Blockchain, Bitcoin and Cryptocurrency Explained

Human beings are social animals and have lived in tight-knit societies to further their odds of survival in a hostile atmosphere. As social beings, humans have both competed and co-operated with fellow human beings in the face of common threats. Over time, humans recognised that a safer and more beneficial way of using resources could be exchanging them without a fight, that is, via a trade transaction. This led to barter and exchange based understanding between them. In primitive societies, transactions involving exchange of say cattle or poultry would be consummated between individuals with the whole society as a witness. Given small and proximate societies, such transactions would become common knowledge in the society. 

In modern trade, what essentially remains a basic peer-to-peer (A-to-B) transaction assumes complexity as geographical distance increases and the ability of participants to directly rely on one another reduces. Third party intermediaries step in to provide required “trust”. “Transparency” afforded by smaller and proximate societies is replaced by “trust”. Record-keeping becomes paper-intensive and maintained by multiple parties: A, B and the intermediate parties. Business processes have evolved where every entity privately records its interpretation of a transaction and later agree or dispute the other entities’ records of the same. This has led to long clearing and settlement cycles extending to days, if not weeks, in case of cross-border transactions. 

Trade and Emergence of Money

Early trade started with barter, but human beings quickly realised need for a common measure or basis to conduct these transactions. “Barter” requiring perfect coincidence of resources and needs between two parties was a strong limiting factor in trade volume. “Money” was invented to act as a common standard of measure, a medium of exchange and a store of value. Over the years, this took many forms (for example, cattle, token, IOU, gold, silver, copper coins) till it reached our current system of “money,” both physical and digital. 

Iwai (1997) discusses Commodity theory (money has evolved spontaneously from one of the useful commodities through barter exchanges), Cartal theory (money was introduced by community agreement or fiat, that is, money is a creature of law), bootstrap theory (money is money simply because it is used as money) and the gifting theory (human beings are fundamentally an exchanging species with three simple obligations: to receive, to give and to reciprocate). 

Money assumed a central role in man’s life by becoming one leg of nearly all transactions he entered into with fellow men. As trade expanded, so did the need for transaction monitoring, accounting, record-keeping and overall “trust” amongst participants. Banking, legal and accounting professions emerged to help with these functions. As disputes arose, there was a need for some “authority or a consensus mechanism” to adjudicate over these disputes. Kings and armies, and later courts took on the role of enforcers/consensus creators for transactions amongst citizens. 

Transparency and the Social Contract

Transparency and common visibility of transaction amongst parties was an important part of successful consummation of early trades to ensure that all tribe members were aware of the transaction so parties to the transaction could not renege on it.

As an interesting aside, this is how a “social contract” like a marriage also took place. The bride and groom to be, and their families would widely publicise the intent to marry among the tribe, hold an elaborate ceremony in the presence of community members to ensure that the social contract is “visible” to all and accepted as such by the society. Other examples of high transparency public displays of important events include coronations, birth showers, marriage and death rituals, peace treaties, convocation of degrees, etc. 

As trade in goods and services became more common place within and across geographically dispersed locations, it became physically and technologically impossible for every trade to be broadcast across the population. Pseudo-transparent measures were introduced as substitutes, for example, advertisements in newspapers, public registration of private documents, access to public records, library copies. However, these were only partial measures and did not permit smaller, simpler, relatively unimportant transactions to be advertised widely. 

Technology and Transparency 

Advances in computing powers over the past few decades have revolutionised trade. As computers became prevalent and telecommunications advanced further, digitisation of records became possible. Automation of existing processes led to significant productivity boost across industries. Most of the new systems automated underlying processes, without questioning or examining them in the light of new technology advancement. As such, many systems have evolved layered upon old technologies leading to a large amount of wastage and compromises.

Fortunately, the same technology that has led to productivity boosts, also enabled information to be freely owned and disseminated. Technology made it possible to widely and transparently disseminate information about bilateral deals, including small and unimportant transactions. It became possible for anyone with an interest in a particular transaction to check and validate it. While superficially trivial, this has opened up a plethora of commercial processes and practices for re-examination. 

Welch (2003) studied how transparency and interactivity affect citizen trust in governments. The findings indicate that internet use is positively associated with transparency satisfaction but negatively associated with interactivity satisfaction. Additionally, both transparency and interactivity are positively associated with trust in government indicating that transparency is a necessary but not sufficient trait for trust in governments. The same trait extends to the world of business and the corporations running them. 

