Distributed Ledgers & Blockchain Technology

Or, the rise of Crypto Currencies.

Technobabble!

When the concept is tried to be explained, it is often lost in translation because of the highly technical jargon surrounding it. To break it down, a ‘Distributed Ledger’ is simply a mechanism to store data. Much like a tangible ledger which proves to be an account of transactions; ‘transactional data’ may also be stored digitally. Currently, data is most widely stored on databases which prove to be a singular entity providing data stores and all data exists on centrally controlled servers. The central authority may be the government, or a multinational conglomerate that provides cloud storage services. However, by nature, a database is a record that may be altered, amended or entries on a database may be deleted. However, the purpose of a ledger is to preserve an immutable and unalterable record of data. Distributed Ledger Technology (DLT) translates the general purpose of a ledger and makes it available technologically. It becomes tricky to understand when it is a distributed ledger.

A distributed ledger is a network of ‘data stores’ with each participant of the network, or each ‘node’ maintains a copy of all the information on that network, i.e. on the blockchain. Thus, the blockchain is one iteration of the distributed ledger technology, made possible by the internet.

Moreover, the data that is stored on each of those nodes, is also cryptographically encoded, thereby preventing any unauthorized access by anyone but the owner of such data. It is the fundamental value driver of the blockchain, promoting its mass adoption as central data stores maintained by centralized entities leaves the data fully at the mercy of that entity. They are then free to do what they please with such information.

Block? Chain?

Imagine a literal box that can store ordinary stick files. Once the box is full of stick files, is is then sealed permanently and a new box is placed on top it, to store the next set of transactions until it is filled and then sealed, and so on. It is also important to note that each block creates an imprint on the subsequent block thereby linking it chronologically to the next block, thereby creating a continuous chain. While the data stored within the blocks are cryptographically encoded to prevent tampering and misuse, the data pertaining to the data stored in those blocks, or meta-data is public knowledge and is available to peruse at will.

Each of those “stick-files”, i.e. the transactions are also run through algorithms (in a process called hashing) which gives an output of fixed characters, which is what is stored in the block. Thus, several layers of cryptography ensure the safety and immutability of data.

Why a blockchain and Crypto Currency?

Self sovereignty and governance. In the traditional system, value is stored in the form of currency (other than assets in other forms of course). And understandably, there is the threat of threat, degradation/wear & tear or simply you may lose it. This led to the creation of banks who would act as the custodian, providing security to such funds (currency). Once banks came into existence, complex economic activity was enabled, routed through the middle man, who would lend the money, they have the custody of, while charging large amounts as interest from the borrower and paying out interest at much lower rates to depositors and making profits out of the difference.

This newfound technology flips that notion on its head and allows an individual and virtually any person to be their own “bank”. Now, not only is peer to peer (P2P) transactions possible without a middle man, it is also possible at a fraction of the cost and can also happen seamlessly across borders. The only requirement is access to the internet.

The undeniable benefits translates into trillions of dollars worldwide as all the associated costs of infrastructure, salaries etc. are all eliminated, making that money to be available in trade and commerce.

Now, is that prima facie beneficial? It is debatable. As a lot of people stand to lose their jobs as banks become virtually irrelevant. The sunk cost of infrastructure that is already in place is also an issue. However, the pros outweigh the cons.

Fundamental Shift

The traditional system fancies a central authority as it has the backing of the government and there are mechanisms for redressal of disputes that certainly occur when money is involved. If you lose your money, or if the bank runs away with your money, you can always go to court, right?

They also prove to be the governing authority regarding the “truthfulness” of a particular transaction. When it comes to physical paper money, if I use a particular note to avail a service or buy a good, it is impossible for me to use that same note once again. There was never an issue of ‘double spending’. However, once the economy became digital, long before crypto currencies came into existence, the issue of double spending was a significant one. Anything digital can be made copies of. This means that I can use currency that I have already spent, to purchase more things. This effectively breaks the system. Computer programs were then developed and the control remained with the central authority that will verify the “truthfulness” of a transaction to prevent double spending. We trust the government, so we trusted the banks, so we trusted that they will maintain integrity of all transactions. However, the data that is stored was never immune to external attacks. Any hack of the servers of a bank, wholly puts all funds in that bank at risk. Moreover, it also leaves the money in the control of that central authority.

Crypto-currencies are a direct result of that trust being broken when the middlemen, i.e. the Banks sold to their trusting customers, financial instruments at a premium, solely to make personal profits, eventually resulting in the Global Financial Crisis in 2008.

Thus, adoption of crypto currencies also brings along with it, a fundament shift in ideology and trust, that was once put in institutions and the government, onto immutable technology.

Now, we still trusted the governments to maintain the integrity of the transactions and when for most part they did and continue to do, why must we shift our trust onto technology, especially when it is not backed by the Government and there is no recourse if I lose my money?

Good Question!

A small fraction of the population that is tech savvy and also has a greater appetite for risk have understood that the sunken costs as mentioned earlier is all irrelevant and the new proposed system of conducting commerce is far more efficient when an unnecessary middleman is cut out. Is that reason enough to make such a fundamental shift? It is a matter of personal opinion, until mass adoption drives people to partake in the new system. Money and transfer of value is no longer limited to arbitrarily determined, territorial boundaries and a truly global economy is emerging, it is only a matter of time until it inevitably becomes the system. Is this Article slightly skewed towards adoption of Crypto currencies? Heck yes! I am all for it, but the purpose of this work is not to convince the readers to adopted. It is best to stay updated on a development that will invariably take the world by storm.

