In the article below we seek to offer a basic introduction to the rationale of a decentralised payment system such as bitcoin, to give a basic description of how the payment system functions. This is to form the basis of why we all have/ or have had ‘blockchain fever’ and Venture Capitalists, banks and governments can’t get enough blockchain.
This is not meant to be a comprehensive technical description. However, the jargon used in this sector makes understanding the overall utility of bitcoin difficult to grasp, so I have tried to keep the language simple to facilitate an easier appreciation of the main concepts.
Why start with bitcoin? Bitcoin is the first living and successful working example of a decentralised payment system and bitcoin gave birth to the notion of a blockchain. Bitcoin created the Cambrian explosion leading to countless digital currencies out there with differing ‘protocols’. Also, you might have heard about the distributed ledger or blockchain hype; well these concepts would not have been possible without bitcoin.
What is bitcoin?
Bitcoin is the first decentralised payment system that the world has seen. Invented by Satoshi Nakamoto and released in the late 00’s.
Satoshi wanted to create a peer-to-peer (P2P) payment system that was designed for the internet age. Bank cards were being used online for payments, but the bank card for remote payments is a deeply flawed payment instrument: purchasing power over someone else’s bank account can be stolen by simply seeing the digits displayed on the front and back of a card. Essentially, the bank card was never designed for online payments.
The incidence today of bank card fraud is colossal. As such, the bank is constantly arbitrating disputes, chargebacks and dealing with identity fraud. All of these costs being incurred simply because the standard payment instrument for online transactions is flawed. It is like driving a car with an in-built hole in the engine for the oil to seep out, but instead of building a car without a hole in the engine you just keep adding oil.
All of that administration and liability leads to the overall costs of the payment system being high and that cost is silently transferred to the users through higher transaction fees charged to merchants and users.
Satoshi wanted a system that would allow for a more accessible, seamless and more secure manner to make remote payments. He/she saw bitcoin, used in conjunction with escrow services, to provide a simple yet extremely secure mechanism for paying remotely for goods/services.
Other payment systems
There have been countless examples of alternative payment systems, however, not all have been successful. Previously, a number of these systems (E-Gold for instance) popped up that were centralised where, for example, all transactions had to be validated by a central authority to be approved. This was no different in reality to electronic money/stored value systems, the most successful of which in this category is Paypal.
Bitcoin does not have an Issuer in the payment system
However, what was new about bitcoin was that there wasn’t a central issuer – someone responsible for the administration of the payment system (i.e. ensuring credits and debits were correct) and or responsible for the backed value.
In most payment systems the value being transferred is a representation of value not value itself. For example with Paypal, I transfer USD10 and they immediately issue USD10 of electronic money for me to use online. The electronic money they issue is a liability to the customer of USD10. In other contexts electronic money can be issued based on real world assets such as gold or other precious metals. In those instances again the issuer has a liability to its customer for the value being issued; and the customer, in fact, does not control the underlying asset.
From Digital Credits to Digital Assets
We don’t understand digital assets. Our first exposure to electronic money has always been in the form of a credit. Even our first exposure to money as a concept has been in the form of a credit rather than an asset.
Money in any form is deeply associated within the social psyche with credit. Cash is a promissory note which is a credit from the Central Bank for the face value of the note. However the credit issued from a Central Bank is a circular notion: the promissory note used to be redeemable for a precious metal such as gold but now it is just redeemable for itself. Private credit institutions being banks hold the vast majority of national currency in an economy and when funds are deposited with them they provide a digital credit to their customers. E-money institutions perform the same function as credit institutions in that they issue digital credits for customers to spend online. Electronic money as a general concept has always been a credit and never an asset.
However, bitcoin is the first time that a digital asset, which can function in a similar way to money, has been created.
Bitcoin is value in itself
This is part of the innovation of bitcoin. Bitcoin is not a representation of value it is value itself. The system is designed with a deflationary supply so that the rarity factor influences its price.
That is party why it has been dubbed ‘digital gold’. Some regulators have even referred to it as a digital commodity (Hong Kong for example).
It follows that if the digital asset is value in itself then users have direct control over it. If they misplace the passwords to access their digital assets then it is like misplacing the keys for a gold vault.
If they have a balance in bitcoin on their wallet they actually have that value in their wallet not a liability that someone will pay them the face value of the asset.
Why do that? Why create the first ever digital asset?
If you are designing a decentralised payment system then you have to remove all central issuers and central counterparties. For the system to be the purest form of P2P payments it has to be used, managed and controlled by the peers in the system. If you introduce an issuer who receives bitcoins from everyone and issues credits representing the right to redeem the credit for bitcoins then you haven’t achieved the full decentralisation of the payment system.