Technology and Trust

The nature of money lends itself admirably to digitisation where the bank balance of an individual represented in a binary form entitle that individual to transfer part of it to purchase goods and services across the globe. So, one half of all transactions very easily lend itself to digitisation. At the same time, tokenisation or title creation of goods and services permitted the second or physical leg of the transaction to also go digital. This opened up a whole era of internet proliferation, e-commerce, digital transactions and micropayments. 

A big problem on the internet has been to establish identity and trust securely. Layers of cryptography and protocols have been designed to automate the patchwork of systems based on open access. Large and small entities are identified primarily by IP addresses registered to them, with “certificates” issued by “Trusted Certification Authorities.” These entities encrypt digital traffic while doing commerce with unknown customers. 

A fresh new breed of “trusted” online entities have emerged that are taking on the role of record-keepers. These entities keep records within their control with no access to this information for ordinary citizens leading to deep “information capture”. Trusted entities appropriated transaction information and exploited it for their own use and profits. The “user” themselves became the “product” leading to rent-seeking behaviour by these entities. In a world where information is power, user-generated information is hoarded and exploited by “trusted entities” like banks, internet service providers, online retailers, social media enterprises and new age information companies. Technology has steered society away from transparency and common visibility and towards the realm of trust.

Elia (2009) postulates that implementation and use of modern information technology tools to foster trust through transparency may be morally unsatisfactory unless they are accompanied by an explicit reference to potential threats or risks to stakeholder interests that are necessary moral protection for stakeholders in any business environment. This is to reinforce the corporation’s claim to add value to a stakeholder while protecting them from harm, wrong or injustice.

Transparency and Trust in the Digital Age

Current systems have evolved via automation of existing layers of inefficiencies over the ages. If examined afresh, advances in technology permit design of systems that enable ascendancy of transparency and push back advance of trust. The next few paragraphs explores a theoretical model for a system where transparency would take precedence over trust in business transactions.

Most trade and service transactions involves two peers: A and B. With current technology, it becomes possible to reimagine record-keeping for this transaction so that reliance on trusted intermediaries is minimised. 

Such a newly designed system could widely publicise:

(i) The fact that a transaction took place.

(ii) The fact that there are two or more parties to the transaction.

(iii) The date and time when it took place.

(iv) The terms of the transaction.

Such wide publicity of the transaction itself could constitute proof of its existence. It would be akin to each party issuing a press release, in a standardised machine-readable format about the transaction. The features required in such a publicity are mentioned below.

(i) To avoid a rogue participant impersonating parties to the transaction, the parties would issue a press release upon their letterhead, from the location of their offices, on their official “secure” website, etc. The participants would put personal marks or other identifiers (for example, company seal) that are unlikely to be in possession of a rogue actor. They would add details like date/time of transaction, terms of transaction, other party(ies) to the transaction. Alternately, the two parties could issue a single joint press release with all the information under their common letterhead, company seal, both their websites, etc.

(ii) A large set of random “trust-less” witnesses could view this press release issued by both parties. They could verify that both press releases indeed contain personal identification marks and other identifiers that should be in their possession. This would lead the witnesses to believe that the press release about the transaction is indeed released by the said parties. 

(iii) These witnesses could compare the two press releases to check for any discrepancy in terms of the transaction and flag them. In case transaction details match, the witnesses would agree through a consensus that the transaction appears identical and originating from its purported participants. The witnesses would “accept” the press releases and further help publicise them in their “accepted” transaction list across the network. So long as more than 51% of such random “trust-less” witnesses agree and accept the transaction, it would become a common knowledge and “truth” in the network. 

(iv) In order to make it more difficult to dispute an accepted transaction, it would be possible to roll up disparate press releases into a block of press releases and further approve them as a block with additional “consensual protocol,” for example, via a conference where the witnesses meet and jointly agree that all the press releases in the block are fair and accepted. Once accepted within a block, the only way to dispute it would be reconvene the conference and go through the elaborate “consensus protocol” process all over again. This would make it even more difficult for parties to dispute transactions that are already accepted individually and in a block. 

(v) Finally, to make it really prohibitive to revisit old transactions, blocks could be chained together, each block referencing a previous block to ensure that if a transaction in a block is disputed, not only will the consensus for that block have to be reworked, but that for all subsequent blocks would have to be redone. This makes the chain strong and extremely difficult to revisit or dispute as more blocks are layered on top of the block containing a specific transaction.

