As mentioned in the Cryptocurrency Definition/Info Post, two of the defining characteristics of cryptos are their security and immutability. But how do they achieve that? Centralized organisations spend large amounts of money on maintaining their security. Despite this, not only are they still vulnerable from outside forces, but they are especially vulnerable to inside forces. If someone has the right keys they can abuse their power for their own benefit. It isn’t comforting to think that all that’s preventing this is a moral conscience or a fear of being caught. With cryptos this becomes irrelevant as nobody has all the keys. Instead, individuals numbering from the hundreds to the thousands collectively own the keys and are not only rewarded for obeying the rules, but penalized for attempting to break them. Let’s look at how this works with an analogy.
In this chapter we tried and explain how cryptos work (at least in their basic form) in an easily understandably way. If you’re not interested in; you can go directly to Smart Contracts below; although I’d recommend at least having a basic understanding of what you’re investing in.
Imagine a simple bank where people can deposit their money for safekeeping. The bank writes down all the transactions in a ledger so as to keep track of everything. Unfortunately, a clever thief breaks into the bank’s office and makes some changes to the ledger so that when they go to withdraw their money the next day the somehow have more than they deposited. The bank checks his ledger and everything seems in order.
Now imagine a second situation where we have a bank with 11 different branches. None of the branches trust each other so they come up with a system. Each one decides not only to keep a record of their own transactions but sends a representative to every other branch to independently write down every transaction their colleagues make. This way if there’s a dispute the branches can compare their ledgers and decide by majority which one is correct. But there’s still a problem: when the representatives are on their way between the branches to compare ledgers they are attacked by the thieves and the ledgers of more than 6 branches are changed. So they add an additional step: at the end of every page of the ledger the banks will put all the values of the transactions from that page into a complex equation and write down what they get in a document for safekeeping. At the end of the next page they will add up all the values again but also use their answer from the previous page. How does this help anything other than making things more complicated?
Now when a band of thieves attack the representatives they not only have to change the entries but make sure that the changes they make still give the same answer when they’re put into the complex equation. This takes the thieves a long time, several weeks in fact. Long before that point the bank realizes something is wrong and take out one of the many copies of the ledger.
There is actually one more thing which makes the system even safer. To stop the bank from colluding against their customers the branches are offered a reward everytime they agree with the majority of the other banks, if they are in the minority they are fined. It turns out to be much more beneficial for the branches to play by the rules than try to break them.
In the next section we will see how this analogy relates to “the blockchain” (the system of ledgers) and the differences between consensus methods.
Different consensus methods
In the previous example we saw that there were competing branches. The “nodes” or “bookkeepers” in cryptos can be thought of as these competing branches. Every time they fill out a page in their ledgers they cross reference it with everyone else’s ledgers. The “blocks” in the blockchain can be thought of as the pages. Finally the complex equation they have to solve with the value of the transactions on the page is called hashing and is much harder to do in reverse (as the thieves were attempting). So what is the benefit of being a “node”? Well every transaction that’s carried out pays a fee to the nodes for processing it and ensuring their security. The fines we talked about in the bank analogy depend on the consensus method, of which there are many types. I will discuss the most important/popular ones below:
(In depth analysis of each is in the works for the more technical minded)
The next advancement in blockchain is heralded to be Smart Contracts and the use of Dapps. You might have heard these buzzwords before but what do they actually mean?
In a normal contract you have two or more parties agreeing to some terms. If I do this, you will do this. If you fail to do this then the transaction will be cancelled etc. These contracts are legally binding so if any party breaks the terms they can be taken to court to be prosecuted.
Smart contracts make this whole process a lot easier. Instead of the terms being legally binding they are bound by the blockchain, meaning that once the contract has been signed by all the parties the terms will be carried through no matter what.
Dapps stand for Decentralized Apps. These work in conjunction with smart contracts by automating the job of middlemen, such as a broker.
For example, let’s say you want to carry out an options contract. Usually the process involves having a broker match your ask with someone else’s bid and once the time arrives making sure that the agreement is honored. With the use of a Dapp the matching can be done by the blockchain itself without any need for a broker. The Smart contract deals with actually enforcing the terms. Once you click buy everything is automated without the need to trust a third party or any administrative costs.
This is just one application. More and more startups are being created around the huge number of possibilities surrounding this technology, from crowdfunded science to advertisers paying the content creators directly and even the consumers for not blocking their advertisements.
This is where things get really exciting. Smart Contracts and Dapps by themselves are limited to dealing with the digital realm, ones and zeros. Some projects are attempting to bridge the gap between the digital and the physical realm by taking things such as commodities, title deeds and products and putting them on the blockchain, assigning them a digital certificate which is legally binding. Let’s look at an example.
Currently buying a house requires lawyers and is a painful and lengthy process. By issuing legally binding digital title deeds and implementing Smart contracts it will be possible to buy a house as easily as you can order an Uber. This also opens up the possibilities of partial ownership of real estate, art, cars, ip etc. in a very intuitive and liquid way.