These days it is impossible to read the financial press without often stumbling upon intriguing hints that something called “the blockchain” is going to disruptively revolutionize banking and financial services. So, in this first of a series of introductory articles, we try to explain clearly and simply what blockchain technology is, and why it is considered highly relevant to the future of finance and banking.
Blockchains are the foundation of modern digital currencies – electronic money whose currency units are strings of bits, ones and zeros, living in computer memories and networks. The concept of digital currencies has been around for decades, but early on, they faced an apparently insurmountable roadblock: the “double-spending problem.”
Suppose user Alice sends a line of code with a monetary value to user Bob. Bob receives the code and can now able to spend it like money. But what is to prevent Alice from making a copy of the code before sending it to Bob, and sending it again to someone else? This is the double-spending problem.
You may have realized that we are calling the two users Alice and Bob because the solution to proving digital asset ownership has something to do with cryptography. In fact, Alice and Bob are often used to explain how cryptography works. Public-key cryptography is the science of easily exchanging securely encrypted messages with “public” decryption keys available in the open and “private” keys given to specific stakeholders. It has been considered a potential foundation for digital currencies since the launch of the PGP (Pretty Good Privacy) public-key encryption system in 1991. But leveraging public-key cryptography to solve the double-spending problem was a very challenging problem – until 2008.
In October 2008, a cryptographer called Satoshi Nakamoto – the name is probably a pseudonym and the person behind the Nakamoto identity has never been found – solved the double-spending problem. In a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” first announced in a popular cryptography mailing list, Nakamoto showed how a decentralized, distributed network of end-user computers, each running a piece of software built upon the public-key cryptography algorithms and communication protocols described in the paper, can keep track of all digital currency transactions between the users of the network in a shared public ledger called the blockchain, while avoiding double-spending.
In the example above, Alice would not be able to twice spend the digital currency code that she had previously sent to Bob, because a record of her first transaction would be on the blockchain, and the network would reject her second transaction.
The first implementation of Nakamoto’s discovery was developed by Nakamoto himself, then joined by a team of brilliant programmers. The team created the first working blockchain and the first working digital currency secured by public-key cryptography. The blockchain and its currency are called Bitcoin.
Of course, you have heard of Bitcoin. Yes, bitcoin is often described by the sensationalist press as an anonymous, highly volatile form of Internet money used by scammers and online drug dealers. You have probably heard of “Mt Gox” and “Silk Road.”
But the sensationalist press entirely misses the point. Bitcoin provides the first demonstration, complete with a working implementation, that blockchain technology can be used to replace legacy obsolescing financial infrastructures with lean, mean and much more efficient infrastructures.
Bitcoin transactions are much faster, much cheaper, and much more secure than legacy financial transactions. Furthermore, each and every bitcoin transaction – we are following the standard convention of using Bitcoin for the blockchain and bitcoin for the currency – is permanently recorded in the tamper-proof public blockchain, which permits much easier record keeping.
The users do not necessarily have to use bitcoin. For example, Alice can send U.S. dollars to Bob using the Bitcoin blockchain as a transparent intermediate step through a payment service provider. The payment service receives U.S. dollars from Alice, converts them to bitcoin by buying bitcoin on an exchange, and sends bitcoin to the payment service used by Bob. The payment is then converted again and sent to Bob.
If Bob is in another country, he can choose to receive the payment in his local currency. The important thing is that, even allowing for reasonable fees charged by the payment services and bitcoin exchanges involved, the transaction is faster and cheaper than traditional transactions. The difference is especially evident for cross-border transactions.
The potential benefits of Bitcoin – faster, cheaper, and traceable transactions – are so dramatic that, over the last couple of years, top banks, stock exchanges and financial service providers have started pilot projects to find out how to integrate blockchain technology in their operations, and venture capital firms are funding blockchain technology startups, with more than $1 billion total funding in 2015 so far.
Some pilot projects in the financial sector use the original Bitcoin blockchain as part of the settlement infrastructure, while others are developing new private blockchains unrelated to Bitcoin. Both approaches have their advantages and disadvantages, based on the design and intended purpose of the blockchain.
Blockchains can differ in structure and function based on a number of variables, such as how the blockchain achieves consensus on a transaction and the role of digital tokens. This newsletter will feature weekly educational discussions of the different aspects of blockchain technology and how it can be applied to real-world problems.
