What is Bitcoin?
To cut through some of the confusion surrounding bitcoin, we need to separate it into two components. On the one hand, you have bitcoin-the-token, a snippet of code that represents ownership of a digital concept – sort of like a virtual IOU. On the other hand, you have bitcoin-the-protocol, a distributed network that maintains a ledger of balances of bitcoin-the-token. Both are referred to as “bitcoin.”
The system enables payments to be sent between users without passing through a central authority, such as a bank or payment gateway. It is created and held electronically. Bitcoins aren’t printed, like dollars or euros – they’re produced by computers all around the world, using free software.
A pseudonymous software developer going by the name of Satoshi Nakamoto proposed bitcoin in 2008, as an electronic payment system based on mathematical proof. The idea was to produce a means of exchange, independent of any central authority, that could be transferred electronically in a secure, verifiable and immutable way.
It differs from fiat digital currencies in several important ways:
1 – Decentralization
Bitcoin’s most important characteristic is that it is decentralized. No single institution controls the bitcoin network. It is maintained by a group of volunteer coders, and run by an open network of dedicated computers spread around the world. This attracts individuals and groups that are uncomfortable with the control that banks or government institutions have over their money.
Bitcoin solves the “double spending problem” of electronic currencies (in which digital assets can easily be copied and re-used) through an ingenious combination of cryptography and economic incentives. In electronic fiat currencies, this function is fulfilled by banks, which gives them control over the traditional system. With bitcoin, the integrity of the transactions is maintained by a distributed and open network, owned by no-one.
2 – Limited supply
Fiat currencies (dollars, euros, yen, etc.) have an unlimited supply – central banks can issue as many as they want, and can attempt to manipulate a currency’s value relative to others. Holders of the currency (and especially citizens with little alternative) bear the cost.
With bitcoin, on the other hand, the supply is tightly controlled by the underlying algorithm. A small number of new bitcoins trickle out every hour, and will continue to do so at a diminishing rate until a maximum of 21 million has been reached. This makes bitcoin more attractive as an asset – in theory, if demand grows and the supply remains the same, the value will increase.
3 – Pseudonymity
While senders of traditional electronic payments are usually identified (for verification purposes, and to comply with anti-money laundering and other legislation), users of bitcoin in theory operate in semi-anonymity. Since there is no central “validator,” users do not need to identify themselves when sending bitcoin to another user. When a transaction request is submitted, the protocol checks all previous transactions to confirm that the sender has the necessary bitcoin as well as the authority to send them. The system does not need to know his or her identity.
In practice, each user is identified by the address of his or her wallet. Transactions can, with some effort, be tracked this way. Also, law enforcement has developed methods to identify users if necessary.
Furthermore, most exchanges are required by law to perform identity checks on their customers before they are allowed to buy or sell bitcoin, facilitating another way that bitcoin usage can be tracked. Since the network is transparent, the progress of a particular transaction is visible to all.
This makes bitcoin not an ideal currency for criminals, terrorists or money-launderers.
4 – Immutability
Bitcoin transactions cannot be reversed, unlike electronic fiat transactions.
This is because there is no central “adjudicator” that can say “ok, return the money.” If a transaction is recorded on the network, and if more than an hour has passed, it is impossible to modify.
While this may disquiet some, it does mean that any transaction on the bitcoin network cannot be tampered with.
5 – Divisibility
The smallest unit of a bitcoin is called a satoshi. It is one hundred millionth of a bitcoin (0.00000001) – at today’s prices, about one hundredth of a cent. This could conceivably enable microtransactions that traditional electronic money cannot.
Why Use Bitcoin?
Bitcoin was originally created as an alternative, decentralized payment method. Unlike international bank transfers at the time, it was low-cost and almost instantaneous. An added benefit for merchants (less so for users) was that it was irreversible, removing the threat of expensive charge-backs.
However, the improvement in domestic payment methods and the rapid development of alternative (non-cryptocurrency) forms of international transfers has reduced bitcoin’s advantage in this area, especially given its increasing fees and frequent network bottlenecks.
Furthermore, the increasing oversight and regulation to prevent money laundering and illegal transactions have restricted the cryptocurrency’s use for privacy reasons.