So Satoshi’s invention was partly to say let’s create a new form of value that can live in the decentralised payment system. If we are successful creating a digital asset such as bitcoin then we can go on to complete the design of the decentralised payment system.
Inherent value in bitcoin means no need for an Issuer
So, in summary, the key with giving inherent value to bitcoin means that bitcoin does not, in practice, need an Issuer do any issuing of digital credits. As a result there is less dependency on any central or single party.
How to create a payment system without a central administrator?
But giving a unique value to a digital asset isn’t enough to turn it into a decentralised payment system.
That is part of the battle won but you now need to take on the technical challenge which is how can you have a payment system with no-one being responsible for the administration of the system?
Visa and Mastercard and SWIFT are payment system networks and they take responsibility for relaying and executing payment instructions to their network members according to their own protocols which members subscribe to when they join the schemes.
How did Satoshi manage to create essentially a Visa payment network but without a single person being responsible for the payment network?
He decentralised the functions of the payment system administrator – creating a prize based competition to incentivise peers in the bitcoin network to do the work required.
Imagine crowdsourcing all of the payment system functions but without compromising on security.
The effect of this meant that rather than having one person responsible for keeping the payment system in order that the entire network would be involved in that process.
No-one owns the bitcoin payment system
Satoshi started with the premise that no-one actually owns the bitcoin payment system or has any special rights over how the payment system functions.
The bitcoin payment system is, in essence, an agreed set of rules that anyone who joins the bitcoin network would agree to.
Not anything dissimilar to joining any payment network. If you were to join SWIFT you would have to agree to their messaging protocol in order to use their telegraphic network to communicate payment instructions to other banks.
Make the transactions public
Then Satoshi thought all the transactions of the payment system should be public for everyone in the network.
These bitcoin transactions are not like publishing your bank statements on Facebook. All transactions are associated with a username (not someone’s personal name or a company’s name). This means everyone just sees usernames in the payment system and not personal data. You can see how many bitcoins a particular user has but you can’t associate that balance to a particular individual.
Bitcoin links every previous transaction to the next one so that it creates a linear transaction chain. There is only one transaction chain for bitcoin. This transaction chain is also called the blockchain, but we will go into that a bit later.
Give everyone the full history of payment transactions
One of the key rules in the bitcoin payment protocol was to agree that everyone in the network had to download the full transaction chain. This meant everyone in the protocol would have a full history of the entire payment system.
Having a full history makes it possible to spot anomalies being introduced into the payment system such as a username trying to send bitcoins that have already been sent (called a double spend).
How to add new transactions to the payment system
So everyone has the same record but how are new transactions added to the history of payment transactions?
First principle is that anyone can transact in the bitcoin network. When a transaction has been signed by one person to another then that message is sent out to the network but it is unconfirmed.
This means the protocol doesn’t just add every single transaction being sent into the network onto the transaction chain.
The protocol has a filtering process to determine which transactions should be added to the transaction chain. Until a transaction has been added to that chain and it has been agreed by the network then it will remain ‘unconfirmed’.
Delegate ‘transaction processing’ to everyone in the network
The next part of the process is the most ingenious in terms of Satoshi’s invention.
As said above Satoshi decentralises the administration of the payment system by having everyone in the network keep a copy of the full transaction chain – that means no one person is responsible for making sure it is accurate.
Then he delegates the responsibility for actually validating the unconfirmed transactions and adding them to the transaction chain. How does Satoshi do that?
Through economic incentives. Satoshi creates a rule in the protocol which is very much like a prize based competition.
The basic competition rules are as follows:
Take a series of unconfirmed transactions
Work out a mathematical challenge based on those transactions
and if you succeed in that challenge then you can add the packet containing the unconfirmed transactions (block) onto the bitcoin transaction chain (or, in other words, the blockchain).
And if you succeed in that mathematical challenge and you can add your block to the blockchain then you can pre-load the block with additional bitcoins as a prize.
The people in the network who collect unconfirmed transactions and package them together and who try and win the mathematical challenge are called the ‘miners’.
Why bother with such an elaborate process?
The main point of the prize based competition and mathematical challenge is for people in the network to be incentivised to expend resources. It is the expenditure of resources that secures the network and ensures that there is only one bitcoin transaction chain (blockchain).
Spinning Roulette Tables – 20 tables at once
(Gambling is just been used here as an example to illustrate the improbability involved).
Winning the bitcoins in the block is simply about getting the right number of preceding zeros as a result of a mathematical challenge.
It is a kind of a huge casino where everyone is playing roulette but that everyone is betting on zero every time. Everyone in the room just keeps spinning the wheel until one of the peers in the network gets zero.
