The Blockchain : Down the Rabbit Hole: Discover the power of the blockchain - Free Preview

Copyright © 2016 Tim Lea. All rights reserved Published by 54 Days Pty Ltd, Sydney Australia. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 Copyright Act , without either the prior written permission of the Publisher. Limit of Liability/Disclaimer of Warranty : While the Publisher and author have made their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. The advice and strategies may not be suitable for your situation. You should seek professional advice where appropriate. Neither the publisher nor the author shall be liable for any loss of profit or any commercial damages, including but not limited to special, incidental, consequential, or other damages. ISBN 978-1-63587-669-7 (e-pub)

Preface What does the blockchain mean to you? ►►

I keep hearing about it in the media - but don’t know what it is!

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I have read some things about it – but just don’t get it.

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Isn’t it just some trendy bandwagon that the financial media is over-hyping?

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Isn’t it just Bitcoin, drugs, and hitmen?

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Block-what?

Whatever your perception of the blockchain, it is gaining traction around the globe with the media increasing their almost insatiable coverage of the technology. The challenge for them, and for all of us, is that the technology is very deep, very powerful, and very complex. Moreover, it’s not a technology that can easily be described in a few words – and that is a major problem. If we think back to the 1990’s, Al Gore, the US senator, and later US Vice-President, first described the internet as

The information superhighway. When he made this reference, we all got it; the media got it. It made it easier for everyone to understand it and to work with it. With the promise of abundant richness of information online, we

Down The Rabbit Hole

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put up with the squealing dog whistle that shrilled from our stateof-the-art 14.4k modem. We put up with images that sluggishly traced their way, one line at a time, onto the gargantuan off-white concrete blocks we used to call computer monitors. We put up with the basic content – because we didn’t know any better. It was new, game-changing and, ultimately, life-changing. For those of you that remember the glory days of plodding along in the slow lane of the infobahn, the blockchain now will hold a great sense of “déjà vu”. For those that don’t, you are about to embrace the latest, leading-edge technology and leading-edge thought, which could lead us all one step closer towards “singularity”, where man and machine blend, where computer code replaces governments and where that computer code is law. Could this take us one stage closer towards the future Armageddon of “Skynet” depicted in the Terminator movie franchise? Who knows? However, the world as we know it is on the road to deep, irreversible, transformative change. The blockchain has the power to remove the need for trust. With it, it has the power to reduce our reliance upon the traditional custodians of trust - the financial institutions, the bankers, the auditors and the lawyers. Being at the very epicentre of trust as we know it today, they are facing change of tsunamic proportions as the technology grows, develops and evolves, bringing with it disruption that these traditionally very conservative segments of our society have never had to face before. Not only will the blockchain disrupt financial services but it also has the potential to disrupt almost every industry. Now we can establish proof of ownership and provenance, quickly and easily. Already this is beginning to change the landscape of


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ownership for diamonds, artwork, even videos. It also has the potential to help those in the third world that have no identity, or the 2bn people in the world that are currently unbanked. It is almost irreversible and fuelled by a Venture Capital sector salivating at the almost limitless opportunities for growth. We are at the stage where the genie is squeezing itself out of the bottle, one-way ticket in hand – and ready for you to command. In this book, you will have the opportunity to make sense of it all - in plain English. While so many of the concepts and ideas are very complex and very technical in nature, the overriding aim is to explain them in easy-to-understand language. By doing so, you will understand how this complex technology works; you will understand its strengths and its weaknesses and how it is used in practice. You will also see the challenges being faced by those who are trying to develop commercial ideas and by those who are early adopters. Most importantly, you will understand how to harness its power and understand why “The blockchain is game-changing; organisation-changing; life-changing.” I decided to write this book to help share my journey of discovery. As I made my journey Down the Rabbit Hole, I discovered a wonderland of opportunity. However, this world of opportunity was shrouded in concepts that were very difficult to grasp and fully understand; concepts that were new; concepts that were radical. I had entered a world where the uber-geek reigned supreme in a cryptographic nirvana, where the crème of the global intelligentsia was shaping the future in front of me. Perhaps most importantly, I came across an expanse of lush, green fields that filled every pocket of the opportunistic horizon; lush,


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green fields where the very foundations of the next paradigm shift in business were being shaped; lush green fields that challenged everything - technically, intellectually and even philosophically. Lush, green fields that have the potential to impact and improve peoples’ lives across the globe very positively. If you have an open mind and your eyes are opened, this journey of discovery will have the potential to impact and improve yours – perhaps irrevocably – as, together, we go Down the Rabbit Hole.


How Best To Use This Book The blockchain, its history, ideas, and philosophies can, at times, be very complex. While I have sought to translate this complexity into easy-to-bite pieces, I have written this book in such a way as to gradually take you on a journey, building your knowledge and understanding of this complexity not only through direct explanation and use cases but also through the experience of learning through story telling. I have deliberately included some great stories from within the global blockchain ecosystem that are interesting and engaging in their own right, and through telling these stories, there will be automatic references to the technology, its strengths, its weaknesses, its potential and its problems. These references are often embedded in the stories in such a way that you will absorb them subconsciously through the osmosis of storytelling. By being fully engaged with the story, you will forget the technology itself. Finally, while you might be tempted to go to the individual chapters that have specific appeal to you, some of the concepts and ideas explained in earlier chapters may not be that clear when taken out of context in a subsequent chapter. For those of you who will do it anyway – and I well and truly hold up a mirror to myself in that regard – I have enclosed a glossary of terms and acronyms, the Crypto-geek’s Almanac, at the end of this book. I suspect this part of the book will become well-thumbed and wellused during the course of your journey.