In some parts of the world, bitcoin is still a more efficient and cheaper way to transfer money across borders, and several remittance startups make use of this feature. Bitcoin’s cost and speed advantages, though, are being eroded as traditional channels improve (and the network’s fees continue to increase), and liquidity remains a problem in many countries.
Also, a number of large and small retailers accept the cryptocurrency as a form of payment, although reports suggest that demand for this function is not high.
And many individuals feel more comfortable holding a part of their wealth in securely-stored bitcoin, where a central authority cannot block access or take a cut.
Recently bitcoin seems to have assumed the role of investment asset, as traders, institutional investors and small savers have woken up to the potential gains from price appreciation.
According to some sources, bitcoin is increasingly being used for money laundering. But we know that you wouldn’t do that. And anyway, bitcoin is not, as is commonly believed, a good vehicle for money laundering, extorsion or terrorism financing, since it is both traceable and transparent – as a spate of recent arrests can attest.
Is Bitcoin Legal?
As the market capitalization of the cryptocurrency market shoots up, through price movements and a surge in new tokens, regulators around the world are stepping up the debate on oversight into the use and trading of digital assets.
This affects all cryptocurrencies, but especially bitcoin, given its market leadership and integration into the global startup ecosystem.
Very few countries have gone as far as to declare bitcoin illegal. That does not, however, mean that bitcoin is “legal tender” – so far, only Japan has gone as far as to give bitcoin that designation. However, just because something isn’t legal tender, does not mean that it cannot be used for payment – it just means that there are no protections for either the consumer or the merchant, and that its use as payment is completely discretionary.
Other jurisdictions are still mulling what steps to take. The approaches vary: some smaller nations such as Zimbabwe have few qualms about making brash pronouncements casting doubts on bitcoin’s legality. Larger institutions, such as the European Commission, recognize the need for dialogue and deliberation, while the European Central Bank (ECB) believes that cryptocurrencies are not yet mature enough for regulation (although with bitcoin almost 10 years old, one is left wondering when we will know it has reached sufficient maturity). In the United States, the issue is complicated further by the fractured regulatory map – who would do the legislating, the federal government or individual states?
Below is a brief summary of pronouncements made by certain countries. This list is updated monthly.
In October 2017, the Australian Senate began debating a bill that would apply anti-money laundering statutes to the country’s cryptocurrency exchanges, as well as mandate criminal charges for exchanges that operate without a license.
That same month, the tax authorities removed the “double taxation” of bitcoin, which was a result of a decision in 2014 to treat the cryptocurrency as a “bartered good” rather than a currency or asset.
As of the end of 2017, cryptocurrency exchanges have to register with the country’s financial intelligence agency Austrac, and comply with customer verification and record preservation requirements.
Further moves are unlikely for now, however, as officials from the central bank recently said that regulation is not needed for the use of cryptocurrencies as payment.
In spite of a strong bitcoin ecosystem, Argentina has not yet drawn up regulations for the cryptocurrency, although the central bank has issued official warnings of the risks involved.
In 2015, Bangladesh expressly declared that using cryptocurrencies was a “punishable offence.”
In 2014, the central bank of Bolivia officially banned the use of any currency or tokens not issued by the government.
Canada was one of the first countries to draw up what could be considered “bitcoin legislation,” with the passage of Bill C-31 in 2014, which designated “virtual currency businesses” as “money service businesses,” compelling them to comply with anti-money laundering and know-your-client requirements.
The government has specified that bitcoin is not legal tender, and the country’s tax authority has deemed bitcoin transactions taxable, depending on the type of activity.
While China has not banned bitcoin (and insists it has no plans to do so), it has cracked down on bitcoin exchanges and appears to be withdrawing preferential treatment (tax deductions and cheap electricity) for bitcoin miners.
In 2014, the National Assembly of Ecuador banned bitcoin and decentralized digital currencies while establishing guidelines for the creation of a new, state-run currency.
The European Union is taking a cautious approach to cryptocurrency regulation, with several initiatives underway to involve sector participants in the drafting of supportive rules. The focus appears to be on learning before regulating, while boosting innovation and taking into account the needs of the ecosystem.
The European Central Bank (ECB), however, is pushing for tighter control over movements of digital currencies as part of a broader crackdown on money laundering, while recognizing the jurisdictional complexities in regulating an asset with no boundaries. In late in 2017, an ECB official stated that the institution did not see bitcoin as a threat, and president Mario Draghi recently confirmed that, in the eyes of the ECB, bitcoin was not “mature enough” for regulation.
