The Realm of Blockchain, Bitcoin and Cryptocurrencies

James Howells, an IT worker had one of the unluckiest days of his life when he lost the hard disk of his computer containing the private key to an account containing about 7500 bitcoins. At its peak, bitcoin was trading at around 18000 dollars, 7500 of which would be worth a whopping 130$ million dollars. It’s like losing the key to an unbreakable stronghold containing a shitload of money. And we talk about us having bad days!! The obvious question that pops up here is what made bitcoins acquire so much value in the first place and why everyone in the tech and finance industry is talking about them. Bitcoin and its inherent nature is something that has always intrigued me because in its core, it is something that goes against the establishment (Not that Iʼm an anti-establishment supporter). No government would want a currency that it cannot regulate. Governments would lose their ruling power and who knows.....the world just might get better.

Before we take the leap of faith into the realm for cryptocurrencies, we need to first establish a common ground on our understanding of money and what problem did it actually solve. Letʼs zone out a bit and enter a realm where thereʼs no money and no modern economy as such. Everything is exchanged using a barter system. Whatʼs a barter system? Itʼs a system where the only way you can “buy” anything is by exchanging what you produce with someone who wants your stuff.

But there is an inherent problem in this way of functioning. Economists call this the problem of “double coincidence of wants”. Simply put, you not only have to find a person who is in need of things that you have to offer but also he needs to offer things what you really need (now try saying that 10 times Xd). Both of your wants need to coincide for the exchange to happen. As you can imagine, you will not always find such a person. Because of this, a lot of potential trades didn’t took place and in turn, a lot of good opportunities for boosting the economy were lost. This is when the concept of using a common medium for trade was established. So people thought why not associate a certain substance with value and everyone just trades stuff in the unit of that substance? So people started associating a value with things like salt, leather, tobacco and subsequently gold. But gold was obviously too valuable to be carried around every time and it was difficult to buy small cheap substances, say a bar of soap with gold. So governments thought, why not print money in terms of something simpler, say paper. This paper currency will have value because it will be backed by gold (The gold standard). In other words, the government will only produce the money in accordance with the amount of gold it had ( This is no longer the case after the Bretton woods summit of 1944). Thus our current system and the economy, in general, was formed. But this currency that we associate value to and that we let control every element of our lives has a couple of major problems that prevent it from achieving the ideal state that we want. The 2 most significant of these problems were:- 

1.  Counterfeiting:- The money should be such that it should be impossible to replicate or counterfeit it. If that's not the case, then anyone could print countless amounts of money for himself and that would destroy its purpose. 
2. Centralisation:-The father of economics Adam Smith had put forth the law of the invisible hand. Simply said, it states that in an ideal economy flow of money should be totally free. There shouldn't exist any rules which could polarize the flow of money in any form. Let’s take an example - The RBI in India is a central authoritarian to Indian currency. It makes financial policies like tax distribution, inflation and many others which govern the flow of money to a large extent. According to the law stated above, such a central authority should not exist.

Counterfeiting is a relatively easy problem to solve. But there was no practical solution to having no central authority AND implementing prevention of counterfeiting simultaneously. India has the Reserve Bank of India in place which generates currency and takes effective measures to ensure that counterfeiting won’t be possible. But as discussed above, it also is the central authoritarian to money without which the country won’t be able to function. How do we solve this deadlock then?

 In 2008, a guy ( or a girl, or a group of guys or a group of girls. Real identity still unknown) with a name Satoshi Nakamoto published a paper named Bitcoin: A Peer-to-Peer Electronic Cash System and the term “Bitcoin” first came into existence. Initially, bitcoin was very slow in garnering interest and was restricted to a few geek users who had a good understanding of the system. The first-ever transaction of bitcoins was for buying 2 large Papa John’s pizzas for 10,000 bitcoins which were worth about 30$ then. But things have definitely changed since then and as of now while I am writing this blog, one bitcoin is valued up to 6,64,746 rupees. Who could have imagined that those 2 pizzas would be worth about $90 million today? But before we get back to drooling over just how wonderful this new currency is, let’s first address the elephant in the room and look into how exactly bitcoins solve the pain points that our traditional fiat currency had. Bitcoin uses a very smart combination of cryptography and some extremely intelligent programming to beat the traditional currency. But before we proceed any further, it is imperative to understand how a bitcoin transaction works.