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How Best To Use This Book

I really hope you enjoy reading this book as much as I have enjoyed writing it, and I look forward to hearing and reading about your own personal growth stories after reading the book. Tim


Table of Contents Preface ��iii How Best To Use This Book �� vii 1. The Blockchain – WTF? �� 1 PART 1: THE FOUNDATIONS OF THE BLOCKCHAIN�� 7 2. The History of The Blockchain ��9 3. How Does The Blockchain Work - In Plain English ?�� 21 4. Blockchain Technology - The Ten Pillars Of Strength �� 34 5. Blockchain Technology - The Ten Major Weaknesses��50 PART 2: THE BLOCKCHAIN’S EARLIEST USES��69 6. The Early Adoption of the Blockchain ��71 7. The Rise and Fall of Silk Road - Bitcoin’s Tainted Brilliance�� 84 8. How secure is the Blockchain? - The $2bn Bitcoin Heists ��107 PART 3: CROSSING THE COMMERCIAL CHASM �� 121 9. Crossing the Commercial Chasm –The Challenges of Blockchain Adoption��123 10. The Blockchain Outside Of Financial Services �� 131 11. Following the Money – Venture Capital Investment In The Blockchain��145 12. The Initial Coin Offering – The Venture Capitalists Get Disrupted��153


PART 4: SMART CONTRACTS�� 165 13. Smart Contracts – The Killer Application or Just Industry Hype?�� 167 14. Why Smart contracts aren’t smart! �� 181 15. The DAO – Who Needs A CEO? ��188 16. When Dreams Are Shattered The DAO $53m Attack and its implications��195 17. Regulation – The Never Ending Game Of Cat And Mouse �� 222 PART 5: THE FUTURE�� 241 18. The Best Is Yet to Come – 10 Alternative Coins To Watch ��243 19. The Cryptocurrency Markets – Following The Future Winners�� 256 20. Identity, Voting, And The Blockchain �� 262 21. Can I Have My Shoes Back? Developing Nations And The Blockchain��267 22. Islamic Finance And The Blockchain – A Perfect Match?��278 23. When Oceans Collide - Convergence With The Internet of Things��285 24. Predictions For The Future Of The Blockchain��294 25. Our Supporters Best Blockchain Quotes��304 26. Conclusions ��307 Staying Up To Date – Blogs/News Sites, Podcasts & YouTube Channels ��312 Glossary��316


1

The Blockchain - WTF?

There was a bone-crisp chillness in the early-winter New York air. The pale shimmer of the sun in the faded blue-jean sky wavered through trees stripped bare of their autumnal delight. It slithered across warmth-whispered faces huddled deep within tightened scarves and ears tinged with the softest rose-bud red. The light northerly breeze whispered its gentle chill, the clouds of puffdry breaths greeting the daily commute with their clockwork-like welcome. Blank faces bathed in a sea of silence carefully avoided the vaguest hint of an extended gaze. Carefully groomed faces etched deep with a sense of contemplation fantasised about their restoration of humanity at the end of ten hours of habitual routine. On Friday, December 2nd, 2015 in New York it was a normal day, a normal dollar. For the equity research team at Goldman Sachs, however, the story was different, very different… For the Goldman Sachs Equity Research team, that day will be viewed as a landmark. It was a landmark that recognised something very powerful was truly happening. It was a landmark that earmarked a new paradigm shift was about to erupt. It was a landmark where a core technology had begun to evolve that had the sheer, unbridled power to enable dramatic, transformative,


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Chapter 1: The Blockchain - WTF?

irreversible change. On that day, the analyst’s note from the Goldman Sachs Emerging Theme Radar report1 simply read,

…the Blockchain, can change … well everything. This statement was to mark one of the first realisations that the blockchain was a technology that had the capability to be ubiquitous, to be applied not just to financial services but to so many other wider applications beyond just Dollars, Euros, and Roubles. The world of financial services in general and the closed bubble of financial technology, in particular, had already begun to see a natural fit earlier in the year. The key driver came from the realisation that the technology that underpins Bitcoin, the world’s first cryptocurrency, was a sleeping giant that had been woken from its slumber. Santander Innovations, part of Banco Santander, were one of the first institutions to see deeper and recognise its potential. In July 2015, they published their ground-breaking report, Fintech 2.0: Rebooting Financial Services.2 In it, one of their major conclusions estimated that up to $20bn of annual cost savings could be made within the infrastructure of the financial services industry using blockchain-based technologies. One of the major challenges, however, was that Bitcoin had a tarnished reputation.

1

http://www.goldmansachs.com/our-thinking/pages/macroeconomic-insightsfolder/what-if-i-told-you/report.pdf

2 http://santanderinnoventures.com/wp-content/uploads/2015/06/The-Fintech-

2-0-Paper.pdf



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Bitcoin itself first came onto the scene in January 2009. The Global Financial Crisis (GFC) was in full flow; major banking institutions had closed their doors; financial confidence was dead, and recession was the de facto standard globally. With its core principal of replacing trust using cryptography, Bitcoin had slowly become a new digital currency that enabled transactions to be conducted online without the need for a trusted third party such as banks or credit card companies. Also, by its almost anonymous nature, it meant that transactions could happen between two individuals who would only be represented by their “public key” address – a string of alphanumeric characters that represent a destination address for a Bitcoin payment. This sense of anonymity was a fact that was quickly picked up by perhaps the earliest, and most headline-grabbing, innovators, the criminal fraternity. In 2011, a website called Silk Road began to operate. It was hidden deep in the Dark Net, a layer of the internet deep below the traditional internet, where sites deliberately seek to maintain complete anonymity and are not indexed by Google or the other search engines. It is an area of the web that many aren’t aware of or, understandably, may fear to discover. Silk Road established itself quickly as a sales site where you could buy almost anything, from illicit drugs to weapons, amongst other nefarious products and services on offer. At the time of its closure by law enforcement agencies in 2013, it had transacted more than $1.2bn of sales with estimated commissions of nearly $80m3 for the operator,

3 The

sealed complaint: United States of America vs Ross William Ulbricht – dated 27th September 2013 Ste of New York.


