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Blockchain
BLUEPRINT FOR A NEW ECONOMY
Blockchain
Bitcoin is starting to come into its own as a digital currency, but the blockchain technology behind it could prove to be much more significant.
This book takes you beyond the currency (“Blockchain 1.0”) and smart contracts (“Blockchain 2.0”) to demonstrate how the blockchain is in position to become the fifth disruptive computing paradigm after mainframes, PCs, the Internet, and mobile/social networking.
Author Melanie Swan, Founder of the Institute for Blockchain Studies, explains that the blockchain is essentially a public ledger with potential as a worldwide, decentralized record for the registration, inventory, and transfer of all assets—not just finances, but property and intangible assets such as votes, software, health data, and ideas.
This book is part of an ongoing O’Reilly series. Mastering Bitcoin: Unlocking
Digital Cryptocurrencies introduces Bitcoin and describes the technology
behind Bitcoin and the blockchain. Blockchain: Blueprint for a New
Economy considers the theoretical, philosophical, and societal impact of
cryptocurrencies and blockchain technologies.
Melanie Swan founded and participated in new markets startups GroupPurchase and Prosper, and developed virtual world digital asset valuation and accounting principles for Deloitte. She is an instructor at Singularity University and an Affiliate Scholar at the Institute for Ethics and Emerging Technologies.
Topics include:
Concepts, features, and functionality of Bitcoin and the blockchain
Using the blockchain for automated tracking of all digital endeavors
Enabling censorship-resistant organizational models
Creating a decentralized digital repository to verify identity
Possibility of cheaper, more efficient services traditionally provided by nations
Blockchain for science: making better use of the data-mining network
Personal health record storage, including access to one’s own genomic data
Open access academic publishing on the blockchain
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Blockchain
Blueprint for a New Economy
Melanie Swan
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Preface
We should think about the blockchain as another class of thing like the Internet—a comprehensive information technology with tiered technical levels and multiple classes of applications for any form of asset registry, inventory, and exchange, including every area of finance, economics, and money; hard assets (physical property, homes, cars); and intangible assets (votes, ideas, reputation, intention, health data, information, etc.). But the blockchain concept is even more; it is a new organizing paradigm for the discovery, valuation, and transfer of all quanta (discrete units) of anything, and potentially for the coordination of all human activity at a much larger scale than has been possible before.
We may be at the dawn of a new revolution. This revolution started with a new fringe economy on the Internet, an alternative currency called Bitcoin that was issued and backed not by a central authority, but by automated consensus among networked users. Its true uniqueness, however, lay in the fact that it did not require the users to trust each other. Through algorithmic self-policing, any malicious attempt to defraud the system would be rejected. In a precise and technical definition, Bitcoin is digital cash that is transacted via the Internet in a decentralized trustless system using a public ledger called the blockchain. It is a new form of money that combines BitTorrent peer-to-peer file sharing1 with public key cryptography.2 Since its launch in 2009, Bitcoin has spawned a group of imitators—alternative currencies using the same general approach but with different optimizations and tweaks. More important, blockchain technology could become the seamless embedded economic layer the Web has never had, serving as the technological underlay for payments, decentralized exchange, token earning and spending, digital asset invocation and transfer, and smart contract issuance and execution. Bitcoin and blockchain technology, as a mode of decentralization, could be the next major disruptive technology and worldwide computing paradigm (following the mainframe, PC, Internet, and social networking/mobile phones), with the potential for reconfiguring all human activity as pervasively as did the Web.
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Currency, Contracts, and Applications beyond Financial Markets
The potential benefits of the blockchain are more than just economic—they extend into political, humanitarian, social, and scientific domains—and the technological capacity of the blockchain is already being harnessed by specific groups to address real-world problems. For example, to counter repressive political regimes, blockchain technology can be used to enact in a decentralized cloud functions that previously needed administration by jurisdictionally bound organizations. This is obviously useful for organizations like WikiLeaks (where national governments prevented credit card processors from accepting donations in the sensitive Edward Snowden situation) as well as organizations that are transnational in scope and neutral in political outlook, like Internet standards group ICANN and DNS services. Beyond these situations in which a public interest must transcend governmental power structures, other industry sectors and classes can be freed from skewed regulatory and licensing schemes subject to the hierarchical power structures and influence of strongly backed special interest groups on governments, enabling new disintermediated business models. Even though regulation spurred by the institutional lobby has effectively crippled consumer genome services,3 newer sharing economy models like Airbnb and Uber have been standing up strongly in legal attacks from incumbents.4 In addition to economic and political benefits, the coordination, record keeping, and irrevocability of transactions using blockchain technology are features that could be as fundamental for forward progress in society as the Magna Carta or the Rosetta Stone. In this case, the blockchain can serve as the public records repository for whole societies, including the registry of all documents, events, identities, and assets.
In this system, all property could become smart property; this is the notion of encoding every asset to the blockchain with a unique identifier such that the asset can be tracked, controlled, and exchanged (bought or sold) on the blockchain. This means that all manner of tangible assets (houses, cars) and digital assets could be registered and transacted on the blockchain.
As an example (we’ll see more over the course of this book), we can see the worldchanging potential of the blockchain in its use
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for registering and protecting intellectual property (IP). The emerging digital art industry offers services for privately registering the exact contents of any digital asset (any file, image, health record, software, etc.) to the blockchain. The blockchain could replace or supplement all existing IP management systems. How it works is that a standard algorithm is run over a file (any file) to compress it into a short 64-character code (called a hash) that is unique to that document.5 No matter how large the file (e.g., a 9-GB genome file), it is compressed into a 64-character secure hash that cannot be computed backward. The hash is then included in a blockchain transaction, which adds the timestamp—the proof of that digital asset existing at that moment. The hash can be recalculated from the underlying file (stored privately on the owner’s computer, not on the blockchain), confirming that the original contents have not changed. Standardized mechanisms such as contract law have been revolutionary steps forward for society, and blockchain IP (digital art) could be exactly one of these inflection points for the smoother coordination of large-scale societies, as more and more economic activity is driven by the creation of ideas.