The Indian central bank has issued a couple of official warnings on bitcoin, and at the end of 2017 the country’s finance minister clarified in an interview that bitcoin is not legal tender. The government does not yet have any regulations that cover cryptocurrencies, although it is looking at recommendations.
Japan was the first country to expressly declare bitcoin “legal tender,” passing a law in early 2017 that also brought bitcoin exchanges under anti-money laundering and know-your-customer rules.
The central bank of Kyrgyzstan declared in 2014 that using cyrptocurrencies for transactions was against the law.
Malaysia’s Securities Commission is working together with the country’s central bank on a cryptocurrency regulation framework.
In 2014, Mexico’s central bank issued a statement blocking banks from dealing in virtual currencies. The following year, the finance ministry clarified that, although bitcoin was not “legal tender,” it could be used as payment and therefore was subject to the same anti-money laundering restrictions as cash and precious metals.
At the end of 2017, Mexico’s national legislature approved a bill that would bring local bitcoin exchanges under the oversight of the central bank.
Towards the end of 2017, Morocco’s foreign exchange authority declared that the use of cryptocurrencies within the country violated foreign exchange regulations and would be met with penalties.
Namibia is one of the few countries to have expressly declared that purchases with bitcoin are “illegal.”
While Nigerian banks are prohibited from handling virtual currencies, the central bank is working on a white paper which will draft its official stance on use of cryptocurrencies as a payment method.
Draft cryptocurrency legislation from the State Duma’s financial regulator is expected in March 2018. The focus appears to be on protecting citizens from scams, while allowing individuals and businesses to work legally with cryptocurrencies.
The efforts of the State Duma have been bolstered by a mandate from Putin himself, issued in October 2017, urging development of a “single payment space” within the Eurasian Economic Union (an alliance of countries including Armenia, Belarus and others), increased scrutiny of token sales, as well as licensing of bitcoin mining operations.
In early 2018, South Korea banned anonymous virtual currency accounts. And in an effort to curb cryptocurrency speculation, the authorities are contemplating a crackdown on exchanges.
In an interesting shift in strategy, a recent report in the South Korean press indicated that the country’s financial authorities are in talks with similar agencies in Japan and China over joint oversight of cryptocurrency investment.
In 2017, the South Africa Reserve Bank implemented a “sandbox approach,” testing draft bitcoin and cryptocurrency regulation with a selected handful of startups.
Singapore has no plans to regulate cryptocurrencies for now, but has reassured the market that it will be keeping an eye on the risks. The central bank, however, is working on a regulatory framework for bitcoin payments, and has issued warnings on bitcoin investments.
After allegedly declaring bitcoin illegal, the Bank of Thailand issued a backtracking statement in 2014, clarifying that it is not legal tender (but not technically illegal), and warning of the risks.
For now, cryptocurrency exchanges are not regulated.
United States of America
The U.S. is plagued by a fragmented regulatory system, with legislators at both the state and the federal level responsible for layered jurisdictions and a complex separation of powers.
Some states are more advanced than others in cryptocurrency oversight. New York, for instance, unveiled the controversial BitLicense in 2015, granting bitcoin businesses the official go-ahead to operate in the state (many startups pulled out of the state altogether rather than comply with the expensive requirements). In mid-2017, Washington passed a bill that applied money transmitter laws to bitcoin exchanges.
New Hampshire requires bitcoin sellers to get a money transmitter license and post a $100,000 bond. In Texas, the state securities commission is monitoring (and, on occasion, shutting down) bitcoin-related investment opportunities. And California is in bitcoin regulation limbo after freezing progress on Bill 1326 which – while criticized for issues such as overly broad definitions – was seen as less oppressive than New York’s BitLicense.
At the federal level, the Securities and Exchange Commission’s focus has been on the use of blockchain assets as securities, such as whether or not certain bitcoin investment funds should be sold to the public, and whether or not a certain offering is fraud.
The Commodities Futures Trading Commission (CFTC) has a bigger potential footprint in bitcoin regulation, given its designation of the cryptocurrency as a “commodity.” While it has yet to draw up comprehensive bitcoin regulations, its recent efforts have focused on monitoring the nascent futures market. It has also filed charges in several bitcoin-related schemes, which underlines its intent to exercise jurisdiction over cryptocurrencies whenever it suspects there may be fraud.
