Few people understand what it is, but Wall Street banks, IT organizations, and consultants are buzzing about blockchain technology. It's hard to remove blockchain from Bitcoin, so we'll start with Bitcoin as we work to understand this technology's potential.
Bitcoin. Blockchain technology. Cryptocurrencies. Initial coin offerings.
Everyone’s talking about them, but what do these terms really mean?
At its peak in January 2018, the total market cap of cryptocurrencies surpassed $800B, according to Coin Market Cap, while the price of bitcoin hit a high of almost $20,000 in December 2017. Initial coin offerings (ICOs) exploded in popularity in 2018, with billions being raised. Huge corporations — like Walmart and Pfizer — have completed blockchain pilots, with many more partnering on projects ranging from remittance to title transfer.
Let’s get started with a broad definition:
What is Blockchain?
Blockchain technology offers a way for untrusted parties to reach consensus on a common digital history. A common digital history is important because digital assets and transactions are in theory easily faked and/or duplicated. Blockchain technology solves this problem without using a trusted intermediary.
This explainer will offer simple definitions and analogies for blockchain technology. It will also define Bitcoin, Bitcoin Cash, Ethereum, Litecoin, blockchain, and initial coin offerings. Along the way, we’ll highlight promising use cases for blockchain technology.
(For a deep dive into how Ethereum works specifically, you can read our What Is Ethereum explainer.)
Lastly, this report will make clear the distinctions between distributed ledger technology and blockchain, and highlight where these technologies have an application – and where they do not.
What is Bitcoin?
Bitcoin is, according to its whitepaper, a “peer-to-peer electronic cash system” that “allow[s] for online payments to be sent directly from one party to another without going through a financial institution.”
The 2008 financial crisis caused a lot of people to lose trust in banks as trusted third parties. Many questioned whether banks were the best guardians of the global financial system. Bad investment decisions by major banks had proved catastrophic, with rippling consequences.
Bitcoin — also proposed in 2008 — presented an alternative.
Bitcoin made digital transactions possible without a “trusted intermediary.” The technology allowed this to happen at scale, globally, with cryptography doing what institutions like commercial banks, financial regulators, and central banks used to do: verify the legitimacy of transactions and safeguard the integrity of the underlying asset.
Bitcoin is a decentralized, public ledger. There is no trusted third party controlling the ledger. Anyone with bitcoin can participate in the network, send and receive bitcoin, and even hold a copy of this ledger if they want to. In that sense, the ledger is “trustless” and transparent.
The Bitcoin ledger tracks a single asset: bitcoin. (Note: “Bitcoin” capitalized refers to the Bitcoin ledger, or protocol, while “bitcoin” in lowercase refers to the currency or a unit of account on the Bitcoin ledger.)
The ledger has rules encoded into it, one of which states that there will only ever be 21M bitcoin produced. Because of this cap on the number of bitcoins in circulation, which will eventually be reached, bitcoin is inherently resistant to inflation. That means that more bitcoin can’t be printed at a whim and reduce the overall value of the currency.
All participants must agree to the ledger’s rules in order to use it.
Bitcoin is politically decentralized — no single entity runs bitcoin — but centralized from a data standpoint — all participants (nodes) agree on the state of the ledger and its rules.
A bitcoin or a transaction can’t be changed, erased, copied, or forged – everybody would know.
That’s it, and it’s a big deal.
The story of Alice and Bob
To understand better how this peer-to-peer electronic cash system allows for online payments to move from one party to another without going through a financial institution, let’s use a simple example.
Here’s a scenario: Alice hands Bob a physical arcade token. Bob now has one token, and Alice has zero. The transaction is complete. Alice and Bob do not need an intermediary to verify the transaction. Alice can’t give Charlie the same token, because she no longer has the token to give — she gave it to Bob.
But what if the same transaction were digital? Alice sends Bob a digital arcade token — via email, for example. Bob should have the digital token, and Alice should not.
Not so fast. What if Alice made copies or “forgeries” of the digital token? What if Alice put the same digital token online for all to download? After all, a digital token is a string of ones and zeros.
If Alice and Bob “own” the same string of ones and zeros, who is the true owner of the digital token? If digital assets can be reproduced so easily, what stops Alice from trying to “spend” the same digital asset twice by also sending it to Charlie?
One answer: a ledger. This ledger will track a single asset: digital arcade tokens. When Alice gives Bob the digital token, the ledger records the transaction. Bob has the token, and Alice does not.
Now, they face a new problem: whose job will it be to hold the ledger? Alice can’t hold it because she might erase the transaction and say that she still owns the digital token, even though she gave it to Bob. It also can’t be Bob, because he could alter the transaction and lie to say that Alice gave him two tokens, doubling his arcade time.
Bob and Alice can solve this problem by using a trusted third party, an intermediary who is not involved in the transaction at all — let’s call him Dave. Dave will hold the ledger and make sure that it’s up-to-date.
This situation is fine — until it’s not.
What if Dave decides to charge a fee that neither Alice or Bob want to pay? Or, what if Alice bribes Dave to erase her transaction? Maybe Dave wants the digital token for himself, and adds a false transaction to the ledger in order to embezzle it, saying that Bob gave him the token?