The above thought experiment can be represented in the following diagram and is the underlying philosophy behind “Blockchain” technology.

 

In a similar example of transparent research in the scientific domain, Grand (2012) discusses the emerging practice of “open science” which makes the entire process of a scientific investigation public thereby extending transparency beyond traditional audiences to bigger and more public audiences. This practice effectively expands the concept of “virtual witnessing” to cover the entire scientific process resulting in a new “trust technology.” 

Blockchain: Restoring Transparency, Re-establishing Trust

In 2008, a pseudonymous individual (or group), under the name Satoshi Nakamoto, proposed a scheme to create a digital currency called Bitcoin. Nakamoto began with the idea of a peer-to-peer transaction in a world without trusted middlemen. Using advancements in computer science, market incentives and cryptography, Nakamoto proposed a system where any participant could transact, query and verify the state of a transaction in Bitcoin anonymously. He designed a system where voluntary nodes could disseminate, verify, propagate transactions and periodically achieve consensus about the true history of transactions without the need for any “trusted” or continuing nodes. Nakamoto followed up his theoretical system with a working system in 2009 that led to the Bitcoin cryptocurrency and its underlying record-keeping technology, Blockchain.

Nakamoto outlined steps in running the network as follows:

(i) Nodes in the network are voluntary and can join and leave anytime.

(ii) Transactions are published across the network.

(iii) Nodes verify transactions and gather transactions into blocks.

(iv) Each node in the network works on finding a difficult puzzle (NP Difficult). resulting in a “Proof of Work” (POW), for example, finding a nonce whose hash (say with SHA256–Secure Hash Algorithm by NSA) begins with a given number of 0s (that automatically adjusts periodically to ensure a nonce is found on average every 10 minutes).

(v) Once a nonce is found, they append it to their block and publish across the network.

(vi) Other nodes in the network check if all transactions in the block are valid and signal acceptance by creating the next block in the chain using the hash of the accepted block as the previous hash.

In order to incentivise nodes to perform POW by expending computing powers, Nakamoto proposed a reward for the miners. This takes the form of a special transaction in a block that starts or creates a new coin to be owned by the mining node. A second incentive is payment of voluntary transaction fees by users for bundling their transactions into the block. Once the node has received some coins, the node has an “ownership” and incentive in the system to keep the network secure and watch out for attackers.

The advantage of POW system is that so long as the network is majority controlled by honest nodes, the probability of an attacker catching up with the cumulative work of other nodes to propagate an inaccurate transaction or block diminishes exponentially as subsequent blocks are added. Once a transaction is say 6 blocks deep it is computationally impractical for an attacker to reverse the transaction. POW ensures a one-processor, one-vote paradigm thus incentivising new nodes to enter the network. 

Bitcoin Blockchain combines developments in software engineering, cryptography and game theory. Davidson (2016) identified that blockchain exploits.

(i) Moore’s law that cost of processing digital information halves every 18 months; and

(ii) Kryder’s Law that cost of storing digital information halves every 12 months and;

(iii) Nielsen’s Law that cost of shipping digital information, that is, bandwidth halves every 24 months.

Bitcoin blockchain is an online, open, decentralised, transparent record of all dealings in bitcoin - every new bitcoin has to be mined, gets a unique ID and its life transaction is stored on it. The blockchain identifies the total number of bitcoins in existence, its chain of transactions and where it currently resides. The record-keeping unit is the minted bitcoin and not the consumer. The blockchain keeps track of every bitcoin and fraction thereof and follows it around to arrive at the current ownership. “Ownership” of the bitcoin is determined by an address that is the Public Key half of a Public Key/Private Key Pair Infrastructure (Merkle 1975/77, Diffie-Hellman 1976). The key pair is the construct from cryptography to ensure privacy for the consumer. A consumer can create as many pairs of Public/Private Keys as she desires. So a consumer wallet can contain one or more Public/Private Key pairs, each with some bitcoins assigned to them.

Bitcoin blockchain rests on earlier work done by pioneers of cryptography and digital cash like Diffie-Hellman’s two-key distribution framework (1976), Merkle’s hash trees (1979), Chaum’s blind signature (1982), Back’s (1997) hashcash, Wei Dai’s b-money (1998), SHA256 hashing functions from NSA and Harold Kinney’s Reusable Proof of Work (2004).