The Uniform Law Commission, a non-profit association that aims to bring clarity and cohesion to state legislation, has drafted the Uniform Regulation of Virtual Currency Business Act, which several states are contemplating introducing in upcoming legislative sessions. The Act aims to spell out which virtual currency activities are money transmission businesses, and what type of license they would require. Critics fear it too closely resembles the New York BitLicense.
Britain’s Financial Conduct Authority (FCA) sees bitcoin as a “commodity,” and therefore does plan to regulate it. It has hinted, however, that it will step in to oversee bitcoin-related derivatives. This lack of consumer protection has been behind recent FCA warnings on the risks inherent in cryptocurrencies.
The government of Ukraine has created a working group composed of regulators from various branches to draft cryptocurrency regulation proposals, including the determination of which agencies will have oversight and access. Also, a bill already before the legislature would bring cryptocurrency exchanges under the jurisdiction of the central bank.
Late in 2017, a senior official from Zimbabwe’s central bank stated that bitcoin was not “actually legal.” While the extent to which it can and cannot be used is not yet clear, the central bank is apparently undertaking research to determine the risks.
How Bitcoin Mining Works
When you hear about bitcoin “mining,” you envisage coins being dug out of the ground. But bitcoin isn’t physical, so why do we call it mining?
Because it’s similar to gold mining in that the bitcoins exist in the protocol’s design (just as the gold exists underground), but they haven’t been brought out into the light yet (just as the gold hasn’t yet been dug up). The bitcoin protocol stipulates that 21 million bitcoins will exist at some point. What “miners” do is bring them out into the light, a few at a time.
They get to do this as a reward for creating blocks of validated transactions and including them in the blockchain.
Backtracking a bit, let’s talk about “nodes.” A node is a powerful computer that runs the bitcoin software and helps to keep bitcoin running by participating in the relay of information. Anyone can run a node, you just download the bitcoin software (free) and leave a certain port open (the drawback is that it consumes energy and storage space – the network at time of writing takes up about 145GB). Nodes spread bitcoin transactions around the network. One node will send information to a few nodes that it knows, who will relay the information to nodes that they know, etc. That way it ends up getting around the whole network pretty quickly.
Some nodes are mining nodes (usually referred to as “miners”). These group outstanding transactions into blocks and add them to the blockchain. How do they do this? By solving a complex mathematical puzzle that is part of the bitcoin program, and including the answer in the block. The puzzle that needs solving is to find a number that, when combined with the data in the block and passed through a hash function, produces a result that is within a certain range. This is much harder than it sounds.
(For trivia lovers, this number is called a “nonce”, which is a concatenation of “number used once.” In the case of bitcoin, the nonce is an integer between 0 and 4,294,967,296.)
Solving the puzzle
How do they find this number? By guessing at random. The hash function makes it impossible to predict what the output will be. So, miners guess the mystery number and apply the hash function to the combination of that guessed number and the data in the block. The resulting hash has to start with a pre-established number of zeroes. There’s no way of knowing which number will work, because two consecutive integers will give wildly varying results. What’s more, there may be several nonces that produce the desired result, or there may be none (in which case the miners keep trying, but with a different block configuration).
The first miner to get a resulting hash within the desired range announces its victory to the rest of the network. All the other miners immediately stop work on that block and start trying to figure out the mystery number for the next one. As a reward for its work, the victorious miner gets some new bitcoin.
At the time of writing, the reward is 12.5 bitcoins, which at time of writing is worth almost $200,000.
Although it’s not nearly as cushy a deal as it sounds. There are a lot of mining nodes competing for that reward, and it is a question of luck and computing power (the more guessing calculations you can perform, the luckier you are).
Also, the costs of being a mining node are considerable, not only because of the powerful hardware needed (if you have a faster processor than your competitors, you have a better chance of finding the correct number before they do), but also because of the large amounts of electricity that running these processors consumes.
And, the number of bitcoins awarded as a reward for solving the puzzle will decrease. It’s 12.5 now, but it halves every four years or so (the next one is expected in 2020-21). The value of bitcoin relative to cost of electricity and hardware could go up over the next few years to partially compensate this reduction, but it’s not certain.
The difficulty of the calculation (the required number of zeroes at the beginning of the hash string) is adjusted frequently, so that it takes on average about 10 minutes to process a block.
