Not another Bitcoin/Blockchain explainer

Bit-Coin Banega Crorepati

So I’ve been trying to wrap my head around bitcoin & blockchain for a bit now. While tech insiders discovered and bought bitcoin a long time ago (relatively), the rest of the world is just catching up, as the wildly volatile cryptocurrency has made mainstream news.

Blockchain technology has sparked nothing short of a technological revolution, and hundreds of startups are using it to do everything from simply “mining” cryptocurrencies, to enabling P2P transactions, to developing “smart contract” software based on blockchain tech, and much more. The world’s leading venture capitalists have invested millions (billions?) of dollars into these startups, if hedging their bets ever so slightly.

A16Z

 

Not another Bitcoin Explainer

After spending a lot more time on this than I probably should have, I have something to share. I think I have a handle on this (but this post’s Facebook comment feed will no doubt prove me wrong).

But you may say, you’re about 5 years too late Suparna. Why even bother? There are thousands of articles, YouTube videos, podcasts explaining bitcoin and its benefits, calling it a “fraud” (Jamie Dimon, CEO of JP Morgan), and defending it. The world really doesn’t need one more article, just like it doesn’t need another “Ronaldo vs. Messi: Who’s the best” video, or Pokemon. You’re right: there’s no shortage of articles explaining the concept of bitcoin and blockchain from a “30000 feet view” in MBA language. Things like it removes the need for a “trusted third party”, enables “seamless P2P transactions”, removes predatory transaction fees (the brokerages would like to differ), and so on.

But I’m sorry, world. For all the material that exists on bitcoin already, I found it pretty hard to move beyond the vocabulary and get inside the guts of the thing, while spending only a reasonable amount of time doing research. So I’ll be taking a crack at applying Feynman’s analogy method here and attempting to explain blockchain in simple terms. Mahatma Gandhi said, “Be the change you wish to see in the world”, so here’s the bitcoin/blockchain explainer I wish I had. Some disclaimers:

  1. This article is aimed at relative beginners, as an “Intro to Blockchain”
  2. The article is kind of long, but hopefully you don’t have to read anything else on the topic after this
  3. Non-casual readers ignore #2. This tech is evolving incredibly rapidly, and some of the stuff I’ll be trying to cover is already considered old school. So while this is a good start, it is certainly not the end
  4. I own a tiny amount of Bitcoin myself, bought as an experiment
  5. Apologies for the puns and the GoT references

Disclaimers taken care of, let’s dive in.

Table of Cointents

There’s a few concepts we need to cover here, so strap in. Satoshi Nakamoto’s (the inventor of Bitcoin) original paper introducing Bitcoin lays them out very nicely (link at the bottom)

  1. Nodes
  2. Incentive
  3. Ledger
  4. Privacy
  5. Authorizing a transaction
  6. Proof of Work
  7. Let’s Play
  8. Double Spend
  9. Blockchain

The analogy we’ll use throughout is a Monopoly game being played by 5 players: Robb, Sansa, Arya, Bran, and Jon.

 

1. Nodes

As everyone is aware, in a normal game of Monopoly, one of the players becomes the “Bank” – they handle currency, lend money if needed, and pay out the “Pass Go – Collect 200” winnings, etc. Now, our players absolutely hate being the Bank, as this person is responsible for handling the heavy Gold Dragons, the game’s currency. So they come up with a nifty way of bypassing the requirements of having a centralized Bank, and physical currency – and going completely cashless in the process (Modi would be proud). Instead of this system, they decide that all transactions will be executed using Fake Gold Dragons (FGDs), and that Robb, Sansa, and Jon will become “Authorizers” – responsible for approving each transaction (each play) as it occurs.

2. Incentives

Why should anyone agree to become an Authorizer (it involves a lot of work, as we’ll see)? For rendering this service, they are compensated with 1 FGD per transaction. Moreover, this is the only way new FGDs enter into circulation, so they’re highly prized.

3. Ledger

The Authorizers use a special book called the Ledger to keep record of all transactions. Each transaction is noted on a new page in the Ledger, as illustrated below (take a look first). In other words, each page carries a record of how many FGDs were transferred from one player to another. Moreover, each new page must reference the page that came before it. Every Authorizer has a copy of the book. Out of Robb, Sansa & Jon, whoever Authorizes the transaction first gets to decide what gets added to a new page. If Jon authorizes a transaction and adds a page to his book, then Sansa & Robb must update their book with identical information. Why is this done? To ensure that everyone’s book says the same thing and that the entire group can agree on one version of the facts. Side note: A copy of the book is always-accessible to every player and they can see every single move ever made in the game, ever, by flipping to the corresponding page.