But for bitcoin you have to have a number of zeros so you need to be spinning at least 20 wheels and to win the prize all 20 wheels have to be zero. Now you can understand the statistical challenge involved.
This process is called ‘mining’ mainly due to the repetitive and highly speculative physical operation involved. With mining you never know when you will strike gold but you keep going as maybe you will.
What is interesting is that when a miner has found the right number he/she is able to show everyone else in the network and everyone in the network will themselves be able to check if the winning number was correctly arrived at. This is not like a casino where you can never be sure if the table is rigged or naturally has a bias for zero. With bitcoin the miners can recreate the ‘roulette spin’ that the winner did to see if it ends up with the same result.
Because of this verification process, the miner who shouts ‘jackpot’ in the mining pool can add his ‘block’ of transactions to the last block. Others in the network will accept the result because they can verify it. This result therefore becomes an objective proveable truth. The network then rallies and supports the declared result.
Once accepted and only at that moment are the transactions in that block ‘confirmed’. Once confirmed then everyone in the network will automatically run the instructions in the transactions on their blockchain. In other words, everyone’s blockchain will be updated in accordance with the protocol.
This decentralised design means bitcoin is accurate yet at the same time extremely resilient as a payment system.
The beginning of the blockchain fever
Barter was the first decentralised P2P payment system invented, as physical assets are exchanged directly between peers. Bitcoin is the first remote P2P fully decentralised payment system invented. But of most interest, in abstract, is that bitcoin simply demonstrated that parties can manage a monetary system of records without any form of loyalty or connection between them or trust. Trust is not needed for bitcoin’s decentralised payment system to work and that is what makes it powerful.
Bitcoin is also extremely resilient as there are over 5000 main peers in the network with the full blockchain. You would have to eliminate all of them to change the transaction history. You would need to collude with more than 50% to change history moving forwards.
But where else could the characteristics of bitcoin be applied?
If we look at a payment system, all it is essentially is a record keeping and communication system. For bitcoin is it an asset register of sorts; bitcoin moves from one username to another username, it is validated by the network and once validated, everyone in the network automatically updates their record of who owns what and in what quantities.
Well of course just replace bitcoin with other assets and you end up with the same benefits that bitcoin offers. That is already being done on bitcoin where bitcoins are been labelled as shares and then transacted in the bitcoin payment system. (Here I am just explaining a few examples but not the detail of the pros and cons of these derivative notions.)
Other initiatives have cropped up where they have evolved the concept of bitcoin as they found the confirmation process in the bitcoin payment system a bit slow. So they created a new protocol where they would appoint certain persons in the network to do the transaction validation to make the process faster. That is the Ripple protocol.
Some institutions have looked at the technology and thought: “I really love this idea of ‘crowdsourcing’ the administration of a record keeping and communications system without compromising on the integrity of the system but I don’t like the idea of everyone in the world being able to see the chain of records even if they will only see usernames”. So they deployed their own private network with their own mathematical challenge to reach agreement on how to validate unconfirmed records/transactions.
Further, certain thought leaders looked at bitcoin as this vast shared database storing one version of the truth. They then thought about how the banking system works with all its information held in silo,s and one bank having to reconcile their information with another bank’s information about a contract, then said maybe bitcoin and the idea of sharing the same ledger is the real value of bitcoin. Bitcoin eliminates post-event reconciliation as the ledger is updated constantly and there is only one version of truth regardless of what that truth is.
But when you look at bitcoin you think well couldn’t it do a bit more than just move an asset from A to B. When a transaction is confirmed, everyone’s piece of bitcoin software automatically updates the transaction ledger. Everyone’s computer essentially computes some instructions such as ‘move 2 bitcoins from username 1 to username 2’. One magnificent idea was to extend what we ask everyone’s computer to do in the network. So rather than just asking everyone’s computer to move 2 bitcoins from username 1 to username 2 it can run a program that does something. This is the world of smart contracts or distributed applications – these programs are distributed because they run on everyone’s computer in the network not on a central server.
In conclusion I hope this article has given you a guided tour of the mechanics and significance of the bitcoin payment system.
As such it should be treated with care as it has potential to offer more social benefits than the internet. If the internet helped with communication and connecting the world, the invention of decentralised payment systems help with financial inclusion and reducing the costs of financial services which benefits everyone.
But beyond that, a system to create a shared untamperable record is a paradigm shift for companies, industries, governments and humanity – the irony of bitcoin was that blockchain was a means to an end now, on reflection, blockchain is the end in itself but what blockchain offers is almost immeasurable in scope.