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who went under the name of Dread Pirate Roberts. He became a nebulous figurehead of the dark side of the new technology. Silk Road, by its financial results, represented a major proven use case for Bitcoin. Not only were the financial results impressive, but it also highlighted the technology was proven in perhaps one of the toughest, most intolerant of environments. After all, the stakes for failure would have been significantly higher given the occupational hazard of dealing with a core audience that has a less-than-traditional view of law and order. Moreover, it is this that represented a major problem for Bitcoin and any technologies associated with it – reputational risk. Reputation is everything for banks and financial institutions. Without it, they are out of business, as the Global Financial Crisis had already proven, to the chagrin of many. So notwithstanding that the new technology had the potential to dispense with trust and had a proven track record of strength and reliability, its reputation meant almost without doubt that it would never be used for traditional banking. That is where the de-coupling of the underlying technology of blockchain from Bitcoin itself has come in. Establishing the generic technology, rather than its association with a tainted brand, meant there was greater scope for development. This has certainly now begun to happen with increased vigour as the Venture Capital (VC) community has started to get in on the act. Investment to the tune of $1.3bn has already been seen to support the technology, with much more on its way. The investment community sees the paradigm shift as being the opportunity to own the real estate behind the shifting paradigm



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by financing its development. From here, it has almost become a self-reinforcing cycle. As the technology attracts ever-increasing media attention, more and more people are beginning to get behind it. So much so, that now we are seeing the major technology players such as Microsoft and IBM getting in on the act. After all, these are the organisations that are trusted by major institutions the world over to enable the safe implementation of the latest technologies. Perhaps, more pragmatically, they are also names that have reputations they cannot afford to lose and are a known, significant name that can be sued in the event of major problems associated with the implementation. No-one will get sacked, necessarily, by taking a safe option that de-risks the implementation of something new within a large corporation or institution. The presence of these organisations has given the technology the credibility it so desperately needs to be commercially rolled out. This credibility further reinforces that the whole blockchain ecosystem is being approached with serious intent, and as it begins to evolve further and grow from strength to strength, it will get stronger and stronger as risks increasingly begin to diminish. This is the driving force behind many organisations committing serious resources, financial and otherwise, to get behind it. The technology is building momentum, and building momentum fast. Will it be the panacea to the banking malaise of the Global Financial Crisis? Will it have the power to affect the dramatic change the media keep promoting? Does it, as Goldman Sachs first stated in December 2015, have the power to change… well, everything?


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To answer these questions, we first need to go back to basics. We need to understand where the technology came from, how it works, its strengths and weaknesses, its potential and its drawbacks. By understanding the basics, you can see where the technology can fit into your agenda, whatever that might be. So, let’s get dirty under the hood so you can begin to understand why there is so much interest in the technology and to help you get to grips with its powerful future.


Part 1

THE FOUNDATIONS OF THE BLOCKCHAIN

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The History Of The Blockchain

In order to get a three-dimensional understanding of the blockchain, its power, and its future, we also need to understand the drivers behind its original production. We need to understand the evolution of the technology, the motivations of the key individuals behind it, and the environment that prompted its creation and launch. These drivers will give an insight into the “why”, the “how” and the “what” of the technology. Together, these have shaped the design of the technology and, as we will see, have had a profound effect on the shape and future direction of the development of the technology. Surprising for many, perhaps, is the fact that while Bitcoin currently has a market capitalisation of close to $12bn, 12 times bigger than its nearest rival, Ethereum. The actual technology, however, was not originally designed with a commercial narrative in mind, but more from the perspective of ideology.

The Original White Paper In October 2008, Satoshi Nakamoto wrote the original white paper4 “Bitcoin: A Peer-to-Peer Electronic Cash System”. At the time of its launch, the world was in crisis. Banks were failing, jobs

4 The

original white paper is available to view at https://Bitcoin.org/Bitcoin.pdf


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Chapter 2: The History Of The Blockchain

were being lost left and right, and economies were slowly grinding to a halt. The engines of major economies were showing signs of seizing up as the flow of lubrication, in the form of inter-bank finance, was drying up. Desperate times called for desperate measures, and on 3 October 2008, the Emergency Economic Stabilization Act of 2008 – usually referred to as the bailout of the US Financial System – was effected into law in the US. In the original 9-page white paper, which I would urge everyone to read, Satoshi summarised the key benefits of Bitcoin when he described the technology in one sentence: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” The timing was almost pinpoint perfection to reflect the events of the Global Financial Crisis, and on 3 January 2009 at 18.15 pm GMT, Bitcoin was launched, but with no fanfare, publicity agents or corporate PR. It was just launched silently into the ether.

Who Is Satoshi Nakamoto? The creator of Bitcoin, Satoshi Nakamoto, is a very elusive figure – very elusive. After releasing his first Bitcoin white paper in late October 2008 on the cryptographic mailing list metzdowd.com, and subsequently releasing the first software that launched the Bitcoin network in January 2009, he continued his involvement with the cryptocurrency until his complete disappearance from the scene in April 2011, never to be heard of again.



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His disappearance, just as Bitcoin was beginning to take off and gain acceptance, marked the beginning of one of the greatest enigmas in the global technology space. Why would the brilliant creator of such an innovative technology as Bitcoin suddenly disappear? Why would his last correspondence to a software developer confirm “I’ve moved on to other things”? Since this time, there has been complete radio silence – no hint of his subsequent activities; no communication; nothing. The mystique is made ever more noticeable because the creator of Bitcoin still has an estimated one million Bitcoins that remain untouched.5 These are valued, at current market rates, at more than $700m. Not only has this added to the aura of mystique around Bitcoin’s creator, but it has also created a manhunt by people all desperate to answer the question “Who is Satoshi Nakamoto?” Here is probably the wealthiest figure in the cryptocurrency space – and no-one knows who he is. Many have declared themselves to be Satoshi. Many have been labelled as Satoshi. A number of top investigative journalists have got in on the act, declaring with aplomb that they have allegedly unmasked Satoshi. So many theories have been put out, ranging from Satoshi being cryptographers in Finland or Australia through to a collective pseudonym for multiple parties working on the project. Thus far, however, none of those claiming to be Satoshi have ever sought to offer proof of his identity by moving any of the original Bitcoins attributable to his name. As a result, theories abound.

