A primer on blockchain

Part one of Responsible investment and blockchain provides a technical primer on blockchain.

Early open public blockchain

Broadly speaking, an open public blockchain is a means for 1) an open network of strangers to 2) keep track of their positions – or states – relative to each other 3) without a (clearly identifiable) central intermediary being present to mediate between them and 4) with all players in the network (theoretically) possessing equal rights and capabilities in the system.

Bitcoin is the first example of this. It is a system that allows an open network of strangers to track who has control over tokens (balances), and to record changes in the ownership of these tokens (transfers). The system essentially allows people to hold and pass tokens between themselves. The term “trustless” is sometimes used in cryptocurrency circles to refer to the property of being able to interact with people you do not know without requiring a third party to mediate.

The concept of the token

A token is a digital object that can be transferred. A bitcoin token is a digital entity that can be seen via a computer and moved around. In the Bitcoin network, there is no central issuer of the token. Rather, new tokens are recorded into existence by a subset of network players called miners as a reward to themselves for facilitating transfers of older tokens. This is an elegant design in that new tokens are granted as incentives to those who validate the transfer of old tokens.

Bitcoin tokens are blank; they have nothing that they entitle the holder to. They are not vouchers, shares, legal tender or anything particular. They are the digital equivalent to a blank piece of paper. Much discussion has thus occurred about what their legal, tax and regulatory treatment should be. Many monetary scholars are sceptical about whether the tokens are money, and the cryptocurrency community vacillates between calling them money, assets and investments.

Key concept: Protocol

Bitcoin is a protocol. This means it is a set of rules. The system only exists if a network of people agree to follow these rules; if they deviate from those rules they are not using the system. Similarly, the current global internet is a set of protocols that enable interconnected computers to speak a common language. The Bitcoin protocol is built on top of the underlying protocol infrastructure of the internet. The protocol rules are encoded in wallets and other pieces of downloadable software that enable people to connect into and interact with the Bitcoin network.

Protocols can be changed. Bitcoin, though, has no clearly identifiable central party that can authorise changes. Rather, it can only change if certain key players in the system – such as the core developers and major miners – agree to change it. This is a political process and in recent years there has been much in-fighting between Bitcoin factions over making changes to the protocol.

The Altcoins

While Bitcoin was the original blockchain-enabled cryptocurrency, the protocol code is open source, which means others can take it, alter it (or fork it) and attempt to convince a network of people to start running new software that embeds a new protocol. The first wave of this innovation was the altcoins, which include, for example, Litecoin, Dogecoin and Peercoin.

Concept: Protocol

Bitcoin combines existing elements from cryptography. Firstly, there is a way to transmit messages into the network stating that you wish to move tokens, which is achieved through public key cryptography and digital signatures. Secondly, there is a way for the network to collectively agree that the transfer has happened and that it cannot therefore happen again (preventing double-spending). This is achieved through a consensus protocol, which in Bitcoin’s case is the proof-of-work process. As this method is energy intensive, new consensus methods such as proof-of-stake have come into play. Peercoin was the first to implement a proof-ofstake method.

Open public Blockchain 2.0

Cryptocurrencies were the first wave of open blockchain innovation. The second major phase was the emergence of systems with a wider range of functionality. At a broad level, these systems are 1) a means for an open network of strangers to 2) keep track of their positions – or states – relative to each other and 3) to automate certain interactions with each other (smart contracts) 4) without a (clearly identifiable) central intermediary 5) with all players (theoretically) possessing equal rights and capabilities in the system.

Leading the way in this Blockchain 2.0 innovation was Ethereum. Bitcoin is essentially a narrow, or single-use, protocol that only enables a limited set of interactions between players – or nodes – on the network. The two main things you can do in the Bitcoin system are 1) receive a single type of token and 2) transfer a single type of token. The creators of Ethereum wanted to enable a wider range of token types as well as automated interaction methods.

Key concept: Smart contracts

Smart contracts are an important new feature introduced within the Ethereum system, although a very misleading term. The closest physical-world analogy for a smart contract is a vending machine, an automated agent that acts on behalf of a seller and behaves deterministically: if you put a coin in a vending machine it is forced to give you something. It thus only enacts a contract when you interact with it. Smart contracts are - roughly speaking - conceptually similar to digital vending machines. Unlike human players on the network, they are automated agents (or robots) that behave deterministically when you interact with them. For example, you can deploy a smart contract programmed to automatically issue share tokens to people upon receiving money tokens from them. We can also imagine linking smart contracts, with one digital robot interacting with another, creating decentralised autonomous organisations . more complex automated systems.

Token categories

At a high level, a blockchain system is a digital information recording, coordination and contracting architecture, but the main mode of interacting within the system involves the transfer of digital tokens that are accounted for on the system. These can be separated into different categories:

The first wave involved tokens that were solely useful in the digital realm. Cryptocurrencies, for example, do not reference anything in the physical world.
The concept of a utility token has emerged. It is used ambiguously, but tends to mean ga token that enables you to interact with our digital infrastructure h. For example, with Ethereum, you must use Ether tokens to activate smart contracts.
There are also tokens that represent financial contracts. Crypto-equity tokens aim to be the blockchain equivalent of share certificates.
Other initiatives attempt to link a token to a realworld asset. For example, Digix Global creates tokens representing physical gold. Creating tokens that reference real-world physical objects or assets is sometimes called tokenisation.
A similar tokenisation process can be seen in the attempt to link tokens to digital or informational goods, such as digital art, licensing rights or IDs.

One key problem is how to fuse a digital token with something that exists outside of the blockchain network. Gold might exist in a warehouse in Singapore, so what would it mean to have a gold-backed token issued on Ethereum? Achieving this requires legal recognition of the blockchain recording within existing law systems. Alternatively, it requires integration with Internet of Things (IoT) infrastructure, such that things in the real world are rendered unusable unless you possess digital keys. For example, one might imagine a car rental service in which the car could only start if you activated it online through a digital access token.

The potential to completely automate processes using smart contracts, though, is limited. Many would require external experts to feed in the information upon which they act. For example, if you wished to programme a weather insurance smart contract, you still need a weather agency to give an official account of what the weather was. These third parties are sometimes referred to as oracles within the blockchain community.

Closed private permissioned blockchain

Much of the current hype around blockchain relates to the corporate or governmental use of elements of the original blockchain protocols within more controlled or closed settings. This is the realm of permissioned blockchain or consortium blockchain, which occasionally blends into the more generic category of distributed ledger technology.

The conceptual outlines of these systems could be summarised as follows. They are 1) a means for a closed network of (loosely) associated parties 2) to keep track of their positions – or states – relative to each other 3) and to automate certain interactions with each other (smart contracts) 3) by coming together under a mutually-agreed shared infrastructure rather than relying on finding ways to make their separate infrastructures interact 5) whilst introducing the potential for different or unequal rights and capabilities in the system.

These private blockchain systems thus reintroduce many concepts from centralised IT management, such as a system administrator that might grant different parties access to the system with different levels of control. You might only gain access if you can authenticate yourself, and you must be authorised to gain different levels of access and functionality.

Major commercial banks were early leaders in this regard. Consortiums like R3 have been designing systems for inter-bank interaction to automate co-ordination and reconciliation processes, which has historically required back-office staff to ensure that banks with different IT systems maintain the same accounts of what has happened. If the banks collectively agree to share infrastructure, they will be able to continue doing what they already do, but more efficiently and with a potentially clearer audit trail.