In other words — what happens when Alice and Bob cannot trust the trusted third party?
Think back to the first physical transaction between Alice and Bob. Is there a way to make digital transactions look more like that?
Here’s a thought: Alice and Bob could distribute the ledger to all their trusted friends, not just Dave, and decentralize trust. Because the ledger is digital, all copies of the ledger could sync together. If a simple majority of participants agree that the transaction is valid (e.g. confirm that Alice actually owns the token she wants to send), it gets added to the ledger.
When a lot of people have a copy of the same ledger, it becomes more difficult to cheat. If Alice or Bob wanted to falsify a transaction, they would have to compromise the majority of participants, which is much harder than compromising a single participant.
Alice can’t claim that she never sent a digital token to Bob — her ledger would not agree with everyone else’s. Bob couldn’t claim that Alice gave him two tokens — his ledger would be out of sync. And even if Alice bribes Dave to change his copy of the ledger, Dave only holds a single copy of the ledger; the majority opinion would show the digital token was sent.
In sum, this distributed ledger works because everyone is holding a copy of the same digital ledger. The more trusted people that hold the ledger, the stronger it becomes.
Such a ledger allows Alice to send a digital token to Bob without going through Dave. In a sense she is transforming her digital transaction into something that looks more like a physical one in the real world, where ownership and scarcity of an asset is tangible and obvious.
How secure is Bitcoin?
You may have noticed a key difference between the above example and Bitcoin. Specifically, Alice’s and Bob’s ledger only allows “trusted friends” to participate. In contrast, Bitcoin is entirely public, and anyone can participate.
How can we get all these untrusted “nodes” to agree on the state of the ledger? How can we avoid bad actors corrupting the ledger?
Let’s think about this for a moment. A public ledger would allow for many more participants. The more participants, the stronger the ledger becomes. Right?
As you may have guessed, it’s not that simple.
Because Bitcoin expands beyond trusted participants and gives anyone access, it opens itself up to bad actors attempting false transactions.
Sure, we also ran a risk of bad actors when it came to Alice’s and Bob’s trusted friends: Dave might turn untrustworthy. However, Bitcoin is free and open to anyone, trusted or not, like a Google document that anyone can read and write to.
How can we get all these untrusted “nodes” to agree on the state of the ledger? How can we avoid bad actors corrupting the ledger?
Bitcoin offers a solution: reward good actors and scare off bad ones, a classic carrot and stick act.
In simple terms, certain Bitcoin participants are incentivized to do the dirty work and maintain the network. These participants — called “miners” — bundle transactions into a “block,” add this newest block to the “chain” of prior blocks (hence: blockchain is used to describe Bitcoin’s unique database structure), and devote immense computational power to the network in the process. For doing this work, these miners are rewarded with bitcoin. With a single bitcoin worth thousands of dollars, this can be a strong incentive.
When miners devote computational power, they also use a tremendous amount of electricity.
This scares away hackers and bad actors because “hacking” Bitcoin to get everyone’s coins would cost a tremendous amount of computing power, electricity, and money. Further, if the Bitcoin community became aware of the hack, it would likely cause the price of bitcoin to drop steeply. This could make such an attack potentially economically self-defeating.
In technical terms, this mining process creates Bitcoin’s consensus mechanism, called “Proof of Work.”
This game-theoretic model creates a ledger that everyone trusts, but nobody controls.
Proof of Work: Bitcoin’s consensus mechanism
Proof of Work (PoW) is the consensus mechanism that underpins the security of the blockchain and the legitimacy of the blocks that are mined, with the aim of building trust in a decentralized network.
To mine a new block, miners solve a complex puzzle that requires non-trivial levels of computing power. Once a miner finds a solution, the new block is broadcast to the network for verification and appended to the blockchain.
The digital nature of cryptocurrencies makes it vulnerable to “double-spending.” From our earlier example, one of the ways Alice could cheat Bob is by sending him a copy of a digital token and keeping the original digital token herself. Whereas a trusted intermediary could keep count and stop this double-spend from happening on a centralized ledger, there’s no one to regulate that in a decentralized ledger.
The PoW protocol makes such an attack on the blockchain network economically infeasible. For a miner to execute a double-spend attack, the miner must mine a block containing a fraudulent transaction and force a fork in the blockchain. The miner would then need control of at least 50% of the Bitcoin network to make the forked blockchain the dominant one. The computing power needed to complete PoW would make likely make this approach extraordinarily expensive — $500K+ per hour for Bitcoin, according to Crypto51.
While the PoW makes blockchain more secure, it is at the same time extremely energy-intensive. Distributed across mining operations all over the world, the Bitcoin network alone is estimated to consume around 7 gigawatts of electricity per year — about the same amount as the country of Switzerland — according to the University of Cambridge. This has raised environmental and ethical concerns.
The PoW model has also led to the creation of large mining pools in countries where electricity is less expensive. These mining operations not only command a large amount of computational power, but are also highly optimized, making competition from a “day miner” very difficult. This shift towards the centralization of mining has caused some to question whether Bitcoin is truly decentralized.
Wait… what is Bitcoin?