Why 10 minutes? That is the amount of time that the bitcoin developers think is necessary for a steady and diminishing flow of new coins until the maximum number of 21 million is reached (expected some time in 2140).
If you’ve made it this far, then congratulations! There is still so much more to explain about the system, but at least now you have an idea of the broad outline of the genius of the programming and the concept. For the first time we have a system that allows for convenient digital transfers in a decentralized, trust-free and tamper-proof way. The repercussions could be huge.
How Does Blockchain Technology Work?
There are three principal technologies that combine to create a blockchain. None of them are new. Rather, it is their orchestration and application that is new.
These technologies are: 1) private key cryptography, 2) a distributed network with a shared ledger and 3) an incentive to service the network’s transactions, record-keeping and security.
The following is an explanation of how these technologies work together to secure digital relationships.
Two people wish to transact over the internet.
Each of them holds a private key and a public key.
The main purpose of this component of blockchain technology is to create a secure digital identity reference. Identity is based on possession of a combination of private and public cryptographic keys.
The combination of these keys can be seen as a dexterous form of consent, creating an extremely useful digital signature.
In turn, this digital signature provides strong control of ownership.
But strong control of ownership is not enough to secure digital relationships. While authentication is solved, it must be combined with a means of approving transactions and permissions (authorisation).
For blockchains, this begins with a distributed network.
A Distributed Network
The benefit and need for a distributed network can be understood by the ‘if a tree falls in the forest’ thought experiment.
If a tree falls in a forest, with cameras to record its fall, we can be pretty certain that the tree fell. We have visual evidence, even if the particulars (why or how) may be unclear.
Much of the value of the bitcoin blockchain is that it is a large network where validators, like the cameras in the analogy, reach a consensus that they witnessed the same thing at the same time. Instead of cameras, they use mathematical verification.
In short, the size of the network is important to secure the network.
That is one of the bitcoin blockchain’s most attractive qualities — it is so large and has amassed so much computing power. At time of writing, bitcoin is secured by 3,500,000 TH/s, more than the 10,000 largest banks in the world combined. Ethereum, which is still more immature, is secured by about 12.5 TH/s, more than Google and it is only two years old and still basically in test mode.
When cryptographic keys are combined with this network, a super useful form of digital interactions emerges. The process begins with A taking their private key, making an announcement of some sort — in the case of bitcoin, that you are sending a sum of the cryptocurrency — and attach it to B’s public key.
A block – containing a digital signature, timestamp and relevant information – is then broadcast to all nodes in the network.
Network servicing protocol
A realist might challenge the tree falling in the forest thought experiment with the following question: Why would there be a million computers with cameras waiting to record whether a tree fell? In other words, how do you attract computing power to service the network to make it secure?
For open, public blockchains, this involves mining. Mining is built off a unique approach to an ancient question of economics — the tragedy of the commons.
With blockchains, by offering your computer processing power to service the network, there is a reward available for one of the computers. A person’s self-interest is being used to help service the public need.
With bitcoin, the goal of the protocol is to eliminate the possibility that the same bitcoin is used in separate transactions at the same time, in such a way that this would be difficult to detect.
This is how bitcoin seeks to act as gold, as property. Bitcoins and their base units (satoshis) must be unique to be owned and have value. To achieve this, the nodes serving the network create and maintain a history of transactions for each bitcoin by working to solve proof-of-work mathematical problems.
They basically vote with their CPU power, expressing their agreement about new blocks or rejecting invalid blocks. When a majority of the miners arrive at the same solution, they add a new block to the chain. This block is timestamped, and can also contain data or messages.
Here’s a chain of blocks:
The type, amount and verification can be different for each blockchain. It is a matter of the blockchain’s protocol – or rules for what is and is not a valid transaction, or a valid creation of a new block. The process of verification can be tailored for each blockchain. Any needed rules and incentives can be created when enough nodes arrive at a consensus on how transactions ought to be verified.
It’s a taster’s choice situation, and people are only starting to experiment.
We are currently in a period of blockchain development where many such experiments are being run. The only conclusions drawn so far are that we are yet to fully understand the dexterity of blockchain protocols.
What is Blockchain Technology?
From a cruising altitude, a blockchain might not look that different from things you’re familiar with, say Wikipedia.