Blockchain 1.0, 2.0, and 3.0
The economic, political, humanitarian, and legal system benefits of Bitcoin and blockchain technology start to make it clear that this is potentially an extremely disruptive technology that could have the capacity for reconfiguring all aspects of society and its operations. For organization and convenience, the different kinds of existing and potential activities in the blockchain revolution are broken down into three categories: Blockchain 1.0, 2.0, and 3.0. Blockchain 1.0 is currency, the deployment of cryptocurrencies in applications related to cash, such as currency transfer, remittance, and digital payment systems. Blockchain 2.0 is contracts, the entire slate of economic, market, and financial applications using the blockchain that are more extensive than simple cash transactions: stocks, bonds, futures, loans, mortgages, titles, smart property, and smart contracts. Blockchain 3.0 is blockchain applications beyond currency, finance, and markets—particularly in the areas of government, health, science, literacy, culture, and art.
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What Is Bitcoin?
Bitcoin is digital cash. It is a digital currency and online payment system in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. The terminology can be confusing because the words Bitcoin and blockchain may be used to refer to any three parts of the concept: the underlying blockchain technology, the protocol and client through which transactions are effected, and the actual cryptocurrency (money); or also more broadly to refer to the whole concept of cryptocurrencies. It is as if PayPal had called the Internet “PayPal,” upon which the PayPal protocol was run, to transfer the PayPal currency. The blockchain industry is using these terms interchangeably sometimes because it is still in the process of shaping itself into what could likely become established layers in a technology stack.
Bitcoin was created in 2009 (released on January 9, 20096) by an unknown person or entity using the name Satoshi Nakamoto. The concept and operational details are described in a concise and readable white paper, “Bitcoin: A Peer-to-Peer Electronic Cash System.”7 Payments using the decentralized virtual currency are recorded in a public ledger that is stored on many—potentially all—Bitcoin users’ computers, and continuously viewable on the Internet. Bitcoin is the first and largest decentralized cryptocurrency. There are hundreds of other “altcoin” (alternative coin) cryptocurrencies, like Litecoin and Dogecoin, but Bitcoin comprises 90 percent of the market capitalization of all cryptocurrencies and is the de facto standard. Bitcoin is pseudonymous (not anonymous) in the sense that public key addresses (27–32 alphanumeric character strings; similar in function to an email address) are used to send and receive Bitcoins and record transactions, as opposed to personally identifying information.
Bitcoins are created as a reward for computational processing work, known as mining, in which users offer their computing power to verify and record payments into the public ledger. Individuals or companies engage in mining in exchange for transaction fees and newly created Bitcoins. Besides mining, Bitcoins can, like any currency, be obtained in exchange for fiat money, products, and services. Users can send and receive Bitcoins electronically for an
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optional transaction fee using wallet software on a personal computer, mobile device, or web application.
What Is the Blockchain?
The blockchain is the public ledger of all Bitcoin transactions that have ever been executed. It is constantly growing as miners add new blocks to it (every 10 minutes) to record the most recent transactions. The blocks are added to the blockchain in a linear, chronological order. Each full node (i.e., every computer connected to the Bitcoin network using a client that performs the task of validating and relaying transactions) has a copy of the blockchain, which is downloaded automatically when the miner joins the Bitcoin network. The blockchain has complete information about addresses and balances from the genesis block (the very first transactions ever executed) to the most recently completed block. The blockchain as a public ledger means that it is easy to query any block explorer (such as https://blockchain.info/) for transactions associated with a particular Bitcoin address—for example, you can look up your own wallet address to see the transaction in which you received your first Bitcoin.
The blockchain is seen as the main technological innovation of Bitcoin because it stands as a “trustless” proof mechanism of all the transactions on the network. Users can trust the system of the public ledger stored worldwide on many different decentralized nodes maintained by “miner-accountants,” as opposed to having to establish and maintain trust with the transaction counterparty (another person) or a thirdparty intermediary (like a bank). The blockchain as the architecture for a new system of decentralized trustless transactions is the key innovation. The blockchain allows the disintermediation and decentralization of all transactions of any type between all parties on a global basis.
The blockchain is like another application layer to run on the existing stack of Internet protocols, adding an entire new tier to the Internet to enable economic transactions, both immediate digital currency payments (in a universally usable cryptocurrency) and longer-term, more complicated financial contracts. Any currency, financial contract, or hard or soft asset may be transacted
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with a system like a blockchain. Further, the blockchain may be used not just for transactions, but also as a registry and inventory system for the recording, tracking, monitoring, and transacting of all assets. A blockchain is quite literally like a giant spreadsheet for registering all assets, and an accounting system for transacting them on a global scale that can include all forms of assets held by all parties worldwide. Thus, the blockchain can be used for any form of asset registry, inventory, and exchange, including every area of finance, economics, and money; hard assets (physical property); and intangible assets (votes, ideas, reputation, intention, health data, etc.).