Physical World Equivalence of the Blockchain

In the physical world people interact amongst one another using physical currency. In India citizens use the Indian rupee issued by Reserve Bank of India (RBI). Before any currency note of any denomination can be “minted” (printed), it has to go through an elaborate process of obtaining approvals authorising it to come into existence. Upon printing, each currency note has a distinct and unique ID number that is recorded as a liability by the RBI, acknowledging its existence and the fact that the RBI “promises to pay the bearer a sum of Rupees equivalent to its face value”. This currency note begins its life by being distributed via currency chests to banking intermediary then to individuals before being used in day to day transaction. The currency note gets “mixed” with other currency notes of similar or different denomination and is used to carry out ongoing transactions. In this way it loses its own identity till it gets soiled and is returned to the RBI, whereupon RBI replaces this with a new currency and records the destruction of the old note via its unique ID number. Given its nature, the transactions remain anonymous. 

If one could record the entire life history of a currency note right from its printing, through all the change of hands it undergoes (say through the use of Aadhaar ID), right till the time it is returned to RBI and destroyed, such a system could keep a record of every note ever minted and where it is currently resting. Such a system would be the Indian equivalent of the blockchain. Table 1 lists some statistics around the bitcoin blockchain.

The Bitcoin Blockchain over the years has proven to be robust and has withstood cryptographic scrutiny and adversary attacks while attracting more users, investors and participants.

Limitations of Bitcoin Blockchain

There are some limitations in the bitcoinb blockchain design currently.

Some of these are:

(i) As the bitcoin blockchain keeps all records (transactions and blocks) linked together the size of the blockchain is about 95 GB (December 2016) and growing. 

(ii) Throughput—at about 7 transactions per second (tps)—the bitcoin blockchain network is slower than current production systems like PayPal (150 tps), SWIFT (~200 tps), Visa (2000 tps) or Twitter (5000 tps). 

(iii) Latency— it currently takes about 10 minutes to create a new block thus introducing latency

(iv) Bitcoin blockchain by design consumes power to perform complex computations as proof of work. There are varying estimates of its power consumption, for example, O’Dwyer (2014) estimated total power used in the bitcoin ecosystem in 2014 at between 0.1 and 10 GW as compared to average Irish electrical production and demand of 3 GW. The computation power of the bitcoin blockchain computers (comprising over 5000 nodes) is eight times more powerful than the computational power of the 500 most advanced supercomputers combined (Cowley 2013). However, POW that consumes the bulk of this power, is a design component of bitcoin blockchain and cannot be easily tampered with. 

(v) Given the theoretically limited supply of bitcoin (21 million), some economists argue that bitcoin could be deflationary in the long run, which could cause its downfall. 

(vi) Improvement in computing devices, for example, quantum computing would likely make the POW computation relatively trivial thereby undermining its design. The bitcoin blockchain would need to devise additional, stronger computational challenges to keep pace with quantum jump in computing prowess.

(vii) As mining has become computationally intensive, the power of individual miners, in relation to, mining pools has diminished. If the trend continues, there could be a situation of a monopoly mining pool emerging and subverting the basic design of the system. Additionally there is a concentration of hash power in a single country, namely, China with attendant geopolitical risks.

(viii) Bitcoin software code is “open source”, written and maintained by voluntary coders working independently in an informal self-governing structure, which has been prone to criticism from various quarters. In order to find acceptance as an industry utility, its internal organisation needs to be redefined. For example, its governance structure is delaying adoption of say “Segregated Witness (SegWit)”, a new protocol that strips signatures from transactions to increase system throughput as 95% consensus is needed to adopt this “hard-fork.”

(ix) Regulatory implications of the revolutionary technology present a dilemma for the legal structures as they currently stand. 

Blockchain or Distributed Ledger as a Generic Technology 

Blockchain or more generally Decentralised Ledger Technology (“DLT”) can be adapted to handle and maintain record of transactions in any digital currency or token or unique identification of any asset. 

Davidson (2016) has described blockchain as a “General Public Technology” (Bresnahan and Trajtenberg 1995, Lipsey et al 2005) along the lines of technologies like the steam engine, electricity and internet. As such it has vast implications for usage across industries and transactions in public and private lives.

Werbach (2016) discusses how blockchain could be the most consequential development in IT since internet by solving age-old human problem of trust through permitting users to trust the output of a system without trusting any actors within it. He further identifies that challenges in blockchain are fundamentally a matter of governance rather than computer science. He envisages the need for law and blockchain to work together through cooperation rather than competition or conflict.