OK, let’s connect all the dots:
- Bitcoin is a decentralized, public ledger. This ledger is known as a blockchain. There is no trusted third party controlling the Bitcoin blockchain. Instead, anyone can read it, write to it, and hold a copy.
- The Bitcoin blockchain tracks a single asset: bitcoin. The blockchain has rules, one of which states that there will only ever be 21M bitcoin. All participants must agree to Bitcoin’s rules in order to use it.
- Because anyone can read it and write to it, Bitcoin needs a method to establish consensus among untrusted nodes — unlike Alice’s and Bob’s distributed ledger shared among trusted friends. It solves this problem via clever economics:
- Incentive: The first miner to verify transactions and devote immense computing power to secure the blockchain can append a block of transactions to the chain of previous blocks. This miner is rewarded with bitcoin, and the race starts over every ten minutes.
- Disincentive: Bad actors are dissuaded from attacking the blockchain, because it’s effectively a money-losing proposition.
What is halving?
Halving reduces the amount of bitcoin awarded per block to miners by half. Also called “the halvening,” it occurs after every 210,000 blocks mined in the Bitcoin blockchain — about every 4 years. Written in the original protocol, halvings are used to limit the supply of new bitcoin and help control the cryptocurrency’s value.
The most recent halving was the third to occur in Bitcoin’s history and took place in May 2020. The mining reward was halved from 12.5 BTC per block to 6.25 BTC per block. For investors, this event was highly anticipated because the first 2 halvings were followed by a bull market, driven by the combination of higher demand and a reduced new supply of bitcoin.
For miners, halvings have acted as a kind of “culling of the herd.” Because halvings reduce revenues, miners that aren’t as efficient as their competitors are at increased risk of being unable to recoup operating costs.
Is Bitcoin a bubble?
Hard to say.
As discussed, Bitcoin’s blockchain technology allows for the creation of a unique and scarce digital asset where everyone knows the history of each particular bitcoin. A single bitcoin is not just a string of ones and zeros: it’s also the first successful (at least so far) censor-proof, portable, easily transactable, durable, and secure digital asset.
Bitcoin’s value is subject to the same supply-and-demand mechanics found in any marketplace. If investors find the above characteristics valuable and demand for bitcoin grows, bitcoin’s price rises, and vice versa.
Bitcoin’s supply is limited to 21M coins, although only about 18.5M have been mined so far. As of August 10, 2020, Bitcoin is valued at about $220B in aggregate.
How did Covid-19 impact Bitcoin?
The global market crash in March triggered by Covid-19 has also led to the prices of crypto assets to drop in one of the sharpest declines in history. The price of Bitcoin fell by nearly 50% in the span of 24 hours.
However, in the months that followed, prices have recovered along with safe-haven assets like gold, as investors looked to stores of value in response to market volatility. While a far cry from the all-time peak of $19,300 in 2017, the price of bitcoin has seen a strong rally, hitting $12,000 in August before losing some ground.
Some analysts predict that Covid-19 could have an overall positive effect on Bitcoin demand by contributing to crypto’s perception as a safe-haven asset.
What are altcoins?
Since Bitcoin launched in 2008, thousands of other cryptocurrencies and altcoins (“alternative coins”) have emerged.
Because Bitcoin’s code is open-source, anyone can use Bitcoin’s code to create an altcoin. Many of them seek to improve on Bitcoin or expand its capabilities. Remember Bitcoin’s rules: it caps the number of bitcoin at 21M and uses the Proof of Work system to secure the network. Other cryptocurrencies use different rules and engage with other economic models.
There’s lots more to Bitcoin that we’re not going to get into. Hashes, public-private key encryption, segregated witness, and sidechains, among other elements, fall outside of the scope of this piece.
What is blockchain?
So far, we’ve discussed two types of ledgers.
The first, Alice’s and Bob’s distributed ledger for digital arcade tokens, is private.
The second, Bitcoin’s decentralized ledger for bitcoin, is public. Anyone can participate. To ensure its public, decentralized ledger remains secure, Bitcoin uses a blockchain.
If we were to define “blockchain” as a technology separate from Bitcoin, it might look something like this:
Blockchain technology offers a way for untrusted parties to reach agreement (consensus) on a common digital history. A common digital history is important because digital assets and transactions are in theory easily faked and/or duplicated. Blockchain technology solves this problem without using a trusted intermediary.
Where else might blockchain make sense?
The short answer: broadly, but in specific instances.
To see what those instances might be, let’s think about why Bitcoin needs blockchain technology. There are three main reasons.
- Bitcoin is a public ledger of bitcoin transactions
- There are untrusted nodes recording transactions on the Bitcoin ledger
- Bitcoin does not want to trust a third party to administer the ledger
Effectively, Bitcoin uses a blockchain to decentralize payments. Where else could we use this unique database architecture to get rid of the middleman? Are there other things that would be more valuable if they were decentralized?
Let’s take this step-by-step. What’s another scenario where everyone needs a record of ownership, and where a trusted third party isn’t preferred?
A couple of immediate use cases come to mind.