The Connected World and Blockchain: The Fifth Disruptive Computing Paradigm
One model of understanding the modern world is through computing paradigms, with a new paradigm arising on the order of one per decade (Figure P-1). First, there were the mainframe and PC (personal computer) paradigms, and then the Internet revolutionized everything. Mobile and social networking was the most recent paradigm. The current emerging paradigm for this decade could be the connected world of computing relying on blockchain cryptography. The connected world could usefully include blockchain technology as the economic overlay to what is increasingly becoming a seamlessly connected world of multidevice computing that includes wearable computing, Internet-of-Things (IoT) sensors, smartphones, tablets, laptops, quantified self-tracking devices (i.e., Fitbit), smart home, smart car, and smart city.
The economy that the blockchain enables is not merely the movement of money, however; it is the transfer of information and the effective allocation of resources that money has enabled in the human- and corporate-scale economy.
With revolutionary potential equal to that of the Internet, blockchain technology could be deployed and adopted much more quickly than the Internet was, given the network effects of current widespread global Internet and cellular connectivity.
Just as the social-mobile functionality of Paradigm 4 has become an expected feature of technology properties, with mobile apps for
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everything and sociality as a website property (liking, commenting, friending, forum participation), so too could the blockchain of Paradigm 5 bring the pervasive expectation of value exchange functionality. Paradigm 5 functionality could be the experience of a continuously connected, seamless, physical-world, multidevice computing layer, with a blockchain technology overlay for payments—not just basic payments, but micropayments, decentralized exchange, token earning and spending, digital asset invocation and transfer, and smart contract issuance and execution—as the economic layer the Web never had. The world is already being prepared for more pervasive Internet-based money: Apple Pay (Apple’s token-based ewallet mobile app) and its competitors could be a critical intermediary step in moving to a full-fledged cryptocurrency world in which the blockchain becomes the seamless economic layer of the Web.
Figure P-1. Disruptive computing paradigms: Mainframe, PC, Internet, Social-Mobile, Blockchain8
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M2M/IoT Bitcoin Payment Network to Enable the Machine Economy
Blockchain is a revolutionary paradigm for the human world, the “Internet of Individuals,” and it could also be the enabling currency of the machine economy. Gartner estimates the Internet of Things will comprise 26 billion devices and a $1.9 trillion economy by 2020.9 A corresponding “Internet of Money” cryptocurrency is needed to manage the transactions between these devices,10 and micropayments between connected devices could develop into a new layer of the economy.11 Cisco estimates that M2M (machine-to-machine) connections are growing faster than any other category (84 percent), and that not only is global IP traffic forecast to grow threefold from 2012 to 2018, but the composition is shifting in favor of mobile, WiFi, and M2M traffic.12 Just as a money economy allows for better, faster, and more efficient allocation of resources on a human scale, a machine economy can provide a robust and decentralized system of handling these same issues on a machine scale.
Some examples of interdevice micropayments could be connected automobiles automatically negotiating higher-speed highway passage if they are in a hurry, microcompensating road peers on a more relaxed schedule. Coordinating personal air delivery drones is another potential use case for device-to-device micropayment networks where individual priorities can be balanced. Agricultural sensors are an example of another type of system that can use economic principles to filter out routine irrelevant data but escalate priority data when environmental threshold conditions (e.g., for humidity) have been met by a large enough group of sensors in a deployed swarm.
Blockchain technology’s decentralized model of trustless peer-to-peer transactions means, at its most basic level, intermediary-free transactions. However, the potential shift to decentralized trustless transactions on a large-scale global basis for every sort of interaction and transaction (human-to-human, human-to-machine, machine-tomachine) could imply a dramatically different structure and operation of society in ways that cannot yet be foreseen but where current established power relationships and hierarchies could easily lose their utility.
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Mainstream Adoption: Trust, Usability, Ease of Use
Because many of the ideas and concepts behind Bitcoin and blockchain technology are new and technically intricate, one complaint has been that perhaps cryptocurrencies are too complicated for mainstream adoption. However, the same was true of the Internet, and more generally at the beginning of any new technology era, the technical details of “what it is” and “how it works” are of interest to a popular audience.
This is not a real barrier; it is not necessary to know how TCP/IP works in order to send an email, and new technology applications pass into public use without much further consideration of the technical details as long as appropriate, usable, trustable frontend applications are developed. For example, not all users need to see (much less manually type) the gory detail of a 32-character alphanumeric public address.
Already “mainstream wallet” companies such as Circle Internet Financial and Xapo are developing frontend applications specifically targeted at the mainstream adoption of Bitcoin (with the goal of being the “Gmail of Bitcoin” in terms of frontend usability—and market share). Because Bitcoin and ewallets are related to money, there is obvious additional sensitivity in end-user applications and consumer trust that services need to establish. There are many cryptocurrency security issues to address to engender a crypto-literate public with usable customer wallets, including how to back up your money, what to do if you lose your private key, and what to do if you received a proscribed (i.e., previously stolen) coin in a transaction and now cannot get rid of it. However, these issues are being addressed by the blockchain industry, and alternative currencies can take advantage of being just another node in the ongoing progression of financial technology (fintech) that includes ATMs, online banking, and now Apple Pay.
Currency application adoption could be straightforward with trustable usable frontends, but the successful mainstream adoption of beyond-currency blockchain applications could be subtler. For example, virtual notary services seem like a nobrainer for the easy, low-cost, secure, permanent, findable registration of IP, contracts, wills, and similar documents. There will doubtlessly remain social reasons that people prefer to interact with a lawyer about certain
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matters (perhaps the humanbased advice, psychoanalysis, or validation function that attorneys may provide), and for these kinds of reasons, technology adoption based exclusively on efficiency arguments could falter. Overall, however, if Bitcoin and the blockchain industry are to mature, it will most likely be in phases, similar to the adoption pattern of the Internet for which a clear value proposition resonated with different potential audiences, and then they came online with the new technology. Initially, the Internet solved collaborative research problems for a subgroup: academic researchers and the military. Then, gamers and avid recreational users came online, and eventually, everyone.
