Hidden Revolutions — Crypto, Blockchain, NFTs
Making sense of the electronic market.
When it comes to early adoption, invisible technologies are often the hardest for humans to relate with. It takes a lot of time and stories to gain a narrative that becomes viable. This is blockchain technology’s problem too.
― Olawale Daniel
With over a trillion dollars in market value, the cryptocurrency/NFT field has clearly grown beyond just an experiment to become a credible industry. Bitcoins are going for over $30k apiece and NFTs are going for millions of dollars. There is even a Bitcoin futures market run by the Chicago Mercantile Exchange.
The extensive interest in crypto by top investment groups has generated hundreds of articles by top publications. But surprisingly, most of these articles provide very little practical understanding of the underlying systems. There is plenty of flowery commentary about how it will change the world (e.g. “regular currency is dead”) and pseudo-jargon hype (web3, alt-tokens, Metaverse catalyst, etc.), but very little concrete details.
The current reality is somewhat more muddy than the jargon would imply. Issues of excessive energy use, fraud, and theft present a negative impression of the whole crypto field. Regardless, there are some important underlying concepts and technologies that can be directly applied to a number of social issues, everything from management of fishing grounds to running a billion dollar organization.
What is the problem being solved?
I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.
― Satoshi Nakamoto
To understand cryptocurrency, you first need to read the original article by Satoshi Nakamoto. First and foremost he was trying to create an electronic currency system (i.e. “coins”) that did not require banks, governments, or other centralized entities to function.
In an electronic currency model, a coin is not tied to a physical asset (e.g. gold). Nor is it dependent on a political or business entity (e.g. a municipal or corporate bond). Instead the coin is defined in terms of an electronic asset — usually a known amount of computer processing power required to perform a specific calculation.
Once you define the coin you need a way of exchanging them, i.e. you need a way of transferring coins from your bank to their bank. But in this case there are no banks. And as part of that there has to be a clear accounting system that records the transaction. Because there is nothing physically being exchanged, this system has to be robust and trustworthy.
So why would one want to do this? At some abstract level it seems beneficial to have a currency that is independent of the whims of a government — even a thoroughly democratic one. But more important than that, if there is indeed a way to create a system you can trust (for specific tasks) independent of a centralized authority, then that may be useful for a number of other social issues.
Why is trust important?
Trust has an unlimited value, The father of all currencies
― Gun Febrianza
The key issue in creating a system like this comes down to trust. In any normal payment system, there are banks or other entities regulated by governments that provide a trusted host to perform the transfers and store the records of the transactions.
In these systems, each bank (or similar) has an internal accounting system that tracks the transactions. If an issue arises (payment not received, duplicate payments, etc.), they refer to their accounting system to determine if and where a fault has occurred. You trust their accounting system because you trust them as a regulated entity.
But what happens if, in effect, you don’t trust anyone? Can you create an electronic network in which trust is cryptographically built-in to the system itself rather than specified by some outside entity?
The solution to achieving this comes down to a few basic underlying concepts:
- Create (or find) a large network of computers to store the data.
- The network should be distributed geographically, politically and commercially.
- Every computer in the network gets a copy of the whole transaction register.
- Every computer validates the data in the register to ensure it hasn’t been altered.
- Trust derives from consensus of the majority of computers.
- The bigger the network, the more trust it instills.
The goal is to create an open accounting system for recording transactions that cannot be (easily) artificially manipulated and does not depend upon the trustworthiness of the individual participants.
What are the key technologies?
Learning how cryptocurrency works is like learning a new language. It is incredibly difficult at the beginning, but once it clicks it will stick with you forever.
― Olawale Daniel
The Network/Miners
First and foremost you need a large network of computers, preferably spread over multiple locations and run by multiple groups. These computers are called miners. They store the transactions and perform all of the work. They need to be connected to a good network to talk to each other. Also they need to be incentivized to be a part of the network (i.e. somehow they need to get paid).
Blockchain
At its basic level, an accounting system stores a permanent record of all transactions that occur between accounts in a ledger. Blockchain is basically just a type of distributed read-only ledger.
