Few people understand what it is, but Wall Street banks, IT organizations, and consultants are buzzing about blockchain technology. It's hard to remove blockchain from Bitcoin, so we'll start with Bitcoin as we work tounderstandthis technology's potential.
Bitcoin. Blockchain. Cryptocurrencies. Initial coin offerings.
Everyones talking about them, but what do these terms really mean?
As of this writing in mid-November 2017, the total market capitalization of cryptocurrencies hovers around $220B (with a single bitcoin trading for upwards of $8,000). Initial coin offerings (ICOs) have exploded in popularity, closing on $3B+ in funding in 2017 alone. Huge corporations like Walmart and Pfizer have completed successful blockchain pilots.
This explainer will offer simple definitions and analogies for blockchain technology. It will also define Bitcoin, Ethereum, blockchain broadly, and initial coin offerings, and highlight promising use cases for the technology. (For a deep dive into how Ethereum works, you can read our What Is Ethereum explainer.)
Lastly, this report will make clear the distinctions between distributed ledger technology and blockchain, and highlight where these technologies have an application and where they do not.
The 2008 financial crisis caused a lot of people to lose trust in banks as trusted third parties. Many questioned whether banks were the best guardians of the global financial system. Bad investment decisions by major banks had proved catastrophic, with rippling consequences.
Bitcoin also proposed in 2008 presented something of an alternative.
According to its whitepaper, Bitcoin was a peer-to-peer electronic cash system. It would allow for online payments [to move] from one party to another without going through a financial institution.
In other words, Bitcoin made digital transactions possible without a trusted intermediary. The technology allowed this to happen at scale, globally, with cryptography doing what institutions like commercial banks, financial regulators, and central banks used to do: verify the legitimacy of transactions and safeguard the integrity of the underlying asset.
Bitcoin is a decentralized, public ledger. There is no trusted third party controlling the ledger.Anyone with bitcoin can participate in the network, send and receive bitcoin, and even hold a copy of this ledger if they want to. In that sense, the ledger is trustless and transparent.
The Bitcoin ledger tracks a single asset: bitcoin (Note: Bitcoin capitalized refers to the Bitcoin ledger, or protocol, while bitcoin in lowercase refers to the currency or a unit of account on the Bitcoin ledger).
The ledger has rules encoded into it, one of which states that there will only ever be 21M bitcoin produced. Because of this cap on the number of bitcoins in circulation, which will eventually be reached, bitcoin is inherently resistant to inflation. That means that more bitcoin cant be printed at a whim and reduce the overall value of the currency.
All participants must agree to the ledgers rules in order to use it.
Bitcoin is politically decentralized no single entity runs bitcoin but centralized from a data standpoint all participants (nodes) agree on the state of the ledger and its rules.
A bitcoin or a transaction cant be changed, erased, copied, or forged everybody would know.
Thats it, and its a big deal.
To understand better how this peer-to-peer electronic cash system allows for online payments to move from one party to another without going through a financial institution, lets use a simple example.
Heres a scenario: Alice hands Bob a physical arcade token. Bob now has one token, and Alice has zero. The transaction is complete. Alice and Bob do not need an intermediary to verify the transaction. Alice cant give Charlie the same token, because she no longer has the token to give she gave it to Bob.
But what if the same transaction were digital? Alice sends Bob a digital arcade token via email, for example. Bob should have the digital token, and Alice should not.
Right?
Not so fast. What if Alice made copies or forgeries of the digital token? What if Alice put the same digital token online for all to download? After all, a digital token is a string of ones and zeros.
If Alice and Bob own the same string of ones and zeros, who is the true owner of the digital token?If digital assets can be reproduced so easily, what stops Alice from trying to spend the same digital asset twice by also sending it to Charlie?
How can Alice and Bob establish unique ownership over the digital token?
One answer: use a database a ledger. This ledger will track a single asset: digital arcade tokens. When Alice gives Bob the digital token, the ledger records the transaction. Bob has the token, and Alice does not.
A trusted third party, an intermediary lets call him Dave will hold the ledger and make sure that its up-to-date. Alice cant hold the ledger because she might erase the transaction and say that she still owns the digital token, although she gave it to Bob. It also cant be Bob, because he could alter the transaction and lie to say that Alice gave him two tokens, doubling his arcade time.
By default, Dave who is not involved in the transaction at all, will have to control the ledger. Dave is trusted.
Thissituation is fine, until its not.
What if Dave decides to charge a fee that neither Alice or Bob want to pay? Or, what if Alice bribes Dave to erase her transaction? Maybe Dave wants the digital token for himself, and adds a false transaction to the ledger in order to embezzle it, saying that Bob gave him the token?
In other words what happens when Alice and Bob cannot trust the trusted third party?
Think back to the first physical transaction between Alice and Bob. Is there a way to make digital transactions look more like that?
Heres a thought: Alice and Bob could distribute the ledger to all their trusted friends, not just Dave, and decentralize trust. Because the ledger is digital, all copies of the ledger could sync together. If a simple majority of participants agree that the transaction is valid (e.g. confirm that Alice actually owns the token she wants to send), it gets added to the ledger.
