Blockchain
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It may be surprising to know that the principles underpinning Bitcoin are 1,500 years old.
In 500 AD, the people of the tiny island of Yap in the western Pacific Ocean began mining and trading gigantic limestone discs called rai stones, a practice that still exists today to some extent (1). Since limestone was nonexistent on Yap, the stones had to be mined from the islands of Palau and then transported hundreds of kilometers by sea to Yap. Many stones were large, weighing up to four metric tons, so mining and transporting them was difficult. Yet the difficulty in obtaining the stones made them valuable in the eyes of the Yapese - valuable enough to be used as currency.
Due to their size, hauling the rai stones around Yap for transaction purposes was not realistic. Instead, the Yapese developed an oral history of ownership in which everyone knew who owned which stones, regardless of their location (there's even one story involving a huge stone that fell to the bottom of the ocean during transport, but the owners vouched for its size, so it was still used as currency). This oral history of ownership was essentially a decentralized, publicly verifiable record of all financial transactions on Yap - a decentralized and public ledger. Decentralized, in that no one person controlled the record of who owned which stones. Public, in that the record of who owned which stones was available to all. The rai stone system was built by the people, for the people.
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A rai stone on display at the Bank of Canada Currency Museum, Ottawa. |
Fast-forward to 1340, when double-entry accounting was created in Italy, followed shortly by the development of banking practices which gradually morphed into the current centralized and private western banking system. Centralized, in that the entire western banking system is underpinned by the US dollar, which in turn is controlled by the Federal Reserve, which in turn is controlled by a small group of bankers (2). Private, in that any bank's database of financial transactions is stored in that bank's computer system, owned and controlled by the bank. Today's western banking system was built by the bankers, for the bankers.
During the Great Recession of 2007-2012, the two-tiered nature of the western world's banking system showed its true colours - entities connected to government (such as Wall Steet banks) received taxpayer-funded bailouts, whereas entities not connected to government (such as regular citizens) received no such bailouts. Someone was disgruntled enough by this situation to propose an alternative.
In 2008, the still-unknown Satoshi Nakamoto drafted an idea to create a peer-to-peer digital currency system, called Bitcoin (3). The idea was to create a digital medium of exchange that would allow two people to make direct currency transactions without needing to go through or "trust" a financial institution - in essence, to cut out the middle-man, cut out the bankers who had so decisively rigged the entire financial system to suit themselves. To achieve this, Nakamoto designated that Bitcoin would exist on something called a blockchain, which was a digital version of a decentralized and public ledger. Decentralized, in that no central authority controlled the ledger. Public, in that it existed on multiple computer systems owned by members of the Bitcoin community.
Sound familiar? It should, for the blockchain is the modern equivalent of the oral history of ownership used by the Yapese 1,500 years ago. It's an old concept, bolstered by new technology.
Blockchain: Old Concept, New Technology
To understand how the blockchain works, it may be helpful to compare how currency is created and distributed in the western banking system versus the blockchain, using the US dollar and Bitcoin as examples.
The US dollar is currently the reserve currency of the western banking system; additional dollars are created via deficit spending and fractional reserve lending (2). Deficit spending involves the creation of bonds (glorified IOUs) by the Treasury, which are then swapped back and forth between the Treasury and Federal Reserve, using the banks as middle-men, with dollars created in the process; there is no cap on the number of dollars that may be created. In like fashion, fractional reserve lending allows banks to lend a portion of their customer deposits to other customers by simply typing additional dollars into existence; again, there is no cap on this process. Once in existence, dollars are distributed in paper or digital form. Everyone is familiar with the distribution of paper dollars from one person to another, but most dollars are now digital, consisting of nothing more than entries on a bank's computer system that is owned by the bank.