In the case of Bitcoin, so far the early adopters are subcultures of people concerned about money and ideology, and the next steps for widespread adoption could be as blockchain technology solves practical problems for other large groups of people, For example, some leading subgroups for whom blockchain technology solves a major issue include those affected by Internet censorship in repressive political regimes, where decentralized blockchain DNS (domain name system) services could make a big difference. Likewise, in the IP market, blockchain technology could be employed to register the chain of invention for patents, and revolutionize IP litigation in the areas of asset custody, access, and attribution.
Bitcoin Culture: Bitfilm Festival
One measure of any new technology’s crossover into mainstream adoption is how it is taken up in popular culture. An early indication that the cryptocurrency industry may be starting to arrive in the global social psyche is the Bitfilm Festival, which features films with Bitcoin-related content. Films are selected that demonstrate the universal yet culturally distinct interpretations and impact of Bitcoin. The festival began in 2013 and has late 2014/early 2015 dates in Berlin (where Bitfilm is based), Seoul, Buenos Aires, Amsterdam, Rio, and Cape Town. Congruently, Bitfilm allows viewers to vote for their favorite films with Bitcoin. Bitfilm produces the film festival and, in another business line, makes promotional videos for the blockchain industry (Figure P-2).
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Figure P-2. Bitfilm promotional videos
Intention, Methodology, and Structure of this Book
The blockchain industry is nascent and currently (late 2014) in a phase of tremendous dynamism and innovation. Concepts, terminology, standards, key players, norms, and industry attitudes toward certain projects are changing rapidly. It could be that even a year from now, we look back and see that Bitcoin and blockchain technology in its current instantiation has become defunct, superseded, or otherwise rendered an artifact of the past. As an example, one area with significant evolving change is the notion of the appropriate security for consumer ewallets—not an insubstantial concern given the hacking raids that can plague the cryptocurrency industry. The current ewallet security standard is now widely thought to be multisig (using multiple key signatures to approve a transaction), but most users (still early adopters, not mainstream) have not yet upgraded to this level of security.
This book is intended as an exploration of the broader concepts, features, and functionality of Bitcoin and blockchain technology, and their future possibilities and implications; it does not support, advocate, or offer any advice or prediction as to the industry’s viability. Further, this text is intended as a presentation and discussion of advanced concepts, because there are many other “Blockchain 101” resources available. The blockchain industry is in an emergent and immature phase and very much still in development with many risks.
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Given this dynamism, despite our best efforts, there may be errors in the specific details of this text whereas even a few days from now information might be outdated; the intent here is to portray the general scope and status of the blockchain industry and its possibilities. Right now is the time to learn about the underlying technologies; their potential uses, dangers, and risks; and perhaps more importantly, the concepts and their extensibility. The objective here is to provide a comprehensive overview of the nature, scope, and type of activity that is occurring in the cryptocurrency industry and envision its wide-ranging potential application. The account is necessarily incomplete, prone to technical errors (though it has been reviewed for technical accuracy by experts), and, again, could likely soon be out-of-date as different projects described here fail or succeed. Or, the entire Bitcoin and blockchain technology industry as currently conceived could become outmoded or superseded by other models.
The underlying sources of this work are a variety of information resources related to Bitcoin and its development. The principal sources are developer forums, Reddit subgroups, GitHub white papers, podcasts, news media, YouTube, blogs, and Twitter.
Specific online resources include Bitcoin industry conference proceedings on YouTube and Slideshare, podcasts (Let’s Talk Bitcoin, Consider This!, Epicenter Bitcoin), EtherCasts (Ethereum), Bitcoin-related news outlets (CoinDesk, Bitcoin Magazine, Cryptocoins News, Coin Telegraph), and forums (Bitcoin StackExchange, Quora).
Other sources were email exchanges and conversations with practitioners in the industry as well as my experiences attending conferences, Bitcoin workshops, Satoshi Square trading sessions, and developer meetups.
This work is structured to discuss three different tiers in the way that the conceptualization of Bitcoin and blockchain technology is starting to gel: Blockchain 1.0, 2.0, and 3.0. First, I cover the basic definitions and concepts of Bitcoin and blockchain technology, and currency and payments as the core Blockchain 1.0 applications. Second, I describe Blockchain 2.0—market and financial applications beyond currency, such as contracts. I then envision Blockchain 3.0, meaning blockchain applications beyond currency, finance, and markets.
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Within this broad category are justice applications such as blockchain governance, uplifting organizations (like WikiLeaks, ICANN, and DNS services) away from repressive jurisdictional regimes to the decentralized cloud, protection of IP, and digital identity verification and authentication. Fourth, I consider another class of Blockchain 3.0 applications beyond currency, finance, and markets, for which the blockchain model offers scale, efficiency, organization, and coordination benefits in the areas of science, genomics, health, learning, academic publishing, development, aid, and culture. Finally, I present advanced concepts like demurrage (incitory) currency, and consider them in the greater context of the widescale deployment of blockchain technology.
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Acknowledgments
I would like to acknowledge Andreas M. Antonopoulos, Trent McConaghy, Steve Omohundro, Piotr Piasecki, Justin Sher, Chris Tse, and Stephan Tual.