Central Authority Vs. Democratic Consensus

Transactions in the traditional system, routed through banks are verified and validated by the computing systems of the banks. Now we trust it, then why not trust the new system that is proposed which is undeniably more efficient and allows for greater economic activity? Its because most people don’t understand how it works!

Who decides if a transaction is true?

Why do they get to decide it?

What do they get for deciding it?

Here it is relevant to understand consensus mechanisms. Sounds confusing? It isn’t, I promise you!

The nodes I mentioned earlier are participants of the network (i.e. the blockchain) that help securing the data that is put on that network. The developers create the code that will run as the blockchain which is essentially the “operating system of the block-chain” much like Windows on your Computer or iOS and Android on your phone. The nodes run the software on their systems and also maintain a copy all the data on the network, thus resulting in the distributed ledger. But why will one want to be a node? Simple, economic incentive. In return for their help in securing the network and validating the transactions and maintaining an immutable record of the data, they are paid. How are they paid? Who pays them? ENTER - crypto currencies.

While it may be a loose description, you may call crypto currencies as ‘by-products of a blockchain’. Since they serve as incentive towards helping secure and validate the network, crypto currencies assume the nature of a store of value.

Note: A blockchain may also exist without any incentive mechanism, i.e. without any crypto currency attached to it. It fully depends on the purpose of the blockchain.

The nodes are rewarded by the preprogrammed software (OS of the blockchain, called the ‘protocol’) designed to release payment (in the form of crypto-currencies) if a necessary pre-condition is met. As the mechanism now works, the payments are made to a node, if a ‘block’ is found.

Proof of Work Vs. Proof of Stake

A slightly technical conversation is inevitable when discussing the fundamentals of crypto-currencies. So bear with me!

Both of the abovementioned terms are ‘consensus mechanisms’ that seek to provide to the network, a single source of truth. Earlier, the central authority would verify if the transactions are true, on a block chain, consensus is made democratic. A majority of the network will need to verify that the particular block under consideration is a valid block, thus ensuring the validity of all the transactions contained in that block.

In a Proof of Work (PoW) model, the nodes are put in competition against one another to get the right of validation of a lock. It is a competition as the protocol is designed in such a way that only the first person to find and validate a block will be rewarded for the same. The most famous (and the first) crypto currency ‘Bitcoin’ runs on a proof of work model, the abovementioned incentive is paid out in Bitcoin.

Work here refers to actual computing work that is required to be done. This is because the protocol (or OS of the blockchain) presents an increasingly difficult puzzle to be solved with each subsequent block, in order to be able to validate that block. Once the node that cracks the puzzle has verified that the block is valid, that information is then relayed (through basic http, which is how you access any website) to the rest of the nodes to receive their consensus, once that consensus is achieved, the block is added to the chain and so on. However, this system proved to be quite rudimentary as the nodes are effectively put in an arms race to amass more computing power to be able to get the right of validation. Due to this, PoW networks are slow and hardly scalable, with high transaction times.

Proof of Stake (PoS) emerged as the solutions to the shortcomings of the PoW model. In the PoS system, the right of validation is vested in a node (Or, validator) as a direct function of the economic value that is “staked”. Much like a politician may stake their reputation on a statement they make, the node will stake economic value (in the form of the native token of that blockchain) in order to get the right to validate the block and thus the incentive for that block. In the Bitcoin blockchain, there is a predetermined mechanism as to how incentive is paid out to the nodes. With each block that is found, a certain number of Bitcoins are released to the node that found the block. This process has come to be known as “mining”.

As opposed to the PoW system, PoS involves staking, i.e. putting up economic stake for the right to validate a block. Thus, greater the economic stake, greater the chance of getting the right to validate a block. In order to prevent a monopoly of the validator with the highest economic stake, the protocol follows a randomized order and will not result in repetition of according the right of validation to the same validator.

I hope you guys are with me so far!

Incentive in a PoS system is paid out of the transaction fee of every transaction in the block that was most recently validated; paid out in the form of the native token of that blockchain.

These consensus mechanisms make such systems virtually immune to cyber (economic) crimes as it would require control of over 51% of the network in order to execute a hack. In PoW, this means that control should be had of over 51% of all computing power in the network, and in PoS system, this would imply that control should of over 51% of all the staked currency. In both cases, it proves to be far too expensive to execute such a hack.

However, this does not mean that it cannot be hacked. Depending on the size of the network and the number of node/validators on the network, relatively new and emerging networks may be hacked and has been.

The economic stake far outweighs any gain a “staker” may make by falsifying the record and if found to be acting maliciously, will be instantly kicked and will lose the economic stake they had put up. Now as there is economic incentive attached to providing the services of “mining” or the activity of staking; crypto currencies have emerged as a new class of tradable financial asset. Unlike shares however, which are only representative of the performance of a company, Digital Financial Assets also are a store of value.

Certainly not confusing, is it??

The technology therefore presents an immutable way of preserving data, transfer of value and a seamless mechanism to conduct peer to peer transactions across borders. The only requirement is to trust the Software. But what if the software itself is malicious? Again, a good question!

Most blockchain developers chose to be documented if they are providing a legitimate service through their creation. This is called being doxxed (although the etymology of the word is in the negative). Moreover, the code that is the “OS of the blockchain” is also made public and open source which encourages peer review, which is integral to any scientific advancement. And if that isn’t enough for all you skeptics out there, the code is also professionally audited and those audit reports are also made available to the public and one can easily access these documents to conduct their own research before partaking in the crypto-economy.

Here is a simple flow-chart to help understand the whole mechanism

What are the kinds of crypto currencies, what purpose do they serve and what does one do with them?

Read on! As I discuss the same in my next work -

“Tokenization of the Economy”