With a blockchain, many people can write entries into a record of information, and a community of users can control how the record of information is amended and updated. Likewise, Wikipedia entries are not the product of a single publisher. No one person controls the information.
Descending to ground level, however, the differences that make blockchain technology unique become more clear. While both run on distributed networks (the internet), Wikipedia is built into the World Wide Web (WWW) using a client-server network model.
A user (client) with permissions associated with its account is able to change Wikipedia entries stored on a centralized server.
Whenever a user accesses the Wikipedia page, they will get the updated version of the ‘master copy’ of the Wikipedia entry. Control of the database remains with Wikipedia administrators allowing for access and permissions to be maintained by a central authority.
Wikipedia’s digital backbone is similar to the highly protected and centralized databases that governments or banks or insurance companies keep today. Control of centralized databases rests with their owners, including the management of updates, access and protecting against cyber-threats.
The distributed database created by blockchain technology has a fundamentally different digital backbone. This is also the most distinct and important feature of blockchain technology.
Wikipedia’s ‘master copy’ is edited on a server and all users see the new version. In the case of a blockchain, every node in the network is coming to the same conclusion, each updating the record independently, with the most popular record becoming the de-facto official record in lieu of there being a master copy.
Transactions are broadcast, and every node is creating their own updated version of events.
It is this difference that makes blockchain technology so useful – It represents an innovation in information registration and distribution that eliminates the need for a trusted party to facilitate digital relationships.
Yet, blockchain technology, for all its merits, is not a new technology.
Rather, it is a combination of proven technologies applied in a new way. It was the particular orchestration of three technologies (the Internet, private key cryptography and a protocol governing incentivization) that made bitcoin creator Satoshi Nakamoto’s idea so useful.
The result is a system for digital interactions that does not need a trusted third party. The work of securing digital relationships is implicit — supplied by the elegant, simple, yet robust network architecture of blockchain technology itself.
Defining digital trust
Trust is a risk judgement between different parties, and in the digital world, determining trust often boils down to proving identity (authentication) and proving permissions (authorization).
Put more simply, we want to know, ‘Are you who you say you are?’ and ‘Should you be able to do what you are trying to do?’
In the case of blockchain technology, private key cryptography provides a powerful ownership tool that fulfills authentication requirements. Possession of a private key is ownership. It also spares a person from having to share more personal information than they would need to for an exchange, leaving them exposed to hackers.
Authentication is not enough. Authorization – having enough money, broadcasting the correct transaction type, etc – needs a distributed, peer-to-peer network as a starting point. A distributed network reduces the risk of centralized corruption or failure.
This distributed network must also be committed to the transaction network’s recordkeeping and security. Authorizing transactions is a result of the entire network applying the rules upon which it was designed (the blockchain’s protocol).
Authentication and authorization supplied in this way allow for interactions in the digital world without relying on (expensive) trust. Today, entrepreneurs in industries around the world have woken up to the implications of this development – unimagined, new and powerful digital relationshionships are possible. Blockchain technology is often described as the backbone for a transaction layer for the Internet, the foundation of the Internet of Value.
In fact, the idea that cryptographic keys and shared ledgers can incentivize users to secure and formalize digital relationships has imaginations running wild. Everyone from governments to IT firms to banks is seeking to build this transaction layer.
Authentication and authorization, vital to digital transactions, are established as a result of the configuration of blockchain technology.
The idea can be applied to any need for a trustworthy system of record.
What Can a Blockchain Do?
Financial institutions have financed the disruption of countless industries over the last 30 years; they have an idea of what a revolutionary technology can do to static incumbents.
So, to stay ahead of change, banks have been proactive in setting up R&D labs, building test centers and establishing partnerships with blockchain developers to fully understand the revolutionary potential of the technology.
Financial institutions were the first to dip their feet in, but academia, governments and consulting firms have also studied the technology.
All of this work is, of course, in addition to what the entrepreneurs and developers are doing, either by finding new ways to use the bitcoin or ethereum blockchains, or else creating entirely new blockchains.
This has been going on for over three years now, and the results are starting to come in.
While some of the waters are still murky, this is what we know a blockchain can do:
Establish digital identity
Combining a public and private key creates a strong digital identity reference based on possession.
A public key is how you are identified in the crowd (like an email address), a private key is how you express consent to digital interactions. Cryptography is an important force behind the blockchain revolution.