Land title is one. It could be quite useful for everyone to have access to a decentralized source of record saying who owns a given parcel of land. The approach could even have some humanitarian implications in scenarios where land has been redistributed without due process or compensation, such as during a war. Once a land distribution is agreed upon, it can be recorded in a distributed ledger and no longer be subject to ongoing debate. A number of companies are working on this, including velox.RE.
In the same vein, a blockchain could be used to establish proof of ownership over any number of physical assets — cars, art, musical instruments, and so on. A paper record of title is prone to forgery and/or physical degradation. Centralized databases may be subject to hacking, human error, and/or tampering. A blockchain means there is no single entity controlling the ledger. Therefore, recording physical assets on a blockchain is a prime example of where the technology might come in handy to track ownership with a tamper-proof, neutral, and resilient system.
Blockchain technology could even prove applicable in virtual worlds. If a virtual world is created — for gaming, or for any number of other reasons — blockchain technology could allow users to purchase and own pieces of that virtual world, just like they might purchase a plot of land.
That’s certainly a bit far out, but Decentraland is one project already working on it. The team raised $25M in August 2017 for its token, MANA, and has promised to build “the first virtual platform owned by its users.”
The supply chain is another major area where blockchain is being applied.
Corporations like Walmart and Nestlé are partnering with IBM to improve food sourcing and tracking. By creating hard to alter records of where each food item is sourced and processed in near real-time, retailers are hoping to be able to isolate and respond to foodborne outbreaks much more quickly than is typically possible.
Ports like Rotterdam are employing blockchain with the aim of simplifying shipping logistics in international trade. Under the current system, new forms and filings are created every time goods are exchanged, leading to redundant records, lost shipments, and administrative costs. A secure, private blockchain could be used to streamline these processes and improve trust between various participants.
Just as blockchain can be used to securely source and track goods and services, some are looking to use the tech to securely track election ballots. States like West Virginia and Utah have started using blockchain apps to help overseas troops cast absentee ballots. However, many experts caution that there are still challenges the technology must overcome before blockchain voting would be suitable for widespread use.
Identity might also be low-hanging fruit. The 2017 Equifax hack exposed the social security numbers of 143M Americans. Social security numbers were never meant to be used for identification — notice how this old social security card states “not for identification.”
Blockchain technology might present a better means of establishing identity. Instead of a state or government issuing it, identity could be verified on an open, global blockchain — controlled by nobody and trusted by everybody. Thus, users could control their own identity. A number of companies are working in this arena, including ID2020 and Civic.
Similarly, Blockstack hopes to build a new decentralized internet, “where users own their data and apps run locally.” Technically speaking, Blockstack is one of the first examples of a decentralized DNS (domain name server) system built using blockchain technology. The company raised $52M in December 2017 and hopes that its new internet will help users “own [their] data and maintain [their] privacy, security, and freedom.” If it works, Blockstack could disrupt many of the internet giants that act as middlemen today — think Google and Facebook. Of course, that’s a big if.
Other potential applications include a platform where traditionally illiquid assets are represented and traded through blockchain-powered tokens. Imagine a decentralized asset market, where you can buy, sell, and trade fractional ownership of high-value paintings, real estate, and companies via interoperable databases, without any kind of intermediary. That’s the kind of liquidity that 0x Project is working to make possible with its protocol for decentralized asset exchanges.
Where does distributed ledger technology make sense?
Let’s back up for a moment.
We mentioned that Alice’s and Bob’s private implementation — where everyone knows and trusts everyone involved — doesn’t need a blockchain (nor does it need miners to verify and append transactions to the cryptographically-protected blockchain).
Without the blockchain’s verification step, we’re left with a “distributed ledger,” or a decentralized spreadsheet that is only accessible to a select group of trusted parties. Because this ledger is private, it doesn’t need the same security measures as the blockchain.
The hype around Bitcoin, blockchain, and cryptocurrencies has contributed to renewed interest in distributed ledger technology. This is the idea of distributing a database among participants to ensure a common record of truth. Bitcoin uses distributed ledger technology and adds a consensus layer on top — the blockchain.
Because Alice and Bob’s participants are trusted and their ledger is private, Bitcoin’s blockchain isn’t needed. In fact, a blockchain might prove unwieldy, slow, and overly complex for Alice and Bob’s ledger, for reasons which we’ll address below. Instead, a trusted third party could be used to lightly administer a distributed ledger.
Bitcoin and Ethereum (which we’ll dive into below) are considered public, “permissionless” blockchains: anyone can access them. On the other hand, if all parties are known and trusted, distributed ledger technology could provide sufficient security. One example of distributed ledger technology is R3’s Corda, which is working with major financial services organizations to improve banking processes.
While distributed ledger technology and blockchain technology each have their own pros and cons, the important thing to remember here is that blockchain technology is not a cure-all. For Bitcoin, a public, permissionless blockchain is the only possible solution. In many other instances, a blockchain would be a terrible idea.
What are the major issues with blockchain technology?
Blockchain technology is really good at some things and absolutely awful at others.
The three major questions about blockchain technology concern its scalability, its anonymity, and its economical viability.
Is blockchain scalable?
For a blockchain to work, lots of participants need to hold up-to-date copies. This means that the same database is held by thousands of nodes. This is fairly inefficient.