Ledger

 

4. Privacy

None of the players trust each other too much (Season 7 vibes), and certainly don’t want all their Fake finances out in the open for everyone to see. So they come up with a way to hide their real identities. Each player has a “public” name, and a secret name. The ledger only contains players’ public names. And while anyone can see the public names written in the ledger, they cannot tie the public name back to the secret name. Confused? Assume for a minute that each player’s secret name is unknown (kind of like how Jon is actually Aegon). So the ledger might say Jon transferred 1 FGD to Sansa (their public names), when in fact “Aegon” will have transferred 1 FGD to “RealSansa”.

5. Authorizing a transaction

The process of authorizing a transaction involves two parts:

Part 1: accurately guessing the answer to a very difficult riddle set by Maester Aemon (who has created a very large number of such riddles. Not much of a riddle if you can only answer using guesses, if you ask me). Why is this totally random activity needed? Because if someone wants to go back and claim a different version of the page later (for whatever nefarious purposes), they would have to redo the work needed to solve the riddle and only then could they add a different version of the page in their own book. As more pages are added over time, it becomes increasingly tougher to change an older page – because you’d have to redo the work for that page, and catch up with all the pages that came after it, even as newer pages are getting added all the time.

Okay, so No riddle answer = No authorization = No fee (remember, the Authorizers get 1 FGD per transaction, which is why they’re doing this at all). Also keep in mind that you can only get to the answer of the riddle by random guesswork.

Part 2: checking through all pages in the book to verify that the payer has enough FGDs to give to the payee.

Whoever completes both parts first gets to authorize a transaction, add it to the book as a new page, and earn the 1 FGD fee.

6. Proof of Work

Apart from something managers like to ask for, “proof of work” is a concept with a very special meaning in our game. From the Bitcoin wiki: “A proof of work is a piece of data which is difficult (costly, time-consuming) to produce but easy for others to verify and which satisfies certain requirements.”

In our case, solving the riddle is proof that the player expended resources in the process of authorization.

For the sake of simplicity, let’s assume that each Authorizer’s guessing speed is more or less equal.

7. Let’s play

Say Bran owns 10 FGDs and wants to transfer all 10 FGDs to Arya in exchange for Fake Braavos. He communicates this intention to the Authorizers in random order: it so happens that Jon hears it before Sansa, and Robb doesn’t hear it for quite a while (side note: in the real world this lag is introduced because “players” are located all over the world, and it takes time to send info from one player to another over lousy internet speeds).

Remember, only the Authorizer who does their job first wins the fee.  As soon as Jon hears Bran’s intention, he begins his guesswork sprint. Soon afterward, Sansa joins the race.

8. Double Spend

While this is going on, Bran announces that he wants to make second 10 FGD transfer to Rickon, who’s just joined the game. Robb hears this intention first and begins his translation run. We know that Bran has already spent his 10 FGDs – but Robb doesn’t know this, because he’s not heard the 1st spend intention yet.

After 30 minutes hard work, Jon gets to the answer, checks that Bran has 10 FGDs, and adds an entry to his book. He just approved the Bran -> Arya 10 FGD transaction.

Sansa & Robb both update their books to reflect this change, as is mandated. When Robb finally cracks his (different) riddle and gets to the verification stage, his book says that Bran has 0 FGDs to give Rickon. So he rejects the Bran -> Rickon 10 FGDs transfer as Bran’s 10 FGDs are already spent.

9. Blockchain / “Pagechain”

This process of addition of authorized, back-referenced pages to the book creates the chain of pages or the “Blockchain”. (In reality the process differs a bit in that each block or page is composed of many transactions, not a single one. We’re assuming a single transaction per block for simplicity).

In conclusion

At this point, you might be wondering (like me), if this newfangled system is in fact better than someone just being the Bank and the players using Gold Dragons. Is it cheaper to expend vast amounts of energy (and Dornish wine) solving pointless guessing games, when compared to paying transaction fees to a bank? As for the problem of moving physical currency around the board, the Bank can keep a ledger noting all transactions and transfer monies in bulk at the end of each playing day. As long as the Bank is trusted by players, everything works smoothly. Why go to such lengths to circumnavigate the Bank?

