Understanding Bitcoin (and Blockchain) through Board Games
Since you are here, I would assume you have at least heard about Bitcoin, the most common name in the rapidly growing Blockchain based cryptocurrency market. Already overwhelmed with fancy sounding technical words? You are not alone. The objective of this blog post is to explain the fundamental principles of the Blockchain, with Bitcoin as an example use case.
This is somewhat of a long read ahead, and you might wonder why you should care. The Bitcoin price, as evidenced in the chart below, should give you enough reason. $1 invested in Bitcoin 7 years back would be worth nearly $8700 today. While there are debates around speculative investment and bubbles in relation to Bitcoin, it’s still worth understanding what a Bitcoin is and how does the underlying Blockchain technology work. Let’s dive in.
So…what really is Bitcoin (a simplified explanation)?
The board game Monopoly and its simple world can help us understand what a Bitcoin is and how it functions. We start with a fixed amount of overall Monopoly money, roll the dice, follow the rules, and transact using this ‘fake ‘money. (Don’t worry if you are not familiar with the game, you will still sail through as long as you can imagine people rolling dice and transacting with fake money for some amusement)
Assume there are only two players — you and me. Whenever I pay you, I give you my fake cash, physically. You can hold it, see it, feel it and verify the transaction. We don’t need a 3rd person to make the transaction. Once I give it to you, the fake money is yours and you can use it as you like in the game. I have no control over this money anymore. If there were four players instead of two, you could have used the money you received from me to transact with other players.
Now, let’s say that the two of us play this game online, say over Skype. We take pictures of our fake Monopoly money and agree to transact online by sending each other these pictures. These pictures of fake money are basically the digital equivalent of our paper-based fake money. Let’s call them fake digital money. Now, let’s say, I need to pay you $500 for a transaction during the game. I will send you a picture of my $500 note.
I suspect the inability to physically touch and feel the money makes you a little skeptical. And rightly so. What if I made a couple of copies of the fake digital money? If all it entails is copy-pasting a few images, I can make as many copies of the Monopoly money without you finding out.
Now, you cannot be sure if you are the sole owner of the digital money I sent you. What if there were four people playing this game online? I could be sending multiple copies of my same $500 picture to all the players.
Something does not sound right. When transactions move from the physical realm to the digital realm, we need some system to keep track of currency exchanged. We could do this by appointing a monopoly banker. This person is responsible for keeping track of each digital money exchange.
Now, I cannot get away with using duplicate digital copies of the currency I own. If I send multiple copies of the same $500 picture, the monopoly banker will invalidate the transaction. The banker knows how much money I have, whom I transacted with, and for what amount.
This is better, but problems still persist. Three in particular:
· How do we trust this monopoly banker? What if he is not accurate with record keeping? What if I bribe him to counterfeit transactions? Or what if I hack his operations?
· What if the number of players increases — say from 4 to 20? Do we think the banker would be able to keep with all transaction flows accurately? Even if he is accurate, could he do it as quickly? Would he start charging fees for each transaction processed?
· This doesn’t feel the same as when you and I were playing monopoly with paper money. The transaction was between you and me. Life was simpler. Now Mr. Banker is involved and is bossing around over my own money. He takes forever to settle balances. It takes a long time for me to move my own money and worse, the banker might now charge me fees for it. Not cool.
You may have already realized by now, but most of the transactions we do over digital bank accounts are like the transactions in the digital Monopoly world described above. Our banking system stands between two parties as the trust-bearer of the transactions. The correct functioning of the system is based on the premise of trusting the intermediary. While this system certainly works, even with real-world banks, we face issues like transaction charges and long processing times, especially for cross-border payments.
So, the question really is… how do we solve this? How about… we make a protected google sheet file for our online monopoly game?
Let’s call this Excel file a digital ledger. Every time anybody needs to transact, they will have to record the exchange of digital money in the ledger. We set up the Excel such that it shows a real-time record of everyone’s overall balance of money. Further, once a transaction has been entered into the Excel cell, it is locked and cannot be changed!
Now, this digital ledger keeps track of all transactions and balances for each player. And since everyone has a copy of the ledger, it’s hard to cheat now. If now I try to send you pictures of fake $500 I do not own, it won’t sync with everyone’s copy of the digital ledger. All the transaction that happen, throughout our online monopoly game, will be recorded in the digital ledger for everyone to see. The transaction is now back to one-on-one (as compared to involving a banker) and hopefully will be much faster (and cheaper).
Now, once I give you my digital money, it’s yours. The ledger keeps track of it. Let us assume that the ledger is protected such that it takes enormous computing power to override other transactions, thus making is practically impossible. Everyone who has a copy of the ledger has a record of it. Plus, the digital ledger is not controlled by one person, so no one can distort or cheat or mismanage. No one controls the ledger, thus creating a perfect decentralized ecosystem. It’s a ledger of the user’s transaction, created by the users and for the users.
