This article will cover some fundamentals of how traditional currencies work, and then using a creative analogy from the past, describing the principles and processes of Bitcoin.
Bitcoin is a household name, known for foreign remittance, money laundering and the occasional heist. But beyond the headlines it is a stable stress tested mechanism of exchange that will soon be affecting all of us, far more deeply than we might expect.
The principles that underpin Bitcoin (distributed blockchain) are now being adopted in more widely innovative ways. Although most of the work in this area has been done by entrepreneurial geeks, more recently large businesses in areas like finance, logistics and advanced weaponry are researching and implementing their own Blockchain solutions to solve a myriad of problems.
The basic principles of blockchain began hundreds of years ago with the introduction of double entry accounting. This simple process of matching debits and credits in a ledger reduced errors and increased the legibility of financial transactions. A bitcoin block is like a page in a ledger. The ledger grows as we add more pages, as with Bitcoin the chain grows as we add more blocks (each one chained to the last).
The entries in a ledger map to the real world movement of a given currency. Throughout history money has taken different forms. Up until around 200 years ago, wooden sticks known as Tally Sticks were still used to record transactions at a government level. A “ledger entry” would be captured in etchings on either end of a stick which was then broken in half, with each party in the transaction taking ownership of a piece. When recombined, the matching halves would validate each party in the exchange. As a peasant, if I had to give five sheep to the government, I could walk away with half a stick that represented that tax and could subsequently be used as a token to trade with to the value of five sheep - though it may be difficult to spend in the local tavern.
Most money systems are based on currencies backed by the authority of governments and monarchs. In the West, new money is issued by private banks, with central banks acting as a lever of control - changing rates of interest to expand and contract the money supply. Although most central banks are devolved from parliaments, it should be remembered that the act of engineering money supply is a fundamentally political act.
In our current system, known as Fractional Reserve, money is created in the form of loans. Private banks can lend (create new money) as long as they already have 10% of the value of those loans in assets. When you take out a mortgage, the 10% you provide to the bank is the collateral the bank needs to create the other 90%. This IOU is marked as a credit on the banks balance sheets. Although the Bank of England creates notes and coins (we’ll forget about Quantitative Easing for the moment), they account for only 3% of the the total supply, private banks have a license to print digital money.
Several important qualities are required for a currency to operate. Firstly it must be fungible (exchangeable with another thing), it must be trusted for that exchange to occur, we must be able to expand the money supply to grow its usage in the economy and it must be accepted widely. Without a monarch or government to back a currency - how can it gain public confidence? Bitcoin has solved many of these problems through the age old tradition of mining.
In traditional coinage, physical coins made of precious metal have an inherent value. Mining is an expensive, random and hazardous pursuit of a scarce resource. The scarcity and difficulty involved in mining creates an implicit value for the mined substance. With Bitcoin, instead of digging through the earth to find random fragments of metal, we create random puzzles to solve.
Now, let’s transport ourselves back in time to an imaginary company in England, we’ll call it the Victorian Coin Currency Company (V3C for short). This company (way ahead of its time) has decided to create its own currency and has implemented a system similar to blockchain, with the exception that it uses humans instead of computers (and they don’t have the internet).
We need motivated workers, but we don’t want to be directly responsible for any employees. To incentivise our workers the system will need to offer rewards. We invite anyone who possesses the relevant bookkeeping skills to come and work at our office to verify transactions. Anyone who completes the task of verifying all the transactions will be awarded a coveted Victoria Coin. This is how new money is created in our system.
If we imagine a giant room filled with accountants who are each independently assembling a single page of a ledger for that day's transactions and also verifying historical entries. It may be quite easy for a particularly talented individual to verify past and present transactions and present them to the master bookkeeper for inclusion - if that was all that was required the quickest scriber would always get there first. What if this speedy scriber was corrupt and could fiddle the books? For this reason it is important to distribute the work.
In order to avoid transaction verification becoming dominated by a handful of superfast workers we need to find a way of randomising which worker may submit their completed work first. We achieve this by giving every worker the same puzzle to solve. Once the puzzle is solved, only then may they submit their work.
The puzzle is a very complex equation where we know a number that is output but we don’t know what the input should be to get than answer. The puzzle is too complex to pick it apart and solve strategically, so all our accountants can do is plug in random numbers and hope with fingers crossed one of their guesses are correct.
Since our organisation is aiming to produce one ledger page per day and we can’t rely on having a fixed number of workers, the rate at which puzzles are solved will vary.
Subsequently, we must vary the difficulty of the puzzle in accordance with the total number of workers. If there are less workers we can make it easier or, if more, harder. An incentive is maintained by the Victoria Coin which makes it more likely any individual will win when there are fewer participants. The effect of this to always have a reasonable number of workers at any given time. As more join, some drop out because the task is less profitable and vice versa.
Through this process, we have a mechanism of creating trust because the whole ledger is re-checked with each new page. Older pages will be regarded as more authoritative than new pages because they have been re-checked many times. We create implicit value through the human attention and energy expended in verifying pages and we have a mechanism of expanding the money supply by creating new coins.
One last problem remains for V3C in order for their new currency to become a success. It must be popular. This is a problem V3C never solved. Because of the problems transacting at distance it would not be accepted by shopkeepers. Post was unreliable and intermittent and could cause huge delays. Sometimes transactions were intercepted and fraudulently modified (the special stamp given to clients to validate their transaction were easily copied) They had some success with large clients and shady underworld characters who would transact directly at the offices of V3C, however, the project ended in failure. The postal network was not secure, reliable or fast enough to bring wide acceptance to the Victoria Coin.
The problems faced by V3C are solved a century later by computers, cryptography and the internet in the form of Bitcoin and the distributed blockchain. Instead of bookkeepers collating transactions and solving puzzles, we now have computer hardware. Rather than collecting a page of transactions each day, Bitcoin targets a block every 10 minutes. Dedicated puzzle solving machines known as ASICs run in server farms around the world collecting together transactions into blocks and verifying the whole history of the chain. Each computer that solves the puzzle first gets a bitcoin. The total cost of energy inputs to the system in the form of electricity bring an implicit value to each coin. In just 8 years, Bitcoin has a total estimated value of 16 billion dollars.
V3C was unable to to handle postal transactions properly because mail was unreliable and vulnerable to interception. It wasn’t possible to be sure that transactions arriving were the same as those originally posted. In modern networking, this problems is solved with asymmetric cryptography. Using this system, we have one very long private (secret) code which is used to identify the owner of a wallet and “sign” transactions. This secret key can generate shorter public codes which provide others an address to send bitcoins. Whilst we can derive addresses and signatures from the private key, we cannot reverse engineer the private key itself from this data.
Although we can now transact globally with Bitcoin, it is still not practical to use in local shops. Since older blocks are more authoritative than newly minted ones, vendors often wait until a number of blocks (often six) have been added to the chain before accepting a transaction as fully verified. An hour delay may be acceptable in online retailing, but even ten minutes (one block) for a skinny flat white feels excessive.
The Bitcoin protocol can be used for more than basic P2P (peer-to-peer) transactions. The protocol also contains a scripting language which tie conditions to the release of funds allowing for the creation of Smart Contracts which we will cover in a later article.
If you would like any futher information or would like to discuss how you/your organisation could benefit from Bitcoin/Blockchain technologies please get in touch.