If we were to look at how technology has developed over the past fifteen years, blockchain runs counter to the logic behind cloud computing. Cloud computing trends toward a single database that multiple nodes can access. These nodes don’t have to hold their own private copy of this database.
Further, nodes holding copies of the blockchain receive constant updates. These nodes are distributed around the world. Because of this, blockchains have high latency (latency is the amount of time it takes for data to move through the network).
As a result, blockchain technology faces scaling issues. Bitcoin can process about 4-5 transactions per second. Ethereum maxes out at about 25 transactions per second. Visa can process over 24,000 transactions per second.
Is blockchain anonymous?
In the early days of Bitcoin, blockchain technology — like many nascent technologies — was popularly associated with illicit activities.
Why was blockchain technology like Bitcoin effective for this kind of enterprise? Even though Bitcoin’s record of transactions is publicly available, the network’s global, decentralized nature means that no single entity — like the US government or Visa — can shut it down, freeze funds, or reverse transactions. And in those early days, it was very hard to link a Bitcoin wallet to a given individual, even if there was evidence that the wallet was used in illicit activities.
One of the reasons why Bitcoin has gained more mainstream popularity as a store of value and as a financial instrument is that it’s no longer as anonymous as it was in those early days. Most major services that allow you to buy and sell Bitcoin use “know your customer” (KYC) standards, and law enforcement agencies have gotten more adept at linking Bitcoin transactions to specific people. There are other projects that have emerged in an effort to use blockchain technology to protect user anonymity (e.g. Monero and ZCash), but these are significantly less mainstream.
Is blockchain economical?
One of the keys to blockchain technology being viable in the long-run is making sure that transactions like Alice and Bob’s can be executed with minimal fees. Fees are important because they incentivize miners to add your transactions to the blockchain in a timely manner — but high fees make it harder to convince potential users to get on board.
In December 2017, the median transaction fee on the Bitcoin network peaked at $34 per transaction. Companies like Stripe and Valve announced they would no longer accept Bitcoin payments due to high fees.
Although fees have come down since the peak, Bitcoin is still not capable of everyday commerce — the platform would have to solve issues with scaling, transaction block time, and more before it’s ready for the big leagues.
What is Ethereum?
We asked earlier what other applications could be built with blockchain technology.
Recall that Bitcoin is, effectively, a decentralized application for payments. Ethereum adds another layer by allowing users to put code on its blockchain that executes automatically. This code is called a “smart contract.” In this way, Ethereum hopes to create a decentralized computing platform — a global supercomputer.
What is a smart contract?
To illustrate a smart contract, let’s say Alice and Bob enter into a bet.
Alice thinks that the temperature tomorrow morning will reach 70 degrees. Bob thinks that it will stay lower. They wager 10 bitcoin on the outcome. If Alice and Bob don’t trust each other, they will have to use a trusted third party as an escrow agent. In other words, they will each have to give the agent that amount of bitcoin, and the agent will distribute the winnings and the amount staked to the winner.
There’s no way around the middleman in this scenario, even using bitcoin.
Ethereum, though, offers a decentralized solution. Alice and Bob could agree to use some basic code — a contract of sorts — to alert the system to what the temperature ended up being and pay out based on who was correct. If the temperature goes higher than 70 degrees, the code pays Alice, otherwise, it pays Bob. Alice and Bob could then place this code (their bet) on Ethereum’s blockchain.
This looks like a “contract,” because all participants in the Ethereum blockchain hold a copy of this agreement. Just like the Bitcoin blockchain knows that Alice sent Bob a bitcoin (in our example above), the Ethereum blockchain knows that Alice and Bob have entered into an agreement. Therefore, this contract is self-enforcing.
Smart contracts like these are what make Ethereum so compelling. Because Ethereum is a blockchain, it’s very hard to attack, change, or forge these smart contracts, just like it’s economically self-defeating to attack Bitcoin.
So, what is Ethereum?
A smart contract allowed Alice and Bob to build a very small decentralized application. What if we could build larger and more complex decentralized applications?
Ethereum wants to be the platform on which these decentralized applications are built.
Recall that Bitcoin is a very simple decentralized application, for payments. Ethereum builds on Bitcoin by incorporating robust computing capabilities and smart contracts. In simple terms, this means that developers can use more complex code to build decentralized applications on top of Ethereum. These apps would be less error-prone, more neutral, and more transparent. They would have lower administrative costs and greater built-in security.
Let’s unpack this:
- Ethereum allows participants to execute code on its ledger, including “smart contracts.” Coupled with its ability to incorporate complex code, Ethereum hopes to be a massive decentralized computer.
- In the same way that Bitcoin uses a blockchain to track bitcoin, Ethereum uses a blockchain to track a cryptocurrency called “ether.” Users spend ether to run programs on the Ethereum supercomputer.
- Because Ethereum is decentralized, once a program is uploaded it can’t be shut down by any sort of centralized actor. Just like Bitcoin, there is no central point of attack.
- Therefore, Ethereum is also a construction set for building decentralized applications. Instead of building their own blockchains from scratch, developers can use Ethereum’s blockchain.