5 https://bitslog.wordpress.com/2013/04/17/the-well-deserved-fortune-of-

satoshi-nakamoto/


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My personal favourite theory, in terms of bizarreness anyway, emanates from the broad translations of the name “Satoshi Nakamoto”. By doing a web search for Japanese baby names,6 you can very quickly find that the name Satoshi as a baby’s name in Japan means “clear thinking, quick witted, wise”. This could be interpreted as Intelligence. Nakamoto, on the other hand, as a Japanese surname,7 means “central origin” or someone who “lives in the middle”, often referencing the Ryukyu islands. So, you’ve guessed it, there is a theory that is gaining some traction, especially amongst the armchair conspiracy theorists, that the creator of Bitcoin is actually the CIA – the Central Intelligence Agency. In fact, there are so many theories it has almost got to the farcical level where you might expect to hear one of the great iconic lines from Monty Python’s Life of Brian: “No, I’m Satoshi and so’s my wife!” To date, no-one has actually been proven to be the creator of the world’s first cryptocurrency or has fully disclosed themselves. However, there may be a clue as to which country the creator is likely to have come from with the very first block ever created, which, at the same time, personifies why Bitcoin was created in the first place.

The Genesis Block The Genesis Block for Bitcoin was produced on 3 January 2009, with this marking the beginning of a long journey for the creation 6

http://www.ourbabynamer.com/meaning-of-Satoshi.html

7 http://www.ancestry.com.au/



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of the world’s first cryptocurrency. In the Genesis Block, there is a hidden message from the creator of Bitcoin that has since become folklore within the Bitcoin and development community. The original data from the very first block of data created in the Bitcoin blockchain is shown below, as seen in Bitcoinwiki:8

Now, it is understandable if you don’t see the hidden message, but when the above block of data is converted into the hexadecimal numbering system, where individual numbers represent numbers and letters, a hidden message appears, as shown below and again as seen in Bitcoinwiki:9

8 https://en.Bitcoin.it/wiki/Genesis_block 9

https://en.Bitcoin.it/wiki/Genesis_block


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In it, the hexadecimal version of the hidden message states:

Chancellor on brink of second bailout for banks. Lo and behold, when you check out The Times newspaper of the same date, as seen in this image via Bitcoinwiki,10 you can see this hidden message refers to the newspaper headline from the UK on Bitcoin’s launch date. While the message may have been inserted to almost timestamp the event, it is also very symbolic. Here was a cryptocurrency whose whole modus operandi was to strip out the very need for banks, and on the first day of its launch, the headlines referenced a significant argument as to why banks need to be taken out of the equation. This symbol has become so powerful within the cryptocurrency space that it is almost impossible to find an original copy of The Times newspaper of this date. All the birthday gift websites that offer a newspaper from your date of birth have long sold out for 3 January 2009. Indeed, we are hearing anecdotally that the market price for a genuine copy of The Times newspaper of that date, with all the original inserts, is around $35,000! So, get hunting… 10 https://en.Bitcoin.it/wiki/Genesis_block



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Given this hidden message, does it mean Satoshi Nakamoto is from the UK, or was, at least, based in the UK at the time the Genesis Block was created? Who knows, but perhaps further clues may be gleaned from the humble beginnings of Bitcoin that sought to create an environment where central authorities and large organisations such as banks did not wield the power they clearly have. It also meant that individual’s privacy could be retained.

Privacy In the Digital Era Ever since the internet first came into the mainstream, its culture has always been “Free!” Content and other material have been made available without charge, supported by advertising. Business models from the “dot-com” era rose and subsequently fell based on the premise that advertising would pay for everything. Audiences were herded together into communities by great free content based around portals of mutual interest. Corporate advertisers rushed in their droves to sell their latest offerings to these relevant tribes. The Darwinian landscape proved the undoing of the advertising-based model, with the subsequent dot-com bust proving the unsustainability of the bread-on-the-water advertising-based models. However, despite the crash, and the lack of viability, the culture of free has remained. The free culture is now almost permanently imprinted into the DNA of the digital economy and its users. “Free” also means that there has been a shift from the pure advertising-based models of the dot-com era to the era of data-driven models. Major corporations use our data to create business models. Facebook,


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for example, knows much about all of us individually, our interests, our interactions, and our habits. Collectively, these paint a psychological picture of our potential buying behaviour, a picture for which corporations will, and indeed do, pay handsomely. So, as individuals, access to free content means we lose a piece of our own freedom. Privacy, while heavily regulated, is increasingly becoming a thing of the past and the lack of it almost a legacy of the dotcom era. The narrative drive for advertising has almost shifted to cyber-stalking. How many times have you been to a website to then find, when you visit Facebook, YouTube, and other social media platforms, that you are presented with advertisements from the same website you have recently visited? Our data has significant value, and our online actions leave a digital fingerprint that creates that value. Privacy is increasingly becoming centrestage in the mainstream but has always been a major issue for the libertarian movement that has been at the leading edge of digital currency creation – the Cypherpunk movement.

The Cypherpunk movement The Cypherpunk movement sought to leverage the use of cryptography and other privacy-based technologies as a catalyst for social and political change. Their core objectives, as detailed in Eric Hughes’s original 1993 Cypherpunk Manifesto,11 were essentially to look at the maintenance of privacy by the individual. The manifesto is very keen to differentiate between privacy and secrecy. Secrecy implies something sinister; privacy 11 The

full Cypherpunk manifesto can be viewed at http://www.activism.net/ cypherpunk/manifesto.html



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involves freedom from government monitoring or corporations controlling and using our personal information. As part of this movement, digital cash was high on the agenda – digital cash that maintained privacy from snooping eyes. The logic for this is, in many ways, laudable. So much information can be gleaned about an individual’s actions and motivation by what they buy. For example, there are social media credit assessment models being developed in the provision of bank credit where the algorithms will try to assess your credit worthiness from the books you buy, your interactions in social media, even the incidence of cat and dog photos in your social media presence. If you are looking for books on bankruptcy, for example, the algorithms may give you a negative mark for your social media credit score. Now while that might seem fairly innocuous, what if a 14-year-old girl has been searching for books on pregnancy or abortion? To libertarians, this is just the tip of the privacy iceberg, because judging someone’s character by their actions will always hold true – even in the digital age. With this objective in mind, many attempts have been made to create the nirvana of a digital currency that cannot be copied and cannot be viewed by snooping eyes – especially governments – with various degrees of success. The first truly recognised incidence of digital cash is recognised as having been developed by a cryptographer, David Chaum, in the early 1990s – Digicash. He used his core Blind Signature Technology12 to create a digital currency, the primary aim of 12 Blind

Signatures for Untraceable Payments,” D. Chaum, Advances in Cryptology Proceedings of Crypto 82, D. Chaum, R.L. Rivest, & A.T. Sherman (Eds.), Plenum, pp. 199-203.


