This article was written by Fred Piechoczek. All views and opinions expressed are strictly his own.
Enter the Dark Net, the world of illicit transactions, drug dealing and money laundering: how to charge for fake medicines sold to the gullible and soon to be debilitated if not dead.
Wads of cash in suitcases do not work well over the Internet. Enter the crypto-currencies, some would say, like Bitcoins. Well, is this the case, and what is really going on? Actually, there is a bright side, and the maths and encryption underlying these new-fangled virtual currencies is likely to have a dramatic effect on mainstream finance. Let’s try and cut through the complexity and see what this is all about.
Much written about the blockchain is complex and opaque, but the blockchain can be simply described. The underlying maths causes fog to descend in the minds of the most talented wordsmiths, but you do not have to know the maths to understand the concept.
How to create transferable value
In the early days of banking you could travel Europe and pay your way. You could bear a letter of credit which said, ‘We know this man and will honour his debt to you.’ This payment mechanism required a correspondent banking network and time-consuming messages (like the SWIFT messages banks use today). Alternatively, you could retrieve the purse beneath your jerkin and drop a gold sovereign on the counter to give immediate value.
Coinage, whether coined by the Sultan or the King, had value that could be established by weighing it in your hand and biting it. Gold or silver was proof of value, authenticated on the coin by a stamp of the profile of the King on the coin. There were multiple issuers of currency and a commonly agreed coinage value. The gold of a coin is not ‘used’: it is a token of value.
A crypto-currency like Bitcoin can achieve the old fashioned status of gold and more. With the blockchain and the crypto-currencies derived from it, you achieve immediate value. This relies on the ‘distributed ledger’ described below, which shares some of the characteristics of multiple issuers, whether King or Sultan.
Gold is mined, refined and smelted. This is a wearisome process, but once it has all been done, the gold is easily identified as gold. For the blockchain, you run a difficult mathematical calculation to reach a solution and create a block. Each successive block is then linked to create a blockchain. This is the ‘gold’ of the Bitcoin. People who use high powered computers to perform these complex calculations are called miners. It is a wearisome process, like mining gold, but once created, the blocks of a chain have value. Like gold, the blockchain is difficult to create but easy to authenticate.
Encryption and authentication
If we have a piece of gold, we can test it anywhere to establish its value, for the metal that it is. For the Bitcoin its value is recorded in the ‘distributed ledger’, for the mathematical computation that it is. The ‘distributed ledger’ is simply a record in many locations (nodes) of the blocks in the blockchain. The blocks are mathematical computations that are all exactly the same at each node. They are ‘agreed’ because they are the same series of mathematical solutions, block by linked block. If one node has the maths wrong, it can be proved and discarded. There is no requirement for central control: the distributed ledgers and their computations prove the ‘intrinsic’ value of the blockchain, like the intrinsic value of gold.
Transfer of value
Value is transferred from one party to another by adding the transaction to the blockchain, and the transfer is recorded and authenticated at each node of the distributed ledger, providing a mathematical record that cannot be disputed. The settlement process can be at the speeds our computers are happy to perform at, almost instant.
In the same way as a currency like Bitcoin can be created out of the blockchain, the blockchain can also be used for any kind of transaction that requires verification, by attaching the transaction to a blockchain. This gives the instant value of the exchange of a gold coin, as compared to the backwards and forwards nature of authentication messages or comparisons to central records.
For the financial world this offers efficiency, speed and cost saving. Systems relying on blockchains can be public or a private with access restricted to members. Substantial activity is underway to apply this technology to trade finance, securities settlement and trading, all of which will be dealt with in detail in future articles.
What this demonstrates is that Bitcoin and the blockchain are not so complicated after all. The same is true of quantum physics and relativity. I started to write proofs of both of these theories of modern science in the margin, but this article was too short and the space in the margin insufficient for me to record these proofs.