 Let us work out a simple example to understand how a transaction is executed in bitcoin. Now, you need to keep in mind that bitcoin does NOT work as our normal currency that we transfer from one bank account to another. It works on the right basis. You owning a bitcoin would imply you having a right to transfer that bitcoin to anyone you see fit. Think this as a password. You spending your bitcoin would imply you transferring that password to someone else. Say, you buy something from me and make me the payment in bitcoin. That would imply that you have transferred the right to use that bitcoin from you to me. Only I can now transfer that bitcoin to anyone. So in a sense, I own that bitcoin now. This explanation is obviously oversimplified. But in a nutshell, this is how it works.

I would love to go into the details of it all and talk about everything ranging from cryptographic signatures, hash functions to things like proof of work and hash puzzles but then this would be a book and not a blog post. So, to keep this post simple and not bore you to death, I have simplified a lot of technicalities. Simplification comes at a cost and I would recommend that you take everything with a pinch of salt. The exact system is much more involved and simplifications such as these tend to smoothen over a lot of details. To start things, the entire bitcoin infrastructure relies on something known as the “Bitcoin Ledger”. And the best way to understand this Ledger thing is to look at how it helps in solving our fiat currency problems.

1. Centralisation:- Bitcoin is based on a “distributed” system known as the blockchain. What distributed means is that there is no single entity (Like RBI for India) that controls the entire system. Then how does this system solves the initial deadlock of a central authority that we talked before? There is one assumption that the bitcoin system follows that you guys should know of before we jump to the solution. It’s a simple and valid assumption that not all the users would be malicious at any given point in time. So even if one of the users start behaving maliciously, other users won't allow his transactions. This happens using something known as a distributed consensus protocol. Imagine blockchain to be a big fat notebook which records all the transactions that happen through the network. Every bitcoin that you spend, however small it may be, will be recorded on this register or notebook (the blockchain ledger). Every single user in the entire network has a copy of this register with themselves. And a transaction gets recorded in everyone’s register only if the person publishing the block gives green flag to it. Now what decides who will publish the block and why would he behave honesty, you would ask? All of these questions will be clarified when we start talking about bitcoin mining. For now, assume that only valid transactions make into the system and not the fraudulent ones. There’s a very smart way in which the bitcoin incentivises users to be honest but we will get to it in some time. All this makes the system extremely foolproof and resilient to any vulnerabilities. 
2. Counterfeiting:- In the bitcoin universe, this is something known as a double-spending problem. In terms of our normal currency, counterfeiting implies printing fake money, right? In the bitcoin sense, this is analogous to using the same bitcoin that you own for multiple transactions. Basically, if I have a bitcoin, is it possible for me to generate a fake copy of it? Or is it possible for me to spend one bitcoin simultaneously at two places to make two fraudulent trades out of it? Something like this should be impossible to pull off for bitcoin to be safe and secure. For all practical purposes, it is indeed impossible to pull this off in the bitcoin network because of 2 revolutionary techs that bitcoin is built on - “BLOCK REWARDS” and “BLOCKCHAIN LEDGER”. The same blockchain ledger that solved our centralisation problem helps curtail the threat of counterfeiting as well. Although the technology used to solve both the problems is same, I’ll attempt to explain the same thing differently just to make things simple to understand. Let’s again take an example – Let’s say there are three people Baburao, Raju and Shyam. Raju is the rightful owner of one bitcoin which he intends to spend lavishly. Raju plans to buy the big bungalow from Baburao and so pays him a bitcoin as a security deposit. Today if we purchase anything at a shop a bill is generated against it as a proof of the transaction, right? Similarly, as this exchange takes place a digital bill is generated against the bitcoin with all the required details ( including the fact that Raju paid this bitcoin to Baburao) on it in an encrypted format. Now suppose Raju also buys some stocks from Shyam (in the expectation that his money will be doubled in 21 days of course xD) and pays him the same bitcoin for it. A new digital bill will be generated for this transaction against that bitcoin. But, now this bill will also contain a copy of the previous bill in it. As any subsequent transaction takes place, a new bill will be generated for it with a copy of its previous bill – which will, in turn, contain a copy of the bill for the transaction before it. This way we will have a sequential record of all transactions the bitcoin has gone through. These records are available publicly to verify for every user. So if Raju tries to scam Shyam by giving him the already spent bitcoin, everyone including shyam will know about it since all his previous transactions, including the one in which he pays the Bitcoin to Baburao, is already recorded. This bill is what constitutes our register or more formally, “The bitcoin ledger”. 