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which was to ensure the privacy of its users. Through the use of secured keys, third parties were prevented from accessing personal information through online transactions. In many ways, this technology was markedly ahead of its time, as e-commerce, as we understand it today, was in its pre-natal stage. With limited support from users at the time and only minimal support from finance institutions, Digicash Inc. filed for Chapter 11 bankruptcy in 1998. Various other attempts to create a digital currency have followed in its path, but most used the existing infrastructure, the payment rails, of the existing financial system. Bitcoin was the first cryptocurrency to be set up that also created its own financial system and did not need the existing infrastructure. It was designed ►►

To have its own monetary system – a maximum of only 21 million Bitcoins will ever be produced (or mined, as it is called). The last Bitcoin is expected to be mined in 2140.

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To have a monetary system that lacks in-built inflation. Every four years, the number of Bitcoins available to be mined are halved. The last halving happened in July 2016.

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To have its own protocols and to be run based purely on computer code.

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Not to be owned by any individual or corporation. Instead, the community owns it itself.

Thus, the entire framework and ecosystem were designed to be completely outside of the direct control of any central authority. Bitcoin is not owned by any government, any individual, let alone a multinational corporation. It is this background of the insatiable



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desire to protect freedom and privacy from central authorities that has driven the underlying development of Bitcoin. This driver remains very much alive today. Bitcoin purists remain very true to their original beliefs, and many have joined the movement to continue to push the “privacy barrow”. While very positive from an ideological perspective, as we will see much later in this book, this ideological framework has caused a number of major problems – especially when the practicality of commercialism conflicts with this underlying ideology.

Bitcoin is a masterpiece of invention. While we may never know who Satoshi Nakamoto is, it is incredible to think that a single Bitcoin is now worth in excess of $720, and it has a market capitalisation of $12bn – not bad for a technology that no-one actually owns. Equally, a Bitcoin is not a physical coin but a cryptographically secure entry in a ledger – and that is all it is. That is powerful. For users to have confidence in Bitcoin’s value, they must believe in the cryptocurrency itself and must feel that it is secure. The technology has proven itself since its launch back in 2009, with the market price rising from nothing in 2009 to where it is today. As we will see in the next section when we go under the hood, this price reflects the power and potential it truly has to offer.


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Bitcoin US $ Price 2012 – 2016 Screenshot from tradingview.com


3

How Does The Blockchain Work (In Plain English)?

I want to take you back into the darkest depths of time. I want to take you back to the time when life was so much simpler; to a time when technology did not rule our lives; to a time when technology wasn’t right at the very core of our day-to-day lives. For me, that time was February 12th, 1995 at 2.16 in the afternoon. It was a cathartic moment for me. It was the exact time at which my eyes and my mind were opened to the unbridled power and potential of the internet. I sat in a small, dingy office in the vibrant, art-soaked, seaside resort of Brighton on the south coast of England. I was in the offices of one of the very first internet providers in the UK. There, on this concrete block of a screen in front of me was my first website. One line at a time, a painting from a local art gallery snaked its way into my consciousness forever. The art gallery, which housed the piece of art, was six miles down the road in the harbour town of Newhaven, the gateway to France. However, what I saw was a different gateway. The internet was a gateway to the world, a gateway to the future. This piece of art could have been from any art gallery anywhere in the world – Los Angeles, Sydney, or Nepal. It really didn’t matter where the art gallery was; it was the technology that was taking me there. This was bigger than anything I had


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Chapter 3: How Does The Blockchain Work (In Plain English)?

ever seen before. Instinctively I felt the internet was going to be unbelievable, gigantic –and here I was right at the forefront of this wave of dramatic and irreversible change. I could see its potential. I could feel its potential. I could smell its potential on the screen in front of me. It was at that point of realisation I said to myself, “I have to be in this business.” The internet was the beginning of a new paradigm. At the time, my partner and I set up an internet café-bar and restaurant, and a web-design house. I found myself giving talks on how the internet worked, how it was game-changing both personally and commercially, and how the internet was about to open up the world to everyone, everywhere.

In the 20 or so years since its beginning, the list of great household names that have been forged into the zeitgeist is quite incredible. It also amazes me how easily we forget what life was like without them. I experienced this first hand on a recent business trip to Shanghai, China. Shanghai is an incredible source of opportunity. As the world’s largest city by population, around 28 million people, it is a vibrant



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reflection of China as a whole that is home to almost 25% of the world’s population of 1.6bn people. While there are significant cultural differences, there is one additional difference which we, as westerners, have to contend with - the Great Firewall of China. Behind this firewall, very few large western brands survive. When I first arrived in Shanghai, not speaking a word of Chinese, I was faced with perhaps the worst technological dilemmas a western traveller can face. “How do you search for a Chinese search engine when you have no access to Google?” Other questions also flooded my mind. How do you find your hotel when you don’t have access to Google maps? How do you show the taxi driver the exact address of your hotel when you can’t access your Gmail account to pick up your hotel booking, especially when 99% of Shanghai taxi drivers don’t speak English? How do you ask friends for help when you can’t access Facebook? Perish the thought, but it meant I would have to start talking to people face to face and try my best to communicate. This experience was so 20th century! These experiences did make me realise, however, how far we had come in 20 short years; how far technology had changed; how it had improved our lives; how much it had changed the way we interact with each other and how much we rely upon it. Where the blockchain is right now is where the internet was back in early 1995 – raw but so full of potential. When I first came across Bitcoin in about 2011, I thought yes, this looks like an interesting experiment. However, there didn’t seem to be a commercial narrative at that time. The level of