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CHAPTER 1
Blockchain 1.0: Currency
Technology Stack: Blockchain, Protocol,
Currency Bitcoin terminology can be confusing because the word Bitcoin is used to simultaneously denote three different things. First, Bitcoin refers to the underlying blockchain technology platform. Second, Bitcoin is used to mean the protocol that runs over the underlying blockchain technology to describe how assets are transferred on the blockchain. Third, Bitcoin denotes a digital currency, Bitcoin, the first and largest of the cryptocurrencies.
Table 1-1 demonstrates a helpful way to distinguish the different uses. The first layer is the underlying technology, the blockchain. The blockchain is the decentralized transparent ledger with the transaction records—the database that is shared by all network nodes, updated by miners, monitored by everyone, and owned and controlled by no one. It is like a giant interactive spreadsheet that everyone has access to and updates and confirms that the digital transactions transferring funds are unique.
The middle tier of the stack is the protocol—the software system that transfers the money over the blockchain ledger. Then, the top layer is the currency itself, Bitcoin, which is denoted as BTC or Btc when traded in transactions or exchanges. There are hundreds of cryptocurrencies, of which Bitcoin is the first and largest. Others include Litecoin, Dogecoin, Ripple, NXT, and Peercoin; the major alt-currencies can be tracked at http://coinmarketcap.com/.
Table 1-1. Layers in the technology stack of the Bitcoin blockchain
Cryptocurrency: Bitcoin (BTC), Litecoin, Dogecoin
Bitcoin protocol and client: Software programs that conduct transactions
Bitcoin blockchain: Underlying decentralized ledger
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The key point is that these three layers are the general structure of any modern cryptocurrency: blockchain, protocol, and currency. Each coin is typically both a currency and a protocol, and it may have its own blockchain or may run on the Bitcoin blockchain. For example, the Litecoin currency runs on the Litecoin protocol, which runs on the Litecoin blockchain. (Litecoin is very slightly adapted from Bitcoin to improve on a few features.) A separate blockchain means that the coin has its own decentralized ledger (in the same structure and format as the Bitcoin blockchain ledger). Other protocols, such as Counterparty, have their own currency (XCP) and run on the Bitcoin blockchain (i.e., their transactions are registered in the Bitcoin blockchain ledger). A spreadsheet delineating some of the kinds of differences between Crypto 2.0 projects is maintained here: http://bit.ly/crypto_2_0_comp.
The Double-Spend and Byzantine Generals’ Computing Problems
Even without considering the many possible uses of Bitcoin and blockchain technology, Bitcoin, at its most fundamental level, is a core breakthrough in computer science, one that builds on 20 years of research into cryptographic currency, and 40 years of research in cryptography, by thousands of researchers around the world.13 Bitcoin is a solution to a long-standing issue with digital cash: the double-spend problem. Until blockchain cryptography, digital cash was, like any other digital asset, infinitely copiable (like our ability to save an email attachment any number of times), and there was no way to confirm that a certain batch of digital cash had not already been spent without a central intermediary. There had to be a trusted third party (whether a bank or a quasibank like PayPal) in transactions, which kept a ledger confirming that each portion of digital cash was spent only once; this is the double-spend problem. A related computing challenge is the Byzantine Generals’ Problem, connoting the difficulty of multiple parties (generals) on the battlefield not trusting each other but needing to have some sort of coordinated communication mechanism.14 The blockchain solves the double-spend problem by combining BitTorrent peer-topeer file-sharing technology with public-key cryptography to make a new form of digital money. Coin ownership is recorded in
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the public ledger and confirmed by cryptographic protocols and the mining community. The blockchain is trustless in the sense that a user does not need to trust the other party in the transaction, or a central intermediary, but does need to trust the system: the blockchain protocol software system. The “blocks” in the chain are groups of transactions posted sequentially to the ledger—that is, added to the “chain.” Blockchain ledgers can be inspected publicly with block explorers, Internet sites (e.g., www.Blockchain.info for the Bitcoin blockchain) where you can see a transaction stream by entering a blockchain address (a user’s public-key address, like 1DpZHXi5bEjNn6SriUKjh6wE4HwPFBPvfx).
How a Cryptocurrency Works
Bitcoin is money, digital cash, a way of buying and selling things over the Internet.
The Bitcoin value chain is composed of several different constituencies: software developers, miners, exchanges, merchant processing services, web wallet companies, and users/consumers. From an individual user’s perspective, the important elements in transacting coin (I’ll use “coin” in the generic sense here) are an address, a private key, and wallet software. The address is where others can send Bitcoin to you, and the private key is the cryptographic secret by which you can send Bitcoin to others. Wallet software is the software you run on your own computer to manage your Bitcoin (see Figure 1-1). There is no centralized “account” you need to register with another company; if you have the private key to an address, you can use that private key to access the coin associated with that address from any Internet-connected computer (including, of course, smartphones). Wallet software can also keep a copy of the blockchain—the record of all the transactions that have occurred in that currency—as part of the decentralized scheme by which coin transactions are verified. Appendix A covers the practicalities of maintaining an altcoin wallet in more detail.
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Figure 1-1. Bitcoin ewallet app and transferring Bitcoin (image credits: Bitcoin ewallet developers and InterAksyon)
eWallet Services and Personal Cryptosecurity
As responsible consumers, we are not used to many of the new aspects of blockchain technology and personal cryptosecurity; for example, having to back up our money.
Decentralized autonomy in the form of private keys stored securely in your ewallet means that there is no customer service number to call for password recovery or private key backup. If your private key is gone, your Bitcoin is gone. This could be an indication that blockchain technology is not yet mature enough for mainstream adoption; it’s the kind of problem that consumer-facing Bitcoin startups such as Circle Internet Financial and Xapo are trying to solve. There is opportunity for some sort of standardized app or service for ewallet backup (for example, for lost, stolen,
bricked, or upgraded smartphones or laptop/tablet-based wallets), with which users can confirm exactly what is happening with their private keys in the backup service, whether they self-administer it or rely on external vendors.