Serve as a system of record
They are good for recording both static data (a registry) or dynamic data (transactions), making it an evolution in systems of record.
In the case of a registry, data can be stored on blockchains in any combination of three ways:
Unencrypted data – can be read by every blockchain participant in the blockchain and is fully transparent.
Encrypted data – can be read by participants with a decryption key. The key provides access to the data on the blockchain and can prove who added the data and when it was added.
Hashed data – can be presented alongside the function that created it to show the data wasn’t tampered with.
Blockchain hashes are generally done in combination with the original data stored off-chain. Digital ‘fingerprints’, for example, are often hashed into the blockchain, while the main body of information can be stored offline.
Such a shared system of record can change the way disparate organizations work together.
Currently, with data siloed in private servers, there is an enormous cost for inter-company transactions involving processes, procedures and cross-checking of records.
A feature of a blockchain database is that is has a history of itself. Because of this, they are often called immutable. In other words, it would be a huge effort to change an entry in the database, because it would require changing all of the data that comes afterwards, on every single node. In this way, it is more a system of record than a database.
Serve as a platform
Cryptocurrencies were the first platform developed using blockchain technology. Now, people have moved from the idea of a platform to exchange cryptocurrencies to a platform for smart contracts.
The term ‘smart contracts’ has become somewhat of a catch-all phrase, but the idea can actually be divided into several categories:
There are the ‘vending machine’ smart contracts coined in the 1990s by Nick Szabo. This is where machines engage after receiving an external input (a cryptocurrency), or else send a signal that triggers a blockchain activity.
There are also smart legal contracts, or Ricardian contracts. Much of this application is based on the idea that a contract is a meeting of the minds, and that it is the result of whatever the consenting parties to the contract agree to. So, a contract can be a mix of a verbal agreement, a written agreement, and now also some of the useful aspects of blockchains like timestamps, tokens, auditing, document coordination or business logic.
Finally, there are the ethereum smart contracts. These are programs which control blockchain assets, executed over interactions on the ethereum blockchain. Ethereum itself is a platform for smart contract code.
Blockchains are not built from a new technology. They are built from a unique orchestration of three existing technologies.
What is a Distributed Ledger?
Ledgers, the foundation of accounting, are as ancient as writing and money.
Their medium has been clay, wooden tally sticks (that were a fire hazard), stone, papyrus and paper. Once computers became normalized in the 1980s and ’90s, paper records were digitized, often by manual data entry.
These early digital ledgers mimicked the cataloguing and accounting of the paper-based world, and it could be said that digitization has been applied more to the logistics of paper documents rather than their creation. Paper-based institutions remain the backbone of our society: money, seals, written signatures, bills, certificates and the use of double-entry bookkeeping.
Computing power and breakthroughs in cryptography, along with the discovery and use of some new and interesting algorithms, have allowed the creation of distributed ledgers.
In its simplest form, a distributed ledger is a database held and updated independently by each participant (or node) in a large network. The distribution is unique: records are not communicated to various nodes by a central authority, but are instead independently constructed and held by every node. That is, every single node on the network processes every transaction, coming to its own conclusions and then voting on those conclusions to make certain the majority agree with the conclusions.
Once there is this consensus, the distributed ledger has been updated, and all nodes maintain their own identical copy of the ledger. This architecture allows for a new dexterity as a system of record that goes beyond being a simple database.
The gist of these new kinds of relationships is that the cost of trust (heretofore provided by notaries, lawyers, banks, regulatory compliance officers, governments, etc…) is avoided by the architecture and qualities of distributed ledgers.
The invention of distributed ledgers represents a revolution in how information is gathered and communicated. It applies to both static data (a registry), and dynamic data (transactions). Distributed ledgers allow users to move beyond the simple custodianship of a database and divert energy to how we use, manipulate and extract value from databases — less about maintaining a database, more about managing a system of record.
Why Use a Blockchain?
As the implications of the invention of have become understood, a certain hype has sprung up around blockchain technology.
This is, perhaps, because it is so easy to imagine high-level use cases. But, the technology has also been closely examined: millions of dollars have been spent researching blockchain technology over the past few years, and numerous tests for whether or not blockchain technology is appropriate in various scenarios have been conducted.
