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The Basics of Bitcoins and Blockchains: An Introduction to Cryptocurrencies and the Technology that Powers Them



The Basics of Bitcoins and Blockchains: An Introduction to Cryptocurrencies and the Technology that Powers Them PDF

Author: Antony Lewis

Publisher: Mango

Genres:

Publish Date: September 15, 2018

ISBN-10: 1633538001

Pages: 408

File Type: Epub

Language: English

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Book Preface

Bitcoin, blockchains, and cryptocurrencies are fascinating to me because there are so many elements to understand. This multidisciplinary nature is one of the reasons I, and so many others, love the industry—it is easy to get sucked into the rabbit hole, and as you try to understand each element, every answer begets more questions. The journey starts with ‘What is Bitcoin?’ but the explanations and answers come from the disciplines of economics, law, computer science, finance, civil society, history, geopolitics, and more. You could create a pretty comprehensive high school curriculum around Bitcoin and have plenty of material to spare.

And this is the very reason why it is so hard to explain. This book is an attempt to cover the basics. It is aimed at the thinking person but assumes that the reader doesn’t have a detailed background in the various disciplines mentioned previously. Different people will find different parts interesting. I try to use analogies where I think they help explain some concepts, but be gentle with me: all analogies break down if stretched too far. And although I have tried to be accurate, there will still be oversimplifications, errors and omissions. What is true today may not be tomorrow: the pace of change is rapid. I am the first to admit that there are limits to my own technical expertise. Nevertheless, I hope that every reader comes away learning something new.

With that, let’s start by defining at a basic level some of the words and concepts we will be exploring later in the book.

Bitcoin1 and Ether are two of the better-known cryptocurrencies or coins (note that the coin on the Ethereum network is called Ether, though is often misnamed in the media as ‘Ethereum’). These are assets or items of value that exist digitally, not physically, and are created by software. They have no issuer as such. No person, company, or entity backs these, and there are no terms of service or guarantees associated with them. Like physical gold, cryptocurrencies simply exist, and are created or destroyed according to the rules articulated in the code that creates and governs them. If you own some cryptocurrency, and we’ll see what that actually means later, it is your asset that you control. It has value, and can be exchanged for other cryptocurrencies, US dollars, or other global sovereign (or fiat) currencies. Its value is determined within marketplaces called exchanges where buyers and sellers come together to trade at mutually agreed prices.

As well as ‘coins,’ units of cryptocurrencies may be described as digital assets. That is, unique data items whose ownership can be passed from account to account. These accounts are technically called addresses, and we will explore what addresses are later. When these digital assets move from one account to another they are all recorded on their respective transaction databases known, because of some unique shared characteristics which we will look into later, as blockchains.

Just to confuse everybody, some digital assets are described as tokens, as in ‘Is it a cryptocurrency or a token?’. Cryptocurrencies and tokens are both types of cryptographically secured digital assets, sometimes known as cryptoassets. These tokens have different characteristics from cryptocurrencies and from each other. Tokens can be fungible (one token being more or less replaceable by another), or non-fungible (where each token represents something unique). Unlike cryptocurrencies, these newer tokens are usually issued by known issuers who stand behind them, and the tokens can represent legal agreements (like financial assets), physical assets (like gold), or future access to products and services.

Where the underlying item is an asset you could think of the token as a digital version of a cloakroom ticket, issued by a cloakroom clerk and redeemable for your coat. Indeed, these tokens are sometimes called DDRs—Digital Depository Receipts. Where the underlying item is an agreement, product or service, you can think of the token as something like a concert ticket issued by a concert organiser and redeemable for entry to a concert at a later date.

To give some real examples, there are tokens that represent everything from gold bullion sitting in a vault somewhere2, through to tokens representing unique ‘CryptoKitties’—collectable digital cats with specific visual attributes determined by their ‘DNA’ code.

Physical and Digital Money

Cash—physical money—is wonderful. You can transfer (or spend or give away) as much of what you have as you want, when you want, without any third parties approving or censoring the transaction or taking a commission for the privilege. Cash doesn’t betray valuable identity information that can be stolen or misused. When you receive cash in your hand, you know that the payment can’t be ‘undone’ (or charged back, in industry jargon) at a later date, unlike digital transactions such as credit card payments and some bank transfers, which is a pain point for merchants. Under normal circumstances, once you have cash, it is yours, it is under your control, and you can transfer it again immediately to somebody else. The transfer of physical money immediately extinguishes a financial obligation and leaves nobody waiting for anything else.