Now it feels like we are back to a transaction mechanism similar to paper-based transactions. But its digital! Hence, its faster, cheaper and easier. I can now play monopoly with you from across the world and 500 friends and family members can join us (assuming there was a version of the game with more players).
The system we put in place above is a simplified version of a Blockchain. In the Blockchain world, the $500 bills are replaced by Bitcoins/cryptocurrency. And the rules of maintaining the digital ledger and making sure it all checks out is the simplified version of Bitcoin protocol.
Bitcoin today can be bought using regular currencies. In other words, people who buy Bitcoin exchange their real-world money for digital money. People who transact using Bitcoin are exchanging this digital currency, and each transaction is recorded on a publicly available, secure and unchangeable digital ledger. There are a bunch of people called “miners” who help maintain the ledger in exchange for a very very small fee. Anyone who is willing to spend some computing power and time can become a “miner”.
No bank or debit card company or digital wallet is involved. It is a transaction of currency between two parties who agree on the amount of digital money they need to exchange and agree to abide by the rules of exchange. The exchange happens online and is recorded on the public ledger (Blockchain) based on predetermined rules of transaction recording (protocol) and everyone who is transacting this way has an up-to-date copy of this ledger.
The benefits of Bitcoin
· Faster transactions: By taking out middle-men such as banks, payment gateways, and e-wallets in transactions, we speed up the transactions dramatically. An international wire transfer can take a couple of days to clear. The settlement of a financial market contract such as a bond, or a stock option usually takes 2 days to clear). With Bitcoin, similar transactions can be done in seconds.
· Cheaper transactions: Since we don’t need middlemen, we can get away from hefty transaction processing charges on merchant sites. Bitcoin transaction fees are minimal and even free in some cases.
· Better security and privacy: Every time we make payments via online payment gateways (such as when you are paying using your MasterCard or Visa credit/debit cards), we give away our account details, phone number, email address and even physical address. This information can be stolen and that is why there are so many illegal credit card transactions or bank frauds. Worse, imagine losing your wallet and struggling to block your card before someone takes a bite out of your moolah. Bitcoins provide a much more secure way to transact if you keep your passwords secure. Further, sometimes we don’t want people knowing what we purchased or our net worth. With Bitcoin, your personal identity and wealth are safe and hidden. People in your Bitcoin network only know that the transaction happened between two digital addresses and nothing more. These addresses cannot be traced back to the individual unless the individual decides to convert the cryptocurrency back into Fiat currency like US Dollar through traditional banking systems. Your digital address is usually a highly encrypted and cryptographically secure alphanumeric code (say vQq8YQTEqcTmW7dfBNuFwgdCD). And no one knows who this code belongs too.
· No Charge-back: Bitcoin transactions are irreversible. Once you have bought it or sold it, it’s done, you cannot reverse the transaction like you have the option to with credit cards. This is a great benefit for merchants who often face charge-backs on goods sold to customers from credit card companies.
The risks of Bitcoin
· Volatility, volatility and more volatility: Value of Bitcoins fluctuate, like the value of any currency. The problem is, Bitcoin prices swing far more widely as compared to any other asset class in the world.
So, while the historical returns of Bitcoins have been huge, the risks have been unprecedented. In the graph below, I have compared the historical volatility of Bitcoin, Equity Benchmark (S&P 500), and Gold (SPDR Gold). You can see the wild fluctuations in Bitcoin prices. Even during the recent periods of rising Bitcoin prices, it has been up to 14x as volatile as S&P 500 and 6x as volatile as Gold.
· Regulatory uncertainty: The Bitcoin market is still growing. Naturally, the regulators are concerned about the functionality, robustness, and transparency of this new currency and the underlying infrastructure. There is little know-how among regular consumers. Regulators are also concerned about massive speculative investments blowing up in users’ faces. How Bitcoin and Blockchain will be regulated is unclear. Some countries like Japan have officially recognized crypto exchanges, while others have banned it.
· Few (but a rising number of) payment outlets: The number of merchants accepting Bitcoin payments is very small but rapidly growing. A lot of payment services have started to offer transactions using Bitcoin. Established companies like Stripe and Square offer payments via Bitcoin.
As of now, most Bitcoin transactions are speculative. This may or may not change in the future depending on the ecosystem around cryptocurrency and the related regulatory environment. But the Blockchain technology (on which Bitcoin is based) has the potential to transform the technological landscape, decentralize services, and displace technology giants.
Get the popcorn ready… this movie just got exciting!
Originally published at medium.com on November 21, 2017.