Rather than being printed or typed into existence, Bitcoins - the reserve currency of the blockchain - are "discovered" via a process called mining; the number of Bitcoins that can ever be mined is capped at 21 million. Anyone can mine Bitcoin, although to do so efficiently requires a special computer, or mining rig, which costs several hundred dollars (or more). Bitcoin is a digital currency that exists on the blockchain, which itself consists of digital "blocks" of transactions arranged into a continuously growing "chain." Bitcoin miners perform a crucial function for the currency by competing with each other to solve difficult mathematical problems, resulting in cryptographic algorithms called hashes that are used to "seal" the current block with the rest of the chain. Every time a miner creates a successful hash for the current block, all the transactions in that block are confirmed, everyone in the Bitcoin community is updated, the block is sealed, and the miner is rewarded with a set number of Bitcoins. The whole process occurs every ten minutes. The newly-minted Bitcoins exist on the blockchain, distributed across multiple computer systems owned by members of the Bitcoin community.
Bitcoin mining rig.
To recap, the fundamental differences between the western banking system and the blockchain, using the US dollar and Bitcoin as examples, are:
(1) In the western banking system, US dollars are printed or typed into existence by a centralized monetary authority, whether it be the Federal Reserve or a bank - as such, they are ultimately controlled by a very small group of bankers. In contrast, Bitcoins on the blockchain are mined into existence by a decentralized network of miners - anyone can mine, although in the case of Bitcoin one must buy a mining rig to do so efficiently.
(2) In the western banking system, most US dollars are digital and exist as deposits on a bank's computer system - the bank may modify these currency deposits as they see fit. In contrast, Bitcoins exist on the blockchain, distributed across multiple computer systems owned by members of the Bitcoin community - it is not possible for anyone to modify the deposits of anyone else; the modifications would be rejected.
By existing on the blockchain, Bitcoin creates a system of currency transactions that works for the people, unlike the current monetary system that works for the bankers. It is crucial to understand that Bitcoin is not the blockchain - it's just a digital currency that operates on the blockchain. Moreover, although the blockchain is a decentralized public ledger that happens to be ideal for currency transactions, it is by no means limited to currency transactions; it can be used for any transaction where a contract needs to be drawn up, such as property or stock market transactions.
Looking beyond Bitcoin, we see many other operating systems exploring the myriad possibilities introduced by blockchain technology. One such system is Ethereum, a digital platform that goes beyond being a mere digital currency by offering a base that others may build upon. Ethereum is working to facilitate transactions using smart contracts, which are self-executing computer programs that have the terms of agreement between buyer and seller written directly into the lines of code. Smart contracts are based on math, thus removing the need to trust (or pay) a middle-man in the facilitation of any transaction, making them more reliable (and cheaper) compared to traditional contract law.
Blockchain: Future Challenges
While the fundamentals of the blockchain may be 1,500 years old, the technology is still in its infancy. As blockchain technology matures, there will be a series of inevitable clashes between a variety of centralized private systems and the decentralized public systems operating on the blockchain, such as Bitcoin and Ethereum. Let's recap the advantages of the blockchain before we discuss its future challenges.
We have already alluded to the two greatest advantages of blockchain technology.
First, disintermediation - the blockchain empowers its users by removing middle-men (and in future, replacing them with smart contracts when necessary), thus enhancing transaction reliability while also lowering transaction times and costs. Using finance as an example, this means that instead of using banks that lend out and modify your deposits, take one or more days for bank-to-bank transfers, and charge debit card and bank transfer fees, blockchain deposits are solely controlled by you, may instantly be transferred anywhere in the world, and have very low (or zero, depending on the digital currency used) transaction fees.
Second, transparency - the blockchain cannot be altered or censored in any way, not even by governments, bankers, or hackers (whenever you hear that a digital currency has been hacked, it is actually one of the centralized exchanges where the currencies are traded that has been hacked - not the blockchain). Using finance as an example, this means that the currency cannot be altered, and since all digital currencies are capped, they are not subject to excessive inflation. If the supreme advantages of this in terms of fairness and equality are not apparent to you, have a think about this quote by British economist John Maynard Keynes:
"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it
in a manner which not one man in a million is able to diagnose."
John Maynard Keynes.
Regarding the greatest future challenges to blockchain technology, we'll restrict the discussion to digital currencies, since they are already starting to face the brunt of these challenges.