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Personal cryptosecurity is a significant new area for consumer literacy, because the stakes are quite high to ensure that personal financial assets and transactions are protected in this new online venue of digital cash. Another element of personal cryptosecurity that many experts recommend is coin mixing, pooling your coins with other transactions so that they are more anonymous, using services like Dark Coin, Dark Wallet, and BitMixer.15 As the marketplace of alternative currencies grows, demand for a unified ewallet will likely rise, because installing a new and separate wallet is required for most blockchain-related services, and it is easy to have 20 different ewallets crowding your smartphone.
Despite their current clunkiness in implementation, cryptocurrencies offer many great benefits in personal cryptosecurity. One of the great advantages is that blockchain is a push technology (the user initiates and pushes relevant information to the network for this transaction only), not a pull technology (like a credit card or bank for which the user’s personal information is on file to be pulled any time it is authorized).
Credit card technology was not developed to be secure on the Internet the way that blockchain models are developing now. Pull technology requires having datastores of customer personal information that are essentially centralized honey pots, increasingly vulnerable to hacker identity theft attacks (Target, Chase, and Dairy Queen are just a few recent examples of large-scale identity-theft vendor database raids). Paying with Bitcoin at any of the 30,000 vendors that accept it as of October 2014 (e.g., Overstock, New Egg, and Dell Computer; see https://bitpay.com/directory#/) means not having to entrust your personal financial information to centralized vendor databases. It might also possibly entail a lower transaction fee (Bitcoin transaction fees are much lower than merchant credit card processing fees).
Merchant Acceptance of Bitcoin
At the time of writing, the main Bitcoin merchant processing solutions for vendors to accept Bitcoin are BitPay and Coinbase in the United States, and Coinify in Europe.16 However, it is difficult for vendors, like the local café, to run two separate payment systems (traditional
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and Bitcoin), so a more expedient future solution would involve integrating Bitcoin payment into existing vendor payment networks. Mobile payment functionality is also needed for quick point-of-sale Bitcoin purchases (for example, a cup of coffee) via mobile phone. CoinBeyond and other companies focus on mobile Bitcoin payments specifically, and BitPay and CoinBase have solutions for mobile checkout. In one notable step forward, Intuit’s QuickBooks accounting software for small businesses makes it possible for vendors to accept incoming Bitcoin payments from CoinBase and BitPay with its PayByCoin module.17
Summary: Blockchain 1.0 in Practical Use
Blockchain is already cash for the Internet, a digital payment system, and it may become the “Internet of Money,” connecting finances in the way that the Internet of Things (IoT) connects machines. Currency and payments make up the first and most obvious application. Alternative currencies make sense based on an economic argument alone: reducing worldwide credit card merchant payment fees from as much as 3 percent to below 1 percent has obvious benefits for the economy, especially in the $514 billion international remittances market, where transaction fees can run from 7 to 30 percent.18 Furthermore, users can receive funds immediately in digital wallets instead of waiting days for transfers. Bitcoin and its imitators could pave the way for currency, trade, and commerce as we know it to be completely redefined. More broadly, Bitcoin is not just a better version of Visa—it could also allow us to do things we have not even thought of yet. Currency and payments is just the first application.19 The core functionality of blockchain currencies is that any transaction can be sourced and completed directly between two individuals over the Internet. With altcoins, you can allocate and trade resources between individuals in a completely decentralized, distributed, and global way. With that ability, a cryptocurrency can be a programmable open network for the decentralized trading of all resources, well beyond currency and payments. Thus, Blockchain 1.0 for currency and payments is already being extended into Blockchain 2.0 to take advantage of the more robust functionality of Bitcoin as programmable money.
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Figure 1-2. Bitcoin price 2009 through November 2014 (source: http://coinmarket cap.com/currencies/bitcoin/#charts)
Relation to Fiat Currency
Considering Bitcoin as the paradigm and most widely adopted case, the price of Bitcoin is $399.40 as of November 12, 2014. The price has ranged considerably (as you can see in Figure 1-2), from $12 at the beginning of 2013 to a high of $1,242 per coin on November 29, 2013 (trading higher than gold—$1,240 per ounce—that day).20 That peak was the culmination of a few factors: the Cyprus banking crisis (March 2013) drove a great deal of demand, for example. The price was also driven up by heavy trading in China until December 5, 2013, when the Chinese government banned institutions (but not individuals) from handling Bitcoin, after which the price fell.21 In 2014, the price has declined gradually from $800 to its present value of approximately $350 in December 2014. An oft-reported though disputed metric is that 70 percent of Bitcoin trades are made up of Chinese Yuan.22 It is difficult to eval‐ uate how much of that figure indicates meaningful economic activity because the Chinese exchanges do not charge trade fees, and therefore people can trade any amount of currency back and forth for free, creating fake volume. Further, much of the Yuan-denominated trade must be speculation (as is true for overall Bitcoin trade), as there are few physical-world vendors accepting Bitcoin and few consumers using the currency for the widespread consumption of goods and services.