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adoption was low, and it felt very niche and very geeky. However, in early 2015, I re-visited that view when I started looking more deeply beneath Bitcoin’s hood – at the underlying technology that drove it. It was there I had my deep feeling of “déjà vu”. Here was an underlying technology that, with the right application and vision, could change so many things. The problem was that the technology was very complex and very hard to understand, and it took a long time to get to grips with. When Al Gore first described the internet as the “Information Super Highway”, here was a descriptor that helped the media spread the word. That descriptor summarised its power and its vision. This hasn’t happened with the blockchain. The blockchain is very hard to describe, if not impossible, in five words because it is so deeply complex but has the potential for wide application. The more times I run introductory workshops on the blockchain, you would think the more this five-word descriptor would naturally come to me. Alas, it hasn’t. In many ways, what we really need to see is the first great use like we did with the internet. Back in 1995, the first use case of the Internet was email. It meant we could replace written letters with electronic ones. We didn’t need to worry about the underlying technology being TCP/IP – Transmission Control Protocol and Internet Protocol – we just sent an email, and the other person received it. It was relatively easy – but it solved so many problems for us. We could communicate as quickly internationally as we could locally. It saved us time, effort, and cash; no stamps, no envelopes. With the blockchain, however, Bitcoin was the first proven use case.



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Bitcoin was launched back in 2009. At the time of launch, blockchain technology was not separated from the use case; it was just blended into what Bitcoin represented. The Bitcoin blockchain, however, was the first blockchain. As a result, it has become the de facto standard for most other blockchains that are in existence today and for those that continue to be created. They all broadly follow the same broad technical structure as the Bitcoin blockchain, all with certain nuances that define their differences. As a result, to understand the blockchain, it is important that we understand the basics of how Bitcoin works. However, instead of going straight into heavy technical detail, let’s approach it in terms of an analogy that we can relate to.

What is the Blockchain (In Plain English)? So, let’s set the scene. What happens if I steal your mobile phone? To establish the truth about my stealing your phone, both of us would typically go to court. A judge, with perhaps the help of a jury, would pass judgement based on the evidence, circumstantial and otherwise, presented from both prosecuting and defending counsels. The truth would be established based on the evidence


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provided, which would fundamentally be based on your word against mine. Let’s now imagine the evidence we present to the judge is from 5,000 independent photographers who have taken a photograph of me stealing your phone. This almost becomes incontrovertible proof that I stole your phone. If I wanted to prove my innocence or try to falsify the facts, I would have to persuade at least 2,500 of these independent photographers to change their images. That would be a significant challenge. After all, I would have to speak to each of them individually to convince them to change their photographic images of me stealing your phone – and without any incentive for them to change the facts, why would they bother? This evidence becomes very strong, unless of course, I had deep pockets and a silver tongue. That said, let’s make the ability for me to change that evidence even harder. Imagine that I have to persuade 50% of all the independent 5,000 photographers to change their images of me stealing your phone in the space of 10 minutes. Because at the end of 10 minutes all the photographs they have taken are going to be locked away in a bank vault and permanently sealed. This is going to make it even tougher for me to change the evidence.



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My chances of getting that elusive job of being the in-house restaurant critic at the local prison have just increased. The final coup de grace is added when we put a combination lock on that bank vault that now houses the 5,000 images of me stealing your phone. This combination lock has more combinations on it than there are grains of sand on the planet. It would take me an estimated 0.65 billion, billion years13 to randomly crack the combination lock of this bank vault that has the 5000 images. Clearly, it is now all but impossible for me to change the facts that I stole your phone. Finally, let’s install a video camera that is connected to the internet that lets anyone see all the images that have been taken and permanently locked away. Not only is the act of my stealing your phone stored on photographs that are permanently locked away, but also there is complete transparency to view the evidence by anyone with access to view the images.

That is how the blockchain works. However, instead of 5,000 independent photographers, we have 5,000 independent computers, called nodes, that are networked together across the globe and connected via the internet. Instead of photographs, we have data. So, in the same way, as the photographers’ images were locked away in a permanently sealed bank vault, data is locked together inside a block of data which is then cryptographically sealed with a seal that has more permutations than there are grains of sand on the planet. This

13 http://Bitcoin.stackexchange.com/questions/2847/how-long-would-it-take-a-

large-computer-to-crack-a-private-key


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cryptographic seal has the same effect as a traditional wax seal, although it is of course significantly more powerful. Each block of data contains a timestamp and a link to the previous block. In this way, we have a timestamped record of a block of data having been recorded and sealed. Because the blocks of data are crytpographically sealed and linked together, we can trace back through previous records. Equally, in the highly unlikely event of a seal being broken, we could go back through the linked data and audit what had happened. All the blocks of data are linked together to form a chain of permanently locked blocks of data – hence the name “blockchain”. The power and beauty of these concurrent blocks of data, however, lies in the way the 5,000 nodes on the network work together. Every one of the 5,000 independent computers holds the same copy of all the blocks of that data that have ever been sealed and linked together. They ultimately collectively agree that those blocks of data are the same across the network through what is known as a “consensus algorithm”, where, broadly speaking, 51% of all the computers on the network have agreed on the data that is housed in the blocks.