Blockchain technology offers new tools for authentication and authorization in the digital world that preclude the need for many centralized administrators. As a result, it enables the creation of new digital relationships.
By formalizing and securing new digital relationships, the blockchain revolution is posed to create the backbone of a layer of the internet for transactions and interactions of value (often called the ‘Internet of Value’, as opposed to the ‘Internet of Information’ which uses the client-server, accounts and master copy databases we’ve been using for over the past 20 years.)
But, with all the talk of building the digital backbone of a new transactional layer to the internet, sometimes blockchains, private cryptographic keys and cryptocurrencies are simply not the right way to go.
Many groups have created flowcharts to help a person or entity decide between a blockchain or master copy, client-server database. The following factors are a distillation of much of what has been previously done:
Is the data dynamic with an auditable history?
Paper can be hard to counterfeit because of the complexity of physical seals or appearances. Like etching something in stone, paper documents have certain permanence.
But, if the data is in constant flux, if it is transactions occurring regularly and frequently, then paper as a medium may not be able to keep up the system of record. Manual data entry also has human limitations.
So, if the data and its history are important to the digital relationships they are helping to establish, then blockchains offer a flexible capacity by enabling many parties to write new entries into a system of record that is also held by many custodians.
Should or can the data be controlled by a central authority?
There remain many reasons why a third party should be in charge of some authentications and authorizations. There are times when third-party control is totally appropriate and desirable. If privacy of the data is the most important consideration, there are ways to secure data by not even connecting it to a network.
But if existing IT infrastructure featuring accounts and log-ins is not sufficient for the security of digital identity, then the problem might be solved by blockchain technology.
As Satoshi Nakamoto wrote in his (or her) seminal work, “Bitcoin: A Peer-to-Peer Electronic Cash System”: “Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable.”
Private key cryptography enables push transactions, which don’t require centralized systems and the elaborate accounts used to establish digital relationships. If this database requires millions of dollars to secure lightweight financial transactions, then there’s a chance blockchains are the solution.
Is the speed of the transaction the most important consideration?
If high performance, millisecond transactions are what is required, then it’s best to stick with a traditional-model centralized system. Blockchains as databases are slow and there is a cost to storing the data – the processing (or ‘mining’) of every block in a chain. Centralized data systems based on the client-server model are faster and less expensive… for now.
In short, while we still don’t know the full limits and possibilities of blockchains, we can at least say the use cases which have passed inspection have all been about managing and securing digital relationships as part of a system of record.
What is a Decentralized Application?
Internet users don’t have sole control over the data they share on today’s websites.
Ethereum is unique in that it attempts to wield the blockchain as a way to correct what its designers believe is a problematic part of the internet’s design.
It’s like a “decentralized appstore” where anyone can publish their unstoppable apps (dapps), which unlike today’s apps (think Gmail or Uber) don’t require a middleman to function or to manage a user’s information.
Dapps connect users and providers directly.
One example is to use this design for a decentralized Twitter that’s resistant to censorship. Once you publish a message to the blockchain, it can’t be erased, not even by the company that created the microblogging system.
There isn’t one definition of a dapp, though, as it’s a newer concept.
A couple of main characteristics are that they’re open source and don’t have a central point of failure.
With this new technology out in the wild, ethereum advocates might feel electrified by the thought of decentralizing “all the things.” But the types of applications that users can build with the computing platform might be somewhat narrow.
The ethereum white paper splits dapps into three types: apps that manage money, apps where money is involved (but also requires another piece), and apps in the “other” category, which includes voting and governance systems.
In the first type of app, a user may need to exchange ether as a way to settle a contract with another user, using the network’s distributed computer nodes as a way to facilitate the distribution of this data.
The second type of app mixes money with information from outside the blockchain.
For example, a crop insurance application that’s dependent on an outside weather feed. (Say a farmer buys a derivative that automatically pays out if there’s a drought that impacts his work.)
To execute, these smart contracts rely on so-called “oracles” that relay up-to-date information about the outside world. (Though, it’s worth noting that some developers are skeptical that this use case can be done in a decentralized way.)
If bitcoin can do away with financial authorities, is it possible to do the same for companies and other types of organizations?
Decentralized autonomous organizations are one particularly ambitious breed of dapp (this is explained further in ‘What is a DAO?’).
The goal is form a leaderless company, program rules at the beginning about how members can vote and how to release company funds and then… let it go.