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Some argue that volatility and price shifts are a barrier to the widespread adoption of cryptocurrency, and some volatility-smoothing businesses have launched to address this: Bitreserve, which locks Bitcoin deposits at fixed exchange rates;23 Realcoin’s cryptocurrency, which is pegged to the US dollar (USD); 24 and Coinapult’s LOCKS, which allow purchasers to peg Bitcoin to the price of gold, silver, the US dollar, the British pound, or the Euro.25 One of the first USD-pegged Bitcoin cryptocurrencies was Ripple’s XRP/USD BitStamp, and there is also BitShares’ BitUSD. Others point out that Bitcoin volatility is less than some fiat currency’s volatility and inflation (making Bitcoin a better relative value choice), and that many operations of Bitcoin are immediate transfers in and out of other currencies for which the volatility does not matter as much in these spot rate (i.e., immediate) transactions.
Bitcoin’s market capitalization as of November 2014 is $5.3 billion (see http://coinmar ketcap.com/), calculated as the current price ($399.40) multiplied by the available supply (13,492,000 Bitcoin). This is already on the order of a small country’s GDP (Bitcoin would rank as the 150th largest world economy on a list of 200). Unlike fiat currencies for which governments can print more money, the money supply of Bitcoin grows at a predetermined (and capped) rate. New currency (in blocks) is being issued at a regular and known pace, with about 13.5 million units currently outstanding, growing to a capped amount of 21 million units in 2040. At a price of roughly $400 Bitcoin per dollar, Bitcoin is infeasible to use directly for daily purchases, and prices and exchanges for practical use are typically denominated in subunits of millibitcoins (a thousandth of a Bitcoin; 1 mBTC = ~$0.40) and Satoshis (a millionth of a Bitcoin; 1 Satoshi = ~$0.000004).
Regulatory Status
Government regulation is possibly one of the most significant factors as to whether the blockchain industry will develop into a full-fledged financial-services industry. As of October 2013, a handful of countries have completely banned Bitcoin: Bangladesh, Bolivia, Ecuador, Iceland (possibly related to using Auroracoin, instead), Kyrgyzstan, and Vietnam. China, as mentioned, banned financial institutions
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from dealing in the virtual currency as of December 2013, although trading volume in Chinese Yuan persists.26 Germany, France, Korea, and Thailand have all looked unfavorably on Bitcoin.
27 The European Banking Authority, Switzerland, Poland, Canada, and the United States continue to deliberate about different Bitcoin-related issues.28 Countries try to match up Bitcoin (and the concept of digital currencies) to their existing regulatory structures, often finding that cryptocurrencies do not quite fit and ultimately concluding that cryptocurrencies are sufficiently different that new legislation might be required. At present, some countries, like the UK, have classified Bitcoin as a currency (and therefore not subject to VAT), whereas other countries, like Australia, were not able to classify Bitcoin as a currency due to laws about nationalized issuance (and Bitcoin therefore is subject to VAT or GST—the goods and services tax).29 In the United States, the Internal Revenue Service treats Bitcoin as property (like stock) and not as money, meaning that users of Bitcoin are liable for capital gains taxes on transactions.30 For taxation, virtual currencies are property, not currency.
However, nearly every other US government agency—including FinCEN (financial crimes enforcement network), banking regulators, and the CFPB, SEC, CFTC, and DOJ—regulate Bitcoin as a currency.31
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CHAPTER 2
Blockchain 2.0: Contracts
From its very beginning, complexity beyond currency and payments was envisioned for Bitcoin; the possibilities for programmable money and contracts were baked into the protocol at its invention. A 2010 communication from Satoshi Nakamoto indicates that “the design supports a tremendous variety of possible transaction types that I designed years ago. Escrow transactions, bonded contracts, third-party arbitration, multiparty signature, etc. If Bitcoin catches on in a big way, these are things we’ll want to explore in the future, but they all had to be designed at the beginning to make sure they would be possible later.”32 As we’ll see in Chapter 3, these structures could be applied beyond financial transactions, to any kind of transaction—even “figurative” ones. This is because the concepts and structure developed for Bitcoin are extremely portable and extensible.
Blockchain 2.0 is the next big tier in the development of the blockchain industry, an area of prodigious activity as of the fall of 2014.33 Because the Blockchain 2.0 space is in development, there are many different categories, distinctions, and understandings of it, and standard classifications and definitions are still emerging. Some of the terminology that broadly refers to the Blockchain 2.0 space can include Bitcoin 2.0, Bitcoin 2.0 protocols, smart contracts, smart property, Dapps (decentralized applications), DAOs (decentralized autonomous organizations), and DACs (decentralized autonomous corporations).
Whereas Blockchain 1.0 is for the decentralization of money and payments, Blockchain 2.0 is for the decentralization of markets more generally, and contemplates the transfer of many other kinds of assets beyond currency using the blockchain, from the creation of a unit of value through every time it is transferred or divided.
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An approximate technological metaphor for Bitcoin is that it is analogous to the protocol stack of the Web. After the underlying Internet technology and infrastructure was in place, services could be built to run on top of it—Amazon, Netflix, and Airbnb—becoming increasingly sophisticated over time and always adding new ways to take advantage of the underlying technology. Blockchain 1.0 has been likened to the underlying TCP/IP transport layer of the Web, with the opportunity now avail‐ able to build 2.0 protocols on top of it (as HTTP, SMTP, and FTP were in the Internet model). Blockchain 2.0 protocols either literally use the Bitcoin blockchain or create their own separate blockchains, but are in the same cryptocurrency decentralized technical architecture model of the three-layer stack: blockchain, protocol, and currency. However, it is important to note that these “new Internet plumbing layers” are very much still in development and any metaphor might become quickly outdated.
