Blockchain. When most people see this word, they either stop listening or become irrationally excited.
Bitcoin, which for most is the closest mental jump from blockchain, conjures up thoughts of unprecedented avarice or, if you’re in the payments industry, the illegal drug trade.
In the last 6 months, interest in the technology has exploded, with new announcements – and scandals – occurring almost every single day. We are at a point with blockchain that is very similar to the excitement that many experienced in the early days of the internet.
Similar to that time, the only people that seem to understand the technology are unable to convey its fantastic value prop to the world – which is why you get techy buzzwords like “distributed ledger” and “trustless,” just like how the internet was at one point described as “information transfer protocols.”
Today we don’t think of the internet in that way at all. We don’t think about HTTP or SMTP or the other building blocks that make up how it works. Instead, we understand why it is important.
For the average user, the internet is a new way to get and communicate information that is quickly becoming fundamental to how we experience the world.
This article will try to explain blockchain technology in a similar way so that we can start to understand how and why it can become a part of our future.
A History of Transactions
To understand the value of blockchains, let’s first think about how transactions work.
In the earliest days of human civilization, all transactions occurred in a barter format. This quickly became impractical because of limits in how the value of different objects could be compared and transferred.
Instead, we developed an elaborate system of IOUs, which eventually went on to become gold-based currency. There were problems with moving away from bartering, however, not the least of which was that the “market” – at this time a physical market – for gold could be manipulated by mining new gold. [i]
This was eventually fixed by fiat value, money that was backed by governments. This development allowed for the creation of a more stable asset – cash, which could be used to transact value between two parties with no validator in between just like gold.
Unlike gold, paper was a relatively common and easily acquirable good. However, paper notes were hard to fake, and it was even harder to pretend to give someone a paper note without ever actually making the transaction. These are the rules that are built into how physical cash works.
Then, digital transactions came along. On computers and over the internet, it is very easy to copy or fake data. To prevent opening the financial ecosystem to rampant fraud, banks and payment networks became intermediaries in transactions and acted as validators to both parties in the transaction. In other words, they became the source of the transaction rules.
Then, the 2008 financial crisis happened. Banks and other financial entities had become involved in the very transactions that they were supposed to monitor, which led to a loss of objectivity in the financial ecosystem.
This resulted in the loss of value for hundreds of millions of people around the world, instigating a push for regulatory overhaul and a search for a “better” solution.
Bitcoin: “A Peer-to-Peer Electronic Cash System”
Shortly after that time, Bitcoin was created as a new way to make digital transactions.
The premise was that, using complex economic theory, cryptography and computer science, the “rules” for a digital transaction could be changed to make them look just like the rules for cash transactions.
In other words, Bitcoin solved the problem of how easy it was to copy and fake digital transactions by making them look just like in-person transactions instead. This was made possible by the underlying blockchain technology.
Note that blockchain and Bitcoin are two separate things. Bitcoin is the first application of blockchain technology in the same way that email was the first application of the technology behind the internet.
It quickly became apparent that Bitcoin had some major problems, however. In the early days, because it came as a reactionary movement to the financial crisis, Bitcoin attracted proponents who were staunchly against traditional financial infrastructure.
These early advocates pushed the technology of the time away from financial services so that know-your-customer and other compliance practices were not brought into the ecosystem. As such, Bitcoin rapidly developed into a payment platform for illegal activities.
Bitcoin has, since then, largely moved away from that unfortunate stereotype/niche, now attracting users from all markets, including some banks[ii].
Ethereum – Blockchain 2.0
But in 2014, Bitcoin wasn’t doing too well. Its price had steadily declined since a peak in January and would continue to do so for almost two more years.
Many in the community had tried to develop applications and financial services using the technology but had failed, partly because Bitcoin was very difficult to build on. For almost a year prior, economists and developers in the industry had begun to ask themselves if blockchain could do more.
Bitcoin had changed the rules for digital transactions to make them look more like cash transactions, so why couldn’t the rules be changed further? Since all of it was being done through computer code, why couldn’t the rules be set to anything?
Then, early in 2014, a 19-year-old programmer and economist named Vitalik Buterin conceived of and founded Ethereum, a different blockchain that would allow people to do just that.
Instead of being a blockchain for financial transactions, like the Bitcoin blockchain, the Ethereum blockchain would be a platform for any transaction. It would also be faster than Bitcoin and, because the rules for a given transaction could be set in any way, it would have the potential to be much safer.
Before we move forward, let’s revisit transactions once again.