Here are some decentralized applications attacking different verticals. Many of these are building on top of Ethereum:
Why does Ethereum matter?
In August 2016, then-Union Square Ventures investor Joel Monegro published a blog post entitled “Fat Protocols.” In it, he examines the protocols or systems on which our modern internet has been built:
“The previous generation of shared protocols (TCP/IP, HTTP, SMTP, etc.) produced immeasurable amounts of value, but most of it got captured and re-aggregated on top at the applications layer, largely in the form of data (think Google, Facebook, and so on).”
In other words, the internet as we know it works because of TCP/IP, HTTP, and SMTP, among others. These protocols are often open-source and maintained by devoted developers.
If the entire internet relies on these protocols, one would expect these protocols to extract value (read: make money). However, that hasn’t happened. Instead, the applications built on top of these protocols have made all the money. Google, Facebook, and Amazon can’t exist without TCP/IP, but they have captured all the value, while TCP/IP has not.
By effectively creating a decentralized supercomputer, Ethereum acts as a base layer for decentralized applications. Ethereum’s built-in cryptocurrency, ether, can be traded on exchanges for dollars or other government-backed currency — just like bitcoin. Therefore, the value of this supercomputer can be captured at the protocol layer.
Why is the price of Ethereum so high?
Ethereum’s blockchain allows for the creation of a decentralized supercomputer. This supercomputer is the first one of its kind.
Computational power is limited, and developers pay with ether to use the Ethereum blockchain. Users also buy and spend ether to interact with its various decentralized applications. For example, CryptoKitties is a popular app built on top of the Ethereum blockchain that allows individuals to buy collectible cartoon cats. In order to purchase a CryptoKitty, you have to use ether.
Ether’s dollar value is subject to supply-and-demand — if investors find the Ethereum blockchain valuable, and developers are building valuable decentralized applications on top of the platform that require the use of ether, then demand might rise and the price of ether could rise. The opposite can also happen.
As more and more applications are built on Ethereum, the demand for ether has gone up, driving up the price of the token.
Ethereum 2.0 is a major update to the Ethereum protocol that aims to make the network more secure, stable, and scalable. Also known as ETH2 or “Serenity,” this update will occur in phases starting sometime in late 2020 or early 2021.
Ethereum 2.0 is intended to overcome current obstacles in scalability and accessibility that hinder the network from mass adoption. The CryptoKitties craze of 2017 showed how explosive demand on a single decentralized app on the Ethereum blockchain could congest the entire network.
Because blocks are mined sequentially, and there’s an upper limit to the number of transactions that fit inside a block, Ethereum can currently only process about 10-25 transactions per second across the entire network — as a comparison, Visa can handle thousands.
In addition, the concentration of mining power has raised concerns over accessibility and the decentralized nature of blockchain. The Proof of Work model has made it very difficult for ordinary miners to compete with large, centralized mining operations and make a profit. Some fear that this could endanger Ethereum’s independence and utility as a decentralized network.
Ethereum 2.0 proposes 3 major changes to address these problems:
- Proof of Stake. Instead of a Proof of Work model in which miners mine new blocks using electricity, the Ethereum network will make a hard fork into a proof-of-stake (PoS) model, in which validators forge new blocks by staking 32 ETH into a smart contract. Any user can become a validator as long as they put in a stake, and validators that are idle or engage in bad behavior are penalized by losing a part of their stake. This is intended to keep the blockchain secure while making the process of creating new blocks more accessible and energy efficient.
- Sharding. The blockchain will be split into 64 interoperating shard chains that each process transactions through a proof-of-stake model. This will enable the network to process far more transactions at once, which will be necessary to allow more decentralized apps to operate on the network.
- Ewasm. The virtual machine that executes code and keeps the network up and running will be replaced. Ethereum wasm (Ewasm) will replace the Ethereum Virtual Machine (EVM), making the network faster and more stable.
These changes are scheduled to be rolled out and tested in phases over the span of multiple years.
Initial coin offerings (ICOs)
What are initial coin offerings?
We’ve now discussed Bitcoin and Ethereum. Both blockchains use a “token” that provides utility. Bitcoin uses bitcoin, while Ethereum uses ether.
Remember how we mentioned other decentralized applications? An initial coin offering is a way for these applications to raise money. Instead of going the traditional venture capital route, a team could announce that — just like bitcoin or ether — it’s issuing a token.
That token might do any number of things. Most of the time, it provides some sort of access to the decentralized application, in the same way that bitcoin provides access to the Bitcoin blockchain (like if you want to send a payment across the globe).
If a team issued a token for a decentralized social media platform, the team could mandate that a user needs to hold a token to access the platform. If demand for the platform goes up, then the token might rise in value.
So, an ICO is simply:
- The sale of tokens by a blockchain company looking to raise funds.
- These tokens are often subsequently traded on cryptocurrency exchanges.
Investors in ICOs hope to turn a profit by buying early access to potentially foundational decentralized applications, just as early investors into bitcoin and ether did.
Why are ICOs so controversial?
Initial coin offerings could represent a big shift in how companies raise money and/or incentivize various stakeholders (e.g., developers, investors, users).