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In its essence, the block chain is defined as:

a peer-to-peer database that is immutable. In other words, once data has been written to the database and has been agreed by at least 51% of the 5,000 independent computers, it is locked permanently and cannot be altered. As with the photographs of me stealing your phone, where I would have to change at least 2,500 individual photographers’ images to change the truth, so it is with the blockchain. At least 51% of the computers would have to be altered to change the stored data. The significance of this is that there is no longer just one single point of attack. Many well documented financial hacks have occurred in the past, where bank data has been changed and re-directed fraudulently to a new account. These changes have typically been made by attacking one central point of weakness – one point of attack, where records are stored and changed. Under a blockchain type of structure, the system is not only decentralised to take away that central point of attack, but the data is also distributed across multiple computers. In our example of the 5,000 computers on the network, this significant centralised weakness is removed. Any hacker or attacker would need to access at least 2,500 computers at the same time to change the data – a significantly harder task. Hacking is a very sophisticated art within the major criminal organisations world-wide. It is not the cliché-ridden Hollywood view of a spotty teenager hacking the systems and making off


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with millions in a split second. Instead, attacks and hacks are often planned months in advance, the perpetrators patiently stalking financial institutions and their key employees over a period of time, gradually encroaching into the institution’s system. The “infection-to-cash cycle”, as it is called, usually starts with infected malware. This is often embedded within other files that finishes up working its way through an organisation’s administrative systems even, for example, to the point of opening the internal camera systems. Gradually and painstakingly the hackers work their way through to locate the weaknesses of a centralised system until their chosen point to strike is identified. With a decentralised, distributed blockchain that has multiple copies of the same database, this process becomes a nightmare. Cyber stalking now has to be multiplied across multiple computer systems across multiple institutions that will comprise “private blockchains”, where only known parties are allowed to participate – e.g., other known financial institutions that have high standards of security. The hackers’ workload increases almost exponentially, making it so much harder to access and change financial data for their own benefit. As in nature, there is safety in numbers. While the cat-and-mouse games between institutions and hackers will always continue to play out, you can probably begin to see, from this comparatively simple structure, the potential of the blockchain from a security point of view alone. This is just one aspect of the blockchain’s potential and power.



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The Importance of Cryptocurrency Miners The concept of mining is an important one to understand as it is an intrinsic part of the infrastructure of the Bitcoin blockchain and most other blockchains that have superseded it. As we saw above, once data is collected together, it is put into blocks, and the blocks are then cryptographically sealed. It is the miners that seal these blocks. While anyone can mine Bitcoin with the right equipment, Miners are typically companies that have access to extensive computer power. This power is usually in the form of banks of specialist, very powerful computers. The miners also usually act as nodes on the network (one of the 5,000 computers in our example above). The Bitcoin protocol requires miners to solve a cryptographic puzzle. By successfully solving the puzzle, the cryptographic seal is then applied to a block of data. Miners compete with each other


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to solve the puzzle, and whichever miner solves the puzzle first is rewarded with a Bitcoin. So, by providing the security for the blockchain, the miners themselves get rewarded with a Bitcoin. Miners also get a second reward for providing support for the underlying infrastructure – by getting rewarded with the transaction fees of keeping the blockchain running. So, for example, if I send you a Bitcoin, there will be a transaction fee for administering the transfer of that Bitcoin. While small (around 3 - 10 cents), it is another reward for being a miner and providing the infrastructure for the Bitcoin network.

The Dynamic between Mined Cryptocurrencies and Transactions Miners are commercial entities, with commercial drivers. To mine Bitcoins, for example, requires miners to have extensive banks, even warehouses, full of computers. As a result, there are direct costs of mining – electricity, the depreciation of the hardware, the teams to administer the network, etc., etc. The harder it is to mine, the more computing power and electricity are required to mine and the greater the costs. So, for a commercial Bitcoin miner to generate a profit, the combination of the value of the Bitcoin and the transaction fees they generate from administering transactions have to be sufficiently more than the costs of mining for them to generate appropriate profit levels. This narrative is particularly important. As part of the Bitcoin mining protocol, the number of Bitcoins that are available to be mined is limited in nature. So, for Bitcoin, only 21 million coins will ever be issued, with the last Bitcoins due



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to be available in around the year 2140. Also, every four years, the annual number of coins available to be mined is halved. This changes the dynamic of mining significantly. With fewer Bitcoins available to be mined, all the competing miners have fewer opportunities to earn Bitcoins. The overall costs they incur, however, still need to be paid. So, unless the value of Bitcoin rises, making it worth their while to continue to mine Bitcoins, the cost of transactions on the Bitcoin network will need to rise to compensate. As a result, we tend to see this seesaw effect between Bitcoin values and transaction fees, resulting in volatility in mining fees and Bitcoin prices, which presents any Chief Financial Officer (CFO) with significant risks when looking at cryptocurrencies. Now, if the number of transactions a CFO administers is low, and the fees are at the level of cents, this won’t present a significant problem. However, if the number of transactions rises significantly, this volatility will become an increasingly difficult issue to manage. Different cryptocurrencies are trying to address this issue of the costs of mining and their relation to transaction fees – but it is important to understand this uncertainty as it presents risks in the adoption of cryptocurrencies in general.


4

Blockchain Technology The Ten Pillars Of Strength

Introduction Bitcoin was an amazing invention. The more I have written about Bitcoin and more latterly the blockchain, the more I have been impressed by the underlying strengths of the very foundations that Bitcoin created. It has opened so many new possibilities that have never been seen before. It is these possibilities that are catching the imagination of so many people, including the media. Media hype, however, is a double-edged sword. On the one hand, it is great in terms of promoting the technology and generating awareness, but on the other, it generates an overexaggerated expectation that it is too early for the technology to deliver. Gartner Inc., the global information technology research, and advisory company summarise this very well within their regularly produced “Gartner Hype Cycle” for emerging technologies. In their latest Hype Cycle report from August 2016, they have included the major emerging technologies and where they are, in terms of expectation versus delivery. Their summary is shown below:


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As we can see, blockchain is regarded as being very close to the peak of inflated expectations, undoubtedly fuelled by the high levels of media coverage that have been seen over the past 12 – 18 months. Indeed, within the Gartner Hype Cycle diagram above, you can see that they believe it will be 5 – 10 years before the blockchain hits mainstream adoption. For financial services, I believe this is probably pretty accurate, but there are various applications that will hit the mainstream earlier, that we will discuss later in the book. These will tend to be simpler ideas and ones that include the idea of provenance or ownership. In this and the next chapte, we will consider the ten core strengths and the ten core weaknesses of the blockchain. Both are vital to understand, as they will provide you with an