In today’s world, nearly every database is centralised, for example, citizen registry, land title registry, assets registry, passport systems. Centralised solutions have the advantage of being efficient to create, establish and enforce rules but they tend to be expensive, monopolistic and prone to abuse over time. Blockchain can potentially disrupt any centralised database. 

Davidson (2016) argues that blockchain as a public database is a revolution in institutions, governance and organisation rather than just a simple technological or monetary innovation. The authors point out that often entrepreneur or technological innovation led competition is met with political response, which while could not compete on cost alone, co-opt legislation or regulation to negate technological innovation models (Williamson 1979). The authors invoke Transaction Cost Economics (TCE) (Coase 1937, 1960) to enquire why certain transactions take place in a market and certain others in an organised firm. They posit that incomplete contracts occur only in an organised firm setting while complete contracts occur in a market. Blockchain only operates on complete contracts and forces certain incomplete contracts away from organised firms towards open markets thereby extending the domain of the markets and reducing the operating space for firms.

Freidlmaier (2016) evaluates blockchain on the basis of Rogers’ (1962) Diffusion of Innovation Theory along five attributes of (i) relative advantage, (ii) compatibility, (iii) complexibility, (iv) trialibility and (v) observability and deduces that while a, b and d above are clearly visible to adopters, attributes c and e are proving elusive for non-expert users of blockchain currently. 

Types of Blockchain

Blockchain has the characteristics of a generalised public utility. It can be viewed as a meta technology like the internet network or world wide web (WWW). Mougyar (2016) has visualised blockchain as below in Figure 1. 

As such, it can support native blockchain applications as also hybrid applications alongside the internet, thereby addressing problems of e-commerce in the internet world. It can also be created as a private network residing inside closed walls for the use and benefit of consortium within a private network. It can enjoy all benefits of DLT without the overheads of managing POW based consensus. In the private blockchain domains, alternate consensus models such as “proof of stake” have emerged as participants are usually part of a “trusted” cohort and not anonymous peers or nodes like in bitcoin blockchain. This has the advantage of dramatically improving scalability.

Pilkington (2015) identifies private, public and hybrid blockchains and identifies similarities and differences between them and particular situations where these would be appropriate. For example, Land registries maintained by public ledgers may not be acceptable or recognised by governments where they are unable to intervene to correct records.

Morini (2016) argues that blockchain use case is not application of technology to a business model, but a reform to the business model itself. The author identifies that blockchain is facilitating a move away from double entry book-keeping and reconciliation paradigm to a single entry record-keeping one, eliminating centuries of waste. He also identifies that while financial contracts are encoded as software currently, blockchain introduces a paradigm where software code is itself the contract. 
This has given rise to blockchain systems like Ethereum which is a Turing-complete blockchain. Ethereum introduced the concept of a Decentralized Autonomous Organization (DAO), a self-running corporation without any individuals that can programmatically enter into transactions upon some event taking place without any manual intervention; basically a network of self-running corporations that could transact among themselves upon some well-defined public events happening or not happening. The applications for such a DAO could be significant within financial services and across other industries and government sectors.

Besides bitcoin blockchain and Ethereum there are multiple other instances of work undertaken in DLT systems. Most of these are collaborative efforts across multiple leading corporations either led by a technology major (for example, HyperLedger project led by Linux Foundation or by an industry association R3 consortium of financial sector players or private entities, for example, Ripple). Table 2, is a comparative table of a few popular Blockchain and DLT systems. 

 

Yli-Huumo (2016) mapped research on the blockchain technology to identify current research topics from a technology perspective. Their analysis revealed that over 80% of 41 primary papers they examined related to bitcoin and the balance to non-bitcoin applications for blockchain. Majority of the papers addressed limitations from a privacy and security perspective while surprisingly few addressed the serious challenges around throughput and latency. Given the novelty of the topic, the authors unsurprisingly found that the vast majority of the papers were published within the previous 18 months indicating a recent and ongoing interest in the field. The authors identify that research around the problems of latency, throughput and size as also versioning, hardfork, softfork is limited and possible areas for future study. 

The potential for blockchain-based technology solutions to fundamentally disrupt many industries and processes remains valid. Its adoption in mission-critical applications would depend on societies, governments and businesses (i) identifying the risks associated with this new technology, (ii) designing and adopting systems to ensure that benefits of the new technology are reaped, while (iii) unknown and potentially dangerous side-effects of adopting this technology are well understood and mitigated.