When a lot of people have a copy of the same ledger, it becomes more difficult to cheat. If Alice or Bob wanted to falsify a transaction, they would have to compromise the majority of participants, which is much harder than compromising a single participant.
Alice cant claim that she never sent a digital token to Bob her ledger would not agree with everyone elses. Bob couldnt claim that Alice gave him two tokens his ledger would be out of sync. And even if Alice bribes Dave to change his copy of the ledger, Dave only holds a single copy of the ledger; the majority opinion would show the digital token was sent.
In sum, this distributed ledger works because everyone is holding a copy of the same digital ledger. The more trusted people that hold the ledger, the stronger it becomes.
Such a ledger allows Alice to send a digital token to Bob without going through Dave. In a sense she is transforming her digital transaction into something that looks more like a physical one in the real world, where ownership and scarcity of an asset is tangible and obvious.
You may have noticed a key difference between the above example and Bitcoin. Specifically, Alices and Bobs ledger only allows trusted friends to participate. In contrast, Bitcoin is entirely public, and anyone can participate.
How can we get all these untrusted nodes to agree on the state of the ledger? How can we avoid bad actors corrupting the ledger?
Lets think about this for a moment. A public ledger would allow for many more participants. The more participants, the stronger the ledger becomes. Right?
As you may have guessed, its not that simple.
Because Bitcoin expands beyond trusted participants and gives anyone access, it runs a higher risk of bad actors and false transactions.
Sure, we also ran a risk of bad actors when it came toAlices and Bobs trusted friends:Dave mightturn untrustworthy. However, Bitcoin is free and open to anyone, trusted or not, like a Google document that anyone can read and write to.
How can we get all these untrusted nodes to agree on the state of the ledger? How can we avoid bad actors corrupting the ledger?
Bitcoin offers a solution: reward good actors and scare off bad ones, a classic carrot and stick act.
In simple terms, certain Bitcoin participants are incentivized to do the dirty work and maintain the network.These participants called miners bundle transactions into a block, add this newest block to the chain of prior blocks (hence: blockchain is used to describe Bitcoins unique database structure),and devote immense computational power to the network in the process. For doing this work, these miners are rewarded with bitcoin.With a single bitcoin priced at upwards of $8,000, this is a very strong incentive.
When miners devote computational power, they also use a tremendous amount of electricity. So much electricity, in fact, that arecent estimate put the Bitcoin blockchains total daily energy consumption at greater thanEcuadors, a country of 17M people.
This scares away hackers and bad actors because hacking Bitcoin to get everyones coins would cost a tremendous amount of computing power, electricity, and money.Further, if the Bitcoin community became aware of the hack, it would likely cause the price of bitcoin to drop steeply. This makes such an attack economically self-defeating.
In technical terms, this mining process creates Bitcoins consensus mechanism, called Proof of Work.
This clever game-theoretic model creates a ledger that everyone trusts, but nobody controls.
OK, lets connect all the dots:
Since Bitcoin launched in 2008, thousands of other cryptocurrencies and altcoins (alternative coins) have emerged.
Because Bitcoins code is open-source, anyone can use Bitcoins code to create an altcoin. Many of them seek to improve on Bitcoin or expand its capabilities. Remember Bitcoins rules: it caps the number of bitcoin at 21M and uses the Proof of Work system to secure the network. Other cryptocurrencies use different rules and engage with other economic models.
Hard to say. Its true that the value of one bitcoin has gone from around $300 in 2015 to above $8,000 in recent weeks. If you had invested $100 in bitcoin in 2011 that bitcoin would be worth over $2.5M today.
As discussed, Bitcoins blockchain allows for the creation of a unique and scarce digital asset where everyone knowsthe history ofeach bitcoin. A single bitcoin is not just a string of ones and zeros, but the first successful (at least so far) censor-proof, portable, easily transactable, durable, and secure digital asset.
Bitcoins value is subject to the same supply-and-demand mechanics found in any marketplace. If investors find the above characteristics valuable and demand for bitcoin grows, bitcoins price rises and vice versa.
Bitcoins supply is limited to 21M coins (although only about 17M have been mined so far). You can do the math, but as of this writing investors value bitcoin at upwards of $120B in aggregate.
To give a sense of how the market values other cryptocurrencies, heres some market information about some of the top ones:
Theres lots more to Bitcoin that were not going to get into. Hashes, public-private key encryption, segregated witness, sidechains, forks, and block size, among other elements, fall outside of the scope of this piece.
So far, weve discussed two types of ledgers.
The first, Alices and Bobs distributed ledger for digital arcade tokens,is private.
The second, Bitcoins decentralized ledger for bitcoin,is public. Anyonecan participate. To ensure its public, decentralized ledger remains secure, Bitcoin uses a blockchain.
If we were to define blockchain as a technology separate from Bitcoin, it might look something like this:
Blockchain technology offers a way for untrusted parties to reach agreement (consensus) on a common digital history. A common digital history is importantbecause digital assets and transactions are in theory easily faked and/or duplicated. Blockchain technology solves this problem without using a trusted intermediary.
