirmed. Now this hash becomes header of Block 2, which has new set of transactions. This block is hashed again, and its hash becomes the header of block 3 and so on. This creates a blockchain, which resides with everybody.

Hashcash creates consensus, meaning that if everyone has the same hash for latest block, then the entire blockchain is kosher. It also makes blockchain immutable, meaning you cannot change the data in old blocks because then you will have different hash of the latest block & it will not match with the consensus.

Hashcash makes blockchain encrypted, immutable & consensual.

Public Key Cryptography: Let’s say person A wants to send a confidential message to person B. To do this, we provide each of these guys with a unique pair of public & private keys. This is similar to having an email id & password. Person A uses his private key to digitally sign his message and encrypts the whole message using the public key of person B. Person B uses his private key to decrypt the message and uses the public key of Person A to verify his digital signatures. This ensures that the message can only originate from Person A and can only be seen by Person B.

Blockchain uses this to authenticate the identity of the parties involved in the transaction. This removes the risk of impersonification. You cannot fake signatures anymore.

Distributed Ledgers: There are 3 kinds of databases — centralized, decentralized & distributed. In centralized systems, all information is stored on one system and everyone connects to that system to retrieve information. This is like streaming from Netflix. If that system goes down all information is lost. In a decentralized system, different pieces of information are stored on different nodes/servers. If one node is down, that particular piece of information gets lost. This is like using internet. In a distributed system, all the information or parts of information are stored on several nodes and each node is connected to each other in a peer-to-peer network, which creates data redundancy.

For example, let’s assume that the world has 10 pieces of information. Some nodes will have all 10 pieces stored, some will have 1,2,3, some will have 3,6,7, some will have 6,7,8 & so on. This creates redundancy in the system. If one node goes down, you can retrieve the same information from another node.

Blockchain uses decentralized database architecture to create a “Trustless” network and remove the risk of a single point of failure.

You combine these three innovations and you have a digital currency whose transactions can be verified & stored in a manner which is immutable, trustless, consensual & cannot be faked. All this without the need of a bank. This digital currency as we know it is bitcoin.

The only problem is how do you incentivize people to use their computers to maintain consensus & store blockchain. Well, every time, they confirm a block of transactions, blockchain generates new bitcoins and gives it to them. Now this of course happens in a pre-defined deflationary manner, but this is how bitcoins are generated and people are incentivized to keep the blockchain running.

Blockchain is not just about digital currencies

As the blockchain community grows, let’s say there is a person, called Vitalik, who realizes that money is not the only thing that we exchange & keep a record of. There are several actions that we take which require a trusted third party to act as a middleman. Consider renting a house. You have to register your agreement, so there is a registrar involved; you have to transfer money, so there are banks involved; you have to submit identity proofs, so there are several government agencies involved; you have to get an NOC, so there is a housing society involved; you deduct TDS on rent, so there are tax authorities involved & so on.

But why do we need so many third parties? In essence, all they do is make sure that the act of renting is happening as per prescribed rules & that they are maintaining a record of all such actions.

So Vitalik says why don’t we use the bitcoin system that we created, but instead of recording transaction in the ledger, we record “executable actions”. And let’s make these actions programmable, meaning you can create customized rules for these executable actions depending on the use-case. These were called smart contracts. Once you have them in place, all actions are enforced, overseen & recorded without any third party. That’s how Ethereum was born.

But more important, this is when people realized that Bitcoin is just one application of blockchain and blockchain as an architecture can be used for innumerable applications, not just a digital currency.

Cryptocurrencies are not currencies, but then why do we need them?

After Ethereum, the crypto community got super-excited. They started working on several projects and the community flourished. Now in this community, let’s say there is a guy called Juan Benet who has a massive amount of data to store. There are two problems: a) data storage costs are high; and b) he doesn’t want to store his data at one place for the risk of losing it. He notices that there are several other people who have the same issue. He also notices that there are millions of people in the world who have extra storage space which they never use.

So he creates a blockchain based protocol called Interplanetary File System or IPFS and he goes to people with extra storage space, let’s call them A,B &C, and tells them that if you store our data as per the rules defined in this protocol, the protocol will generate a token called filecoin which will be given to you. In addition, you will receive filecoins from the users who want to store data in your storage space.

B agrees. But A&C refuse, as they think filecoin has no value today. But Juan wants all A, B & C in the network to create a critical level of storage space. So, he does something interesting. He pre-mines some filecoins, goes out in the market and offers them to anyone who can see their demand increasing in the future. Now clearly people who want to use this storage system buy a lot of these filecoins. But some of the investors who see a high demand for decentralized storage systems also buy these filecoins. As a result, Juan ends up selling $250m worth of filecoins & in doing so, he establishes two things:

1) Filecoin is now worth $5, so all A, B, C are now ready to provide their storage space. Juan has effectively jump-started the network

2) Filecoin has become a commodity whose value is now pegged to its utility & future demand

This is an example of a successful ICO or Initial Coin Offering. ICOs, if done correctly, can jump-start networks & create value for everyone.

The image below rightly captures the science behind jump-starting a network. In a traditional model, one had to spend money to get users to attract more users. In a crypto world, the users are attracted by providing them a financial utility.

This also establishes the fact that Cryptocurrency is a misnomer. 95% of cryptocurrencies are utility tokens. They are like commodities with fixed supply whose value depend upon their utility. And just like real world commodities, there are several secondary markets called Crypto Exchanges, where these tokens trade real time with significant volumes. So, while we may be 30 years away from a Utopian blockchain world, people can still make a lot of money by participating in these blockchain networks & earning tokens. And that is why we have 1000s of blockchain projects today, disrupting almost everything as we know it.

So, what have we learned today?

We have learned that Blockchain is not just bitcoin. Blockchain is an architecture which uses advanced mathematical & computational concepts to create a Trustless Decentralized Network. Using this architecture, people have created various kinds of application-based protocols. These protocols are commonly referred as blockchains & this is where most of the investor money has gone across the globe. Most of these protocols have a native utility token. It is not a currency. It is a commodity whose value depends upon it’s utility which in turn depends upon the adoption of that protocol. So, cryptocurrencies are not currencies. They are an innovative way of monetizing the protocols & incentivizing the community.