At the same time, ICOs are on shaky regulatory footing — in recent months, the SEC has become increasingly interested in highlighting misinformation about ICOs, and many have come under fire for a lack of transparency, no viable product, or even fraud.
If the SEC or other regulators ultimately rule that a given token is a security, then many of the teams behind these ICOs could be guilty of illegal securities offerings. The Howey Test, created by the Supreme Court in the 1940s to determine if certain transactions were classified as securities, is also commonly applied to ICOs.
According to this test, a transaction constitutes the purchase of a security if it satisfies the following four conditions:
- The transaction is an investment of money (or comparable financial instruments)
- The investment is entered into with an expectation of profit
- The investment of money (or comparable financial instruments) is in a common enterprise
- Profit comes from the work of a third party or promoter
In February 2018, SEC Chairman Jay Clayton said, “I want to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.” At around the same time, the SEC subpoenaed a number of cryptocurrency hedge funds and organizations that held ICOs. You can read more about regulatory concerns in this analysis.
What are utility tokens?
Teams holding ICOs are adamant that they do not represent securities offerings and instead market their coins or tokens as part of an entirely new asset class altogether.
Again, let’s use Bitcoin to illustrate.
Bitcoin is a token that provides ownership of a unit of account on the Bitcoin ledger. It is impossible to participate in the Bitcoin ledger without owning bitcoins; bitcoins are the network’s exclusive means of exchange. In this sense, bitcoin isn’t a security, but rather utility within a network. When teams call their tokens a “utility token” or “utility coin” to verbally distance themselves from securities law, this is what they’re referencing.
However, many of these teams have yet to build functional networks for which their tokens would provide utility. Teams often present a whitepaper in lieu of an investment memorandum, product, or roadmap, and ICOs regularly raise upwards of $10M, stoking concerns of overcapitalization. Many of these companies could run the risk of mismanagement after receiving such large sums.
What is Bitcoin Cash?
Bitcoin Cash is not the same thing as Bitcoin, although it shares much of its history with that protocol.
Bitcoin Cash is a new network that “forked” from the Bitcoin network at the beginning of August 2017. In the blockchain space, a “fork” is what happens when developers in the network decide to materially change the code of the platform. Nodes, run by miners, can update to the new code — if enough nodes make the switch, it can become a completely new platform with its own token.
When a significant number of nodes running a protocol like Bitcoin agree to update to new and significantly different software, it creates a new blockchain that (1) has the same history as the previous protocol leading up to the fork but (2) has a different history than the previous protocol following the fork.
In 2017, a group of developers thought that the Bitcoin protocol was straying from what they saw as its primary function: serving as a ubiquitous, low-fee, fast-execution, peer-to-peer means of transferring value. They decided to fork Bitcoin in order to create a new cryptocurrency, Bitcoin Cash, that would be solely focused on serving as that kind of value transfer.
Why is Bitcoin Cash controversial?
Supporters of Bitcoin Cash and Bitcoin commonly spar over the functionality of the two coins.
While Bitcoin supporters identify the original blockchain as the “true” Bitcoin protocol and dismiss Bitcoin Cash, supporters of Bitcoin Cash claim that their protocol does a better job of fulfilling Bitcoin’s initial goal of being peer-to-peer cash.
Why all the bad blood? There’s a number of possible explanations, but a common one is about ensuring the long-term viability of the crypto sector.
When the Bitcoin community fragments and pulls users away from the main protocol with other blockchains (like Bitcoin Cash), some feel that it threatens the united front — in other words, a fractured space will make it more difficult for widespread adoption.
Why is Bitcoin Cash valuable?
Controversy aside, is the value proposition of Bitcoin Cash a sound one? Like the crypto sector at large, the price is highly volatile.
Because Bitcoin Cash is focused on a single function — ubiquitous, low-fee, fast-execution, peer-to-peer value transfer — it could be valuable if merchants accept it as a form of value transfer, and consumers use it as such.
Bitcoin Cash has progressively been accepted by more merchants since its fork from Bitcoin. Recently, the thousands of merchants that use BitPay were given the option to accept Bitcoin Cash. More broadly, the Accept Bitcoin Cash Initiative tracks merchants, by industry, who accept Bitcoin Cash (as of 9/6/18, only 750 merchants accept the token as payment).
On the other hand, the number of transactions of the Bitcoin Cash network have been almost uniformly an order of magnitude less than the number of transactions on the Bitcoin network — in the past few months, Bitcoin has averaged around 300K transactions per day, whereas Bitcoin Cash has averaged around 20K.
What is Litecoin?
Another altcoin that’s gradually entered the popular vernacular is Litecoin. It was invented in 2011 by former Google engineer Charlie Lee to act as a cheaper and faster version of Bitcoin. It’s a lower-priced cryptocurrency that’s almost identical to Bitcoin — there are just a few minor tweaks that are intended to make it a more fitting tool for daily commerce.
In May 2017, Litecoin was listed on Coinbase, where Lee was a head engineer. It instantly became the fourth most valuable cryptocurrency in the world, and prices jumped 25% overnight.
It is worth noting, however, that Lee sold all of his holdings in December 2017 due to a “conflict of interest.”