Blockchain divides the ledger into a sequence of blocks. Bitcoin’s blocks are roughly 500 transactions each. When a new block is created it is copied to all of the computers in the network. So in theory all computers in the network have an identical copy of the whole blockchain.
For it to be read-only, you have to have a way to verify data has not been altered. Blockchain achieves this by creating a hash of the records. A hash is a function which takes a big number (or text) and converts it to a smaller number of fixed length.
This number is unique and if the big number changes even the tiniest amount the hash result will also change. So if you are given data and the blockchain gives you the hash, you can run your own hash on the data and verify they match (and thus haven’t been changed).
Each block contains the hash of the previous block. So the chain of blocks creates a self-referencing sequence. The longer the chain, the more difficult it is to alter the data in a block, since you then have to regenerate all of the hashes in subsequent blocks as well.
The longest chain is determined by the majority of the miners as being the correct (i.e. trusted) chain and they attach the next new block to the end of that.
Bitcoin/Crypto
Now that we have a way of recording the transactions in a trusted way, we can introduce the concept of an electronic currency that rides on top of that. The creators of Bitcoin realized that for the system to grow, they needed to incentivize miners to host the blockchains. Fortunately they were able to come up with a way to achieve both goals simultaneously.
Their solution is based upon the concept of proof-of-work. Proof-of-work defines a unit of value based upon performing a task of known effort and duration. In this case, the task involves performing a calculation that requires a specific amount of computer processing cycles.
The calculation involves hashing the block a second time to also include a random value called a nonce. The difficulty level of calculating this second hash can be dynamically adjusted by the system based upon different factors — such as the number of miners in the system.
When a miner finds this new hash for a block (which means they have performed a known amount of work), they get rewarded with coins. Thus the base value of the coins are tied to the processing cycles needed for the work. One system provides both reward and valuation.
Wallet
Next we need a place to store the coins that have been generated. A wallet is an electronic account used to store and manage cryptocurrency. Wallets provide mechanisms for exchanging coins with other people (via their wallets) and in some cases converting between different crypto currencies.
Each wallet has a unique identifier associated with it like a bank account id. And it is protected by a public/private key mechanism to ensure only the owner of the wallet can initiate transactions on its contents. Coins are not stored in wallets as individual data objects per se. The current contents of the wallet is in effect the difference between the coin transactions coming in versus the ones going out.
Gas
Gas is the term for a type of fee that can be included with a transaction to help prioritize its execution. Gas is another way the miners are paid for the computing time required to process a transaction. It is paid as the difference between the coins coming in on a transaction and those going out.
Satoshi theorized that as cryptocurrency matured, the bulk of payments to miners would transition to transaction fees. Regardless at some point all of the coins will be generated (e.g. 21 million for Bitcoin) and the only remaining revenue stream for miners will be gas fees or similar.
Ethereum
Ethereum is a competitor to Bitcoin that expands the lexicon of blockchain to a larger range of applications. Ethereum defines the concept of a distributed state machine and execution of code on the blockchain itself. In addition, Ethereum provides connection points to other systems for a range of functions such as storing large files and connecting to other data sources (weather, stock, etc.).
To achieve this Ethereum has a programming language built-in (see Smart Contracts below). This is a very powerful concept that makes the platform very extensible and applicable to a wide range of problems. A large number of derivative systems are built on top of Ethereum, which in turn increases its market size and thus improves its trust and stability.
Smart Contracts
Smart contracts are a type of Ethereum account that can initiate transactions without human intervention. Just like with human accounts, there is a guaranteed unique address associated with each instance. This address can be thought of as the contract id.
Smart contracts execute code specified in the smart contract language. Given the right inputs, the code executes and produces one or more outputs (i.e. transactions). Moreover it can contain persistent information (i.e. state), such as a customer code, location, or other metadata.
Smart contracts are the basis for implementing a wide range of higher level systems including banking, escrows, and other ownership structures (such as NFTs and DAOs described below).
Swarm/IPFS
Although you can store small chunks of data within the Ethereum transactions, it is not cost effective to store larger files (e.g. images). Thus Ethereum is designed to interface with distributed file systems like Swarm and IPFS to perform that function.