The short answer: in unique instances.
Specifically, a blockchain is needed for Bitcoin because:
Effectively, Bitcoin uses a blockchain to decentralize payments. Where else could we use this unique database architecture to get rid of the middleman? Are there other things that could bedecentralized?
Lets take this step-by-step. Whats another scenario where everyone needs a record of ownership, and where a trusted third party isnt preferred?
A couple of immediate use cases come to mind.
Land title is one. It could be quite useful for everyone to have access to a decentralized source of record saying who owns a given parcel of land. Considering that coups and wars often redistribute land unfairly and/or incorrectly, this could not only prove useful, but also have humanitarian implications. Once a land distribution is agreed upon, it can be recorded in a distributed ledger and no longer be subject to ongoing debate. A number of companies are working on this, including velox.RE.
In the same vein, a blockchain could be used to establish ownership over any number of physical assets cars, art, musical instruments, and so on. Lets think about why this makes sense.
A paper record of title is prone to forgery and/or physical degradation. Centralized databases are prone to hacking, human error, and/or tampering. A blockchain means there is no single entity controlling the ledger. Therefore, recording physical assets on a blockchain is a prime example of where the technology might come in handy to track ownership with a tamper-proof, neutral, and resilient system.
Identity might also be low-hanging fruit. The recent Equifax hack exposed the social security numbers of 143M Americans. Social security numbers were never meant to be used for identification; notice how this old social security card proudly states not for identification.
Blockchain technology might present a better means of establishing identity. Instead of a state or government issuing it, identity could be verified on an open, global blockchain controlled by nobody and trusted by everybody. Thus, users could control their own identity. A number of companies are working in this arena, including ID2020 and Civic.
The applications for blockchain technology extend well beyond these two examples.
Lets back up for a moment.
We mentioned that Alices and Bobs private implementation where everyone knows and trusts everyone involved doesnt need a blockchain (or miners to verify and append transactions to the cryptographically-protected blockchain).
Without blockchains verification step, were left with a distributed ledger, basically a decentralized spreadsheet that is only accessible to a select groupof trusted parties. Because this ledger is private, it doesnt need the same security measures as Bitcoin.
Its important to make this distinction.
The hype around Bitcoin, blockchain, and cryptocurrencies has contributed to renewed interest in distributed ledger technology. This is the idea of distributing a database among participants to ensure a commonrecord of truth. Bitcoin uses distributed ledger technology and adds a consensus layer on top the blockchain.
Because Alices and Bobs participants are trusted and their ledger is private, Bitcoins blockchain isnt needed. In fact, a blockchain might prove unwieldy, slow, and overly complex for Alices and Bobs ledger, for reasons which well address below. Instead, a trusted third party could be used to lightly administer a distributed ledger.
Bitcoin and Ethereum (which well dive into below) are considered public, permissionless blockchains. This means anyone can access them.
On the other hand, if all parties are known and trusted, distributed ledger technology could provide sufficient security.One example ofdistributed ledger technologyis R3s Corda, which is working with major financial services organizations to improve banking processes.
Whiledistributed ledger technology and blockchain technology each have their own pros and cons, the important thing to remember here is that blockchain is not a cure-all. For Bitcoin, a public, permissionless blockchain is the only possible solution. In many other instances, a blockchain would be a terrible idea.
Blockchains are really good at a couple of things and absolutely awful at others.
Weve addressed the distributed ledger versus blockchain debate above. Another major issue is scaling blockchains.
For a blockchain to work, lots of participants need to hold up-to-date copies. This means that the same database is held by thousands of nodes. This is fairly inefficient.
If we were to look at how technology has developed over the past fifteen years, blockchain runs counter to the logic behind cloud computing. Cloud computing trends toward a single database that multiple nodes can access. These nodes dont have to hold their own private copy of this database.
Further, nodes holding copies of the blockchain receive constant updates. These nodes are distributed around the world. Because of this, blockchains have high latency (latency is the amount of time it takes for data to move through the network). As a result, blockchains face scaling issues. Bitcoin can process about 3-4 transactions per second. Ethereum maxes out at about 20 transactions per second. Visa can process over 1,500 transactions per second.
Scaling is just one of the issues facing blockchain technology, but its an important one.
We asked earlier what other applications could be built with blockchain technology.
Recall that Bitcoin is, effectively, a decentralized application for payments. Ethereum adds another layer by allowing users to put code on its blockchain that executes automatically. This code is called a smart contract. In this way, Ethereum hopes to create a decentralized computing platform a global supercomputer.
To illustrate a smart contract, lets say Alice and Bob enter into a bet.
Alice thinks that the temperature tomorrow morning will reach 70 degrees. Bob thinks that it will stay lower. They wager 10 bitcoin on the outcome. If Alice and Bob dont trust each other, they will have to use a trusted third party as an escrow agent. In other words, they will each have to give the agent that amount of bitcoin, and the agent will distribute the winnings and the amount staked to the winner.
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