  1. Lack of trust in existing financial systems: Banks have a terrible reputation. They’ve been repeatedly caught over the years manipulating financial systems for the benefit of insiders, at the expense of trusting customers. Bitcoin removes the need to trust any third party to process payments, because the verification of a transaction is dependent ONLY on anonymous, decentralized computational (riddle-guessing) power. As long as any 51% of the CPUs (guessers) on the system are “honest” for any transaction, you don’t need any single entity to stay honest for every transaction.
  2. Be anonymous online: At the same time, if someone wants to purchase illegal substances, they’d much rather do it completely outside the traditional financial systems, which are regulated, and require some form of identity capture
  3. Kill transaction fees: Banks earn fees for being the “trusted party” in a transaction between strangers. Think escrow account. For this service, they charge a fee (understandably). Cryptocurrencies remove the need for a trusted third party, and therefore ideally there should be 0 transaction fees. However there is a cost introduced into the system, that of solving the proof of work puzzle.

So what?

Blockchain technology undoubtedly has very real applications apart from cryptocurrencies, and very exciting things will likely occur in this space. The problem of computational resource wastage is also already being addressed, so that shouldn’t hold back progress here.

But will Bitcoin (and similar cyptocurrencies) be around in the long term? It remains to be seen, and their widespread use certainly depends on regulations that are being considered, and even introduced by several governments. An unregulated global currency is too much of a threat to existing powers. China recently banned trading Bitcoin and shut down exchanges, resulting in the price slump. Fiat currencies like the US dollar are as much of a “widely accepted myth” as Bitcoin, they just have the blessing of various governments.

While we wait, I’ll be holding on to my minuscule bitcoin stash, chain se.

 

Additional reading

  1. Bitcoin: A Peer-to-Peer Electronic Cash System, Satoshi Nakamoto
  2. NYT DealBook, Marc Andreessen
  3. Bitcoin for 5 year olds, Coindesk blog
  4. Why China would want to shut down Bitcoin, MarketWatch

 

Featured image credit: The Innovation Blog

2 Replies to “Not another Bitcoin/Blockchain explainer”

  1. Nice read/primer on the tech behind blockchain.

    Some contradictory thoughts:

    1. Banks have a bad rep no doubt, but it isn’t for messing up retailers’ payments. They have problems where they screw people over for self profits in other divisions : trading, investment banking, structuring, market manipulations (FX, rates) Bitcoin (or blockchain even) can’t solve more these problems in all likelihood. Additionally, banks are probably the most regulated entities after the crisis for good reason, and the manipulation incentive has declined drastically because of the large fines that come with it.

    2. I just dont think bitcoins are nearly as democratic as they are generally made to sound. The Dornish red is after all cheaper wholesale!

    3. And further on point 2 above, even though China is going around shutting shops, I somehow think the most advantaged from BTC is China! I think right now it is in their interests to have bitcoin around, let it bloom and gain acceptance around the world and _then_ regulate it! And the reason they are shutting down exchanges (and curiously, not mining!) is to send a message to other economies that says “Do not worry; Beijing is as worried about BTC as other countries and doesnt really see great benefits that might worry other nations”. Time shall test the conspiracy theory!

    1. Thanks 🙂 Your views are always super insightful.

      I broadly agree with all points, and point #2 is especially spot on.

      #1: Very true. You could argue that banks’ capacity to take on leverage (and risk) is dependent on how much savings they have left? Probably not a great argument. My point (not phrased too well) was that scandals like these give banks a bad rep – and cause people to lose trust, regardless of the actual reasons the scandals unfolded.

      Could you explain #3 a bit please? Specifically : “Do not worry; Beijing is as worried about BTC as other countries and doesnt really see great benefits that might worry other nations”
      Also on #3: it is much harder to regulate something once it is being used by a large number of people and once livelihoods depend on it. Case in point: Uber. When cities / nations try to outlaw Uber (like London is doing now), they call upon their millions of riders and thousands of drivers to protest the regulation/ban. Uber has won several times now using this tactic. It is politically and practically very difficult to seriously clamp down on Uber at this stage because of their scale. BTC is still a fringe deal, so easier to regulate / ban altogether. Then again, China can clamp down on anything if they want 😛

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