These systems are implemented using concepts similar to Ethereum, such as large decentralized peer-to-peer networks and division of the data into hashed chunks. They are also designed to be highly resilient and read-only.
NFTs
Non Fungible Tokens (NFTs) are a specific type of smart contract that is tied to an asset of some kind. Unlike electronic coins, each NFT is unique. You can think of it as the contract representing unique ownership for that asset. In theory it assures that that asset is only owned by one person and can’t be double-sold (unless you want it to be).
There are two kinds of assets that can be tied to an NFT: a physical object (e.g. a bottle of wine) or an electronic object (e.g. digital art, games, etc.). The NFT contains, indirectly, a reference to the object in some form. For a physical object the reference might refer to the physical name and storage location of the object. For an electronic object the reference may be an identifier in a storage system (e.g. Swarm, IPFS) that contains the object.
It is important to remember that NFTs are not coins. The NFT itself is just a contract. The value associated with an NFT is defined by the value of the asset associated with it.
DAOs
Decentralized Autonomous Organizations (DAOs) are a type of business structure (either for-profit or not-for-profit) that work on a completely decentralized leadership structure — i.e. no-one is in charge. All decisions of the business are determined by a vote of the majority, and every transaction is visible to all the members.
DAOs are also implemented using a type of smart contract. The smart contract framework ensures the rules of the collective voting structure are strictly adhered to, and that all transactions are managed properly and publicly accessible.
DAOs are a useful structure for very specific types of applications such as charities, alliances, or management of commons (see below). They have also been used as a management structure for venture funds with mixed success.
A deeper meaning
Understanding blockchain makes you go mad, unless you start your own cult
― Arif Naseem
Blockchain networks form a type of commons. A commons is a shared system accessible to all members of a society. Some examples of commons are a chunk of land (e.g. a shared grazing field), water (fishing grounds), or a public accounting system (blockchain). The goods in the system are referred to as a resource.
Within the commons created by the blockchain network, cryptocurrencies form a special type of resource called a Common Pool Resource (CPR). A CPR is a type of limited resource that all members of the society can access, and that can become depleted (e.g. fish in a fishery).
The key differentiator for blockchains over other commons systems is the way it implements an efficient management framework without having a central authority. In effect, it synthesizes trust within a trust-less society. This opens up some interesting possibilities to apply it to other problem domains.
On top of that, DAOs are a handy prepackaged system for “programming” a CPR management system. In her book Governing the Commons, Elinor Ostrom demonstrates the advantages of managing scarce resources by the society itself rather than by a central authority (e.g. government regulation). DAOs provide an electronic platform for performing this function.
Issues and Challenges
Bitcoin is absolutely the Wild West of finance, and thank goodness. It represents a whole legion of adventurers and entrepreneurs, of risk takers, inventors, and problem solvers. It is the frontier. Huge amounts of wealth will be created and destroyed as this new landscape is mapped out.
- Erik Voorhees
There are a number of issues and challenges around blockchain, NFTs and cryptocurrency that have come to the forefront as their use has expanded. A number of these are critical to resolve or improve quickly if the market is to survive and grow.
Many of the issues occur where the network interfaces to the outside world. This is the point at which the trust within the electronic world needs to translate into trust in the physical world. No matter how much trust you create within the network, the moment you leave it (either physically or electronically) that all goes out the window.
Energy Use
The proof-of-work calculation requires a significant amount of computing power and thus electricity. It is estimated that the current cryptocurrency miners use more energy each year than Finland. Given the global goal of reducing greenhouse gas emissions, this is a significant concern.
One potential solution is to switch to a reward system that requires less computing power, such as the proof-of-stake model proposed for the Ethereum 2.0 spec. In a proof-of-stake model, the reward is determined in part by the miner committing a number of coins as their security deposit. The security deposit theoretically discourages miners from trying to cheat or break the system.
Fraud & Money Laundering
Cryptocurrency and NFTs have been associated with a number of schemes to defraud investors or steal their money. Issues include coins disappearing from wallets, NFTs being oversold, and entire wallet systems shutting down without notice. As mentioned previously, these issues primarily occur at the interface point (i.e. gateway) with the outside world.