Coming to the second piece of tech-“BLOCK REWARDS”, let’s clear some air around what exactly is it, how is it related to bitcoin mining and why is bitcoin mining not an easy way to make you a millionaire as some people portray it to be. 

The first question that we’ll attempt to answer is what incentivises the users to behave honestly? Obviously, we can’t construct our system on an assumption that all nodes will behave honestly. This assumption needs strong backing to ensure security and fairness. The system needs to penalise the users that behave unfairly or incentivise the users that behave honestly in some way. Also, why would other users spend their computational resources to verify the transaction that takes place in the bitcoin network? The answer to all these question is "BLOCK REWARDS". What bitcoin system does is, it rewards those users who verify the transactions and publish them in the blockchain. Simply put, users who make sure that the transactions are fair and write those transactions into the main register are rewarded. And the rewards are the bitcoins itself. This incentivises users to behave fairly because if they wouldn’t, they’ll lose their chance to earn the rewards. And the rewards are pretty substantial and not worth the risk of behaving unfairly. This is the only way new bitcoins are generated in the system and this is what we call "Bitcoin MINING". Currently, users are rewarded with 12.5 bitcoins and this number halves every 4 years. These rewards will continue to decrease until they will become 0 by 2140. At this point, there will be around 21 million bitcoins in the system. And what after that? Well, this is not a thing to worry about because there is another way miners can be rewarded. And this reward is the transaction fees. How this works is, miners are paid a small transaction fee by the users for verifying their transactions. So even if the block rewards cease to exist, the system will still function elegantly.

 The fairness in the system is ensured by another revolutionary concept from cryptography known as Hash Puzzles. This works on the merit system in a way that users get a chance to write on the register and earn the bitcoins only if they are able to solve a mathematical puzzle (read about "Proof of work" if you wanna know more about this). And the only way this puzzle can be solved is by "trial and error". What this means is, there is no algorithm or an equation to find the answer to this puzzle. You need to repeatedly try different numbers and check if it solves the puzzle or not. You need to repeatedly put random numbers in the puzzle and "hope" that one of them solves it. This implies that even if you buy say all the computing power of the world, it will only increase your probability of solving the puzzle and won't guarantee anything. So in a way, it is quite possible that a small Japanese kid with his pink mobile phone might beat you with all your supercomputing strength. This is because you need to guess just one damn number correctly. So a lucky one could guess it in his first attempt and claim the reward while you’d be sitting there in muck cursing in every goddamn language that you know of. Even against all these odds, people still are mining bitcoins like crazy because of the conversion rate. I mentioned earlier that 1 bitcoin is worth nearly 6 lakh rupees. So if you are successful to mine 12.5 bitcoins, you would earn a bounty worth nearly 75 lakh. You mine bitcoins a few times and you are basically set for your lifetime. 

I hope that by this point you can acknowledge the beauty of the wonderful currency. All this and we have barely scraped the surface. The underlying technology of blockchain on which the bitcoin is built is phenomenal. Blockchain finds its application is Domain Name Servers(DNS), Distributed databases and companies like Google and Facebook are heavily investing in its R&D hoping to find the next "electricity". If some of you guys follow financial news closely, FB recently announced libra, its own semi-decentralised cryptocurrency that would be integrated with WhatsApp, Instagram and all other FB products. Companies like Anglelist have already started developing platforms for ICO offerings (Initial coin offering, just like IPOs of shares).

But there are many legal restrictions on this worldwide. The Reserve Bank of India has announced a ban on sale or purchase of cryptocurrencies for any entities regulated by them. And not just India but many other countries like China, Canada, Taiwan, Vietnam etc have many legal restrictions on it. This is just another area where we are gonna see a paradigm shift that too in our lifetimes. There will be definitely some very very interesting times ahead. I want us all to swim with the tide to make the most of it. And the easiest way to ensure that, would be to acquire knowledge about all these so that when the things change, we adapt to it quickly and maybe even benefit out of it.

I will definitely keep you abreast about all these new changes that are happening in the tech as well as the financial industry. Do not forget to subscribe to the blog so that you don’t miss out on any post.

Until then…..Happy Investing

Nikhil Mudholkar and Aditya Shrivastava 

nikhilrmudholkar29@gmail.com
adityashri981@gmail.com