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understanding of both the motivations to develop the technology and the core features that are likely to inhibit its adoption and growth. While we will be considering the relative merits of the technology, it is important to understand that the technology is still very new and is still developing and growing. As the whole blockchain ecosystem continues to develop worldwide, its wheels greased with ever-increasing venture capital funding, we will see constant improvements in the technology. Many of the weaknesses we will look at will be ironed out over time, and many of the inhibitors to adoption will fade away. That said, the blockchain ecosystem is dynamic, with its DNA still being forged. As a result, while extensive improvements are likely over time, they will have with them added challenges – the dragon’s teeth effect, if you like. Solving one problem may prompt others to rise in its wake, creating an ever-increasing game of catch-up. The blockchain ecosystem will tend to be on shifting sands over the next few years. It will undoubtedly be full of iterations and deep changes in the short to medium term, as it creates its path towards long-run maturity, stability, and extensive commercial usage. So, let’s look first at the ten core strengths of the blockchain. As we begin to consider the ten pillars of strength for the blockchain in general and cryptocurrencies, in particular, we will also notice that some of the strengths can ironically be seen to be weaknesses as well. While this might appear strange to you now as you read this, you will understand how this is the case as we progress, with this becoming more apparent as we explore the strengths further.



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1. Creating a digital currency that cannot be copied A right click of your mouse; a quick scroll; “Save as…”. It’s that easy to copy images on line. Whether it’s photographs, spreadsheets, research papers, videos, the power of the internet has been driven by its intrinsic capability to share almost anything quickly and easily. That is very powerful. On the flip side, however, it is also one of its greatest weakness – just ask the Hollywood studios or the independent photographers squeezing out a living from their creative art, seeing their livelihood being eroded away, one right click at a time. Copying anything digital is easy. Bitcoin, as a digital currency and the world’s first cryptocurrency, however, was different. To have a secure digital currency that will instil confidence, we need a digital currency which cannot be copied or reproduced. This has been an ongoing problem that has caused so many headaches for digital currency enthusiasts and cryptographers over the years – the issue of what is known as “double spending”. Double spending relates to the ability to spend the same digital currency twice. Let’s use an example to give this some perspective. If I take out a $10 note from my pocket to buy you a cup of coffee and give it to the barista, we both know that the barista has received the banknote. While the note could be forged, the barista can see, touch and feel it; it is in his hand. I cannot give the same note to someone else. However, what happens with digital currencies? If I give the barista $10 worth of a digital currency through my smartphone, how does he know that he will get his money and


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that I won’t go to another café straight away and buy a sandwich, thus spending the same money twice? Every single transaction ever made on the Bitcoin network since its inception in 2009 is stored on each and every node that makes up the Bitcoin network, i.e., the computers that are connected to the network. Everyone on the network knows about any confirmed transaction and has an agreed form of this database of transactions, a ledger if you like. Currently the size of the Bitcoin Blockchain on each node is around 90 gigabites in size. This means that the history of every previous transaction of every Bitcoin is permanently available for everyone to see, and for every node to reference and process. So, it is easy to audit the fact that your Bitcoin address has valid Bitcoins available at a given point in time. The only down side can come from the length of time taken for a Bitcoin transaction to be formally confirmed by all computers on the network.

Size of the Bitcoin blockchain Source: Blockchain.info



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While different cryptocurrencies have different times for the creation of each block, it can take six confirmations for a Bitcoin transaction to be confirmed. With each block on the Bitcoin network taking 10 minutes to be created, six confirmations is about an hour. This delay can leave someone open to fraud from what is known as a double spending attack.

Here’s how it works. In our case, we have bought a cup of coffee from Barista 1 with Bitcoin. Barista 1 then gets his Bitcoins after six confirmations. However, if we go to Barista 2 directly afterwards and buy a second cup of coffee, whoever gets six confirmations first will get the cleared Bitcoin payment, and the person who comes second will get nothing. This becomes a challenge if the coffee has already been released by both baristas. The best practice, in principal, is for the barista to wait for one hour for the confirmations before releasing the coffee – which is not always going to be practical. As we can see, the ability not to double spend the same Bitcoin is a great strength but the practicalities of having to wait for sixty minutes for confirmation is a weakness. The strength of the security becomes a weakness. Many companies are looking at speeding up the confirmation timings because it is impractical


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to have to wait for a commercial transaction for an hour, especially in fast-paced environments such as equity trading.

2. Removing the Need for Trust If we think back to the Global Financial Crisis (GFC), one of the key reasons behind the whole crisis getting increasingly worse was the lack of trust that grew between financial institutions. Once Lehman Brothers, at one time the fourth largest investment bank in the US, collapsed, there was the contagion effect of noone knowing which bank was going to be next. There was an air of suspicion and distrust. The global banking system is made up of financial institutions that lend money and borrow money from each other in the course of day-to-day dealings and then settle their accounts usually at the end of the business day. The domino effect of lacking trust and not knowing who might be the next to cease trading made banking very difficult. It is not surprising that Bitcoin was launched at the time of the GFC in January 2009. A Bitcoin transaction directly between two parties is based solely on their private keys and public keys. You send a Bitcoin via your private key, and you receive a Bitcoin via your public key. There is no third-party bank or credit card company required in the middle to approve or validate that the transaction has occurred. It is the blockchain technology itself that validates the transaction. In essence, by removing the potential need for trusted thirdparty institutions, we as individuals have the capacity to be our own banks by controlling our own cryptocurrency wallets that contain our cryptocurrency coins. Down The Rabbit Hole

I hope you enjoyed your free sample of the book. If you would like to buy the book please visit the Amazon Kindle Store here. Thanks for all your support. Tim

The Blockchain : Down the Rabbit Hole: Discover the power of the blockchain - Free Preview

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