In the payments industry, we typically think of a transaction as purely monetary, but there are plenty of other types of transactions that happen around us every day. Liking something on Facebook, for instance, is a type of social transaction. Turning on a light initiates a series of electrical transactions. Watching an advertisement is a transaction of attention/time. We normally don’t think about it, but all of these transactions are also associated with value, which is often converted back into money.
People regularly generate wealth from social media popularity, which is value that is reconciled against the number of social media interactions they receive. You pay an electricity bill to reconcile the electricity transacted to you against its value. Advertising platforms/publishers are paid by company marketing departments for the value they receive from the watcher’s attention.
In the past, these were all intangible assets, which was why it was very hard to track and pay for them. Another way to think about this is that the cost of setting up and tracking a “market” on these assets was too high as compared to their value, which is why we traded corn – but not attention – as a commodity.
Imagine a world where you could get paid a small amount of value by fish farms and other stakeholders to recycle plastic. Or a world where you can automatically sell the electricity you generate from the solar panels on your roof back into the grid in times of excess.
Building the rules for these markets means that we can build incentives for people to act in certain ways or make it impossible to cheat in others.
How Ethereum Works
By making it possible to build a unique set of rules for any type of transaction, Ethereum became a computing platform.
Basically, Ethereum acts as a world computer that everyone has access to and can build apps on – apps that can never be turned off, hacked or cheated (unless they are designed poorly).
On Ethereum, anyone can create and interact with “smart contracts,” pieces of unchangeable and fully transparent code that are saved to the Ethereum blockchain.
Adding anything to the blockchain, such as making and saving the record of a new transaction, costs a tiny amount of money called “gas.” Gas is paid using “Ether,” the native currency of Ethereum.
The gas that you pay for your transaction goes directly towards anyone else in the ecosystem who wants to participate in the process of computing, validating and saving your transaction. You are essentially “purchasing” those resources from the communal network on a transaction-by-transaction basis.
This is incredibly powerful because, for the first time, we can create applications that track value on a global scale for next to no cost. And since we can write the rules for all of the transactions that happen in these apps, we are able to come up with revolutionary new ways to handle fraud.
For instance, since we can easily see what an app’s smart contracts do and when/how a given user transacts an asset, we can know with 100% certainty how an asset/product was used after purchase.
In fact, using additional smart contracts, we can even limit the user’s ability to launder value by stopping them from transacting anywhere other than to those specific contracts. This is akin to “removing” the ability for a purchaser to do anything but watch TV with a newly purchased television, including reselling it to launder money.
The Future of Money and Financial Services
It is undoubtedly the case that Ethereum, and the other similar platforms that have since been created, will change how we think about money.
If we can attach value to everything and transact it easily and securely, then what becomes the point of the complex IOU system that we have developed and maintained for thousands of years?
What will it be like to live in a world where you can create value for yourself by watching advertisements or writing about truth or creating amateur music? What effect will connecting all of these unconnected supplies with needs on the other side of the world have for the global economy?
There is often a fear in the banking and financial sector that blockchain will obviate the need for financial services. For example, since blockchains are global networks that make transactions safe for counterparties, the card networks could become unnecessary in a blockchain-based future.
Even with financial payments, I think this is a very limited view. The card networks provide a lot of value in terms of fraud prevention and identity verification that is separate from their value as a global transaction settlement system.
We can go one step further, however. If all value becomes trackable through transactions, then it’s quite possible that everything becomes a type of payment.
That means that everything needs to be plugged into the financial ecosystem for fraud checks and identity validation. If that’s the case, how can the existing financial ecosystem be involved in this new market?
At Connext, we advocate the position that the financial services industry is going to explode over the course of the next few years.
In five to 10 years, banks and traditional payment providers may not do the same things they are currently doing, because a lot of the value they provide in storing and transacting value will become commonplace.
However, they will still play just as important of a role in everyone’s lives in other, equally important, ways. We encourage these entities to continue to innovate and find the new aspects of this ecosystem that will become valuable.
We also encourage existing service providers to learn about the industry and wonder to themselves, what comes after money?
Arjun Bhuptani is the founder of Connext.
[i] This is a dramatic oversimplification, of course. There were many other problems with the gold standard that eventually led to its abandonment, but they are outside of the scope of this article.
[ii] A recent report (https://info.elliptic.co/whitepaper-fdd-bitcoin-laundering) found that Bitcoin laundering accounted for 1% of all transactions, lower than the 2-5% of GDP that is laundered every year.