The problem with digital currency is that it can be easily copied and counterfeited. The inventor of bitcoin, Satoshi Nakamoto[1], came up with an ingenious solution to what is known as the “double spend” problem: give everyone who so desires a copy of the transaction ledger. While it is relatively simple to “cook the books” on a single ledger, it is nearly impossible to alter hundreds or thousands of ledgers, especially if those ledgers are dispersed in a variety of locations. So long as there is a means of comparing multiple, distributed ledgers, the system itself provides the trust in ledger integrity.
Also, it is not necessary to compare all ledgers to each other. One need only compare a few ledgers to get a high degree of confidence that the subject ledger is legitimate. With two ledgers one can make one comparison. With four ledgers, it is possible to make six comparison. With six ledgers, it is possible to make 15 comparisons. It takes fewer than 50 ledgers to make a possible 1,000 comparisons! This relationship is known as Metcalfe’s law and is discussed later.
Providing everyone a copy of the transaction ledger poses a major problem. Would you want your bank history in the hands of anyone and everyone? The information would need to be encrypted, and done so in a way that would be virtually impossible to break or hack. To accomplish this, Nakamoto invented the blockchain.
How is this different from a traditional encrypted ledger?
Here is a sample ledger that has been encrypted using traditional means:[2] Although it looks complicated, experts would be able to crack this code in a reasonable time.
With blockchain encryption, there are several layers of encryption, including encryption within encryption. Specifically, the previous encrypted record is included as part of the next record. This “nesting doll” effect makes it impossible to change only one record.
In the example below, we take the encoded transaction and add an encoded portion (called a hash) of the previous transaction. Think of a hash as a sausage grinder. You put two kinds of meat and some spices through the grinder. Once ground, you cannot undo the sausage into its original ingredients. But if you have the recipe, you can make the same sausage and do a taste test to ascertain the recipe is the same. This taste test is called a “proof of work.” A blockchain is like a string of linked sausages, but each new sausage has a bit of the previous sausage in it too.
With a database, this is a set of linked encrypted records:
The actual encryption and blockchain implementation for cryptocurrencies is more robust than this relatively simple example. Most use public key encryption technology. Public keys may be disseminated widely, and private keys which are known only to the owner. This accomplishes two functions: authentication, where the public key verifies that a holder of the paired private key sent the message, and encryption, where only the paired private key holder can decrypt the message encrypted with the public key.
To validate that a transaction is legitimate, one just needs a public key and the previous stored record, which is also public. This approach also permits viewing the transaction ledger amounts, while preserving a degree of privacy (some would say anonymity) about the parties to the transaction.
As blockchains are shared and everyone can see what is on the blockchain, this allows the system to be transparent and as a result trust is established.
Blockchain is simple and cheap to implement. Nakamoto provided his blockchain code in full when Bitcoin was developed. Any first year university computer science student can build a blockchain application.
Blockchain allows the quicker settlement of transactions as it does not require a lengthy process of verification, reconciliation, and clearance because a single version of agreed upon data is already available on a shared ledger between financial organizations. No third party or clearing houses are required in the blockchain model, this can massively eliminate overhead costs in the form of fees that are paid to clearing houses or trusted third parties.
[1] Satoshi Nakamoto is believed to be a pseudonym. In our research, we have concluded that Nakamoto represents at least two individuals who collaborated on the project, both of whom are now deceased.
[2] For cryptologists, this was encoded using a Vigenere cypher with a random key.