The evolution of monetary systems and what is used for money evolves. As it does, new problem are created that did not exist before. This is the case with digital currency.
When using physical currency, whether that is paper, coins, or horses, double spending is impossible. If one has $5 in banknotes, and it is used for payment of an item in a shop, that same money cannot be spent again by the individual. It is now out of his or her possession.
Shifting to a digital currency, regardless of the nature of it, creates the potential for a unit of the currency to be spent twice. Of the system is not aware of the first transaction, then we could see the same units spent again.
The double spend problem is the challenge with ensuring that digital currency is not easily duplicated.
Banks And Other Financial Institutions
Our present monetary system is made up of mostly fiat currency. Under this system, the banks are the ones responsible for the ledger. Their task is to keep track of the money by charting all transactions. Individual banks keeps the balances of all their customers' accounts and then engage in interbank settlement. This is often done with the cooperation of the central bank.
This situation is extended to all financial institutions running networks that are part of the monetary system. This includes payment systems such as Visa, SWIFT, ATM networks, and commercial banks. On the investment side, brokerage firms also maintain ledgers that interact with money market accounts.
Financial intermediaries are necessary, to a degree, to ensure double spending does not take place. Since most of the transactions related to trade or commerce involved physical currency, ensuring the non-duplication is vital. These institutions continually update their ledgers, monitoring all cash flow throughout their networks and recording the balances.
The system is effective in this regard yet is highly centralized.
Blockchain and Cryptocurrency
The pursuit of decentralized solutions regarding digital currency dates back to the 1980s. It was the Cypherpunk crowd that started the process in this direction. Many set up digital cash networks such as eCash and Bit Gold. Early attempts were thwarted for various reasons.
Systems of this nature do not have centralized entities to settle disputes. For this reason, a solution was required that did not have a centralized quorum, an feature that was part of Bit Gold.
In 2008, the Bitcoin White Paper was released by Satoshi Nakamoto. In it, a peer-to-peer, electronic payment system was laid out. This was the first time that the double spend problem was solved for a digital currency.
Cryptocurrency became the solution that was sought for the better part of two decades.
Bitcoin, handled this problem by creating a decentralized system of nodes that worked to solve cryptographic puzzles. The nodes competed against each other to arrive at a solution. The one that can up with the answer was able to add the latest transactions to a block and attach that to the chain. For this, a block rewards, coins tied to that blockchain, were issued.
The key was each node ran a copy of the software, updating the ledger with each new block. The winner block producer would transmit the new information to all other nodes who would verify and update their copies.
Any transactions that did not match consensus were rejected by the others.
As the transactions were incorporated into the ledger, wallet balances were updated. A blockchain uses what is known as Distributed Ledger Technology (DLT) which reduced the risk of block validators inserting inaccurate information. Since all nodes have a copy of the ledger, it is easy to see when one is out of alignment.
When a network is made up of node operators who are unrelated, we end up with a decentralized system. Since all are incentivized to keep the ledger accurate, the double spend problem is eliminated.
The process is the same no matter what mechanism is used for consensus. Most popular are:
- Proof-of-Work (PoW) - Bitcoin and Litecoin
- Proof-of-Stake (PoS) - Ethereum and Cardano
- Delegated-Proof-of-Stake (DPoS) - Hive
Security is important for any online application. When it comes to money, it is crucial. The integrity of a decentralized ledger must be beyond question. Here is where trust is added in a trustless system.
There is huge financial incentive for attacks to try and gain control of a blockchain system. If this is accomplished, transactions can be pushed through that move money around, draining funds from the proper wallets. Under the PoW mechanism, this is known as a 51% attack. Those seeking to infiltrate gain control of 51% of the hash rate and then can alter the ledger.
Bitcoin has likely passed the point where a 51% attack is not feasible. Other systems are working on ensuring their coin distribution is such that no individual or group can gain control of the block producers. Those with pre-mines or founders' stakes find this difficult since a large percentage of the coins are in the hands of only a few wallets.