These analogies might be like calling Chrome a “Napster 2.0,” or Facebook or AdBlock a “Web Browser 3.0.” The key idea is that the decentralized transaction ledger functionality of the blockchain could be used to register, confirm, and transfer all manner of contracts and property. Table 2-1 lists some of the different classes and examples of property and contracts that might be transferred with the blockchain. Satoshi Nakamoto started by specifying escrow transactions, bonded contracts, third-party arbitration, and multiparty signature transactions. All financial transactions could be reinvented on the blockchain, including stock, private equity, crowdfunding instruments, bonds, mutual funds, annuities, pensions, and all manner of derivatives (futures, options, swaps, and other derivatives).
Table 2-1. Blockchain applications beyond currency (adapted from the Ledra Capital Mega Master Blockchain List; see Appendix B)34
Class
General
Financial transactions Stock, private equity, crowdfunding, bonds,
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mutual funds, derivatives, annuities, pensions
Public records
Identification
Private records
Attestation
Physical asset keys
Intangible assets
Public records, too, can be migrated to the blockchain: land and property titles, vehicle registrations, business licenses, marriage certificates, and death certificates. Digital identity can be confirmed with the blockchain through securely encoded driver’s licenses, identity cards, passports, and voter registrations. Private records such as IOUs, loans, contracts, bets, signatures, wills, trusts, and escrows can be stored. Attestation can be executed via the blockchain for proof of insurance, proof of ownership, and notarized documents. Physical asset keys (which is explored further in Chapter 3) can be encoded as digital assets on the blockchain for controlled access to homes, hotel rooms, rental cars, and privately owned or shared-access automobiles (e.g., Getaround). Intangible assets (e.g., patents, trademarks, copyrights, reservations, and domain names) can also be protected and transferred via the blockchain.
For example, to protect an idea, instead of trademarking it or patenting it, you could encode it to the blockchain and you would have proof of a specific cargo being registered with a specific datetime stamp for future proof (as is discussed in “Digital Art: Blockchain Attestation Services (Notary, Intellectual Property Protection)” on page 37).
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Financial Services
A prime area for blockchain businesses is interfacing cryptocurrencies with traditional banking and financial markets. Venture capital–backed Ripple Labs is using blockchain technology to reinvent the banking ecosystem and allow traditional financial institutions to conduct their own business more efficiently. Ripple’s payment network lets banks transfer funds and foreign exchange transactions directly between themselves without a third-party intermediary, as is now required: “Regional banks can now move money bilaterally to other regional banks without having to relay those funds through an intermediary.”35 Ripple is also developing a smart contracts platform and language, Codius. Another potential symbiosis between the traditional banking industry and Bitcoin is exemplified by Spanish bank Bankinter’s Innovation Foundation investment in Coinffeine, a Bitcoin technology startup that aims to make it possible for end users to buy and sell Bitcoin directly without an exchange.36 Other businesses are also connecting Bitcoin to traditional financial and payments market solutions. PayPal is an instructive example because its development as a platform has parallels with Bitcoin, and it is on the Bitcoin adoption curve itself. PayPal was initially an innovative payments market solution outside of the traditional financial-services market, like Bitcoin, but has since become a more formal business within the regulated industry, collecting and validating detailed personal information about its customers. PayPal had been known for being on the edge of financial inno‐ vation, but it then became more corporate focused and lost the possibility of providing early market leadership with regard to Bitcoin. Now, PayPal has been incorporating Bitcoin slowly, as of September 2014 announcing partnerships with three major Bitcoin payment processors: BitPay, Coinbase, and GoCoin.37 Also in September 2014, Paypal’s Braintree unit (acquired in 2013), a mobile payments provider, is apparently working on a feature with which customers can pay for Airbnb rentals and Uber car rides with Bitcoin.38 In the same area of regulation-compliant Bitcoin complements to traditional financial services is the notion of a “Bitbank.” Bitcoin exchange Kraken has partnered with a bank to provide regulated financial services involving Bitcoin.39 There is a clear need for an analog to and innovation around traditional financial products and services for Bitcoin—for
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example, Bitcoin savings accounts and lending (perhaps through userselected rules regarding fractional reserve levels). BTCjam is an example of such decentralized blockchain-based peer-to-peer lending. Tera Exchange launched the first US-regulated Bitcoin swaps exchange, which could make it possible for institutional and individual investors to buy Bitcoin contracts directly through its online trading platforms. Part of the offering includes an institutional Bitcoin price index, the Tera Bitcoin Price Index, to be used as the benchmark for trading USD/XBT contracts.40 In the same space, startup Vaurum is building an API for financial institutions to offer traditional brokerage investors and bank customers access to Bitcoin.
Another project is startup Buttercoin, a Bitcoin trading platform and exchange for high-volume transactions (200,000–500,000 Bitcoin, or $70–$175 million), targeted at a business clientele who has a need to complete large-scale Bitcoin transactions.41 Buttercoin is partnered with capital markets firm Wedbush Securities, itself one of the first security analysts to cover Bitcoin and accept Bitcoin payments for its research.
Other ventures are more radically positioned against artificial unregulated monopolies in the current stock trading market infrastructure, like the Depository Trust Company and the National Securities Clearing Corporation, or DTCC, which is involved in the clearing and settlement of securities. Overstock CEO Patrick Byrne and Counterparty created a new venture, Medici, announced in October 2014, to provide a decentralized stock market for equity securities in the blockchain model.42
Crowdfunding
Another prime example of how financial services are being reinvented with blockchain-based decentralized models is crowdfunding. The idea is that peer-topeer fundraising models such as Kickstarter can supplant the need for traditional venture capital funding for startups. Where previously a centralized service like Kickstarter or Indiegogo was needed to enable a crowdfunding campaign, crowdfunding platforms powered by blockchain technology remove the need for an intermediary third party. Blockchain-based crowdfunding platforms make it possible for startups