But there is a big problem with traditional physical cash: it doesn’t work at a distance. Unless you carry it in person, you can’t transfer physical cash to someone on the other side of the room, let alone on the other side of the planet. This is where digital money becomes highly useful.

Digital money differs from physical money in that it relies on bookkeepers who are trusted by their customers to keep accurate accounts of balances they hold. To put it another way, you can’t own and directly control digital money yourself (well, you couldn’t until Bitcoin came along, but more on that later). To own digital money, you must open an account somewhere with someone else—a bank, PayPal, an e-wallet. The ‘someone else’ is a third party whom you trust to keep books and records of how much money you have with them—or, more specifically, how much they must pay you on demand or transfer to someone else at your request. Your account with a third party is a record of an agreement of trust between you: simultaneously how much you have with them, and how much they owe you.

Without the third party, you would need to keep bilateral records of debts with everyone, even people who you may not trust or who may not trust you, and this is not feasible. For example, if you bought something online, you could attempt to send the merchant an email saying ‘I owe you $50, so let’s both record this debt’. But the merchant probably wouldn’t accept this; firstly, because they probably have no reason to trust you, and secondly, because your email is not very useful to the merchant—they can’t use your email to pay their staff or suppliers.

Instead, you instruct your bank to pay the merchant, and your bank does this by reducing how much your bank owes you, and, at the other end, increasing how much the merchant’s bank owes them. From the merchant’s point of view, this extinguishes your debt to the merchant, and replaces it with a debt from their bank. The merchant is happy, as they trust their bank (well, more than they trust you), and they can use the balance in their bank account to do other useful things.

Unlike cash, which settles using the transfer of physical tokens, digital money settles by increasing and decreasing balances in accounts held by trusted intermediaries. This probably seems obvious, though you may not have thought of it this way. We’ll come back to this later, as bitcoins are a form of digital money which share some properties of physical cash.

There is a big difference between online card payments, where you type the numbers, and physical card payments, where you tap or swipe the physical card. In the industry, an online credit card payment is known as a ‘card not present’ transaction, and swiping your card at the cashier’s till in a shop counts as a ‘card present’ transaction. Online (card not present) transactions have higher rates of fraud, so in an effort to make fraud harder, you need to provide more details—such as your address and the three digits on the back of the card. Merchants are charged higher fees for these types of payments to offset the cost of fraud prevention and the losses from fraud.

Cash is an anonymous bearer asset which does not record or contain identity information, unlike many forms of digital money that by law require personal identification. To open an account with a bank, wallet, or other trusted third party, regulations require that the third party can identify you. This is why you often need to supply information about yourself, with independent evidence to back that up. Usually that means a photo ID to match name and face, and a utility bill or other ‘official’ registered communication (for example from a government department) to validate your address. Identity information is not just collected when opening accounts. It is also collected and used for validation purposes when some electronic payments are made: when you pay online using a credit or debit card you need to supply your name and address as a first gateway against fraud.

There are exceptions to this identity rule. There are some stored value cards that don’t require identity, for example public transport cards in many countries, or low-limit cash cards used in some countries.

Do payments need to be linked to identity? Of course not. Cash proves this. But should they? This is a big question that raises legal, philosophical and ethical issues that remain subject to ongoing debate. Credit card information is frequently stolen, along with personally identifying information (name, addresses, etc) which creates a cost to society.

Is it a fundamental right to be able to make payments which are shielded from the eyes of the state governments? And should people have the ability to make anonymous digital payments, as they do with physical cash? To what extent should our financial transactions be anonymous or, at the very least, private? And what, if any, are the reasonable limits to that privacy? Should the public sector or the private sector provide the means for electronic payments and financial privacy? Should a nation state be able to block an individual’s ability to make digital payments, and with what limits? How can we reconcile financial privacy with the prevention of support for illegal activities, including the funding of terrorism? I won’t provide answers to these big questions in this book, but the fundamental questions concerning financial privacy are inevitably raised when understanding the game-changing innovation that is Bitcoin.


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