Banks, remittance giants, almost all financial institutions seem to be intrigued by the growing popularity of Bitcoin and the underlying technology of Blockchain and heavily investing into it. This long-overdue article is aimed at presenting a working explanation of the technology which will be followed by articles on Blockchain’s use in particular sectors like Banking, Governance, E-commerce, Healthcare, etc.
BitCoin(BTC) is a virtual currency – which is created, stored, validated by a decentralized peer-to-peer network. For easy understanding, lets draw an analogy to a traditional currency, say the Rupee.
A BTC is similar to the Rupee in the following ways –
- Transactions : A BTC transaction is similar to making a digital payment – say via Paypal, NetBanking – for any goods or loans.
- Storage : There are BTC wallets akin to existing payment wallets like Paytm etc.
- Trading : Similar to USDINR forex trading platforms, there are BTC exchanges which facilitate liquidity in the BTC markets.
Now, lets look at the differences : –
- Clearing: Rupee’s valuation against USD or any other country is influenced by India’s monetary policy and thereby, the Reserve Bank of India (among a lot of other factors) and each monetary transaction/transfer undergoes the approval of the central governing body. In case of BTC, due to its peer-to-peer decentralised nature, it doesn’t rely on a central body. It is a completely open financial network. It doesn’t need any central clearing body to monitor each transaction. It relies on the robustness of the idea of decentralised trust to self-monitor the network, thereby democratising trust.
- Tracking: BTC transactions are recorded using the blockchain technology, in a special log book, which can be described as an immutable ledger of transactions (to be discussed later in the article).
- Acceptance: Unlike Rupee which is accepted in India alone, BTC is universal in nature as it is accepted as a mode of payment throughout the world. It is unfair to compare it to the US Dollar (which is the most widely accepted and traded currency in the world), but for the sake of over-simplification, BTC is a much better version of a universal currency as compared to the USD or the Euro.
What is Blockchain?
Blockchain is a distributed database that maintains a continuously-growing list of records. These records, called blocks, are secured from tampering and revision as each block contains a timestamp and a link to a previous block(working explanation provided in the next section). These are the underlying building blocks for BitCoins and other cryptocurrencies.
Blockchain is part database, part development platform (upon which newer products can be built), part network enabler and more. Blockchain exhibits the following 10 properties :
- Computing Infrastructure
- Transaction Platform
- Decentralised Database
- Distributed Accounting Ledger
- Development Platform
- Open Source Software
- Financial Services Martketplace
- Peer-to-Peer Network
- Trust Services Layer
The digital currency function is perhaps the most ‘visible’ one given all the talk on bitcoins. As mentioned earlier, BTC transactions are not monitored by a single central entity but rather by a decentralised set of non-cooperating nodes/entities. These nodes/entities break down the transaction details into smaller parts and store it securely in their databases with a timestamp to indicate the time and a hash pointer/key (ownership pointers) to indicate the transfer of BTC from party A to party B.
The concept behind a blockchain/digital ledger is similar to say, a safe (which has money) being operated by a master key (owner) which is made up of smaller keys given to different individuals (where no two individuals know each other) to ensure security.
How does Blockchain technology work?
Following is a visual explanation of how Blockchain technology powering BTC works.
Lets run through an example transaction, say ‘1BTC is being transferred from Bill Gates to Warren Buffet’. The information of the above sentence is first converted to a unique (to avoid repetitions/collisions) cryptic (to avoid attacks) short form (for efficient storage) via advanced cryptographic algorithms (SHA 256 in case of bitcoins). This cryptic short form, say ‘1BTC-BG-WB’, is now stored in a block and approved by Bill Gates with his secret key (akin to a password) and a public key (akin to an email id) transferring the ownership to Warren Buffet. The block which has recorded this transaction will get 0.001BTC (say) as mining fees.
A block is a part of a blockchain which records some or all of the recent transactions, and once completed goes into the blockchain as permanent database. Each time a block gets completed, a new block is generated. There is a countless number of such blocks in the blockchain. All blocks are linked to each other (like a chain) in proper linear, chronological order with every block containing a pointer to the previous block and a cryptic short form (hash) of all the data on the previous block.
To use conventional banking as an analogy, the blockchain is like a full history of banking transactions. Bitcoin transactions are entered chronologically in a blockchain just the way bank transactions are.
Why should we use Blockchain technology?
The short answer is – We should. Else we’ll fade into oblivion.
The long answer is – We should use blockchain for the following important reasons :
- Disintermediation – Two parties (Bill Gates & Warren Buffet) are able to make an exchange without the oversight or intermediation of a third party (banks), strongly reducing time, transaction costs and largely eliminating counterparty risk.
- Tamper Proof – Following up on the above example, when ‘1BTC-BG-WB’ was stored in the block, it had been signed by a secret and a public key. IF someone were to change the details of the transaction, the keys will no longer be valid, thus preventing any tampering of old records.
- Empowerment – Users are in control of all their information and transactions
What are the current bottlenecks?
Despite all the good things, we are still a long way to go before Blockchain and Bitcoin become status quo. Major bottlenecks in this not-so-long journey are –
- Regulations : Blockchain is challenging our existing version of Trust, Security and Reliability. Hence, we see resistance from government agencies and policy makers who are trying to understand and regulate this new technology. Sovereign currencies are being challenged by the emergence of Bitcoins, which in turn leads to several central banks, including RBI, to setup teams to fully understand the implications and finally regulate bitcoins.
- Scalability vs Decentralisation : Increasing adoption of cryptocurrencies has raised concerns about their ability to scale while maintaining the decentralised nature. While Visa does ~2000 transactions/sec, the blockchain network currently does 7 per second.
- Polarisation of mining power : Nations, like China, having cheaper computing hardware and energy rates currently own a large share of the blockchain mining power (the share is expected to increase further) which goes against the philosophy of decentralisation.
In conclusion, as with any upcoming technology, there is still a large amount of skepticism and reservation against the Blockchain Technology. But due to increased awareness owing to the pioneering efforts of the early adopters, this technology is now being used by several startups and corporations to develop new products and improve the existing ones. Over the course of the next few days, we shall explore the applications of this technology in different industries.