Litecoin vs. Bitcoin: what’s the difference?
Litecoin has an intended function that’s identical to Bitcoin Cash, but with a different origin story. Both of these cryptocurrencies are designed for small, daily transactions, but Bitcoin Cash forked from Bitcoin while Litecoin was early spinoff that never relied on the Bitcoin blockchain — which probably explains why it isn’t as controversial.
There are a couple of key differences between Litecoin and Bitcoin:
Litecoin has a different “hashing algorithm” than Bitcoin. This basically means that the kind of computational process that miners use to add new blocks in the blockchain is different.
The upshot of this is that there are fewer highly specialized Litecoin mining pools than there are Bitcoin mining pools, making it more accessible for the population at large to mine (although specialized Litecoin-mining computers are now on the rise).
Litecoin is faster than Bitcoin. The altcoin adds new blocks added to its blockchain roughly every 2.5 minutes, in contrast to Bitcoin’s 10-minute block frequency. In practice, this means that transactions can be confirmed more quickly on Litecoin than on Bitcoin.
Decentralized finance (DeFi)
What is DeFi?
Decentralized finance (DeFi) is an ecosystem of smart contracts that allows participants to offer and access financial services in a peer-to-peer format, without relying on traditional intermediaries like banks, credit unions, or brokerages.
This means that users can lend, borrow, and invest cryptos relying solely on decentralized blockchain protocols.
The MakerDAO is a decentralized lending protocol and one of the most popular DeFi dapps (decentralized applications). The protocol allows users to use ETH as collateral to borrow DAI, a digital token pegged to the dollar. The dapp allows investors to go long on ETH: users can spend the DAI borrowed to buy even more ETH, which can then be cycled back into the vault to borrow more DAI. This creates decentralized leverage — investors can bet on the price of ETH for only a small initial sum.
A variety of dapps are being built to facilitate trading, banking, and investing solely through smart contracts. Compound, for example, allows users to earn interest or borrow crypto against collateral. Through Uniswap, users can swap tokens or provide liquidity and earn fees. With Augur, users can bet on real world events and earn payouts automatically based on the results.
The DeFi space has been growing rapidly: the total value locked in DeFi increased by 5x since the start of 2020, surpassing $3B in July 2020, according to DeFi Pulse.
What are stablecoins?
Stablecoins are virtual currencies pegged to an asset such as fiat money or gold. The most popular stablecoins are pegged to the dollar, with the value of one unit being close to $1. Most stablecoins maintain this price stability through a reserve of fiat, other cryptos, or precious metals held as collateral.
Stablecoins provide the price stability needed to encourage everyday transactions that major crypto assets simply do not have. Cryptos such as BTC or ETH are not well suited for everyday use because of their extreme volatility — in 2010, one early Bitcoin adopter paid for 2 pizzas with 10K BTC, worth around $41 then and over $80M now.
Broadly, there are 4 types of stablecoins based on how price stability is achieved:
- Fiat-backed. These stablecoins have a cash reserve equal to the value of stablecoin issued. For example, Tether, the stablecoin with the largest market cap, has a dollar in the bank for every Tether issued, according to the issuer. TrueUSD, LBXPeg, and the Gemini Dollar also fall under this category.
- Commodity-backed. These stablecoins are backed by a reserve of physical assets such as gold, oil, or real estate. For instance, Digix Gold is backed by a reserve of gold, with one DGX representing one gram of gold.
- Crypto-backed. These stablecoins are collateralized by other cryptocurrencies. To protect against the volatility of the cryptos held as collateral, they are often over-collateralized. For example, the DAI stablecoin (valued at $1 and collateralized by Ethereum) has a collateralization ratio of 150%, meaning every DAI created is backed by at least $1.50 of ETH.
- Non-collateralized. These stablecoins rely solely on algorithms that automatically regulate supply to keep prices stable. They are the most decentralized type of stablecoin because their value isn’t tied to any other asset, but they also need continuous demand to work. Basis is one example.
Currently, the most dominant use for stablecoins is to provide liquidity in the crypto markets. Because most crypto exchanges don’t have relationships with traditional banks, it can be hard to buy or sell cryptos with fiat money. On the other hand, stablecoins are easier to buy or sell with fiat on a number of exchanges. So traders sell stablecoins to buy other cryptos in bigger exchanges like Coinbase, or buy stablecoins to keep their assets secure when the market is volatile.
Stablecoins, particularly those that are fiat or commodity-backed, have been criticized by some for relying on a central issuing authority to hold their value, running counter to crypto’s decentralized thesis. For instance, the company issuing Tether has been accused of mixing funds to cover up losses for Bitfinix, a controversial crypto exchange with the same CEO. Although proper, periodic audits can help, users must ultimately trust the central authority to have the funds necessary to back the stablecoin.
The future of blockchain technology
Ultimately, blockchain is as much a political and economic hypothesis as a technological one. Blockchain technology provides a new way to think about how we agree on things. For the first time, multiple untrusted parties can create and agree on a single source of truth, without the use of a middleman. The technology’s implications for traditional middlemen and corporate players are therefore potentially enormous.
As the landscape evolves, the future of blockchain will likely take on forms yet to be imagined.
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