The first challenge is that the rich still get richer. The mining process used by Bitcoin is called Proof of Work; whenever a mathematical problem is solved, a hash created, and a block sealed, the "proof" that a successful miner spent the requisite "work" (time and resources) to solve that problem is evident for all to see. However, one problem with Proof of Work is that it still rewards people who can afford to buy mining rigs, thus people with enough money behind them benefit more (although to be fair, the discrepancy is nothing compared to the scale at which the rich get richer in today's banking practices). To solve this issue, next generation currencies and platforms have adopted various approaches. The digital currency used by the platform Cardano, for example, is created using Proof of Stake; instead of being mined, blocks are created by forgers, with each forger chosen in a pseudo-random way depending on their "stake" which is based on the amount of currency they hold and how long they have held it. importantly, when a forger is chosen, the age of their currency is reset to zero so that they must wait a certain period of time before they are eligible to forge another block. This reduces inequity between rich and poor. Perhaps an even better example of a solution to the inequity of mining is the method chosen by the platform New Economy Movement, called Proof of Importance, in which digital currency is created by harvesters, with each harvester chosen by being assigned an "importance" score that is mainly based on the number of transactions they make with their account, not the size of it. This reduces inequity between rich and poor even more. The innovative solutions used by operating systems such as Cardano and New Economy Movement will make blockchain currencies more equitable than either the existing banking system or Bitcoin could ever hope to be.
A second challenge is energy consumption. Bitcoin's mining-based Proof of Work process requires vast amounts of computing power, which in turn requires vast amounts of energy; it has been estimated that the total power required for Bitcoin calculations is comparable to that used by entire countries (4). Fortunately, the Proof of Stake, Proof of Importance, and other innovative processes currently being adopted by many digital currencies and platforms will create far more efficient power-consuming strategies, so this problem is already being solved.
A third challenge is impending government regulations. This possibility scares some people away from the blockchain, but it really shouldn't. Digital currencies have no physical form, and the government has a dismal track record whenever it tries to regulate or halt things without physical form, such as internet gambling or movie downloads; making these things illegal has done nothing to stop them from spreading. True, blockchain currencies do require a degree of physical infrastructure so that they can be maintained and updated by their development team as well as traded on exchanges. However, if the government of any country decides to heavily regulate or make digital currencies illegal, this relatively modest infrastructure is easily transportable to more favourable jurisdictions; there will always be another country that embraces that which others do not (moreover, in the case of exchanges, these will eventually be replaced with atomic swaps, which allow currencies to be traded without the need for an exchange). Yet another argument that is often brought up is that a person holding digital currency may at some point want to trade it for something physical. Yet even when governments make certain physical items illegal (historical examples include alcohol, drugs, and gold), the market simply moves underground and continues to operate. Thus, any government's threat to regulate or halt digital currencies on the blockchain is a nuisance, but not a serious threat.
There are many other future challenges to digital currencies operating on the blockchain, including volatility, scalability, intraoperability, and privacy. To cut a long story short, various digital currencies are already working to address all of these challenges. I believe they will all be solved.
The recent speculative frenzy surrounding blockchain-based digital currencies has stolen the limelight, but it is not the currencies themselves that are exciting, it is the blockchain itself that is exciting; it changes the great game by putting the ball back into the court of the people. This is the reason there are so many fervent blockchain supporters; the speculators will come and go, but the supporters will remain - and grow in numbers.
Coin prices may make today's headlines, but the blockchain will make history.
It's not about getting rich, it's about improving the social good.
Solace.
References
(1) https://btcmanager.com/story-ancient-bitcoin-tale-goes-back-5th-century/.
(2) https://www.wanderingsolace.com/value-december-2017.html.
(3) https://bitcoin.org/bitcoin.pdf.
(4) https://www.washingtonpost.com/news/energy-environment/wp/2017/12/19/why-the-bitcoin-craze-is-using-up-so-much-energy/?utm_term=.29a666534d3a