The gateway is also responsible for translating the internal blockchain account id into a physical account number in the outside world. It is not so much that there is anonymity in the crypto network; it is more a question of how these internal ids map to accounts on the outside. So even though there is 100% visibility on the flow of transactions within the network, money can be obfuscated by passing through an unregulated gateway.
For cryptocurrency each gateway is by necessity a single, physical entity that has to be trusted to hold fiat currency and properly manage and monitor conversions to/from the electronic network. These gateways act like banks storing or transferring depositor’s money, yet lack most of their regulation and oversight.
The solution is to either fully regulate them (including mechanisms for reporting suspicious transactions), or figure out how to extend the trust system to include them. Some efforts along these lines are being made, such as implementing a proof-of-stake system for parties outside the network itself.
Valuation
The market value of an asset is affected by a number of factors including current trends, manufacturing/production cost, and regulations among others. Market size is a big driver of value. If the market is small, or is flooded with over supply, the long-term value decreases. Often markets spring up for the latest hot trend and then quickly die away (e.g. Beanie Babies).
One challenge with cryptocurrency is the ease with which new currencies can be created. At this point there are over 10,000 cryptocurrencies. Many of these have minuscule markets and will die out quickly. Others have carved out niches in specialized communities and will continue in that segment, albeit with limited liquidity.
The top five or ten currencies (Bitcoin, Ethereum, Tether, etc.) have established markets in the tens of billions of dollars and have enough liquidity to establish a good chance of survival. However there will inevitably be consolidation as the market matures. This will most likely be driven by the burden of increased regulation and the decrease in reward to the miners driven by a switch to less energy intensive (and thus less profitable) algorithms like proof-of-stake.
There is a similar issue for NFTs. As mentioned previously, NFTs derive their value from the asset they reference and its rarity not from the NFT itself. NFTs are comparable, in some respects, to trading cards. The value of the trading card depends upon not just its rarity, but also upon who created it, how it looks, and how big the market is for that particular brand/content. Some cards increase in value while others drop.
NTFs & Ownership
There is a lot of misunderstanding of what someone is purchasing with an NFT. When an NFT is created, it is embedded with the asset identifier pointing to its storage location (e.g. Swarm/IPFS). At this point you have access to the asset just like everyone else in the world. So the question is what are you actually purchasing?
For other kinds of “normal” (non-crypto) assets, when you purchase them they are initially only visible to you. For example if you purchase a photo on Photostock to use on your website, you are given a private link to download a high resolution image. Similarly if you purchase a trading card, it is in your private possession by default.
Then at some point later you can choose how to use this asset — display it on your website, show it to other people, lend it to a library, etc. And when you do that, you choose not only how to present it, but also the audience that can see it. This flow from private to public (or not) is a fundamental element of ownership.
NFTs do not currently have any of this. There is no way to differentiate between owning an asset from presenting it. If your NFT asset is electronic, then it is visible to everyone immediately. This confuses people into believing that what they are purchasing is the concept of the picture (i.e. the copyright or trademark) rather than the particular instance.
For NFTs to survive, additional frameworks for private/public ownership and dissemination have to be put in place. And for NFTs associated with physical objects, the mechanisms of trust must somehow be extended to the physical world to more clearly tie the physical possession of the object to its related electronic ownership.
What is next?
Scientific knowledge is as much an understanding of the diversity of situations for which a theory or its models are relevant as an understanding of its limits.
― Elinor Ostrom
It is clear that these systems have a ways to go before being considered safe, robust and mature. But it is important to differentiate between the value of the current implementations versus judging the underlying concepts themselves.
The root ideas of open accountability, highly resilient distributed read-only systems, peer-to-peer voting, and trust models based upon cryptographic algorithms have some important economic and social applications.
As society and technology continues to develop, there is a natural evolution from unlimited resource environments to commons-driven situations. Leveraging tools like smart contracts, these systems could provide a flexible and extensible engine for intelligent management of CPRs without resorting to burdensome government regulation.
However to achieve this goal, the hype bubble around this field has to be dialed back a bit, and a real effort has to be made to correct the deficiencies and enhance the protections for normal users. Hopefully some of the cleverness of people (groups?) like Satoshi Nakamoto can be used to tackle these problems before it is too late.