Introduction to Blockchains

blockchain /ˈblɒktʃeɪn/ : A system in which a record of transactions made in bitcoin or another cryptocurrency [is] maintained across several computers that are linked in a peer-to-peer network.

Oxford Dictionary

blockchain: A digitized, decentralized and continuously growing public ledger that consist[s] of records called blocks, which are linked and secured using cryptography.

Urban Dictionary

Welcome to Blockchain Certificate program. We will take you on a journey of learning about blockchain technology and the cryptocurrencies that use them.

Maybe you’re coming in with only a general idea of what blockchains are, or maybe you’re totally confused. That’s okay. This is such a new topic that even the above dictionaries don’t have entirely correct definitions – and those were the best we could find!

In this course, we will start with blockchain technologies’ historical context in computer science and finance. We will identify what problems blockchains are invented to solve, then we’ll go into the basics of how blockchains work. In following courses, we’ll expand on these ideas and show you real-world implementations and nitty-gritty details. You’ll eventually be prepared for your capstone project – building a cryptocurrency from scratch!^[1]

Historical Context of Banking and Money

The origin of the word ledger is legger, the Dutch word for lay. A ledger is the principal financial bookkeeping log of transactions between a business and its counterparties. By enabling a summing of all debits and credits, a ledger determines the balance of each counterparty’s account at the business. For a bank, keeping a ledger is essential.

Banks have been around for a long time. For example, the Roman Empire had a complex banking system with loans, interest, and deposits. A guild of bankers, the Argentarii, had members in cities across the empire.^[2] Bankers kept a meticulous ledger of each deposit, withdrawal, and borrowing.

It’s always been terribly dangerous (read “inefficient”) to store physical money, and to make large payments with it. In Roman times, it took at least 27 days to travel from London to Rome, for instance, and real estate was easily worth several tons of silver and gold. Then, as now, it was natural for a large, geographically-dispersed economy to demand ledgered, paper-based transactions. Roman bankers were familiar with their own customers’ signatures and spending habits, and there arose a local payment system using perscriptio – paper cheques. Guild bankers were also familiar with each other’s signatures and could write perscriptio cashable in other cities.^[3]

Banking hasn’t changed much for 2000 years. It all depends on trust. The problem is that trust implies risk. Written signatures can be forged. Bankers can be robbed, make mistakes or lie, and pass losses onto their customers. Some customers are treated better than others. There’s a huge amount of room for human error.

Worse, when things go really awry, people can lose faith in that interconnected network of ledgered money – there’s a domino effect that endangers the whole economy. Even Rome suffered from bank runs, general economic panics, and bailouts!^[4]

What is money?

Economists usually consider money as something with these 5 properties^[5]:

1. Fungibility – each unit is interchangeable with each other
2. Durability – it doesn’t age or wear out after repeated use
3. Portability – it can be spent easily in transactions
4. Cognizability – it’s easy to calculate its price in terms of other goods and services
5. Stability – it can be readily spent or saved as a store of value

Commodity money

• Natural technology – arises spontaneously even in animals
• Gold and silver, traditionally (but also food, land, oil, diamonds, cigarettes, etc.)
• Money enters the system by coinage from mining^[6]
• Supply is constrained by the productivity of mines
• Must be physically stored and transported, with large amounts of operational risk and demurrage
• Transactions and loans occur peer-to-peer, in the physical realm 🙂
• Pricing is purely market-based
• Business cycles form when lots of people switch between spending and saving
• Risks of debasement^[7] and counterfeiting^[8]

Chequing

• Ancient technology
• Commodities are held as deposits in a bank
• Transactions are made between accounts on a ledger and authorized by signatures (something-you-know, like a password)
• Lower operational costs than commodities, but introduces fees
• Introduces the risk of bounced cheques and counterparty risk from bank defaults
• Allows credit markets to form^[9]
• Eventually evolved into electronic systems with account numbers and automated clearinghouses, but essentially the same thing

Banknotes

• Medieval technology
• Money enters the system from issuers as loans or in exchange for commodities^[10]
• Value is based on the issuer’s promise to redeem it back for the underlying commodity^[11]
• Eliminates chequing fees, but increases counterfeiting

Fiat Money

• Medieval technology
• Dollars, pound sterling, francs, yen, etc.^[12]
• Not backed by any commodities
• Money enters the system by loans (or giveaways) from a central bank
• Supply is only constrained by the willingness of the central bank to issue more money
• Demand is backstopped by defining it as “legal tender” – legally requiring it as payment for taxes – as well as for loan payments back to the central bank
• Pricing is influenced by government control of the central bank^[13]

Debit & Credit Cards

• 20th century technology
• Visa and Mastercard, plus minor and/or regional players such as Interac in Canada
• Essentially the same as interbank chequing with signatures, but introduces a second layer of security: something-you-have
• Depends on proof of ownership of the card itself – either by allowing a carbon paper imprint, magstripe swipe, chip-and-PIN challenge, or other confirmation code
• Allows nearly-instant payments over telephone networks by connecting to a centralized ledger
• Transactions are often buffered then paid off at the end of every month with a cheque or equivalent
• Visa was bootstrapped on September 18, 1958 with a drop of 60,000 unsolicited, pre-activated credit cards in Fresno, California – resulting in a 22% payment delinquency rate!^[14]
• Introduces the risk of credit card skimming and increases the risk of identity theft
• Introduces the risk of fraudulent chargebacks – payments that are reversed after an arbitrary period of time due to false claims of stolen cards

Internet Payments

• 1990s-2000s technology
• Paypal and Stripe, plus minor players
• Uses passwords and email accounts as the fundamental something-you-know/have
• Gateway functionality allows payments backed with any credit card or bank account, thus forming a strong network effect, commoditizing those older systems, and capturing their fees^[15]
• Reduces the risk of identity theft because merchants aren’t exposed to banking information
• Increases the risk of account hacking and chargebacks (nevertheless)
• Increases the risk of market monopolization, feature stagnation, and a single point of failure and censorship
• The most direct competitor to cryptocurrencies…

^[1] Basic programming skills, preferably in a C-like language, are a prerequisite for this program.

^[2] L. Schmitz, Smith’s Dictionary of Greek and Roman Antiquities – The Argentarii, 1875.

http://libertystreeteconomics.newyorkfed.org/2013/02/historical-echoes-cash-or-credit-payments-and-finance-in-ancient-rome.html

^[3] Romae Vitam, Ancient Roman Banking, retrieved 2018.

http://www.romae-vitam.com/ancient-roman-banking.html

^[4] W. Davis, The Influence of Wealth in Imperial Rome, Chapter 1: The Business Panic of 33 A.D., 1910. https://en.wikisource.org/wiki/The_Influence_of_Wealth_in_Imperial_Rome/The_Business_Panic_of_33_A.D.

^[5] Any introductory economics textbook author will list 5-7+ such properties.

^[6] You could argue that all physical currencies are derivatives of time. This isn’t an idle thought – it’s very relevant to Bitcoin and proof-of-work.

^[7] Governments have been known to confiscate all gold when politically expedient. When this happened in Rome, everyone got their coins back, except they were smaller. https://en.wikipedia.org/wiki/Roman_currency

In the United States in the 1930s, people got paper money in exchange for their confiscated gold, but the gold was held in Fort Knox and sold to foreign governments.

https://en.wikipedia.org/wiki/London_Gold_Pool

^[8] For fake gold stories, see http://www.americanfreepress.net/html/fort_knox_conundrum__208.html

^[9] Banks can lend more money than they have actually stored in the vault, with the expectation of making up for it by collecting interest from other loans. Prices become stabler because the money supply can quickly expand and contract to meet demand. Prices can destabilize, however, because bankruptcies can domino throughout the economy. See https://en.wikipedia.org/wiki/Money_supply

^[10] At one time there were over 5,000 different types of banknotes issued by various American banks.

https://en.wikipedia.org/wiki/Wildcat_banking

^[11] Banknotes are, philosophically, bearer bonds.

^[12] Most major government-issued currencies that are now fiat were once more-or-less convertible to US dollars, and in turn to gold, until 1971. https://en.wikipedia.org/wiki/Nixon_shock

^[13] Government banned private banknotes and monopolized money issuance in order to fund their own deficits and control interest rates, supposedly for the good of the nation.

^[14] J. Nocera, The Day the Credit Card was Born, The Washington Post, November 4 1994.

^[15] And from collecting interest on balances: https://www.feedough.com/how-does-paypal-make-money/